Shengkai Innovations, Inc. - FORM 10-Q

Attached files

file	filename
EX-32.1 - EXHIBIT 32.1 - Shengkai Innovations, Inc.	exh_321.htm
EX-32.2 - EXHIBIT 32.2 - Shengkai Innovations, Inc.	exh_322.htm
EX-31.2 - EXHIBIT 31.2 - Shengkai Innovations, Inc.	exh_312.htm
EXCEL - IDEA: XBRL DOCUMENT - Shengkai Innovations, Inc.	Financial_Report.xls
EX-31.1 - EXHIBIT 31.1 - Shengkai Innovations, Inc.	exh_311.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2011

[ ]	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _______ to _______

Commission file number: 001-34587

SHENGKAI INNOVATIONS, INC.

(Exact name of small business issuer as specified in its charter)

Florida	11-3737500
(State or other jurisdiction of incorporation or organization)	(IRS Employer identification No.)

No. 106 Zhonghuan South Road Airport Industrial Park Tianjin, People’s Republic of China	300308
(Address of principal executive offices)	(Zip Code)

(86)22-5883-8509

(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 issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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 [X] 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 [ X] 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 [ ] (Do not check if a smaller reporting company)	Smaller reporting company [X]

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

APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY

PROCEEDINGS DURING THE PRECEDING FIVE YEARS:

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes [ ] No [ ]

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

The number of shares of the Registrant’s common stock outstanding as of November 9, 2011 is 33,276,611 shares of common stock, $0.001 par value.

TABLE OF CONTENTS

		Page
	PART I
Item 1.	Financial Statements.
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operation.
Item 3.	Quantitative and Qualitative Disclosures About Market Risk.
Item 4.	Controls and Procedures.
	PART II
Item 1.	Legal Proceedings.
Item 1A.	Risk Factors.
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds.
Item 3.	Defaults Upon Senior Securities.
Item 4.	(Removed and Reserved).
Item 5.	Other Information.
Item 6.	Exhibits.
SIGNATURES

PART I—FINANCIAL INFORMATION

Item 1. Financial Statements.

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

AS AT SEPTEMBER 30, 2011 AND JUNE 30, 2011

(Stated in US Dollars)

	September 30, 2011		June 30, 2011
ASSETS
Current Assets
Cash and cash equivalents	$	62,935,344	$	59,870,108
Restricted cash		303,227		1,386,873
Accounts receivable, net		9,841,650		12,623,359
Notes receivable		353,677		217,502
Other receivables4		2,752,065		2,722,300
Advances to suppliers		253,991		274,814
Inventories5		2,349,231		2,532,485
Total Current Assets		78,789,185		79,627,441
Property, plant and equipment, net6		54,092,197		53,921,084
Construction in progress		-		-
Land use rights, net7		2,543,774		2,534,059
Other intangible assets, net8		5,182,299		5,370,148
TOTAL ASSETS	$	140,607,455	$	141,452,732

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities
Notes payable9		303,227		1,386,873
Accounts payable		2,912,232		3,829,491
Advances from customers		537,472		227,451
Other payables and accrued expenses10		1,045,411		2,350,144
Income tax payable		516,882		1,816,995
Total Current Liabilities		5,315,224		9,610,954
Warrant liabilities		256,472		168,442
Preferred (conversion option) liabilities		1,966,811		5,782,014
TOTAL LIABILITIES	$	7,538,507	$	15,561,410

Commitments and Contingencies16	$	-	$	-

See accompanying notes to consolidated financial statements

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS (Continued)

AS AT SEPTEMBER 30, 2011 AND JUNE 30, 2011

(Stated in US Dollars)

	September 30, 2011		June 30, 2011
STOCKHOLDERS’ EQUITY
Preferred stock – $0.001 par value 15,000,000 shares authorized; 3,087,368 and 5,987,368 issued and outstanding as of September 30, 2011 and June 30, 2011, respectively.12	$	3,087	$	5,987
Common stock - $0.001 par value 100,000,000 shares authorized; 33,276,611 and 29,776,611 shares issued and outstanding as of September 30, 2011 and June 30, 2011, respectively.		33,277		29,777
Additional paid-in capital		68,501,155		63,554,251
Statutory reserves		11,196,604		11,196,604
Retained earnings		43,613,928		42,669,590
Accumulated other comprehensive income		9,720,897		8,435,113
TOTAL STOCKHOLDER’S EQUITY		133,068,948		125,891,322
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	140,607,455	$	141,452,732

See accompanying notes to consolidated financial statements

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

	Three months ended September 30,
	2011				2010

Revenues		$	11,011,127		$	17,174,516
Cost of sales			(6,196,651	)		(7,220,428	)
Gross profit			4,814,476			9,954,088
Operating expenses:
Selling expenses			(1,051,480	)		(1,602,572	)
General and administrative expenses			(3,406,035	)		(2,061,646	)
Total operating expenses			(4,457,515	)		(3,664,218	)
Income from operations			356,961			6,289,870
Other income, net			13,473			57,971
Interest income, net			165,942			18,744
Changes in fair value of instruments - gain			926,637			21,704,751
Income before income taxes			1,463,013			28,071,336
Income taxes12			(518,675	)		(1,126,251	)
Net income			944,338			26,945,085
Foreign currency translation adjustment			1,285,784			1,316,026
Comprehensive income			2,230,122			28,261,111

Basic earnings per share13		$	0.03		$	1.16

Diluted earnings per share13		$	0.03		$	0.76

Basic weighted average shares outstanding13			32,751,068			23,191,165

Diluted weighted average shares outstanding13			36,105,827			35,277,322

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

	Three months ended September 30,
	2011			2010
Cash flows from operating activities
Net income	$	944,338		$	26,945,085
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		929,917			147,044
Amortization		254,089			231,906
Provision for doubtful accounts		44,402			-
(Gain) on disposal of property, plant and equipment		-			(3,780	)
Changes in fair value of instruments – (gain)		(926,637	)		(21,704,751	)
Stock based compensation		2,146,968			1,032,564
Changes in operating assets and liabilities:
(Increase) decrease in assets:
Accounts receivable		2,850,347			(2,077,742	)
Notes receivable		(133,619	)		73,743
Other receivables		(3,304	)		(277,752	)
Advances to suppliers		23,259			14,624
Inventories		207,172			645,023
Increase (decrease) in liabilities:
Notes payable		(1,093,491	)		175,916
Accounts payable		(951,308	)		(301,712	)
Advances from customers		306,793			(529,844	)
Other payables		(1,251,412	)		(352,668	)
Accruals		(71,761	)		616
Income tax payable		(1,313,407	)		60,040
Net cash provided by operating activities		1,962,346			4,078,312
Cash flows from investing activities
Proceeds from disposition of property, plant and equipment		(43,661	)	-
Purchase of property, plant and equipment		(403,440	)		(9,643	)
Payment of construction in progress		(131,198	)		(4,521,029	)
Purchase of intangible assets		-			(1,966	)
Increase in advances to suppliers for purchase of equipment and construction		-			(1,011,827	)
Decrease/(increase) in restricted cash		1,093,491			(228,148	)
Net cash provided by (used in) investing activities		515,192			(5,772,613	)

See accompanying notes to consolidated financial statements

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

	Three months ended September 30,
	2011			2010

Net increase (decrease) in cash and cash equivalents		$	2,477,538	$	(1,694,301	)

Effect of exchange rate changes on cash and cash equivalents			587,698		320,989

Cash and cash equivalents–beginning of year			59,870,108		20,995,182

Cash and cash equivalents–end of year		$	62,935,344	$	19,621,870

Supplementary cash flow information:

Interest received		$	165,942	$	18,739

Taxes paid		$	1,832,081	$	1,066,211

Non-cash transaction:
Preferred stock conversion to common stock		$	2,900	$	-
Common stock issuance		$	600	$	-

See accompanying notes to consolidated financial statements

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

1. ORGANIZATION AND PRINCIPAL ACTIVITIES

Shengkai Innovations, Inc. (“SKII”) was incorporated in the State of Florida on December 8, 2004. Prior to June 9, 2008, SKII has only nominal operations and assets. On October 23, 2008, SKII changed its name from Southern Sauce Company, Inc. to Shengkai Innovations, Inc.

On June 9, 2008, SKII executed a reverse-merger with Shen Kun International Limited (“Shen Kun”) by an exchange of shares whereby SKII issued 20,550,000 shares of common stock at $0.001 par value in exchange for all Shen Kun shares. Immediately after the closing of the reverse-merger, SKII had a total of 22,112,500 shares of common stock outstanding, with the Shen Kun shareholders (and their assignees) owning approximately 92.9% of the outstanding common stock on a non-diluted basis. Shen Kun became a wholly-owned subsidiary of SKII.

The exchange transaction was accounted for as a reverse acquisition in accordance with Accounting Standards Codification (“ASC”) 805, “Business Combinations” (formerly included under Statement of Financial Accounting Standards No. 141 (revised 2007), Business Combinations). For financial reporting purposes, this transaction is classified as a recapitalization of SKII and Shen Kun. The accompanying consolidated financial statements were retroactively adjusted to reflect the effects of the recapitalization of the financial statements of SKII and the historical financial statements of Shen Kun. The 1,562,500 shares of Shengkai Innovations, Inc. outstanding prior to this stock exchange transaction were accounted for at the net book value at the time of the transaction, which was a deficit of $62,206. The consolidated statements of operations include the results of operations of Tianjin Shengkai Industrial Technology Development Co., Ltd. and Shengkai (Tianjin) Limited for the three months ended September 30, 2011 and 2010.

Shen Kun formed Sheng Kai (Tianjin) Ceramic Valves Co., Ltd., which was renamed to Shengkai (Tianjin) Limited in April 2010 (“SK” or “WFOE”), which entered into a series of agreements with Tianjin Shengkai Industrial Technology Development Co., Ltd (“Shengkai”) including but not limited to consigned management, technology service, loan, exclusive purchase option, equity pledge, etc. The agreements were entered on May 30, 2008. As a result of entering the abovementioned agreements, WFOE deem to control Shengkai as a variable interest entity as required by Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 810-10 (formerly FASB Interpretation No. 46 (revised March 2003) Consolidation of Variable Interest Entities -- an Interpretation of ARB No. 51).

Shengkai (Tianjin) Trading Ltd., which is wholly-owned by WFOE, was organized as a corporation under the laws of the People’s Republic of China (“PRC”) on June 25, 2010 with a total registered capital of RMB500,000. Shengkai (Tianjin) Trading Ltd. is primarily engaged in the international trading of non-valve products to better serve the Company’s international customers. It has not started operations as of September 30, 2011.

In connection with the reverse merger transaction, on June 11, 2008, SKII sold 5,915,526 Units for aggregate gross proceeds of $15,000,000, at a price of $2.5357 per Unit. Each Unit consists of one share of Southern Sauce Series A Convertible Preferred Stock, par value $0.001 per share (the “Preferred Shares”), convertible into one share of common stock, par value $0.001 per share (the “Common Stock”), and one Series A Warrant to purchase Common Stock equal to 120% of the number of shares of Common Stock issuable upon conversion of the Preferred Shares (“Warrant”). Additionally, on July 18, 2008, SKII sold 1,971,842 Units for aggregate gross proceeds of $5,000,000, at a price of $2.5357 per Unit. Each Unit consists of one Preferred Share, convertible into one share of Common Stock, par value $0.001 per share, and one Warrant to purchase Common Stock equal to 120% of the number of shares of Common Stock issuable upon conversion of the Preferred Shares.

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

1. ORGANIZATION AND PRINCIPAL ACTIVITIES (CONTINUED)

SKII, through its subsidiaries is now in the business of manufacturing and sale of industrial ceramic valves and components.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

(a) Basis of presentation and method of accounting

The unaudited consolidated financial statements of Shengkai innovations, Inc. and subsidiaries (the “Company”) have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. However, the information included in these interim financial statements reflects all adjustments (consisting solely of normal recurring adjustments) which are, in the opinion of management, necessary for the fair presentation of the consolidated financial position and the consolidated results of operations. Results shown for interim periods are not necessarily indicative of the results to be obtained for a full year. The consolidated balance sheet as of June 30, 2011 has been derived from the audited consolidated financial statements included in the Company’s Annual Report on Form 10-K. These interim financial statements should be read in conjunction with that report.

The Company maintains its general ledger and journals with the accrual method accounting for financial reporting purposes. The financial statements and notes are representations of management. Accounting policies adopted by the Company conform to generally accepted accounting principles in the United States of America (“U.S. GAAP”) and have been consistently applied in the presentation of financial statements.

(b) Principles of consolidation

The Company’s consolidated financial statements are compiled in accordance with U.S. GAAP. All significant inter-company accounts and transactions have been eliminated. The consolidated financial statements include 100% of assets, liabilities, and net income or loss of those subsidiaries.

The Company includes four subsidiaries since its reverse-merger on June 9, 2008. The detailed identities of the consolidating subsidiaries are as follows:

Name of Company	Place of incorporation	Attributable interest

Shen Kun International Limited	British Virgin Islands		100	%

Shengkai (Tianjin) Limited, formerly Sheng Kai (Tianjin) Ceramic Valves Co., Ltd	PRC		100	%

*Tianjin Shengkai Industrial Technology Development Co., Ltd.	PRC		100	%

Shengkai (Tianjin) Trading Ltd.	PRC		100	%

*Deemed variable interest entity (“VIE”) member

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

The preparation of the financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Management makes these estimates using the best information available at the time the estimates are made; however actual results could differ materially from those estimates.

(d) Economic and political risks

The Company’s operations are conducted in the PRC. Accordingly, the Company’s business, financial condition and results of operations may be influenced by the political, economic and legal environment in the PRC, and by the general state of the PRC economy.

The Company’s operations in the PRC are subject to special considerations and significant risks not typically associated with companies in North America and Western Europe. These include risks associated with, among others, the political, economic and legal environment and foreign currency exchange. The Company’s results may be adversely affected by changes in the political and social conditions in the PRC, and by changes in governmental policies with respect to laws and regulations, anti-inflationary measures, currency conversion, remittances abroad, and rates and methods of taxation, among other things.

(e) Restricted Cash

Restricted cash represents amounts held by a bank as security for bank acceptance notes and therefore is not available for the Company’s use. The restricted cash is expected to be released within the next six months.

(f) Accounts receivable

Accounts receivable are carried at net realizable value. The Company establishes an allowance for doubtful accounts based on management’s assessment of the collectability of accounts receivable. A considerable amount of judgment is required in assessing the amount of the allowance. The Company considers the historical level of credit losses and applies percentages to aged receivable categories. The Company makes judgments about the creditworthiness of each customer based on ongoing credit evaluations, and monitors current economic trends that might impact the level of credit losses in the future. Beginning from the year ended June 30, 2011, the management established the general provisioning policy to make allowance equivalent to 100% of accounts receivable aged over 1 year. Additional specific provision is made against accounts receivable to the extent which they are considered to be doubtful.

Bad debts are written off when identified after exhaustive efforts at collection. The Company does not accrue interest on accounts receivable. If accounts receivable are provided for, they would be recognized in the consolidated statement of operations within operating expenses.

The Company sells its products to both agents/distributors and end-users. Normally the Company requires payment on delivery for agents/distributors. Usual credit term to end-user customers is about 1 to 3 months after receipt and acceptance of goods by customers. 5%-10% of total contract price may be retained from payment until the warranty (usually up to 1.5 years) expires.

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

(g) Property, plant and equipment

Property, plant and equipment are carried at cost less accumulated depreciation. Depreciation is provided over their estimated useful lives, using the straight-line method. Estimated useful lives of the property, plant and equipment are as follows:

Buildings	20 – 40 years
Machinery and equipment	3 – 20 years
Office equipment	3 – 10 years
Motor vehicles	10 years

The cost and related accumulated depreciation of assets sold or otherwise retired are eliminated from the accounts and any gain or loss is included in the statement of operations. The cost of maintenance and repairs is charged to income as incurred, whereas significant renewals and betterments are capitalized.

(h) Construction in progress

Construction in progress represents direct costs of construction incurred. Capitalization of these costs ceases and the construction in progress is transferred to property, plant and equipment when substantially all the activities necessary to prepare the assets for their intended use are completed. No depreciation is provided until it is completed and ready for intended use.

(i) Land use rights

According to PRC laws, the government owns all the land in the PRC. Companies or individuals are authorized to possess and use the land only through land use rights granted by the PRC government. Land use rights are being amortized using the straight-line method over the term of rights of 50 years commencing from the date of acquisition.

(j) Other intangible assets

Other intangible assets include patent rights and software costs which are stated at acquisition cost less accumulated amortization. Amortization expense is recognized using the straight-line method over the estimated useful life. Patent rights are carried at cost and amortized on a straight-line basis over the period of rights of 10 years commencing from the date of acquisition of equitable interest. Software costs are carried at cost and amortized on a straight-line basis over the period from 3 to 10 years.

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

(k) Accounting for the impairment of long-lived assets

The Company periodically evaluates the carrying value of long-lived assets to be held and used, including intangible assets subject to amortization, when events and circumstances warrant such a review, pursuant to the guidelines established in Statement of Financial Accounting Standards (“SFAS”) No. 144 (now known as "ASC 360"). The carrying value of a long-lived asset is considered impaired when the anticipated undiscounted cash flow from such asset is separately identifiable and is less than its carrying value. In that event, a loss is recognized based on the amount by which the carrying value exceeds the fair market value of the long-lived asset. Fair market value is determined primarily using the anticipated cash flows discounted at a rate commensurate with the risk involved. Losses on long-lived assets to be disposed of are determined in a similar manner, except that fair market values are reduced for the cost to dispose.

During the reporting periods, there was no impairment loss.

(l) Inventories

Inventories are stated at lower of cost or net realizable value. Cost is determined by the weighted average basis and includes all expenditures incurred in bringing the goods to the point of sale and putting them in a saleable condition. In case of manufacturing inventories and work in progress, cost includes an appropriate share of production overheads based on normal operating capacity. Net realizable value is the estimated selling price in the ordinary course of business less any applicable selling expenses. The Company has no reserve for inventories for the three months ended September 30, 2011 and 2010.

(m) Cash and cash equivalents

Cash and cash equivalents consist of cash on hand and bank deposits with original maturities of nine months or less, which are unrestricted as to withdrawal and use. The Company maintains bank accounts in the U.S.A., mainland China and Hong Kong.

	September 30,		June 30,
	2011		2011
Cash on hand	$	6,287	$	1,814
Bank deposits:
Bank of China		87,424		50,578
Industrial and Commercial Bank of China		971,191		961,417
Industrial Bank Co. Ltd.		382,586		447,773
Shanghai Pudong Development Bank		61,144,158		57,770,717
The Hong Kong and Shanghai Banking Corporation Limited		20,687		20,840
JPMorgan Chase Bank		322,569		461,992
China Construction Bank		442		154,977
	$	62,935,344	$	59,870,108

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

(n) Fair value of financial instruments

FASB ASC 820 (formerly SFAS No. 157 Fair Value Measurements) establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. The hierarchy prioritizes the inputs into three levels based on the extent to which inputs used in measuring fair value are observable in the market

These tiers include:

•

Level 1—defined as observable inputs such as quoted prices in active markets;

•

Level 2—defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and

•

Level 3—defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions.

The carrying amounts of financial assets and liabilities, such as cash and cash equivalents, accounts receivable, notes receivable, other receivables, advances to suppliers, accounts payable, notes payable, other payables and accrued expenses and advances from customers, approximate their fair values because of the short maturity of these instruments.

Accounting guidance on fair value measurement and disclosures permits entities to choose to measure many financial instruments and certain other items at fair value. It was effective for fiscal year beginning July 1, 2009. Upon its adoption and at this time, we do not intend to reflect any of our current financial instruments at fair value (except that we are required to carry our derivative financial instruments at fair value). However, we will consider the appropriateness of recognizing financial instruments at fair value on a case by case basis in future periods.

The summary of fair values of financial instruments as of September 30 and June 30, 2011 are as follows:

September 30, 2011
Instrument	Fair Value		Carrying Value		Level		Valuation Methodology
Derivative warrant liabilities	$	256,472	$	256,472		3	Black-Scholes
Embedded conversion liability	$	1,966,811	$	1,966,811		3

June 30, 2011
Instrument	Fair Value		Carrying Value		Level		Valuation Methodology
Derivative warrant liabilities	$	168,442	$	168,442		3	Black-Scholes
Embedded conversion liability	$	5,782,014	$	5,782,014		3

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

(n) Fair value of financial instruments (continued)

The following represents a reconciliation of the changes in fair value of financial instruments measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three months ended September 30, 2011 and 2010:

	For the Three Months Ended September 30,
	2011			2010
Beginning balance: Derivative liabilities	$	5,950,456		$	77,802,675
Conversion from preferred to common		(2,800,536	)		-
Changes in fair value		(926,637	)		(21,704,751	)
Ending balance: Derivative liabilities	$	2,223,283		$	56,097,924

(o) Revenue recognition

Revenue represents the invoiced value of goods sold and is recognized upon the delivery of goods to customers. Revenue is recognized when all of the following criteria are met:

- Persuasive evidence of an arrangement exists;

- Delivery has occurred or services have been rendered;

- The seller’s price to the buyer is fixed or determinable, and

- Collection is reasonably assured.

There were no sales returns and allowances for the three months ended September 30, 2011 and 2010. The Company does not provide unconditional right of return, price protection or any other concessions to its customers.

(p) Costs of sales

Cost of sales consists primarily of direct material costs, direct labor cost, direct depreciation and related direct expenses attributable to the production of products. Write-down of inventory to lower of cost or market is also reflected in cost of revenues.

(q) Advertising

The Company expensed all advertising costs as incurred. Advertising expenses included in the selling expenses for the three months ended September 30, 2011 and 2010 were $0 and $0, respectively.

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

(r) Warranty expense

The Company generally provides one year warranty to most customers, or in some cases up to one and a half years. Historically warranty expense has been maintained at a very low percentage of sales revenue; therefore the Company does not accrue, but expenses all warranty expenses as incurred under selling expenses. The Company is closely monitoring warranty expense and will start to accrue it as soon as we identify that warranty expense regularly reaches certain percentage of total revenue. Warranty expenses for the three months ended September 30, 2011 and 2010 were $41,735 and $40,689, respectively.

(s) Research and development costs

The Company expensed all research and development costs as incurred. Research and development expenses included in the general and administrative expenses for the three months ended September 30, 2011 and 2010 were $315,191 and $133,346, respectively.

(t) Retirement benefit plans

The employees of the Company are members of a state-managed retirement benefit plan operated by the government of the PRC. The Company is required to contribute a specified percentage of payroll costs to the retirement benefit scheme to fund the benefits. The only obligation of the Company with respect to the retirement benefit plan is to make the specified contributions.

Retirement benefits in the form of contributions under defined contribution retirement plans to the relevant authorities are charged to the statements of operations as incurred. The retirement benefit expenses included in general and administrative expenses for the three months ended September 30, 2011 and 2010 were $69,990 and $45,714, respectively.

(u) Share-based compensation

Share-based compensation includes 1) stock options and common stock awards granted to employees and directors for services, and are accounted for under FASB ASC 718 "Compensation - Stock Compensation", and 2) warrants and common stock awards granted to consultants which are accounted for under FASB ASC 505-50 "Equity-Based Payment to Non-employees".

All grants of common stock awards and stock options/warrants to employees, directors and consultants are recognized in the financial statements based on their grant date fair values. The Company has elected to recognize compensation expense using the straight-line method for all common stock awards and stock options/warrants granted with service conditions that have a graded vesting schedule, with a corresponding charge to additional paid-in capital.

The Company estimates fair value of common stock awards based on the number of shares granted and the quoted price of the Company's common stock on the date of grant.

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

(u) Share-based compensation (continued)

The fair value of stock options is estimated using the Black-Scholes model. The Company's expected volatility assumption is based on the historical volatility of the Company's stock as well as historical volatility of comparable public companies, due to its relatively short trading history. The expected life assumption is presumed to be the mid-point between the vesting date and the end of the contractual term, as is permitted for "plain vanilla" employee stock options. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of grant.

FASB ASC 718 requires forfeitures to be estimated at the time of grant and revised, if necessary, in the subsequent period if actual forfeitures differ from initial estimates. Forfeiture rate is estimated based on historical and future expectation of employee turnover rate and are adjusted to reflect future change in circumstances and facts, if any. Share-based compensation expense is recorded net of estimated forfeitures such that expenses were recorded only for those stock options and common stock awards that are expected to vest.

(v) Income tax

Deferred tax assets and liabilities are recognized for the future tax consequence attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to be applied to taxable income in the years in which those temporary differences are expected to reverse. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the statement of operations in the period that includes the enactment date. A valuation allowance is provided for deferred tax assets if it is more likely than not these items will either expire before the Company is able to realize their benefits, or that future deductibility is uncertain.

The Company uses FASB ASC 740 (formerly FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”)). – AN INTERPRETATION OF FASB STATEMENT NO. 109, ACCOUNTING FOR INCOME TAXES. The Interpretation addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements. Under FASB ASC 740, we may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement. FASB ASC 740 also provides guidance on recognition, classification, interest and penalties on income taxes, accounting in interim periods and requires increased disclosures. At September 30 and June 30, 2011, the Company did not have a liability for unrecognized tax benefits.

(w) Value-added tax (“VAT”)

Enterprises or individuals, who sell commodities, engage in repair and maintenance or import or export goods in the PRC are subject to a value-added tax in accordance with the PRC laws. The standard value-added tax rate is 17% of the gross sales price and the Company records its revenue net of VAT. A credit is available whereby VAT paid on the purchases of semi-finished products or raw materials used in the production of the Company’s finished products can be used to offset the VAT due on the sales of the finished products. Therefore, the amounts of VAT recoverable included in other receivables on the balance sheets represent the excess of VAT paid on purchases over the VAT due on sales at September 30 and June 30, 2011, respectively, which can be used to offset future VAT that is due on sales.

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

(x) Foreign currency translation

The accompanying consolidated financial statements are presented in United States dollars (“US$” or “$”), while the functional currency of the Company is Renminbi (“RMB”), as determined based on the criteria of Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) ASC 830 “Foreign Currency Matters”. The consolidated financial statements are translated into United States dollars from RMB at year-end exchange rates as to assets and liabilities and average exchange rates as to revenues and expenses. Capital accounts are translated at their historical exchange rates when the capital transactions occurred. The resulting transaction adjustments are recorded as a component of other comprehensive income with in shareholders’ equity. Gains and losses from foreign currency transactions are included in net income.

The exchange rates used to translate amounts in RMB into USD for the purposes of preparing the consolidated financial statements were as follows:

September 30, 2011
Balance sheet	RMB 6.40180 to US$1.00
Statement of operations and comprehensive income	RMB 6.42305 to US$1.00
June 30, 2011
Balance sheet	RMB 6.46400 to US$1.00
Statement of operations and comprehensive income	RMB 6.63665 to US$1.00
September 30, 2010
Balance sheet	RMB 6.69810 to US$1.00
Statement of operations and comprehensive income	RMB 6.78032 to US$1.00

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

(y) Cash and concentration of risk

Cash includes cash on hand and demand deposits in bank accounts. Total cash in the banks at September 30 and June 30, 2011 amounted to $62,935,344 and $59,870,108, respectively. The Company has not experienced any losses in such accounts and believes it is not exposed to significant financial institution risks on its cash in bank accounts. Also see Note 3 for credit risk details.

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

(z) Statutory reserves

As stipulated by the PRC’s Company Law and as provided in SK and Shengkai’s Articles of Association, SK and Shengkai’s net income after taxation can only be distributed as dividends after appropriation has been made for the following:

	(i)	Making up cumulative prior years’ losses, if any;
	(ii)	Allocations to the “Statutory surplus reserve” of at least 10% of income after tax, as determined under PRC accounting rules and regulations, until the fund amounts to 50% of the Company's registered capital, which is restricted for set off against losses, expansion of production and operation or increase in registered capital;
	(iii)	Allocations of 5-10% of income after tax, as determined under PRC accounting rules and regulations, to the Company's “Statutory common welfare fund”, which is restricted for capital expenditure for the collective benefits of the Company's employees; and
	(iv)	Allocations to the discretionary surplus reserve, if approved in the shareholders’ general meeting.

On December 31, 2003, Shengkai established a statutory surplus reserve as well as a statutory common welfare fund and commenced to appropriate 10% and 5%, respectively of the PRC net income after taxation to these reserves. The amounts included in the statutory reserves were surplus reserve of $11,196,604 and $11,196,604 as at September 30 and June 30, 2011, respectively.

(aa) Comprehensive income

Comprehensive income is defined to include all changes in equity except those resulting from investments by owners and distributions to owners. Among other disclosures, all items that are required to be recognized under current accounting standards as components of comprehensive income are required to be reported in a financial statement that is presented with the same prominence as other financial statements. The Company’s current component of other comprehensive income is the foreign currency translation adjustment.

(ab) Recent accounting pronouncements

In July 2010, the FASB issued ASU 2010-20 an accounting update to provide guidance to enhance disclosures related to the credit quality of a company's financing receivables portfolio and the associated allowance for credit losses (“FASB ASC Topic 310”). Pursuant to this accounting update, a company is required to provide a greater level of disaggregated information about its allowance for credit loss with the objective of facilitating users' evaluation of the nature of credit risk inherent in the company's portfolio of financing receivables, how that risk is analyzed and assessed in arriving at the allowance for credit losses, and the changes and reasons for those changes in the allowance for credit losses. The revised disclosures as of the end of the reporting period are effective for the Company beginning in the second quarter of fiscal 2011, and the revised discourses related to activities during the reporting period are effective for the Company beginning in the third quarter of fiscal 2011. The adoption of such standard did not have a material impact on the Company's consolidated financial statements and disclosures.

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

(ab) Recent accounting pronouncements (continued)

In December 2010, the FASB issued ASU 2010-28 an accounting pronouncement related to intangibles – goodwill and other (“FASB ASC Topic 350”), which requires a company to consider whether there are any adverse qualitative factors indicating that an impairment may exist in performing step 2 of the impairment test for reporting units with zero or negative carrying amounts. The provisions for this pronouncement are effective for fiscal years, and interim periods within those years, beginning after December 15, 2010, with no early adoption. We will adopt this pronouncement for our fiscal year beginning July 1, 2011. The adoption of this pronouncement is not expected to have a material impact on our consolidated financial statements.

In December 2010, the FASB issued ASU 2010-29 an accounting pronouncement related to business combinations (“FASB ASC Topic 815”), which specifies that if a public entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business combination(s) that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. It also expands the supplemental pro forma disclosures under Topic 805 to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. The amendments in this Update are effective prospectively for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010. Early adoption is permitted. The adoption of this pronouncement is not expected to have a material impact on our consolidated financial statements.

In January 2011, the FASB issued ASU 2011-01 an accounting pronouncement related to receivables (“FASB ASC Topic 310”). The amendments in this update temporarily delay the effective date of the disclosures about troubled debt restructurings in ASU 2010-20 for public entities. The delay is intended to allow the Board time to complete its deliberations on what constitutes a troubled debt restructuring. The effective date of the new disclosures about troubled debt restructurings for public entities and the guidance for determining what constitutes a troubled debt restructuring will then be coordinated. Currently, that guidance is anticipated to be effective for interim and annual periods ending after June 15, 2011. The adoption of this pronouncement is not expected to have a material impact on our consolidated financial statements.

The FASB has issued Accounting Standards Update (ASU) No. 2011-02, Receivables (Topic 310): A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring. The FASB believes the guidance in this ASU will improve financial reporting by creating greater consistency in the way GAAP is applied for various types of debt restructurings.

The ASU clarifies which loan modifications constitute troubled debt restructurings. It is intended to assist creditors in determining whether a modification of the terms of a receivable meets the criteria to be considered a troubled debt restructuring, both for purposes of recording an impairment loss and for disclosure of troubled debt restructurings.

In evaluating whether a restructuring constitutes a troubled debt restructuring, a creditor must separately conclude that both of the following exist: (a) the restructuring constitutes a concession; and (b) the debtor is experiencing financial difficulties. The amendments to FASB Accounting Standards Codification™ (Codification) Topic 310, Receivables, clarify the guidance on a creditor’s evaluation of whether it has granted a concession and whether a debtor is experiencing financial difficulties.

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

(ab) Recent accounting pronouncements (continued)

For public companies, the new guidance is effective for interim and annual periods beginning on or after June 15, 2011, and applies retrospectively to restructurings occurring on or after the beginning of the fiscal year of adoption. For nonpublic entities, the amendments to the Codification in the ASU are effective for annual periods ending on or after December 15, 2012, including interim periods within those annual periods. Early application is permitted.

The FASB has issued Accounting Standards Update (ASU) No. 2011-03, Transfers and Servicing (Topic 860): Reconsideration of Effective Control for Repurchase Agreements. The ASU is intended to improve financial reporting of repurchase agreements (“repos”) and other agreements that both entitle and obligate a transferor to repurchase or redeem financial assets before their maturity.

In a typical repo transaction, an entity transfers financial assets to a counterparty in exchange for cash with an agreement for the counterparty to return the same or equivalent financial assets for a fixed price in the future. FASB Accounting Standards Codification™ (Codification) Topic 860, Transfers and Servicing, prescribes when an entity may or may not recognize a sale upon the transfer of financial assets subject to repo agreements. That determination is based, in part, on whether the entity has maintained effective control over the transferred financial assets.

The amendments to the Codification in this ASU are intended to improve the accounting for these transactions by removing from the assessment of effective control the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets. The guidance in the ASU is effective for the first interim or annual period beginning on or after December 15, 2011. The guidance should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. Early adoption is not permitted.

The FASB has issued Accounting Standards Update (ASU) No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. This ASU represents the converged guidance of the FASB and the IASB (the Boards) on fair value measurement. The collective efforts of the Boards and their staffs, reflected in ASU 2011-04, have resulted in common requirements for measuring fair value and for disclosing information about fair value measurements, including a consistent meaning of the term “fair value.” The Boards have concluded the common requirements will result in greater comparability of fair value measurements presented and disclosed in financial statements prepared in accordance with U.S. GAAP and IFRSs.

The amendments to the FASB Accounting Standards Codification™ (Codification) in this ASU are to be applied prospectively. For public entities, the amendments are effective during interim and annual periods beginning after December 15, 2011. For nonpublic entities, the amendments are effective for annual periods beginning after December 15, 2011. Early application by public entities is not permitted. Nonpublic entities may apply the amendments in ASU 2011-04 early, but no earlier than for interim periods beginning after December 15, 2011.

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

(ab) Recent accounting pronouncements (continued)

The FASB has issued Accounting Standards Update (ASU) No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income. This ASU amends the FASB Accounting Standards CodificationTM (Codification) to allow an entity the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. ASU 2011-05 eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders' equity. The amendments to the Codification in the ASU do not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income.

ASU 2011-05 should be applied retrospectively. For public entities, the amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. For nonpublic entities, the amendments are effective for fiscal years ending after December 15, 2012, and interim and annual periods thereafter. Early adoption is permitted.

The FASB has issued Accounting Standards Update (ASU) No. 2011-08, Intangibles-Goodwill and Other (Topic 350): Testing Goodwill for Impairment. ASU 2011-08 is intended to simplify how entities, both public and nonpublic, test goodwill for impairment. ASU 2011-08 permits an entity to first assess qualitative factors to determine whether it is "more likely than not" that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test described in Topic 350, Intangibles-Goodwill and Other. The more-likely-than-not threshold is defined as having a likelihood of more than 50%.

ASU 2011-08 is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted, including for annual and interim goodwill impairment tests performed as of a date before September 15, 2011, if an entity’s financial statements for the most recent annual or interim period have not yet been issued or, for nonpublic entities, have not yet been made available for issuance.

3. CONCENTRATIONS OF CREDIT RISK AND MAJOR CUSTOMERS

Financial instruments which potentially expose the Company to concentrations of credit risk, consists of cash and accounts receivable as of September 30 and June 30, 2011. The Company performs ongoing evaluations of its cash position and credit evaluations to ensure sound collections and minimize credit losses exposure.

As of September 30 and June 30, 2011, almost all the Company’s bank deposits were placed with banks in the PRC where there is currently no rule or regulation mandated on obligatory insurance of bank accounts. Relatively small bank deposits were maintained with the banks in the U.S.A and Hong Kong.

For the three months ended September 30, 2011 and 2010, more than 90% of the Company’s sales were generated from the PRC. In addition, nearly all accounts receivable as of September 30 and June 30, 2011 also arose in the PRC.

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

3. CONCENTRATIONS OF CREDIT RISK AND MAJOR CUSTOMERS (CONTINUED)

The maximum amount of loss exposure due to credit risk that the Company would bear if the counterparties of the financial instruments fail to perform represents the carrying amount of each financial asset in the balance sheet.

Normally the Company does not require collateral from customers or debtors.

For the three months ended September 30, 2011 and 2010, there was no single customer who accounts for 10% or more of the Company’s revenue. As at September 30 and June 30, 2011, there was no customer who accounts for 10% or more of the Company’s accounts receivable.

For the three months ended September 30, 2011 and 2010, there was no single supplier who accounts for 10% or more of the Company’s purchase. As at September 30 and June 30, 2011, there was no supplier who accounts for 10% or more of the Company’s accounts payable.

4. OTHER RECEIVABLES

Other receivables consist of the followings:

	September 30, 2011		June 30, 2011

Advance to employees	$	30,723	$	159,783
Tender deposits		134,815		71,003
Sundry		40,650		1,582
VAT recoverable		2,545,877		2,489,932
	$	2,752,065	$	2,722,300

5. INVENTORIES

Inventories consist of the followings:

	September 30, 2011		June 30, 2011

Finished goods	$	827,708	$	794,972
Work in process		60,659		80,750
Raw materials		1,460,864		1,656,763
	$	2,349,231	$	2,532,485

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

6. PROPERTY, PLANT AND EQUIPMENT

Property, plant and equipment consist of the followings:

	September 30, 2011			June 30, 2011
At cost
Buildings	$	40,123,793		$	37,585,092
Machinery and equipment		17,388,281			18,699,955
Office equipment		179,466			309,558
Motor vehicles		524,185			486,302
		58,215,725			57,080,907
Less: accumulated depreciation
Buildings		(1,798,454	)		(1,265,064	)
Machinery and equipment		(2,017,193	)		(1,607,358	)
Office equipment		(121,547	)		(118,135	)
Motor vehicles		(186,334	)		(169,266	)
		(4,123,528	)		(3,159,823	)
Property, plant and equipment, net	$	54,092,197		$	53,921,084

Depreciation expenses included in the cost of sales for the three months ended September 30, 2011 and 2010 were $787,941 and $93,136, respectively. Depreciation expenses included in the general and administrative expenses for the three months ended September 30, 2011 and 2010 were $141,975 and $53,908, respectively.

7. LAND USE RIGHTS

	September 30, 2011				June 30, 2011

Cost of land use rights		$	2,981,322		$	2,952,634
Less: Accumulated amortization			(437,548	)		(418,575	)
Land use rights, net		$	2,543,774		$	2,534,059

Amortization expenses for land use rights for the three months ended September 30, 2011 and 2010 were $14,857 and $4,504, respectively.

Amortization expense for the next five fiscal years and thereafter is as follows:

2012 (for 3 remaining quarters)	$	44,720
2013		59,626
2014		59,626
2015		59,626
2016		59,626
Thereafter		2,260,550
	$	2,543,774

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

8. OTHER INTANGIBLE ASSETS

	September 30, 2011			June 30, 2011
At cost:
Patent rights	$	7,966,509		$	7,889,851
Software		1,634,904			1,621,198
		9,601,414			9,511,049
Less: Accumulated amortization
Patent rights		(4,022,306	)		(3,786,354	)
Software		(396,809	)		(354,547	)
		(4,419,115	)		(4,140,901	)
Other intangible assets, net	$	5,182,299		$	5,370,148

Amortization expenses for other intangible assets for the three months ended September 30, 2011 and 2010 were $239,231 and $227,402 respectively.

Amortization expense for the next five fiscal years and thereafter is as follows:

2012 (for 3 remaining quarters)	$	720,076
2013		960,101
2014		960,101
2015		959,944
2016		957,797
Thereafter		624,280
	$	5,182,299

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

9. NOTES PAYABLE

	September 30, 2011		June 30, 2011
Due November 6, 2011		46,237
Due January 6, 2012		31,241
Due January 6, 2012		15,621
Due January 6, 2012		15,621
Due January 6, 2012		15,621
Due January 6, 2012		15,621
Due January 6, 2012		15,621
Due January 6, 2012		15,621
Due January 6, 2012		15,621
Due January 6, 2012		15,621
Due January 6, 2012		15,621
Due January 6, 2012		15,621
Due January 6, 2012		7,810
Due January 6, 2012		7,810
Due January 6, 2012		7,810
Due January 6, 2012		7,810
Due January 6, 2012		7,810
Due January 6, 2012		7,810
Due January 6, 2012		7,810
Due January 6, 2012		7,810
Due January 6, 2012		7,059
Due November 6, 2011, subsequently repaid on due dates					45,792
Due September 30, 2011, subsequently repaid on due dates					154,702
Due September 30, 2011, subsequently repaid on due dates					162,400
Due August 31, 2011, subsequently repaid on due dates					17,172
Due August 21, 2011, subsequently repaid on due dates					719,987
Due August 12, 2011, subsequently repaid on due dates					114,171
Due July 25, 2011, subsequently repaid on due dates					172,649
Total	$	303,227		$	1,386,877

All the notes payable are subject to bank charges of 0.05% of the face value on each transaction. Bank charges for notes payable for the three months ended September 30, 2011 and 2010 were $128 and $558 respectively.

The interest-free notes payable are secured by $303,227 and $1,386,873 restricted cash as of September 30 and June 30, 2011, respectively.

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

10. OTHER PAYABLES AND ACCRUED EXPENSES

	September 30, 2011		June 30, 2011

Commission payable	$	333,862	$	727,372
Expense payable		130,262		181,846
Sundry PRC taxes payable		331,081		983,292
Sundry		49,858		187,907
Accrual		200,348		269,727
	$	1,045,411	$	2,350,144

11. PUBLIC OFFERINGS AND WARRANTS ISSUED IN 2010

On November 24, 2010, the Company closed a public offering of 2,456,800 shares of common stock at $5.50 per share, resulting in approximately $13.5 million in gross proceeds. On December 22, 2010, the Company closed a public offering of 1,058,646 shares of common stock at $5.50 per share, resulting in approximately $5.8 million in gross proceeds. Global Hunter Securities, LLC and Maxim Group LLC (collectively the “Underwriters”) acted as the joint book runners for both offerings.

In connection with the public offerings, the Company issued to the Underwriters warrants (the “Underwriters’ Warrants”) to purchase 122,840 and 40,946 shares, respectively, of Common Stock of the Company according to the Underwriting Agreement dated November 19, 2010 and December 17, 2010, respectively. The Underwriters’ Warrants are exercisable in whole or in part at any time and from time to time. The exercise price, expiration date and total number of shares eligible to be purchased with the Underwriters’ Warrants are summarized in the following table:

Number of shares		Exercise price		Contractual term

	163,786	$	6.875	3.0 years

The Company’s functional currency is RMB, which is different from the strike price of the Underwriters’ Warrants denominated in US dollars. According to ASC 815-40-15-7I, if the denominated currency of an equity-linked financial instrument’s strike price is different from the entity’s functional currency, an equity-linked financial instrument is not indexed to the entity’s own stock. ASC 815-40-55-36 illustrates the implementation of the above standard. Therefore, the Company determined that the Underwriters’ Warrants shall not be considered indexed to the entity’s own stock and accordingly records such Underwriters’ Warrants as a liability measured at fair value with changes in fair value recognized in earnings for each reporting period. See Note 2(n).

No Underwriters’ Warrants have been exercised, forfeited or expired since issuance.

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

12. PREFERRED STOCK AND WARRANTS ISSUED IN 2008 FINANCING

On June 11, 2008, the Company sold 5,915,526 Preferred Shares and stock purchase warrants for cash consideration totaling $15 million dollars (the “June 2008 Financing”). The exercise price, expiration date and number of shares eligible to be purchased with the warrants are summarized in the following table:

Series of warrant	Number of shares		Exercise price		Contractual term

Series A		7,098,632	$	3.52	5.0 years

The Preferred Shares have liquidation rights senior to common stock and to any other class or series of stock issued by the Company not designated as ranking senior to or pari passu with the Preferred Shares. In the event of a liquidation of the Company, holders of Preferred Shares are entitled to receive a distribution equal to $2.5357 per share of Preferred Shares prior to any distribution to the holders of common stock or any other stock that ranks junior to the Preferred Shares. The Preferred Shareholders are not entitled to dividends unless paid to Common Shareholders. Any dividend paid will have the same record and payment date and terms as the dividend payable to the Common Stock. The Preferred Shares will participate based on their respective as-if conversion rates if the Company declares any dividends. Holders of Preferred Shares also have voting rights required by applicable law and the relevant number of votes shall be equal to the number of shares of Common Stock issuable upon conversion of Preferred Shares. At any time, each Preferred Share is convertible into 1 share of Common Stock adjusted from time to time to the Conversion Rate. The Conversion Rate is computed as the Liquidation Preference Amount ($2.5357 per share) divided by the Conversion Price. The Conversion Price is initially $2.5357 per share but can adjust for anti-dilution. The holder can also void the conversion or exercise its Buy-in Rights. The Buy-in-Rights entitle the holder to be protected in the case that the Company is unable to deliver the shares upon conversion while the holder has transacted to sell such underlying shares to a third party. The Preferred Shares have registration rights that the Company is required to have a registration statement filed with the SEC within 45 days after the earlier of the date of the Second Closing or June 30, 2008, and declared effective by the SEC not later than November 27, 2008. We filed the initial registration statement on August 7, 2008, and it was declared effective by the SEC on August 21, 2008.

The Warrants were issued at an exercise price of $3.52 per share. The exercise price can adjust for dilutive events. The Warrants are immediately exercisable. However, if after exercise the holder would become a holder of greater than 9.9% of common stock they cannot exercise without filing a waiver with the company. The waiver is required to be filed 61 days prior to exercise and by filing the waiver the restriction is removed. (Since the company is required to accept the waiver this restriction is not considered significant in valuing the warrant.) The Warrants expire 5 years from the date of issuance. The Warrants are freely transferable upon registration. The Warrants are subject to the same Registration Rights Agreement as that of the Preferred Shares. If a registration statement providing for the resale of the Common Stock issued upon exercise of the Warrant is not declared effective after 180 days after the issuance date, the Warrants can be cashless exercised. Also, the Warrants have Buy-in Rights similar to those of the Preferred Shares.

The gross proceeds of the transaction were $15 million. The proceeds from the transaction were originally allocated to the Preferred Shares, Warrants and beneficial conversion feature based on the relative fair value of the securities. The Company evaluated whether a relative fair value approach or residual fair value approach was more appropriate given the terms and accounting treatment related to the financial instruments involved. Given that the Warrants were not originally classified as a liability, the relative fair value method was used. The Warrants were first valued using the Black-Scholes valuation model. The Company valued the Warrants at issuance at $1.84 per warrant with the following assumptions: common stock fair market value of $2.55, expected life of 5 year, volatility of 100% and an interest rate of 4.5%.

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

12. PREFERRED STOCK AND WARRANTS ISSUED IN 2008 FINANCING (CONTINUED)

The Company originally recognized a beneficial conversion feature discount on the Preferred Shares at their intrinsic value, which was the fair value of the common stock at the commitment date for the Preferred Shares investment, less the effective conversion price but limited to the $15 million of proceeds received from the sale. The Company originally recognized the $7.8 million beneficial conversion feature in the equity as a transfer from retained earnings to additional paid in capital as dividends in the accompanying consolidated financial statements on the date of issuance of the Preferred Shares since the Preferred Shares were convertible at the issuance date. The accounting treatment for such preferred stock and warrants were re-evaluated and adjustments were made during the year ended June 30, 2010.

On July 18, 2008 the Company sold 1,971,842 shares of Preferred Shares and stock purchase warrants for cash consideration totaling $5 million dollars (the “July 2008 Financing”). The exercise price, expiration date and number of shares eligible to be purchased with the Warrants are summarized in the following table:

Series of warrant	Number of shares		Exercise price		Contractual term

Series A		2,366,211	$	3.52	5.0 years

The Preferred Shares have liquidation rights senior to common stock and to any other class or series of stock issued by the Company not designated as ranking senior to or pari passu with the Preferred Shares. In the event of a liquidation of the Company, holders of Preferred Shares are entitled to receive a distribution equal to $2.5357 per share of Preferred Shares prior to any distribution to the holders of common stock or any other stock that ranks junior to the Preferred Shares. The Preferred Shareholders are not entitled to dividends unless paid to Common Shareholders. Any dividend paid will have the same record and payment date and terms as the dividend payable to the Common Stock. The Preferred Shares will participate based on their respective as-if conversion rates if the Company declares any dividends. Holders of Preferred Shares also have voting rights required by applicable law and the relevant number of votes shall be equal to the number of shares of Common Stock issuable upon conversion of Preferred Shares. At any time, each Preferred Share is convertible into 1 share of Common Stock adjusted from time to time to the Conversion Rate. The Conversion Rate is computed as the Liquidation Preference Amount ($2.5357 per share) divided by the Conversion Price. The Conversion Price is initially $2.5357 per share but can adjust for anti-dilution. The holder can also void the conversion or exercise its Buy-in Rights. The Buy-in-Rights entitle the holder to be protected in the case that the Company is unable to deliver the shares upon conversion while the holder has transacted to sell such underlying shares to a third party. The Preferred Shares have registration rights that the Company is required to have a registration statement filed with the SEC within 45 days after the date of the Closing Date, or September 1, 2008, and declared effective by the SEC not later than December 15, 2008. We filed the initial registration statement on August 7, 2008, and it was declared effective by the SEC on August 21, 2008.

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

12. PREFERRED STOCK AND WARRANTS ISSUED IN 2008 FINANCING (CONTINUED)

The gross proceeds of the transaction were $5 million. The proceeds from the transaction were originally allocated to the Preferred Shares, Warrants and beneficial conversion feature based on the relative fair value of the securities. The Company evaluated whether a relative fair value approach or residual fair value approach was more appropriate given the terms and accounting treatment related to the financial instruments involved. Given that the Warrants were not originally classified as a liability, the relative fair value method was used. The Warrants were first valued using the Black-Scholes valuation model. The Company valued the Warrants at issuance at $1.84 per warrant with the following assumptions: common stock fair market value of $2.55, expected life of 5 year, volatility of 100% and an interest rate of 4.5%.

The Company originally recognized a beneficial conversion feature discount on the Preferred Shares at its intrinsic value, which was the fair value of the common stock at the commitment date for the Preferred Shares investment, less the effective conversion price but limited to the $5 million of proceeds received from the sale. The Company originally recognized the $2.6 million beneficial conversion feature in the equity as a transfer from retained earnings to additional paid in capital as dividends in the accompanying consolidated financial statements on the date of issuance of the Series A preferred shares since the Preferred Shares were convertible at the issuance date. The accounting treatment for such preferred stock and warrants were re-evaluated and adjustments were made during the year ended June 30, 2010.

In connection with the June 2008 Financing and the July 2008 Financing, in the event of the Company’s failure to timely convert, additional damages would become due. In the event the Company does not have sufficient shares or is prohibited by law or regulation, then the holder can require cash redemption. The redemption price would equal 130% of the Liquidation Preference Amount plus additional amounts based on the difference between the bid prices on the conversion date and the date the Company has sufficient shares. The holder can also void the conversion or exercise its Buy-in Rights. The Buy-in-Rights entitle the holder to be protected in the case that the Company is unable to deliver the shares upon conversion while the holder has transacted to sell such underlying shares to a third party. In addition, in the event of a merger, consolidation or similar capital reorganization (prior to conversion) the holders can request to be redeemed at 110% of liquidation value.

On April 30, 2010, the Company entered into a Warrant Amendment agreement with each of the holders of the Warrants in the June 2008 Financing and July 2008 Financing, namely Vision Opportunity China, LP and Blue Ridge Investments, LLC, to amend their respective warrants. In particular, the parties have agreed to delete Sections 4(d), (e) and (f) of their Warrants and replace Section 4(d) with a provision to allow the Company to issue additional shares of common stock or common stock equivalents at a price less than the conversion price of the warrants with the consent of the majority holders of the warrants.

During the course of internal evaluation, the Company re-evaluated its accounting treatment as of July 1, 2009 for the warrants issued in June 2008 Financing and July 2008 Financing, the denominated currency of the strike price of which is different from the entity’s functional currency. According to ASC 815-40-15-7I, if the denominated currency of an equity-linked financial instrument’s strike price is different from the entity’s functional currency, an equity-linked financial instrument is not indexed to the entity’s own stock. ASC 815-40-55-36 illustrates the implementation of the above standard. The Company’s primary operations are conducted in the PRC through its subsidiaries, SK and Shengkai, and the operating incomes and expenses are transacted in Renminbi (RMB), which is different from the strike price of the warrants, which are denominated in US dollars. Therefore, the Company determined that warrants shall not be considered indexed to the entity’s own stock and hence adjusted the classification of the Warrants effective from the beginning of fiscal year 2010, i.e. July 1, 2009, on which date ASC 815 should have been adopted, by recording the warrants as a liability measured at fair value with changes in fair value recognized in earnings for each reporting period and recording a cumulative-effect adjustment to the opening balance of retained earnings. See Note 2(n).

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

12. PREFERRED STOCK AND WARRANTS ISSUED IN 2008 FINANCING (CONTINUED)

During the course of internal evaluation, the Company re-evaluated its accounting treatment as of July 1, 2009 for the Preferred Shares issued in the June 2008 Financing and July 2008 Financing. The Certificate of Designations of the Preferred Shares includes a down-round provision pursuant to which, if the Company issues any additional shares of common stock at a per share price of less than $2.5357, the conversion ratio will be adjusted downward to reflect such lesser issued price. The down-round provision changed for the period commencing on the two (2) year anniversary of the Original Issue Date as set forth in Section 5 (e)(i) and 5(e)(ii) thereof. Although the adjustment under the Section 5(e)(ii) is different from the Section 5(e)(i), the nature of the down-round provision is not changed under both sections. The Company performed a complete assessment of the preferred stock and concluded that the Preferred Shares issued in the June and July 2008 Private Placements is within the scope of ASC 815-40-55-33 due to the down-round provisions included in the terms of the agreements. Pursuant to ASC 815-40-55-33, the down-round provision precludes the embedded conversion option of the Preferred Shares from being considered indexed to the entity’s own stock. Accordingly, the Company adjusted its accounting effective from the beginning of fiscal year 2010, i.e. July 1, 2009, on which date ASC 815 should have been adopted, by bifurcating the embedded conversion option of the Preferred Shares which should be recorded as a liability measured at fair value with changes in fair value recognized in earnings for each reporting period and recording a cumulative-effect adjustment to the opening balance of retained earnings. See Note 2(n).

As of September 30, 2011, the holders of Preferred Shares under the “June 2008 Financing” had converted an aggregate of 4.8 million Preferred Shares into the Company’s Common Stock for the same amount. No Series A Warrants have been exercised, forfeited or expired since issuance.

13. SHARE-BASED COMPENSATION

The Company’s 2010 Incentive Stock Plan (the “2010 Plan”) adopted by our Board of Directors and approved by our shareholders, permits the grant of incentive stock options, non-statutory stock options, stock awards or restricted stock purchase offer, to our officers, employees, consultants and non-employee directors. The 2010 Plan provides for the issuance of up to 2,211,250 shares of common stock (subject to adjustment for stock split and similar events). Option awards generally vest in three to four equal installments and have 5 year contractual terms. The Company’s general policy is to issue new shares of common stock to satisfy stock option exercises or grants of unvested shares.

On March 31, 2010, the Company granted 1,651,125 shares of non-statutory stock options to key employees and 310,000 shares to independent directors as compensation, these options have a 5 year contractual term. The options granted to key employees vest in three equal annual installments of 33.3%, with exercise price of $7.97 per share. Options granted to independent directors vest in three equal annual installments of 33.3% or in four equal annual installments of 25%, with exercise price of $3 per share. On June 22, 2010, the Company issued 150,000 shares of non-statutory stock options to Mr. Chen Wang, CEO, and 100,125 shares of options to Ms. Wei Guo, VP International Sales of Shengkai. These options have a 5 year contractual term, vest in three equal annual installments of 33.3%, with exercise price of $8.13 per share.

The Company accounts for share-based payments in accordance with ASC 718. Accordingly, the Company expenses the fair value of awards made under its share-based plan. That cost is recognized in the consolidated statement of operations over the requisite service period of the grants. Total compensation expense related to the stock options for the three months ended September 30, 2011 and 2010 were $1,021,468 and $1,032,564, respectively, and were recorded as general and administrative expense. As of September 30, 2011, there was $4,284,403 of unrecognized compensation costs related to nonvested share-based compensation arrangements granted under the 2010 Plan. That cost is expected to be recognized over a weighted average period of 1.2 years. 1,200,417 options have vested up to September 30, 2011, out of which none vested during the quarter then ended.

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

13. SHARE-BASED COMPENSATION (CONTINUED)

The fair value of the stock options granted was estimated at the date of grant using the Black-Scholes option pricing model with the following assumptions: volatility of 100%, the risk-free interest rate of 1.6%, expected dividend yield of 0% and expected life of 3.5 to 4 years.

Expected volatilities utilized in the model are based on the historic volatility of the Company’s stock price as well as volatility of comparable companies. The risk free interest rate is derived from the U.S. Treasury yield with a remaining term equal to the expected life of the option in effect at the time of the grant. Since the Company has limited option exercise history, it has elected to estimate the expected life of an award based upon the SEC-approved “simplified method” noted under the provisions of Staff Accounting Bulletin No. 107 with the continued use of this method extended under the provisions of Staff Accounting Bulletin No. 110. With the vesting period forms the lower bound of the estimate of expected term and the life of the option forming the upper bound.

The above assumptions were used to determine the weighted average grant date fair value of stock options of $5.63 per share for the options granted on March 31, 2010 and June 22, 2010.

A summary of the Company’s stock option activity as of September 30, 2011, and changes during the three months then ended are presented in the following table:

	Options		Weighted- Average Exercise Price

Outstanding at July 1, 2011		2,211,250	$	7.29
Granted		-		-
Exercised		-		-
Forfeited or Expired		-		-
Outstanding at September 30, 2011		2,211,250	$	7.29
Vested at September 30, 2011		1,200,417	$	7.61

The following table summarizes information about stock options outstanding at September 30, 2011:

		Options Outstanding					Options Exercisable
Exercise Price			Number Outstanding	Weighted Average Remaining Contractual Life (years)		Weighted Average Exercise Price	Number Exercisable		Weighted Average Exercise Price


$	8.13		250,125	3.73	$	8.13	83,375	$	8.13
$	3.00		310,000	3.5	$	3.00	90,000	$	3.00
$	7.97		1,651,125	3.5	$	7.97	1,027,042	$	7.97
			2,211,250	3.53	$	7.29	1,200,417	$	7.61

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

13. SHARE-BASED COMPENSATION (CONTINUED)

A summary of the status of the Company’s nonvested shares as of September 30, 2011, and changes during the three months then ended, are presented below:

Nonvested Shares	Shares		Weighted Average Grant Date Fair Value

Nonvested at July 1, 2011		1,010,833	$	5.76
Granted		-		-
Vested		-		-
Forfeited		-		-
Nonvested at September 30, 2011		1,010,833	$	5.76

The Company’s 2011 Incentive Stock Plan (the “2011 Plan”) adopted by our Board of Directors and ratified and approved by our shareholders on March 4, 2011, permits the grant of incentive stock options, non-statutory stock options, stock awards or restricted stock purchase offers, to our officers, employees, consultants and non-employee directors. The 2011 Plan provides for the issuance of up to 2,670,661 shares of common stock (subject to adjustment for stock split and similar events). The Company’s general policy is to issue new shares of common stock to satisfy stock option exercises or grants of unvested shares.

On March 18, 2011 and June 22, 2011, our Board of Directors approved to grant an aggregate of 1,200,000 and 1,470,000 shares, respectively, of the Company’s common stock as stock awards under the 2011 Plan to certain key employees in order to incentivize them and retain their valued services with the Company. 2,070,000 of the approved stock awards have been issued during the fiscal year ended June 30, 2011 and the remaining 600,000 shares have been issued during the quarter ended September 30, 2011.

The Company accounts for share-based payments in accordance with ASC 718. Accordingly, the Company expenses the fair value of awards made under its share-based plan. The Company estimates fair value of common stock awards based on the number of shares issued and the quoted price of the Company's common stock on the date of issuance. That cost is fully recognized in the consolidated statement of operations. Total compensation expense related to the common stock awards for the three months ended September 30, 2011 and 2010 was $1,125,500 and $0, respectively, and were recorded as general and administrative expense.

14.	INCOME TAXES

SKII is registered in the State of Florida whereas its subsidiary, Shen Kun being incorporated in the British Virgin Islands, is not subject to any income tax and conducts all of its business through its PRC subsidiaries, SK, Shengkai and Shengkai (Tianjin) Trading Ltd. (see Note 1).

SK, Shengkai and Shengkai (Tianjin) Trading Ltd., being registered in the PRC, are subject to PRC’s Enterprise Income Tax. On March 16, 2007, the National People’s Congress of China approved the new Corporate Income Tax Law of the People’s Republic of China (the “New CIT Law”), which is effective from January 1, 2008. Prior to January 1, 2008, the CIT rate applicable to our subsidiaries in the PRC was 33%. After January 1, 2008, under the New CIT Law, the corporate income tax rate applicable to our Chinese subsidiaries is 25%.

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

14. INCOME TAXES (CONTINUED)

In accordance with the New CIT Law, enterprises established under the laws of foreign countries or regions and whose “place of effective management” is located within the PRC territory are considered PRC resident enterprises and subject to the PRC income tax at the rate of 25% on worldwide income. The definition of “place of effective management" refers to an establishment that exercises, in substance, overall management and control over the production and business process, personnel, accounting and properties of an enterprise. As of September 30, 2011, no detailed interpretation or guidance has been issued to define “place of effective management”. Furthermore, as of September 30, 2011, the administrative practice associated with interpreting and applying the concept of “place of effective management” is unclear. If the Company’s non-PRC incorporated entities are deemed PRC tax residents, such entities would be subject to PRC tax under the New CIT Law. The Company has analyzed the applicability of this law, and has not accrued for PRC tax on such basis as of September 30, 2011. The Company will continue to monitor changes in the interpretation or guidance of this law.

The New CIT Law also imposes a 10% withholding income tax, subject to reduction based on tax treaty where applicable, for dividends distributed by a foreign invested enterprise to its immediate holding company outside China. Such dividends were exempted from PRC tax under the previous income tax law and regulations. A foreign invested enterprise is subject to the withholding tax starting from January 1, 2008. There was no such dividends distributed in the three months ended September 30, 2011 or 2010.

In April 2010, Shengkai was awarded the status of “high technology” enterprise for the calendar years 2009 through 2011, of which Shengkai enjoys a preferential enterprise income tax rate of 15%. However, for the year ended June 30, 2009, we already used income tax rate of 25% to provide and pay for income taxes. For the period from July 1, 2009 to December 31, 2009, we used income tax rate of 25% to provide and pay for income taxed. After January 1, 2010, we used the preferential income tax rate of 15% to provide and pay for income tax expenses. We did not record any tax refund receivable as of September 30, 2011 as we are not sure whether the refund of the overpaid income tax expenses during the calendar year 2009 would be approved by the local tax bureau. Income taxes payable was $516,882 and $1,816,995 at September 30 and June 30, 2011, respectively.

Income tax expenses consist of the following:

	For the Three Months Ended September 30,
	2011			2010
Current		$	518,675		$	1,126,251
Deferred			-			-
Total		$	518,675		$	1,126,251

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

14. INCOME TAXES (CONTINUED)

Reconciliation from the expected income tax expenses calculated with reference to the statutory tax rate in the PRC of 25% for three months ended September 30, 2011 and 2010 is as follows:

	For the Three Months Ended September 30,
	2011		2010

Income before income taxes	$	1,463,013	$	28,071,336
Income (loss) before income taxes from non-Chinese headquarters and subsidiaries		(2,166,056)		1,141,736
Income before income taxes from Chinese subsidiaries		3,629,069		29,213,072

Income tax expenses for Chinese subsidiaries computed at the PRC statutory rate of 25%		907,267		7,303,268
Preferential tax rate effect of 10% on Shengkai for the period ended September 30		(362,907)		(750,829)
Permanent difference		(25,685)		-
	$	518,675	$	1,126,251

15. EARNINGS PER SHARE

Basic earnings per share is computed by dividing net income available to common shareholders by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is computed by dividing net income available to common shareholders by the weighted average number of shares of common stock, common stock equivalents and potentially dilutive securities outstanding during each period. Potentially dilutive shares of common stock consist of the common stock issuable upon the conversion of convertible debt, preferred stock, stock options and warrants. The Company uses the if-converted method to calculate the dilutive preferred stock and the treasury stock method to calculate the dilutive shares issuable upon exercise of warrants and stock options.

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

15. EARNINGS PER SHARE (CONTINUED)

The calculation of the basic and diluted earnings per share attributable to the common stockholders is based on the following data:

	For the Three Months
	Ended September 30,
	2011			2010
Earnings:
Net income		$	944,338		$	26,945,085
Earnings for the purpose of basic earnings per share		$	944,338		$	26,945,085
Effect of dilutive potential common stock			-			-
Earnings for the purpose of dilutive earnings per share		$	944,338		$	26,945,085
Number of shares:
Weighted average number of common stock for the purpose of basic earnings per share			32,751,068			23,191,165
Effect of dilutive potential common stock
-Conversion of Series A convertible preferred stock			3,354,759			6,987,368
-Exercise of A Warrants			-			4,915,774
-Exercise of options			-			183,015
Weighted average number of common stock for the purpose of dilutive earnings per share			36,105,827			35,277,322
Earnings per share:
Basic earnings per share		$	0.029		$	1.162
Dilutive earnings per share		$	0.026		$	0.764

SHENGKAI INNOVATIONS, INC.

(F/K/A SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(Stated in US Dollars)

16. COMMITMENTS AND CONTINGENCY

The manufacturing facility and a headquarters’ building completed in September 2010 are on a plot of land in Tianjin, China which was obtained in October, 2008. Certain construction contracts were executed. The total amount of executed contracts was $35,132,286 (RMB224,909,871), of which $33,315,486 (RMB213,279,079) had been paid as of September 30, 2011. The remaining balance of $1,816,800 (RMB11,630,792) will substantially be settled after completion of inspection and final acceptance of the construction project by relevant government authorities, with certain amount to be held from payment as warranty deposit till approximately one year after such final acceptance.

Certain equipment and machinery contracts for the above-mentioned recently completed manufacturing facility were executed. The total amount of executed contracts was $16,335,952 (RMB104,579,500), of which $15,340,100 (RMB98,204,250) had been paid as of September 30, 2011. The remaining balance of $995,852 (RMB6,375,250) primarily represented the amount held from payment as warranty deposit till approximately one year after installation and acceptance.

17. SEGMENT INFORMATION

The Company is principally engaged in one segment of the manufacturing and selling of ceramic valves in the PRC. Nearly all revenues are generated in the PRC and substantially all identifiable assets of the Company are located in the PRC. Accordingly, no segmental analysis is presented.

A breakdown of the Company's revenues for the three months ended September 30, 2011 and 2010 in terms of customers' industry classification is as follows:

	For the Three Months Ended September 30,
Customer industry	2011		2010
Electric power	$	3,504,935	$	11,220,835
Petrochemical and chemical		6,717,545		5,273,444
Aluminum, metallurgy and others		788,647		680,237
Total Sales	$	11,011,127	$	17,174,516

18. AMENDMENT TO ARTICLES OF INCORPORATION

On September 30, 2010, the Board of the Company approved an amendment to the Company’s Articles of Incorporation to increase the total number of authorized shares of Common Stock of the Company from 50,000,000 to 100,000,000 shares (the “Amendment”). The Amendment was ratified on September 30, 2010 by the holder of a majority of the Company’s outstanding shares of Common Stock. The Amendment was effective on November 2, 2010, the date on which it was filed with the State of Florida.

19. SUBSEQUENT EVENTS

The Company evaluated subsequent events through the time of filing this quarterly report on Form 10-Q and no significant events occurred subsequent to the balance sheet date but prior to the filing of this report that would have a material impact on our Consolidated Financial Statements.

Item 2. Management’s Discussion and Analysis or Plan of Operation.

Cautionary Notice Regarding Forward-Looking Statements

In this quarterly report, references to “Shengkai Innovations,” “VALV,” “the Company,” “we,” “us,” and “our” refer to Shengkai Innovations, Inc.

We make certain forward-looking statements in this report. Statements concerning our future operations, prospects, strategies, financial condition, future economic performance (including growth and earnings), demand for our services, and other statements of our plans, beliefs, or expectations, including the statements contained under the captions “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Business,” as well as captions elsewhere in this document, are forward-looking statements. In some cases these statements are identifiable through the use of words such as “anticipate,” “believe,” “estimate,” “expect,” “intend,” “plan,” “project,” “target,” “can”, “could,” “may,” “should,” “will,” “would,” and similar expressions. We intend such forward-looking statements to be covered by the safe harbor provisions contained in Section 27A of the Securities Act of 1933, as amended (the “Securities Act”) and in Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). The forward-looking statements we make are not guarantees of future performance and are subject to various assumptions, risks, and other factors that could cause actual results to differ materially from those suggested by these forward-looking statements. Because such statements are subject to risks and uncertainties, actual results may differ materially from those expressed or implied by the forward-looking statements. Indeed, it is likely that some of our assumptions will prove to be incorrect. Our actual results and financial position will vary from those projected or implied in the forward-looking statements and the variances may be material. You are cautioned not to place undue reliance on such forward-looking statements. These risks and uncertainties, together with the other risks described from time to time in reports and documents that we file with the SEC should be considered in evaluating forward-looking statements.

The nature of our business makes predicting the future trends of our revenue, expenses, and net income difficult. Thus, our ability to predict results or the actual effect of our future plans or strategies is inherently uncertain. The risks and uncertainties involved in our business could affect the matters referred to in any forward-looking statements and it is possible that our actual results may differ materially from the anticipated results indicated in these forward-looking statements. Important factors that could cause actual results to differ from those in the forward-looking statements include, without limitation, the following:

·	the effect of political, economic, and market conditions and geopolitical events;

·	legislative and regulatory changes that affect our business;

·	the availability of funds and working capital;

·	the actions and initiatives of current and potential competitors;

·	investor sentiment; and

·	our reputation.

We do not undertake any responsibility to publicly release any revisions to these forward-looking statements to take into account events or circumstances that occur after the date of this report. Additionally, we do not undertake any responsibility to update you on the occurrence of any unanticipated events which may cause actual results to differ from those expressed or implied by any forward-looking statements.

The following discussion and analysis should be read in conjunction with our consolidated financial statements and the related notes thereto as filed with the SEC and other financial information contained elsewhere in this Report.

Overview

We were incorporated in Florida on December 8, 2004 and have since undergone a change in business. In October 2008, our shareholders approved our name change from “Southern Sauce Company, Inc.” to “Shengkai Innovations, Inc.”

As a result of the reverse merger, financing and related transactions described in our current report on Form 8-K/A filed with the SEC on June 23, 2008, the Company ceased to be a shell company and became a holding company of Shen Kun International Limited (“Shen Kun”), a company incorporated under the laws of British Virgin Islands on November 7, 2007. Shen Kun holds 100% of the equity interests in Shengkai (Tianjin) Limited (“SK WFOE”), a wholly foreign owned enterprise organized under the laws of the People’s Republic of China (“PRC”), which, in turn, through contractual relationships, controls the business of Tianjin Shengkai Industrial Technology Development Co., Ltd. (“Tianjin Shengkai”), a PRC company that designs, manufactures and sells ceramic valves.

On June 25, 2010, Shengkai (Tianjin) Trading Ltd., which is wholly owned by SK WFOE, was organized as a corporation under the laws of the PRC, with a total registered capital of RMB500,000. Shengkai (Tianjin) Trading Ltd. is primarily engaged in the international trading of non-valve products to better serve the Company’s international customers. Currently, Shengkai (Tianjin) Trading Ltd. has not started any operations.

Because SK WFOE and Tianjin Shengkai’s operations are the only significant operations of the Company and its affiliates, this discussion and analysis focuses on the business results of SK WFOE and Tianjin Shengkai, comparing their business results in the three months ended September 30, 2011 to the three months ended September 30, 2010.

General

SK WFOE and Tianjin Shengkai, the entities through which we run our operations, are prominent ceramic valve manufacturers. We have about 17 years of experience and possess a unique method for creating ceramic valves.

We believe that we are one of the few ceramic valve manufacturers in the world with research and development, engineering, and production capacity for structural ceramics, and are able to produce large-sized ceramic valves with calibers of 150mm or more. Our product categories include a broad range of valves in nearly all industries and are sold throughout the PRC, to Europe, North America, Middle East and other countries in the Asia-Pacific region. Totaling over 200 customers, we became a supplier of China Petroleum & Chemical Corporation (“CPCC” or “Sinopec”) in 2005; we joined the supply network of China National Petroleum Corporation (“CNPC”) in 2006 and subsequently received a CNPC Certificate of Material Supplier for valve products in 2011. We are currently the only domestic ceramic valve manufacturer entering into the Sinopec and CNPC supply system.

Results of Operations

Comparison of the Three Months Ended September 30, 2011 and 2010

Revenue

In recent months, because of the heightened suspicions on the integrity of PRC companies, enquiries into our business and domestic customers mounted by certain shareholders and interested parties without the Company’s approval or endorsement have resulted in severely damaged relations with some of our important domestic customers. This has resulted in considerable loss of business since June 2011, and a higher turnover in our sales agents and representatives. Some of our other customers have seized this opportunity to demand price cuts from us. Meanwhile, some of our competitors also have seized this opportunity to take away our customers.

As a result, revenue for the three months ended September 30, 2011 decreased by $6,163,389 or 35.9% to $11,011,127, from $17,174,516 for the three months ended September 30, 2010. Total ceramic valves output for the quarter ended September 30, 2011 was 1,978 sets, compared with 4,456 sets for the quarter ended September 30, 2010.

Ceramic valve is a relatively new technology with a very low market penetration rate compared to traditional metal valves which are currently prevalent in market. In response to the recent business disruptions and changes in the global ceramic valves industry as described above, management of the Company has decided to gradually phase out its less profitable domestic market segments including the electric power market and focus on expanding its presence in the more profitable domestic and foreign oil and chemical industries. Approximately 92.8% of our source of revenue came from customers in the electric power, petrochemical and chemical industries for the three months ended September 30, 2011, compared with 96.0% for the three months ended September 30, 2010.

The electric power industry contributed significantly less to our revenue, generating approximately 31.8% of total revenue for the three months ended September 30, 2011, compared with 65.3% for the three months ended September 30, 2010. Revenue from the electric power industry was $3,504,935 for the three months ended September 30, 2011, a decrease of $7,715,900 or 68.8% from $11,220,835 for the comparable period in fiscal 2011. This decrease was primarily attributable to the business disruptions and hence the strategic shift of market orientation as mentioned above.

Revenue from the petrochemical and chemical industry accounted for approximately 61.0% of total revenue for the three months ended September 30, 2011, compared with 30.7% for the three months ended September 30, 2010. The revenue from the petrochemical and chemical industry was $6,717,545 the three months ended September 30, 2011, an increase of $1,444,101 or 27.4% from $5,273,444 for the comparable period in fiscal 2011. The increase was primarily due to our continuous efforts to market our products to the petrochemical and chemical industry, offset by the impacts from the afore-mentioned business disruptions, though not as much as to the electric power market segment. We focus more marketing efforts on the petrochemical and chemical industries because most of their production and supply processes involve highly corrosive and abrasive media or other severe conditions, and therefore we believe that our ceramic valves are a good fit for these sectors because of their superior durability.

Revenue from other industries, including the aluminum and metallurgy industries, accounted for approximately 7.2% of total revenue for the three months ended September 30, 2011, compared with 4.0% for the three months ended September 30, 2010. The revenue for other industries was $788,647 for the three months ended September 30, 2011, an increase of $108,410 or 15.9% from $680,237 for the comparable period in fiscal 2011. Such other industries have not been the Company’s marketing focus because of less educated and lower quality customer base and less promising future prospects in terms of potential market size, selling price and profit margin. Revenue from these industries has remained low. In the preceding quarters, there was increased revenue from some iron and steel mills who introduced new blast furnace gas cleaning systems, which require highly anti-abrasive ceramic valves. Orders from those new projects have been completed by the end of the fiscal year ended June 30, 2011.

In the immediate future, we expect that total revenues for the quarter ended December 31, 2011 may continue to drop along with the pace of the Company’s gradual phasing out the electric power and other markets before our efforts towards new customers and new markets pay off. Total revenue is estimated between $10.0 million and $10.5 million.

Cost of Sales and Gross Profit

Cost of sales for the three months ended September 30, 2011 was $6,196,651, a decrease of $1,023,777 or 14.2% compared to $7,220,428 for the comparable period in fiscal 2011. The cost of sales as a percentage of net revenues increased by approximately 14.3% to 56.3% in the three months ended September 30, 2011 from 42.0% during the comparable period in fiscal 2011.

Gross profit for the three months ended September 30, 2011 was $4,814,476, a decrease of $5,139,612 or 51.6% compared to $9,954,088 for the comparable period in fiscal 2011. The decrease was attributable to both decrease in revenue and increase in costs. The gross margin for the three months ended September 30, 2011 was 43.7%, compared to 58.0% for the comparable period in fiscal 2011. The decrease in gross margin between the two comparison periods was primarily attributed to increase in depreciation expenses and material costs, which were spread over a smaller revenue base. During the past twelve months, new fixed assets of approximately $49.2 million were added to property, plant and equipment. The corresponding additional depreciation expenses recorded in cost of goods sold was approximately $0.7 million for the quarter ended September 30, 2011. Since the fourth quarter of fiscal 2011, prices for steel raw materials and steel die-casting components, our major raw materials, had increased by approximately 13% compared with those in the quarter ended September 30, 2010.

We estimate that our gross margin for the next quarter ended December 31, 2011 would remain at a similar level as that for the current quarter.

Selling Expenses

Selling expenses for the three months ended September 30, 2011 were $1,051,480, a decrease of $551,092 or 34.4%, from $1,602,572 for the comparable period in fiscal 2011. The major component of selling expenses was commissions paid to agents for introducing new sales, which was approximately $0.9 million for the three months ended September 30, 2011, a decrease of approximately $0.5 million or 35.9% from approximately $1.4 million for the three months ended September 30, 2010. Selling expenses as a percentage of total sales revenue increased slightly to 9.5% for the three months ended September 30, 2011 from 9.3% for the comparable period in fiscal 2011, as some other minor components of selling expenses are relatively rigid and did not diminish proportionally to revenue decrease. Since commissions, the major component of selling expenses, are a fixed percentage of revenue, we expect selling expenses for the future quarters to change proportionately with revenue change.

General and Administrative Expenses

General and administrative (“G&A”) expenses for the three months ended September 30, 2011 were $3,406,035, an increase of $1,344,389 or 65.2% compared to $2,061,646 for the comparable period in fiscal 2011. Included in G&A expenses for the three months ended September 30, 2011 was a non-cash charge of $2,146,968, which was the share-based compensation costs on i) the options to independent directors, management and key employees issued in March and June, 2010, under the Company’s 2010 Incentive Stock Plan, and ii) the stock awards to management and key employees issued in September 2011, under the Company’s 2011 Incentive Stock Plan. The non-cash share-based compensation costs included in the G&A expenses for the comparable period in fiscal 2011 was $1,032,564. G&A expenses (excluding the non-cash items) for the three months ended September 30, 2011 were $1,259,067, an increase of $229,985 or 22.3% compared to $1,029,082 for the comparable period in fiscal 2011.The increase in G&A (excluding the non-cash items) expenses over the comparable periods of fiscal 2011 and 2012 was primarily attributable to the increase in depreciation costs from $53,908 to $141,975 as a result of the new headquarters building, as well as increase in research and development costs from $133,346 to $315,191. The amortization of land use rights and other intangible assets for the three months ended September 30, 2011 was $254,089, an increase of $22,183 or 9.6% compared to $231,906 for the comparable period in fiscal 2011.

Changes in Fair Value of Instruments

For the three months ended September 30, 2011, the Company incurred non-cash gain in an aggregate amount of approximately $0.9 million related to its issuance of Series A warrants and Series A convertible preferred stock in the Private Placements in June and July, 2008, as well as issuance of warrants to underwriters in the public offerings in November and December 2010, pursuant to provision of FASB ASC Topic 815, “Derivative and Hedging” (“ASC 815”). The accounting treatment of the warrants resulted from the difference between the Company's functional currency in Renminbi and the denominated currency of the strike price of the warrants in U.S. dollars. The accounting treatment of the preferred stock resulted from a down-round provision providing anti-dilution protection to the preferred stockholders. Both warrants and the embedded conversion option of Series A convertible preferred stock are recorded as liabilities measured at fair value with changes in their fair value recognized in earnings for the three months ended September 30, 2011. Fair value of the instruments was primarily a function of the price of our common stock. A decrease in our stock price over the three months resulted in a decrease in fair value of the instruments, which are liabilities; hence a gain was recognized for the reporting period. For the comparable period in fiscal 2011, the Company recognized a non-cash gain of approximately $21.7 million due to the decrease in our stock price over that period.

Provision for Income Taxes

Provision for income taxes for the three months ended September 30, 2011 was $518,675, a decrease of $607,576 or 53.9% from $1,126,251 for the comparable period in fiscal 2011. Excluding the approximately $2.1 million share-based compensation cost and the approximately $0.9 million gain from changes in fair value of instruments, adjusted income before taxes was approximately $2.7 million for the three months ended September 30, 2011 compared with approximately $7.4 million for the comparable period in fiscal 2011, after adjusting for the approximately $1.0 million share-based compensation cost and approximately $21.7 million gain from changes in fair value of instruments. In April 2010, Tianjin Shengkai, the Company’s operating entity in Tianjin, PRC, was awarded the status of “high technology” enterprise for the calendar years 2009 through 2011. Hence Tianjin Shengkai enjoys a preferential enterprise income tax rate of 15% starting from January 1, 2010 through December 31, 2011, compared with the standard tax rate of 25%.

Net Income

Net income (per U.S. GAAP) for the three months ended September 30, 2011 was $944,338, a decrease of $26,000,747 or 96.5% from $26,945,085 for the comparable period in fiscal 2011. Based on a greater weighted average number of shares, diluted earnings per share were $0.03 compared to diluted earnings per share of $0.76 in the first quarter of fiscal 2011. During the first quarter, the number of diluted shares was 36,105,827 compared with 35,277,322 diluted shares in the first quarter of fiscal 2011.

Excluding the approximately $2.1 million share-based compensation cost and the approximately $0.9 million gain from changes in fair value of instruments, adjusted net income (non-GAAP) was approximately $2.2 million for the three months ended September 30, 2011 compared with approximately $6.3 million for the comparable period in fiscal 2011, after adjusting for the approximately $1.0 million share-based compensation cost and approximately $21.7 million gain from changes in fair value of instruments. The decrease was attributable to the factors described above. Based on a greater weighted average number of shares, non-GAAP earnings were $0.06 per diluted share compared with $0.18 per diluted share in the first quarter of fiscal 2011.

Liquidity and Capital Resources

Cash and Cash Equivalents

Our cash and cash equivalents at the beginning of the three months ended September 30, 2011 were $59,870,108 and increased to $62,935,344 by the end of the period, an increase of $3,065,236 or 5.1%. The increase was primarily attributable to the internal cash flows generated from operations, release of restricted cash, as well as effects of exchange rate change.

We believe that after taking into account of our current cash position and cash generated from operating activities, we have adequate operating funds to sustain working capital, capital expenditures and milestone payments for the next twelve months. From time to time, we may identify new expansion opportunities, research and development projects and significant marketing initiatives for which there will be a need to use cash.

We manage our cash based on thorough consideration of our corporate strategy, business environment as well as the macro economic situation. Factors we take into account when managing our cash include interest rates, foreign currency fluctuation as well as the flexibility in executing our corporate strategy.

Net Cash Provided by Operating Activities

Net cash provided by operating activities was $1,962,346 for the three months ended September 30, 2011, a decrease of $2,115,966 or 51.9% from $4,078,312 for the comparable period in fiscal 2011. The adjusted net income, after deducting the non-cash gain from changes in fair value of instruments and adding back the non-cash share-based compensation cost, was $2,164,669 for the three months ended September 30, 2011, a decrease of $4,108,229 or 65.5% from $6,272,898 for the comparable period in fiscal 2011. The decrease in net cash inflow from operations was primarily attributable to the decrease in net income, despite the reduced working capital used between the two comparable periods in fiscal 2012 and fiscal 2011, as reflected by larger cash provided by changes in accounts receivable offset by decreased notes, accounts and other payables over the three months ended September 30, 2011 and 2010, respectively.

Net Cash Used in Investing Activities

Net cash provided by investing activities was $515,192 for the three months ended September 30, 2011, compared to net cash used of $5,772,613 for the three months ended September 30, 2010, an increase in cash inflow of $6,287,805. The change was primarily attributable to significant reduction in capital expenditures and decrease in restricted cash incurred during the three months ended September 30, 2011 compared to the same period in fiscal 2011.

Net Cash Provided by Financing Activities

There was no cash provided by or used in financing activities for the three months ended September 30, 2011 or 2010.

Capital Expenditures

In October 2008, we successfully won a bid on a land use right over a plot of land approximately 43,566.3 square meters in size. The land is located in Tianjin, PRC and the bid price was approximately $1.9 million (RMB12.6 million). The formal contract was signed with the government on January 23, 2009, with the Company due to pay the bid price in full by March 25, 2009. The land was purchased to construct corporate headquarters and to build a new manufacturing facility to expand our production capacity. Expenditures committed under related construction contracts totaled $35,132,286 (RMB224,909,871), of which $33,315,486 (RMB213,279,079) had been paid as of September 30, 2011. The remaining balance of $1,816,800 (RMB11,630,792) will substantially be settled after completion of inspection and final acceptance of the construction project by relevant government authorities, with certain amount to be held from payment as warranty deposit till approximately one year after such final acceptance. Certain equipment and machinery contracts for the above-mentioned recently completed manufacturing facility have also been executed, total amount of which was approximately $16,335,952 (RMB104,579,500), of which $15,340,100 (RMB98,204,250) had been paid as of September 30, 2011. The remaining balance of $995,853 (RMB6,375,250) primarily represented the amount held from payment as warranty deposit till approximately one year after installation and acceptance.

Trends

In response to the recent business disruptions and changes in the global ceramic valves industry as described above, management of the Company has decided to gradually phase out its less profitable domestic market segments including the electric power market and focus on expanding its presence in the more profitable domestic and foreign oil and chemical industries where ceramic valve products typically command higher prices than the domestic Chinese market. The Company plans to substantially raise prices to match industry levels and to reflect its superior product quality. The Company also expects to streamline operations through headcount reduction and other cost-saving measures to conserve capital and reduce the impact of any revenue loss during this transition. Finally, the Company plans to leverage its self-developed ceramic material technologies to continue in-house and joint research and development of innovative and superior-performance products for the international oil and chemical markets and commit its resources to expanding the acceptance of its products overseas.

As such, we expect that in the immediately following quarter ended December 31, 2011, revenue from the electric power industry would continue to drop, and major contribution to our sales would be from the petrochemical and chemical industry. We estimate that for the quarter ended December 31, 2011, total revenue would be between $10.0 million and $10.5 million, and gross margin would be approximately 43%. We expect the Company to continue to run with positive but significantly reduced cash flow from operations. Such decrease may persist until our marketing and sales efforts on some new customers and projects pay off, and the expansion in the international market picks up meaningfully. Successful penetration into international oil and chemical markets would also require the Company to obtain various certifications, including but not limited to ISO14000 and OHSAS 18000 and other firm-specific supplier qualifications, which will take time to go through various application procedures, develop new products and invest in additional or different equipment.

Inflation

We believe that inflation has not had a material or significant impact on our revenue or our results of operations.

Contractual Obligations

We have certain fixed contractual obligations and commitments that include future estimated payments. Changes in our business needs, cancellation provisions, changing interest rates, and other factors may result in actual payments differing from the estimates. We cannot provide certainty regarding the timing and amounts of payments. We have presented below a summary of the most significant assumptions used in our determination of amounts presented in the tables, in order to assist in the review of this information within the context of our financial position, results of operations, and cash flows.

The following table summarizes our contractual obligations as of September 30, 2011, and the effect these obligations are expected to have on our liquidity and cash flows in future periods.

	Totals		Less Than 1 Year		1 to 3 Years		Thereafter

Capital expenditures (1)	$	2,812,653	$	2,812,653	$	-		-

(1) Capital expenditures are commitments for the construction of a new manufacturing facility and for the purchase of new equipment and machinery. See Note 16 - Commitments and Contingency in the notes to the financial statements, included elsewhere in this report. The Company entered into certain construction contracts for building a new manufacturing facility and a headquarters building. The total amount of executed contracts was $35,132,286 (RMB224,909,871), of which $33,315,486 (RMB213,279,079) had been paid as of September 30, 2011. The construction of both the manufacturing facility and the headquarters building were substantially completed in September 2010. The Company has also executed certain equipment and machinery contracts totaling $16,335,952 (RMB104,579,500), of which $15,340,100 (RMB98,204,250) had been paid as of September 30, 2011.

Off Balance Sheet Arrangements

None.

Critical accounting policies and estimates

The financial statements are prepared in accordance with accounting principles generally accepted in the United States, which require us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Management makes these estimates using the best information available at the time the estimates are made. However, actual results could differ materially from those estimates (See Note 2 in the Notes to Financial Statements).

Revenue recognition

Revenue represents the invoiced value of goods sold and is recognized upon the delivery of goods to customers, net of value added tax (“VAT”). Revenue is recognized when the following four criteria are met: persuasive evidence of an arrangement exists, delivery has occurred, the selling price is fixed or determinable, and collectability is reasonably assured.

Intangible assets

Intangible assets represent land use rights, patent rights and other assets (such as use of software) in the PRC. Land use rights are carried at cost and amortized on a straight-line basis over the period of rights of 50 years commencing from the date of acquisition of equitable interest. Patent rights are carried at cost and amortized on a straight-line basis over the period of rights of 10 years commencing from the date of acquisition of equitable interest. Others are software costs which are carried at cost and amortized on a straight-line basis over the period from 3 to 10 years.

Foreign currency translation

New Financial Accounting Pronouncements

Item 3. Quantitative and Qualitative Disclosures about Market Risk.

N/A.

Item 4. Controls and Procedures.

Our management is responsible for establishing and maintaining a system of disclosure controls and procedures (as defined in Rule 13a-15(e)) under the Exchange Act) that is designed to ensure that information required to be disclosed by the Company in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time specified in the Commission's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Exchange Act is accumulated and communicated to the issuer's management, including its principal executive officer or officers and principal financial officer or officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.

Pursuant to Rule 13a-15(b) under the Exchange Act, the Company carried out an evaluation with the participation of the Company’s management, including Wang Chen, the Company’s Chief Executive Officer (“CEO”), and David Ming He, the Company’s Chief Financial Officer (“CFO”), of the effectiveness of the Company’s disclosure controls and procedures (as defined under Rule 13a-15(e) under the Exchange Act) as of the three months ended September 30, 2011. Based upon that evaluation, the Company’s CEO and CFO also concluded that the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in the reports that the Company files or submits under the Exchange Act, is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including the Company’s CEO and CFO, as appropriate, to allow timely decisions regarding required disclosure.

Changes in Internal Controls over Financial Reporting

Our management, with the participation of our CEO and CFO, performed an evaluation as to whether any change in our internal controls over financial reporting occurred during the quarter ended September 30, 2011. Based on that evaluation, our CEO and CFO concluded that no change occurred in the Company's internal controls over financial reporting during the quarter ended September 30, 2011 that has materially affected, or is reasonably likely to materially affect, the Company's internal controls over financial reporting.

PART II – OTHER INFORMATION

Item 1. Legal Proceedings.

To our knowledge, there is no material litigation pending or threatened against us.

Item 1A. Risk Factors.

N/A.

Item 2. Unregistered Sale of Equity Securities and Use of Proceeds.

None.

Item 3. Defaults Upon Senior Securities.

To our knowledge, there are no material defaults upon senior securities.

Item 4. (Removed and Reserved).

Item 5. Other Information.

None.

Item 6. Exhibits.

(a) Exhibits

Exhibit Number		Description of Exhibit

31.1		Certification of Principal Executive Officer pursuant to Pursuant to Section 302 Of the Sarbanes-Oxley Act of 2002
31.2		Certification of Principal Financial Officer pursuant to Pursuant to Section 302 Of the Sarbanes-Oxley Act of 2002.
32.1		Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2		Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101.INS		XBRL Instance Document*
101.SCH		XBRL Schema Document*
101.CAL		XBRL Calculation Linkbase Document*
101.LAB		XBRL Label Linkbase Document*
101.PRE		XBRL Presentation Linkbase Document*
101.DEF		XBRL Definition Linkbase Document*

* Attached as Exhibits 101 to this report are the following financial statements from the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2011 formatted in XBRL (eXtensible Business Reporting Language): (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Operations and Comprehensive Income, (iii) the Consolidated Statements of Cash Flows, and (iv) related notes to these financial statements tagged as blocks of text. The XBRL-related information in Exhibits 101 to this Quarterly Report on Form 10-Q shall not be deemed “filed” or a part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, and is not filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to the liabilities of those sections.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	SHENGKAI INNOVATIONS, INC.

Date: November 9, 2011	By:	/s/ Wang Chen
		Name: Wang Chen
		Title: Chief Executive Officer
		(principal executive officer)

Date: November 9, 2011	By:	/s/ David Ming He
		Name: David Ming He
		Title: Chief Financial Officer
		(principal financial and accounting officer)

Attached files

Shengkai Innovations, Inc. Reports

Also read