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EX-32.2 - EXHIBIT 32.2 - GENERAL STEEL HOLDINGS INCv393821_ex32-2.htm
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EX-31.1 - EXHIBIT 31.1 - GENERAL STEEL HOLDINGS INCv393821_ex31-1.htm
EX-31.2 - EXHIBIT 31.2 - GENERAL STEEL HOLDINGS INCv393821_ex31-2.htm

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

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

 

For the quarterly period ended September 30, 2014

 

or

 

¨ 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 001-33717

 

General Steel Holdings, Inc.

(Exact name of registrant as specified in its charter)

 

Nevada   41-2079252
(State or other Jurisdiction of   (I.R.S. Employer Identification No.)
Incorporation or Organization)    

 

Level 21, Tower B, Jia Ming Center

No. 27 Dong San Huan North Road

Chaoyang District, Beijing, China 100020 

(Address of Principal Executive Office, Including Zip Code)

 

+86 (10) 5775 7648

 

(Registrant's Telephone Number, Including Area Code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  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 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 definition 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

 

As of November 7, 2014, 60,922,382 (excluding 2,472,306 shares of treasury stock) shares of common stock, par value $0.001 per share, were outstanding.

 

 
 

  

Table of Contents

 

    Page
Part I.  FINANCIAL INFORMATION  
     
Item 1. Unaudited Financial Statements. 3
     
  Condensed Consolidated Balance Sheets as of September 30, 2014 and December 31, 2013. 3
     
  Condensed Consolidated Statements of Operations and Comprehensive (Loss) Income for the Three and Nine months ended September 30, 2014 and 2013. 4
     
  Condensed Consolidated Statements of Cash Flows for the Nine months ended September 30, 2014 and 2013. 5
     
  Notes to Condensed Consolidated Financial Statements. 6
     
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations. 38
     
Item 3. Quantitative and Qualitative Disclosures about Market Risk 60
     
Item 4. Controls and Procedures. 60
     
Part II. OTHER INFORMATION  
     
Item 1. Legal Proceedings. 61
     
Item 1A. Risk Factors. 61
     
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds. 61
     
Item 3. Defaults Upon Senior Securities. 61
     
Item 4. Mine Safety Disclosure. 61
     
Item 5. Other Information. 61
     
Item 6. Exhibits. 62
     
Signatures 63

 

2
 

   

PART I – FINANCIAL INFORMATION

 

ITEM 1. UNAUDITED FINANCIAL STATEMENTS

 

 

GENERAL STEEL HOLDINGS, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED BALANCE SHEETS

(UNAUDITED)

(In thousands)

 

   September 30,   December 31, 
   2014   2013 
ASSETS          
           
CURRENT ASSETS:          
Cash  $22,108   $31,967 
Restricted cash   383,250    399,333 
Notes receivable   66,984    60,054 
Restricted notes receivable   109,510    395,589 
Loan receivable   14,625    - 
Loan receivable - related party   -    4,540 
Accounts receivable, net   8,481    4,078 
Accounts receivable - related parties   2,153    2,942 
Other receivables, net   77,232    54,716 
Other receivables - related parties   71,980    54,106 
Inventories   250,017    212,921 
Advances on inventory purchase   43,374    44,897 
Advances on inventory purchase - related parties   127,899    83,003 
Prepaid expense and other   3,943    1,388 
Prepaid taxes   11,935    28,407 
Short-term investment   2,763    2,783 
TOTAL CURRENT ASSETS   1,196,254    1,380,724 
           
PLANT AND EQUIPMENT, net   1,516,009    1,271,907 
           
OTHER ASSETS:          
Advances on equipment purchase   15,655    6,409 
Investment in unconsolidated entities   16,742    16,943 
Long-term deferred expense   496    668 
Intangible assets, net of accumulated amortization   23,121    23,707 
TOTAL OTHER ASSETS   56,014    47,727 
           
TOTAL ASSETS  $2,768,277   $2,700,358 
           
LIABILITIES AND DEFICIENCY          
           
CURRENT LIABILITIES:          
Short term notes payable  $784,323   $1,017,830 
Accounts payable   589,283    434,979 
Accounts payable - related parties   265,744    235,692 
Short term loans - bank   248,289    301,917 
Short term loans - others   60,340    62,067 
Short term loans - related parties   223,460    126,693 
Current maturities of long-term loans - related party   67,249    53,013 
Other payables and accrued liabilities   50,568    45,653 
Other payable - related parties   101,475    94,079 
Customer deposits   186,807    87,860 
Customer deposits - related parties   113,674    64,881 
Deposit due to sales representatives   29,917    24,343 
Deposit due to sales representatives - related parties   2,308    1,997 
Taxes payable   3,930    4,628 
Deferred lease income, current   2,171    2,187 
Capital lease obligations, current   6,825    4,321 
TOTAL CURRENT LIABILITIES   2,736,363    2,562,140 
           
NON-CURRENT LIABILITIES:          
Long-term loans - related party   4,875    19,644 
Deferred lease income, noncurrent   73,077    75,257 
Capital lease obligations, noncurrent   388,615    375,019 
Profit sharing liability at fair value   149,363    162,295 
TOTAL NON-CURRENT LIABILITIES   615,930    632,215 
           
TOTAL LIABILITIES   3,352,293    3,194,355 
           
COMMITMENTS AND CONTINGENCIES          
           
DEFICIENCY:          
Preferred stock, $0.001 par value, 50,000,000 shares authorized, 3,092,899 shares issued and outstanding as of September 30, 2014 and December 31, 2013   3    3 
Common stock, $0.001 par value, 200,000,000 shares authorized, 58,394,688 and 58,234,688 shares issued, 55,922,382 and 55,762,382 shares outstanding as of September 30, 2014 and December 31, 2013, respectively   58    58 
Treasury stock, at cost, 2,472,306 shares as of September 30, 2014 and December 31, 2013   (4,199)   (4,199)
Paid-in-capital   107,249    106,878 
Statutory reserves   6,485    6,243 
Accumulated deficits   (472,871)   (414,798)
Accumulated other comprehensive income   (189)   729 
TOTAL GENERAL STEEL HOLDINGS, INC. DEFICIENCY   (363,464)   (305,086)
           
NONCONTROLLING INTERESTS   (220,552)   (188,911)
           
TOTAL DEFICIENCY   (584,016)   (493,997)
           
TOTAL LIABILITIES AND DEFICIENCY  $2,768,277   $2,700,358 

 

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

 

3
 

 

GENERAL STEEL HOLDINGS, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE (LOSS) INCOME

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2014 AND 2013

(UNAUDITED)

(In thousands, except per share data)

 

   For the three months ended September 30,   For the nine months ended September 30, 
   2014   2013   2014   2013 
                 
SALES  $456,142   $514,549   $1,476,784   $1,534,330 
                     
SALES - RELATED PARTIES   106,680    95,546    268,262    380,707 
TOTAL SALES   562,822    610,095    1,745,046    1,915,037 
                     
COST OF GOODS SOLD   447,263    511,932    1,460,018    1,550,829 
                     
COST OF GOODS SOLD - RELATED PARTIES   105,949    89,932    269,885    387,446 
TOTAL COST OF GOODS SOLD   553,212    601,864    1,729,903    1,938,275 
                     
GROSS PROFIT (LOSS)   9,610    8,231    15,143    (23,238)
                     
SELLING, GENERAL AND  ADMINISTRATIVE EXPENSES   (16,434)   (19,661)   (56,336)   (59,464)
CHANGE IN FAIR VALUE OF PROFIT SHARING LIABILITY   14,727    39,164    11,758    95,437 
                     
INCOME (LOSS) FROM OPERATIONS   7,903    27,734    (29,435)   12,735 
                     
OTHER INCOME (EXPENSE)                    
Interest income   2,767    2,835    10,025    8,657 
Finance/interest expense   (19,422)   (22,842)   (74,736)   (68,915)
Gain (loss) on disposal of equipment and intangible assets   (21)   17    (117)   113 
Income from equity investments   32    47    99    137 
Foreign currency transaction gain (loss)   3,146    322    1,329    448 
Lease income   542    542    1,630    1,613 
Other non-operating (expense) income, net   (18)   770    108    1,560 
Other expense, net   (12,974)   (18,309)   (61,662)   (56,387)
                     
(LOSS) INCOME BEFORE PROVISION FOR INCOME TAXES AND NONCONTROLLING INTEREST   (5,071)   9,425    (91,097)   (43,652)
                     
PROVISION FOR INCOME TAXES                    
Current   93    25    205    201 
Deferred   -    -    -    - 
Provision for income taxes   93    25    205    201 
                     
NET (LOSS) INCOME   (5,164)   9,400    (91,302)   (43,853)
                     
Less: Net (loss) income attributable to noncontrolling interest   (1,674)   5,599    (33,229)   (10,939)
                     
NET (LOSS) INCOME ATTRIBUTABLE TO GENERAL STEEL HOLDINGS, INC.  $(3,490)  $3,801   $(58,073)  $(32,914)
                     
NET (LOSS) INCOME  $(5,164)  $9,400   $(91,302)  $(43,853)
                     
OTHER COMPREHENSIVE (LOSS) INCOME                    
Foreign currency translation adjustments   (3,232)   (2,547)   509    (12,283)
                     
COMPREHENSIVE (LOSS) INCOME   (8,396)   6,853    (90,793)   (56,136)
                     
Less: Comprehensive (loss) income attributable to noncontrolling interest   (1,701)   4,782    (31,802)   (15,508)
                     
COMPREHENSIVE (LOSS) INCOME ATTRIBUTABLE TO GENERAL STEEL HOLDINGS, INC.  $(6,695)  $2,071   $(58,991)  $(40,628)
                     
WEIGHTED AVERAGE NUMBER OF SHARES                    
Basic and Diluted   55,878    55,141    55,845    54,976 
                     
(LOSS) INCOME PER SHARE                    
Basic and Diluted  $(0.06)  $0.07   $(1.04)  $(0.60)

  

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

 

4
 

  

GENERAL STEEL HOLDINGS, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2014 AND 2013

(UNAUDITED)

(In thousands)

  

   2014   2013 
CASH FLOWS FROM OPERATING ACTIVITIES:          
Net loss  $(91,302)  $(43,853)
Adjustments to reconcile net loss to cash provided by (used in) operating activities:          
Depreciation, amortization and depletion   71,696    64,955 
Change in fair value of derivative liabilities   -    (1)
Change in fair value of profit sharing liability   (11,758)   (95,437)
(Gain) loss on disposal of equipment and intangible assets   117    (113)
Recovery of doubtful accounts   (324)   (251)
Reservation of mine maintenance fee   403    315 
Stock issued for services and compensation   371    692 
Amortization of deferred financing cost on capital lease   14,585    15,338 
Income from equity investments   (99)   (137)
Foreign currency transaction gain   (1,329)   (448)
Deferred lease income   (1,630)   (1,613)
Changes in operating assets and liabilities          
Notes receivable   49,973    32,138 
Accounts receivable   (4,142)   (483)
Accounts receivable - related parties   768    11,968 
Other receivables   (22,765)   (3,466)
Other receivables - related parties   (18,291)   (55,744)
Inventories   (41,206)   4,191 
Advances on inventory purchases   1,195    1,996 
Advances on inventory purchases - related parties   (45,566)   (27,882)
Prepaid expense and other   (2,567)   (1,016)
Long-term deferred expense   167    373 
Prepaid taxes   16,286    8,250 
Accounts payable   (50,586)   113,592 
Accounts payable - related parties   17,178    54,364 
Other payables and accrued liabilities   4,979    (3,742)
Other payables - related parties   8,089    (12,844)
Customer deposits   99,726    (33,185)
Customer deposits - related parties   49,335    (7,981)
Taxes payable   (665)   (7,317)
Other noncurrent liabilities   -    1,384 
Net cash provided by operating activities   42,638    14,043 
           
CASH FLOWS FROM INVESTING ACTIVITIES:          
Restricted cash   13,174    (72,676)
Loans to related parties   -    1,460 
Cash proceeds from short term investment   -    (80)
Cash proceeds from sales of equipments and intangible assets   43    16 
Equipment purchase and intangible assets   (117,826)   (75,326)
Net cash used in investing activities   (104,609)   (146,606)
           
CASH FLOWS FINANCING ACTIVITIES:          
Capital contributed by noncontrolling interest   -    18,028 
Restricted notes receivable   283,563    10,218 
Borrowings on short term notes payable   1,264,884    1,348,631 
Payments on short term notes payable   (1,491,237)   (1,370,832)
Borrowings on short term loans - bank   286,852    258,357 
Payments on short term loans - bank   (337,007)   (155,390)
Borrowings on short term loan - others   47,755    148,678 
Payments on short term loans - others   (32,389)   (169,558)
Borrowings on short term loan - related parties   47,189    362,202 
Payments on short term loans - related parties   (23,353)   (274,718)
Deposits due to sales representatives   5,761    (6,521)
Deposit due to sales representatives - related parties   325    531 
Payments on long-term loans - related party   -    (22,856)
Principal payment on capital lease obligation   (1,285)   - 
Net cash provided by financing activities   51,058    146,770 
           
EFFECTS OF EXCHANGE RATE CHANGE IN CASH   1,054    1,417 
           
(DECREASE) INCREASE IN CASH   (9,859)   15,624 
           
CASH, beginning of period   31,967    46,467 
           
CASH, end of period  $22,108   $62,091 

 

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

 

5
 

  

GENERAL STEEL HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

Note 1 – Organization and Operations

 

General Steel Holdings, Inc. (the “Company”) was incorporated on August 5, 2002 in the state of Nevada. The Company through its 100% owned subsidiary, General Steel Investment, operates steel companies serving various industries in the People’s Republic of China (“PRC”). The Company’s main operation is manufacturing and sales of steel products such as steel rebar, hot-rolled carbon and silicon sheets and spiral-weld pipes. The Company, together with its subsidiaries, majority owned subsidiaries and variable interest entity, is referred to as the “Group”.

  

On April 29, 2011, a 20-year Unified Management Agreement (“the Agreement”) was entered into between the Company, the Company’s 60%-owned subsidiary Shaanxi Longmen Iron and Steel Co., Ltd. (“Longmen Joint Venture”), Shaanxi Coal and Chemical Industry Group Co., Ltd. (“Shaanxi Coal”) and Shaanxi Iron and Steel Group (“Shaanxi Steel”). Shaanxi Steel is the controlling shareholder of Shaanxi Longmen Iron and Steel Group Co., Ltd (“Long Steel Group”) which is the non-controlling interest holder in Longmen Joint Venture, and Shaanxi Coal, a state owned entity, is the parent company of Shaanxi Steel. Under the terms of the Agreement, all manufacturing machinery and equipment of Longmen Joint Venture and the $605.8 million (or approximately RMB 3.7 billion) of the constructed iron and steel making facilities owned by Shaanxi Steel, which includes one 400 m 2 sintering machine, two 1,280 m 3 blast furnaces, two 120 ton converters and some auxiliary systems, are managed collectively as a single virtual asset pool (“Asset Pool”). Longmen Joint Venture manages the Asset Pool as the principal operating entity and is responsible for the daily operations of the new and existing facilities. The Agreement leverages each of the parties’ operating strengths, allowing Longmen Joint Venture to derive the greatest benefit from the cooperation and the newly constructed iron and steel making facilities. At the designed efficiency level, the facilities contribute three million tons of crude steel production capacity per year.

 

Longmen Joint Venture pays Shaanxi Steel for the use of the constructed iron and steel making facilities an amount equaling the depreciation expense on the equipment constructed by Shaanxi Steel as well as 40% of the pre-tax profit generated by the Asset Pool. The remaining 60% of the pre-tax profit is allocated to Longmen Joint Venture. As a result, the Company’s economic interest in the profit or loss generated by Longmen Joint Venture decreased from 60% to 36%. However, the overall capacity under the management of Longmen Joint Venture increased by three million tons, or 75%. The Agreement improved Longmen Joint Venture’s cost structure through sustainable and steady sourcing of key raw materials and reduced transportation costs. The distribution of profit is subject to a prospective adjustment after the first two years based on each entity’s actual investment of time and resources into the Asset Pool. There has been no adjustment to the Agreement from its inception to the present time nor intention to make future adjustment by the Company and Shaanxi Steel.

 

The parties to the Agreement established the Shaanxi Longmen Iron and Steel Unified Management Supervisory Committee ("Supervisory Committee") to ensure that the facilities and related resources are operated and managed according to the stipulations set forth in the Agreement. The Board of Directors of Longmen Joint Venture, of which the Company holds 4 out of 7 seats, requires a simple majority vote and remains the controlling decision-making body of Longmen Joint Venture and the Asset Pool. See Note 2(c) “Consolidation of VIE.”

 

The Agreement constitutes an arrangement that involves a lease which meets certain of the criteria of a capital lease and therefore the assets constructed by Shaanxi Steel are accounted for by Longmen Joint Venture as a capital lease. The profit sharing liability portion of the lease obligation, representing 40% of the pre-tax profit generated by the Asset Pool, is accounted for by Longmen Joint Venture as a derivative financial instrument at fair value. See Notes 2 “Summary of significant accounting policies”, 15 “Capital lease obligations” and 16 “Profit sharing liability”.

 

Note 2 – Summary of significant accounting policies

 

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). The financial statements include the accounts of all directly, indirectly owned subsidiaries and the variable interest entity listed below. All material intercompany transactions and balances have been eliminated in consolidation. In the opinion of management, all adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation of the financial statements have been included. Interim results are not necessarily indicative of results to be expected for the full year. The information included in this Form 10-Q should be read in conjunction with information included in the 2013 annual report on Form 10-K/A filed on August 19, 2014.

 

6
 

 

(a)Basis of presentation

 

The consolidated financial statements of the Company reflect the activities of the following major directly owned subsidiaries: 

 

Subsidiary  Percentage
of Ownership
 
General Steel Investment Co., Ltd.  British Virgin Islands   100.0%
General Steel (China) Co., Ltd. (“General Steel (China)”)  PRC   100.0%
Baotou Steel – General Steel Special Steel Pipe Joint Venture Co., Ltd.  PRC   80.0%
Yangpu Shengtong Investment Co., Ltd. (“Yangpu Shengtong”)  PRC   99.1%
Tianjin Qiu Steel Investment Co., Ltd. (“Qiu Steel”)  PRC   98.7%
Longmen Joint Venture  PRC   VIE/60.0%
Maoming Hengda Steel Company, Ltd. (“Maoming Hengda”)  PRC   99.0%

 

Tianwu

 

Prior to November 19, 2013, the Company held a 60.0% equity interest in Tianwu General Steel Material Trading Co., Ltd. (“Tianwu”). 32% interest was held by General Steel (China) and 28% interest was held by Yangpu Shengtong. On November 19, 2013, the Company sold its 28% equity interest of Tianwu held by Yangpu Shengtong to Tianjin Dazhan Industry Co., Ltd., a related party through indirect common ownership, for $13.6 million (RMB 84.3 million) while retaining 32% interest held by General Steel (China). As a result of this transaction, the Company met the criteria under ASC 810-10-40-4 to deconsolidate Tianwu at the disposal date and recognized a gain of $1.0 million in the fourth quarter of 2013 in accordance with ASC 810-10-40-5. At the same time, General Steel (China)’s remaining 32% interest is accounted for as an investment in unconsolidated subsidiaries using the equity method. See Note 2(t) - Investments in unconsolidated entities for details.

  

  (b) Principles of consolidation – subsidiaries

  

The accompanying unaudited condensed consolidated financial statements include the financial statements of the Company, its subsidiaries, its variable interest entity (“VIE”) for which the Company is the ultimate primary beneficiary, and the VIE’s subsidiaries.

 

Subsidiaries are those entities in which the Company, directly or indirectly, controls more than one half of the voting power; or has the power to govern the financial and operating policies, to appoint or remove the majority of the members of the board of directors, or to cast a majority of votes at the meeting of directors.  

 

A VIE is an entity in which the Company, or its subsidiary, through contractual arrangements, bears the risks of, and enjoys the rewards normally associated with ownership of the entity, and therefore the Company or its subsidiary is the primary beneficiary of the entity. 

 

All significant inter-company transactions and balances have been eliminated upon consolidation.

 

  (c) Consolidation of VIE

 

Prior to entering into the Unified Management Agreement on April 29, 2011, Longmen Joint Venture had been consolidated as the Company’s 60% direct owned subsidiary. Upon entering into the Unified Management Agreement on April 29, 2011, Longmen Joint Venture was re-evaluated by the Company to determine if Longmen Joint Venture is a VIE and if the Company is the primary beneficiary.

 

Longmen Joint Venture’s equity at risk is considered insufficient to finance its activities and therefore Longmen Joint Venture is considered to be a VIE.

 

The Company would be considered the primary beneficiary of the VIE if it has both of the following characteristics:

 

  a. The power to direct the activities of the VIE that most significantly impact the VIE’s economic performance; and
  b. The obligation to absorb losses of the VIE that could potentially be significant to the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE.

 

A Supervisory Committee was formed during the negotiation of the Unified Management Agreement. Given there is both a Supervisory Committee and a Board of Directors with respect to Longmen Joint Venture , the powers (rights and roles) of both bodies were considered to determine which party has the power to direct the activities of Longmen Joint Venture, and by extension, whether the Company continues to have the power to direct Longmen Joint Venture’s activities after this Supervisory Committee was formed and the significant investment in plant and equipment by owners of the Longmen Joint Venture partner. The Supervisory Committee, in which the Company holds 2 out of 4 seats, requires a ¾ majority vote, while the Board of Directors, on which the Company holds 4 out of 7 seats, requires a simple majority vote. As the Supervisory Committee’s role is limited to supervising and monitoring management of Longmen Joint Venture and in the event there is any disagreement between the Board and the Supervisory Committee, the Board prevails, the Supervisory Committee is considered subordinate to the Board. Thus, the Board of Directors of Longmen Joint Venture continues to be the controlling decision-making body with respect to Longmen Joint Venture. The Company, which controls 60% of the voting rights of the Board of Directors, has control over the operations of Longmen Joint Venture and as such, has the power to direct the activities of the VIE that most significantly impact Longmen Joint Venture’s economic performance.

 

7
 

 

In connection with the Unified Management Agreement, the Company, Shaanxi Coal and Shaanxi Steel may provide such support on a discretionary basis or as needed in the future. See Note 2 item (d) Liquidity.

 

The Company has the obligation to absorb losses and the rights to receive benefits based on the profit allocation as stipulated by the Unified Management Agreement that are significant to the VIE. As both conditions are met, the Company is the primary beneficiary of Longmen Joint Venture and therefore, continues to consolidate Longmen Joint Venture as a VIE.

 

The Company believes that the Unified Management Agreement between Longmen Joint Venture and Shaanxi Coal is in compliance with PRC law and is legally enforceable. However, PRC law and/or uncertainties in the PRC legal system could limit the Company’s ability to enforce the Unified Management Agreement, which in turn, may lead to reconsideration of the VIE assessment and the potential for a different conclusion. If the Unified Management Agreement cannot be enforced, the Company would not consolidate Longmen Joint Venture as a VIE. However, the current PRC legal system has not limited the Company’s ability to enforce the Unified Management Agreement nor does the Company believe it is likely to do so in the future. The Company makes an ongoing assessment to determine whether Longmen Joint Venture is a VIE.

 

The carrying amount of the VIE and its subsidiaries’ consolidated assets and liabilities are as follows:

 

   September 30, 2014   December 31, 2013 
   (in thousands)   (in thousands) 
Current assets  $1,037,052   $1,282,054 
Plant and equipment, net   1,508,595    1,262,144 
Other noncurrent assets   37,724    29,014 
Total assets   2,583,371    2,573,212 
Total liabilities   3,145,353    (3,040,879)
Net liabilities  $(561,982)  $(467,667)

 

VIE and its subsidiaries’ liabilities consist of the following:

 

   September 30, 2014   December 31, 2013 
   (in thousands)   (in thousands) 
Current liabilities:          
Short term notes payable  $776,198   $988,364 
Accounts payable   579,077    393,816 
Accounts payable - related parties   257,548    235,116 
Short term loans - bank   204,576    267,688 
Short term loans - others   54,163    55,844 
Short term loans - related parties   222,792    125,236 
Current maturities of long-term loans – related party   56,199    56,614 
Other payables and accrued liabilities   41,277    37, 028 
Other payables - related parties   96,094    88,914 
Customer deposits   108,340    87,661 
Customer deposits - related parties   17,876    18,359 
Deposit due to sales representatives   29,917    24,343 
Deposit due to sales representatives – related parties   2,308    1,997 
Taxes payable   2,511    3,357 
Deferred lease income   2,171    2,187 
Capital lease obligations, current   6,825    4,321 
Intercompany payable to be eliminated   60,501    21,420 
Total current liabilities   2,518,373    2,412,265 
Non-current liabilities:          
Long term loans - related parties   15,925    16,043 
Deferred lease income - noncurrent   73,077    75,257 
Capital lease obligations, noncurrent   388,615    375,019 
Profit sharing liability at fair value   149,363    162,295 
Total non-current liabilities   626,980    628,614 
Total liabilities of consolidated VIE  $3,145,353   $3,040,879 

 

8
 

 

   Three months ended
September 30, 2014
   Three months ended
September 30, 2013
 
   (in thousands)   (in thousands) 
Sales  $559,317   $606,444 
Gross profit  $9,010   $8,122 
Income from operations  $9,746   $30,306 
Net income attributable to controlling interest  $(3,378)  $8,284 

 

   Nine months ended
September 30, 2014
   Nine months ended
September 30, 2013
 
   (in thousands)   (in thousands) 
Sales  $1,740,645   $1,903,933 
Gross profit (loss)  $15,020   $(23,704)
(Loss) income from operations  $(21,420)  $20,558 
Net loss attributable to controlling interest  $(49,489)  $(18,335)

 

Longmen Joint Venture has two 100% owned subsidiaries, Yuxin Trading Co., Ltd. (“Yuxin”) and Yuteng Trading Co., Ltd. (“Yuteng”). Longmen Joint Venture also has two consolidated subsidiaries, Hualong and Huatianyulong, in which it does not hold a controlling interest. Hualong and Huatianyulong are separate legal entities which were established in the PRC as limited liability companies and subsequently invested in by Longmen Joint Venture in June 2007 and July 2008, respectively. However, these two entities do not meet the definition of variable interest entities. Further consideration was given to whether consolidation was appropriate under the voting interest model, specifically where the power of control may exist with a lesser percentage of ownership (i.e. less than 50%), for example, by contract, lease, agreement with other stockholders or by court decree.

 

Hualong

 

Longmen Joint Venture, the single largest shareholder, holds a 36.0% equity interest in Hualong. The other two shareholders, who own 34.67% and 29.33% respectively, assigned their voting rights to Longmen Joint Venture in writing at the time of the acquisition of Hualong. The voting rights have been assigned through the date Hualong ceases its business operations or the other two shareholders sell their interest in Hualong. Hualong’s main business is to supply refractory. The assets, liabilities and the operating results of Hualong are immaterial to the Company’s consolidated financial statements as of September 30, 2014 and December 31, 2013, respectively, and for the three and nine months ended September 30, 2014 and 2013, respectively.

 

Huatianyulong

 

Longmen Joint Venture holds a 50.0% equity interest in Huatianyulong and the other unrelated shareholder holds the remaining 50.0%. The other shareholder assigned its voting rights to Longmen Joint Venture in writing at the time of acquisition of Huatianyulong. The voting rights have been assigned through the date Huatianyulong ceases its business operation or the other unrelated shareholder sells its interest in Huatianyulong. Huatianyulong mainly sells imported iron ore. The assets, liabilities and the operating results of Huatianyulong are immaterial to the Company’s consolidated financial statements as of September 30, 2014 and December 31, 2013, respectively, and for the three and nine months ended September 30, 2014 and 2013, respectively.

 

The Company has determined that it is appropriate for Longmen Joint Venture to consolidate Hualong and Huatianyulong with appropriate recognition in the Company’s financial statements of the non-controlling interests in each entity, beginning on the acquisition dates as these were also the effective dates of the agreements with other stockholders granting majority voting rights in each entity, and thereby, the power of control, to Longmen Joint Venture.

  

(d)Liquidity

 

The Company’s accounts have been prepared under the going concern basis. The going concern basis assumes that assets are realized and liabilities are extinguished in the ordinary course of business at amounts disclosed in the financial statements. The Company’s ability to continue as a going concern depends upon aligning its sources of funding options (debt and equity) with the expenditure requirements of the Company and repayment of the short-term debt facilities as and when they fall due.

 

The steel business is capital intensive and as a normal industry practice in the PRC, the Company is highly leveraged. Debt financing in the form of short term bank loans, loans from related parties, financing sales, bank acceptance notes, and capital leases have been utilized to finance the working capital requirements and the capital expenditures of the Company. As a result, the Company’s debt to equity ratio as of September 30, 2014 and December 31, 2013 were (5.7) and (6.5), respectively. As of September 30, 2014, the Company’s current liabilities exceed current assets by $1.5 billion.

 

9
 

 

Longmen Joint Venture, as the most important entity of the Company, accounted for a majority of the total sales of the Company. As such, the majority of the Company’s working capital needs come from Longmen Joint Venture. The Company’s ability to continue as a going concern depends heavily on Longmen Joint Venture’s operations, as well as its ability to obtain external financial supports, including but not limited to lines of credit from banks and vendor financing. If Longmen Joint Venture does not maintain a sufficient level of financial support by renewing its financing terms with existing financing sources or obtaining new sources of financial support, there may be an immediate negative impact on the Company’s operations and its ability to continue as a going concern. Longmen Joint Venture has obtained different types of financial support, which are listed below by category:

 

Lines of credit

 

The Company has lines of credit from the listed major banks totaling $141.4 million with expiration dates ranging from November 28, 2015 to January 30, 2016.

 

Banks  Amount of
Line of Credit
(in millions)
   Repayment Date
China Minsheng Bank   97.5   November 28, 2015
China Everbright Bank   19.5   January 21, 2016
Huaxia Bank   24.4   January 30, 2016
Total  $141.4    

 

As of the date of this report, the Company utilized $80.0 million of these lines of credit.

 

Vendor financing

 

Longmen Joint Venture signed additional vendor financing agreements, which will provide liquidity to the Company in a total amount of $893.8 million with the following companies:

 

Company  Financing Period  Financing Amount
(in millions)
 
         
Company A – related party  July 30, 2014 – July 30, 2019  $243.8 
Company B – third party  January 22, 2014 – January 22, 2017   162.5 
Company C – third party  October 1, 2013 – March 31, 2016   487.5 
Total     $893.8 

 

Company A, a related party company and Company B, a third party company, are both Longmen Joint Venture’s major coke suppliers. They have been doing business with Longmen Joint Venture for many years. On July 30, 2014, Company A signed a five-year agreement with Longmen Joint Venture to finance its coke purchases up to $243.8 million. Company B signed a three-year agreement with Longmen Joint Venture on January 22, 2014 to finance its coke purchases up to $162.5 million. According to the above signed agreements, both Company A and B will not demand any cash payments during their respective financing periods. As of the date of this report, the Company’s payables to Company A and Company B were approximately $72.2 million and $78.6 million, respectively.

 

Company C is a Fortune 500 Company. On June 28, 2013, Company C signed an agreement with Longmen Joint Venture to finance Longmen Joint Venture’s purchase of iron ore for an amount up to $487.5 million to commence on October 1, 2013 and end on March 31, 2015. On August 1, 2014, Company C signed an extension agreement with the Company and extended the financing terms to March 31, 2016. Subject to the terms of the agreement, Longmen Joint Venture is subject to a penalty of 0.05% of the daily outstanding balance owed to Company C in an event of late payment. As of the date of this report, the Company did not have payable to Company C.

 

Other financing

 

On March 5, 2014, April 22, 2014, April 23, 2014, and October 30, 2014, Longmen Joint Venture signed two-to-three-year payment extension agreements with Company D, E, F, G, H and I listed below. In addition, Shaanxi Steel, a related party, agreed to finance the construction of Longmen Joint Venture’s #5 blast furnace, which commenced in March 2013, for construction-related payments up to $321.8 million (RMB 1.98 billion) and would not demand payment from Longmen Joint Venture until it would have available funds for repayment. As of September 30, 2014, Longmen Joint Venture’s payable related to the construction of the #5 blast furnace amounted to $218.9 million. In total, Longmen Joint Venture can obtain $662.6 million in financial support from payment extensions granted by the following seven companies:

 

10
 

 

Company  Financing Period  Financing Amount
(in millions)
 
        
Company D – related party  April 22, 2014 – April 22, 2017  $81.3 
Company E – related party  April 23, 2014 – April 23, 2017   86.0 
Company F – related party  April 22, 2014 – April 22, 2017   81.3 
Company G – related party  March 5, 2014 – March 5, 2016   56.9 
Company H – related party  March 5, 2014 – March 5, 2016   56.9 
Company I – related party  October 30, 2014 – October 30, 2017   81.3 
Shaanxi Steel – related party  Extended until funds available for repayment   218.9 
Total     $662.6 

 

As of the date of this report, our payables to Company D, Company E, Company F, Company G, Company H, Company I and Shaanxi Steel are approximately $16.3 million, $41.4 million, $11.6 million, $0, $0, $0 and $81.3 million, respectively.

 

Amount due to sales representatives

 

Longmen Joint Venture entered into agreements with various entities to act as the Company’s exclusive sales agents in specified geographic areas.  These exclusive sales agents must meet certain criteria and are required to deposit a certain amount of money with the Company. In return, the sales agents receive exclusive sales rights in a specified area and discounted prices on products they order. These deposits bear no interest and are required to be returned to the sales agent once the agreement is terminated. As of September 30, 2014, Longmen Joint Venture has collected a total amount of $32.2 million. Historically, this amount is quite stable and we do not expect a big fluctuation in this amount for the next twelve months from September 30, 2014 onwards.

 

With the financial support from the banks and the companies above, management is of the opinion that the Company has sufficient funds to meet its future operations, working capital requirements and debt obligations until the end of September 30, 2015. The detailed breakdown of Longmen Joint Venture’s estimated cash flows are listed below.

 

   Cash inflow (outflow)
(in millions)
 
   For the twelve months
ending September 30,
2015
 
Current liabilities over current assets (excluding deferred lease income) as of September 30, 2014 (unaudited)  $(1,537.9)
Projected cash financing and outflows:     
Cash provided by lines of credit from banks   141.4 
Cash provided by vendor financing   893.8 
Cash provided by other financing   662.6 
Cash provided by sales representatives   32.2 
Cash projected to be used in operations in the twelve months ending September 30, 2015   (33.5)
Cash projected to be used for financing cost in the twelve months ending September 30, 2015   (58.0)
Net projected change in cash for the twelve months ending September 30, 2015  $100.6 

 

As a result, the unaudited condensed consolidated financial statements as of September 30, 2014 have been prepared on a going concern basis.

  

(e)Use of estimates

 

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the accompanying consolidated financial statements and footnotes. Significant accounting estimates reflected in the Company’s consolidated financial statements include the fair value of the profit sharing liability, the useful lives of and impairment of property, plant and equipment, potential losses on uncollectible receivables, the allowance for inventory valuation, the interest rate used in the financing sales, the fair value of the assets recorded under capital leases and the present value of the net minimum lease payments of the capital leases. Actual results could differ from these estimates.

 

(f)Concentration of risks and uncertainties

 

The Company’s operations are carried out 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’s economy. The Company’s operations in the PRC are subject to specific considerations and significant risks not typically associated with companies in North America and Western Europe. The Company’s results may be adversely affected by changes in governmental policies with respect to laws and regulations, anti-inflationary measures, currency conversion and remittance abroad, and rates and methods of taxation, among other things.

 

11
 

 

The Company has significant exposure to the price fluctuation of raw materials and energy prices as part of its normal operations. The Company does not utilize any open commodity contracts to mitigate such risks.

 

Cash includes demand deposits in accounts maintained with banks within the PRC, Hong Kong and the United States. Total cash (including restricted cash balances) in these banks on September 30, 2014 and December 31, 2013 amounted to $405.4 million and $431.3 million, including $ 5.1 million and $ 2.0 million that were deposited in Shaanxi Coal and Chemical Industry Group Financial Co., Ltd., a related party, respectively. As of September 30, 2014, $ 0.1 million cash in the bank was covered by insurance. The Company has not experienced any losses in its bank accounts and deposits its cash in a number of different banks to minimize its exposure to credit risk.

 

The Company’s five major customers are all distributors and collectively represented 16.0% and 16.9% of the Company’s total sales for the three and nine months ended September 30, 2014, respectively. None of the five major customers accounted for more than 10% of the total sales for the three and nine months ended September 30, 2014. The Company’s five major customers represented 25.5% and 23.4% of the Company’s total sales for the three and nine months ended September 30, 2013, respectively. None of the five major customers individually accounted for more than 10% of the total sales for the three months or the nine months ended September 30, 2013. None of the five major customers has accounts receivable, including related parties, with the Company as of September 30, 2014 and December 31, 2013, respectively.

 

For the three and nine months ended September 30, 2014, the Company purchased 18.8% and 29.5% of its raw materials from five major suppliers, respectively. None of the five major suppliers individually accounted for more than 10% of the total purchases for the three and nine months end September 30, 2014. Purchases from the five major suppliers represented 15.3% and 29.3% of the Company’s total purchases for the three months and nine months ended September 30, 2013, respectively. None of the five major suppliers individually accounted for more than 10% of the total purchases for the three months or nine months ended September 30, 2013, respectively. These five suppliers accounted for 25.7% and 29.1% of total accounts payable, including related parties, as of September 30, 2014 and December 31, 2013, respectively. None of the five major suppliers individually accounted for more than 10% of total accounts payable as September 30, 2014 and December 31, 2013.

 

(g)Foreign currency translation and other comprehensive income

 

The reporting currency of the Company is the U.S. dollar. The Company’s subsidiaries and VIE in China use the local currency, Renminbi (“RMB”), as their functional currency. Assets and liabilities are translated at the unified exchange rate as quoted by the People’s Bank of China at the end of the period. The statements of operations are translated at the average translation rates and the equity accounts are translated at historical rates. Translation adjustments resulting from this process are included in accumulated other comprehensive income in the statement of equity. Transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the functional currency are included in the results of operations as incurred. 

 

Translation adjustments included in accumulated other comprehensive income amounted to $(0.2) million and $0.7 million as of September 30, 2014 and December 31, 2013, respectively. The balance sheet amounts, with the exception of equity, at September 30, 2014 and December 31, 2013 were translated at 6.15 RMB and 6.11 RMB to $1.00, respectively. The equity accounts were stated at their historical rate. The average translation rates applied to the statements of operations for the three months ended September 30, 2014 and 2013 were 6.16 RMB and 6.16 RMB, respectively. The average translation rates applied to the statements of operations for the nine months ended September 30, 2014 and 2013 were 6.15 RMB and 6.21 RMB, respectively. Cash flows are also translated at average translation rates for the periods; as a result, amounts reported on the statement of cash flows will not necessarily agree with changes in the corresponding balances in the consolidated balance sheet.

 

The PRC government imposes significant exchange restrictions on fund transfers out of the PRC that are not related to business operations. These restrictions have not had a material impact on the Company because it has not engaged in any significant transactions that are subject to the restrictions.

 

(h)Financial instruments

 

The accounting standard regarding fair value of financial instruments and related fair value measurements defines financial instruments and requires disclosure of the fair value of financial instruments held by the Company. The Company considers the carrying amount of cash, short term investments, accounts receivable, other receivables, accounts payable and accrued liabilities, to approximate their fair values because of the short period of time between the origination of such instruments and their expected realization. For short term loans and notes payable, the Company concluded the carrying values are a reasonable estimate of fair values because of the short period of time between the origination and repayment and as their stated interest rates approximate current rates available. The carrying value of the long term loans-related party approximates its fair value as of the reporting date as their stated interest rates approximate current rates available.

 

The accounting standards define fair value, establish a three-level valuation hierarchy for disclosures of fair value measurement and enhance disclosure requirements for fair value measures. The three levels are defined as follow:

 

12
 

 

  · Level 1 inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.
  · Level 2 inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the assets or liability, either directly or indirectly, for substantially the full term of the financial instruments.
  · Level 3 inputs to the valuation methodology are unobservable and significant to the fair value.

 

The Company analyzes all financial instruments with features of both liabilities and equity, pursuant to which warrants previously issued by the Company were required to be recorded as a liability at fair value and marked to market each reporting period. The warrants were accounted for as derivative liabilities and recorded at their fair value, with the change in fair value charged or credited to income each period.  The warrants expired unexercised on May 13, 2013. Prior to their expiration, the fair value of the warrants was estimated using a binomial lattice model, using level 3 inputs.

 

As described in Note 15 - Capital lease obligations, payments related to the capital lease of the Asset Pool consist of two components: (1) a fixed monthly payment of $2.3 million (RMB 14.6 million), based on Shaanxi Steel’s cost to construct the assets, to be paid for the 20 year term of the Unified Management Agreement; and (2) 40% of any remaining pre-tax profits from the Asset Pool, which includes Longmen Joint Venture and the constructed iron and steel making facilities. The aforementioned profit sharing component meets the definition of a derivative instrument under ASC 815-10-15-83 and, accordingly, the profit sharing liability is accounted for separately as a derivative liability. It was recognized initially at its estimated fair value at inception. The estimated fair value is adjusted each reporting period, with changes in the estimated fair value of the profit sharing liability charged or credited to operating income each period.

 

The Company determines the fair value of the profit sharing liability using Level 3 inputs by considering the present value of Longmen Joint Venture’s projected profits/losses, discounted based on our average borrowing rate, which is currently 7.3%.

 

The fair value of the profit sharing liability will change each period as a result of (a) any changes in our estimate of Longmen Joint Venture’s projected profits/losses over the remaining term of the Agreement, (b) any change in the discount rate used, based on changes in our current or expected borrowing rate, (c) the change in fair value related to the passage of time and change in the number of future periods over which the present value of future cash flows is estimated and (d) any difference between the previously estimated operating results for the current period and actual results.

 

Each period, the Company considers whether the discount rate based on the Company’s average borrowing rate should be adjusted based upon the current and expected future financial condition of the Company. To date, the Company has not considered any adjustment to be necessary based upon, but not limited to, the following assumptions:

 

  · because the joint venture partner of Longmen Joint Venture is a state-owned enterprise with an excellent credit history, PRC banks grant similar credit treatment to Longmen Joint Venture in terms of credit availability
  · the current average borrowing rate of enterprises in the steel industry in the PRC is similar to this borrowing rate
  · the current new/renewal borrowing rates of the Company’s bank loans are similar to prior periods
  · the People’s Bank of China has not recently adjusted any borrowing rate  
  · PRC bank interest rates are not industry specific. The downtrend in the steel industry did not materially impact the bank borrowing rates for steel companies
  · the bank interest rates are assessed by each individual bank and governed by the Chinese banking regulatory bodies. Reports from credit rating research firms are not commonly used by PRC banks

 

The projected profits/losses in Longmen Joint Venture are based upon, but not limited to, the following assumptions:

 

  · projected selling units and growth in the steel market
  · projected unit selling price in the steel market
  · projected unit purchase cost in the coal and iron ore markets
  · selling and general and administrative expenses to be in line with the growth in the steel market
  · projected bank borrowings
  · interest rate index
  · gross national product index
  · industry index
  · government policy

 

From inception to December 31, 2012, the assumptions underlying the estimated fair value did not change significantly. Beginning in the first quarter of 2013, the assumptions related to unit selling prices and costs were revised, resulting in a reduction of the estimated profit sharing liability. These assumptions were further revised during 2013. The above assumptions were again reviewed by the Company at September 30, 2014 and the assumptions related to the projected growth in the steel market and costs were revised, resulting in a further reduction of the estimated profit sharing liability. For the nine months ended September 30, 2014, the Company recognized a gain on the change in the fair value of the profit sharing liability of $11.8 million due to a $17.1 million reduction in the fair value of profit sharing liability resulting from the change in estimates of future operating profits and a $3.4 million reduction resulting from the Asset Pool’s operating results for the nine months ended September 30, 2014 being slightly less favorable than previously estimated as of December 31, 2013, offset by a $8.8 million loss from the present value discount. The estimated fair value of the profit sharing liability at September 30, 2014 is $149.4 million.

 

13
 

 

Changes in any of the assumptions used to estimate the fair value of the profit sharing liability will change the liability accordingly. If we were to reduce the projected bank borrowing rate used to discount the liability to a present value by 1.0% and other factors remained unchanged, our profit sharing liability as of September 30, 2014 would have been $170.5 million and we would decrease the gain from the change in the fair value of the profit sharing liability by $21.2 million. If we were to reduce the projected selling units and growth in the steel market rate by 1.0% and other factors remained unchanged, our profit sharing liability as of September 30, 2014 would have been $142.6 million and we would increase the gain from the change in the fair value of the profit sharing liability by $6.8 million.

 

The following table sets forth by level within the fair value hierarchy, the Company’s financial assets and liabilities that were accounted for at fair value on a recurring basis as of September 30, 2014:

 

(in thousands)  Carrying Value as
of September 30,
2014
   Fair Value Measurements at September 30,
2014
Using Fair Value Hierarchy
 
       Level 1   Level 2   Level 3 
Profit sharing liability  $149,363   $-   $-   $149,363 
Total  $149,363   $-   $-   $149,363 

 

The following table sets forth by level within the fair value hierarchy the Company’s financial assets and liabilities that were accounted for at fair value on a recurring basis as of December 31, 2013:

 

(in thousands)  Carrying Value as
of December 31,
2013
   Fair Value Measurements at December 31,
2013
Using Fair Value Hierarchy
 
       Level 1   Level 2   Level 3 
Profit sharing liability  $162,295   $-   $-   $162,295 
Total  $162,295   $-   $-   $162,295 

 

The following is a reconciliation of the beginning and ending balance of the assets and liabilities measured at fair value on a recurring basis for the nine months ended September 30, 2014 and for the year ended December 31, 2013:

 

   September 30, 2014   December 31, 2013 
   (in thousands)   (in thousands) 
Beginning balance  $162,295   $328,828 
Change in fair value of profit sharing liability:          
Change in estimate of future operating profits   (17,146)   (183,528)
Change in discount rate   -    - 
Interest expense - present value discount amortization   8,795    16,872 
Difference between the previously estimated operating results for the current period and actual results   (3,407)   (7,913)
Change in derivative liabilities - warrants   -    1 
Exchange rate effect   (1,174)   8,035 
Ending balance  $149,363   $162,295 

 

Except for the derivative liabilities related to the profit sharing liability and to the warrants issued by the Company, which expired on May 13, 2013, the Company did not identify any other assets or liabilities that are required to be presented on the balance sheet at fair value.

 

(i)Notes receivable

 

Notes receivable represents trade accounts receivable due from various customers where the customers’ banks have guaranteed the payment. The notes are non-interest bearing and normally paid within three to six months. The Company has the ability to submit requests for payment to the customer’s bank earlier than the scheduled payment date, but will incur an interest charge and a processing fee.

 

Restricted notes receivable represents notes receivable pledged as collateral for short-term loans and short-term notes payable issued by banks.

 

14
 

 

Interest expense for early submission requests for payment for the three months ended September 30, 2014 and 2013 amounted to $10.2 million and 9.6 million, respectively, and amounted to $37.1 million and $26.9 million, respectively, for the nine months ended September 30, 2014 and 2013.

 

(j)Plant and equipment, net

 

Plant and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets with a 3%-5% residual value. The depreciation expense on assets acquired under capital leases is included with depreciation expense on owned assets. The estimated useful lives are as follows:

 

Buildings and improvements   10-40 Years
Machinery   10-30 Years
Machinery and equipment under capital lease   10-20 Years
Other equipment   5 Years
Transportation equipment   5 Years

  

The Company assesses all significant leases for purposes of classification as either operating or capital. At lease inception, if the lease meets any of the four following criteria, the Company will account for it as a capital lease; otherwise it will be treated as an operating lease: a) transfer of ownership to lessee at the end of the lease term, b) bargain purchase option, c) lease term is equal to 75% or more of the estimated economic life of the leased property, d) the present value of the minimum lease payments is 90% or more of the fair value of the leased asset.

 

Construction in progress represents the costs incurred in connection with the construction of buildings or new additions to the Company’s plant facilities. No depreciation is provided for construction in progress until such time as the assets are completed and are placed into service. Maintenance, repairs and minor renewals are charged directly to expense as incurred. Major additions and betterments to buildings and equipment are capitalized. Interest incurred during construction is capitalized into construction in progress. All other interest is expensed as incurred.

 

Long lived assets, including buildings and improvements, equipment and intangible assets, are reviewed if events and changes in circumstances indicate that their carrying amount may not be recoverable, to determine whether their carrying value has become impaired. The Company considers assets to be impaired if the carrying value exceeds the future projected cash flows from related operations. The Company also re-evaluates the periods of depreciation and amortization to determine whether subsequent events and circumstances warrant revised estimates of useful lives.

 

(k)Intangible assets

 

Finite lived intangible assets of the Company are reviewed for impairment if events and circumstances require. The Company considers assets to be impaired if the carrying value exceeds the future projected cash flows from related operations. The Company also re-evaluates the periods of amortization to determine whether subsequent events and circumstances warrant revised estimates of useful lives.  As of September 30, 2014, the Company expects these assets to be fully recoverable.

 

Land use rights

 

All land in the PRC is owned by the government. However, the government grants “land use rights.”  General Steel (China) acquired land use rights in 2001 for a total of $3.9 million (RMB 23.7 million). These land use rights are for 50 years and expire in 2050 and 2053. The Company amortizes the land use rights over the twenty-year business term because its business license has a twenty-year term.

 

Long Steel Group contributed land use rights for a total amount of $24.1 million (RMB 148.3 million) to the Longmen Joint Venture. The contributed land use rights are for 50 years and expire in 2048 to 2052.

 

Maoming Hengda has land use rights amounting to $2.7 million (RMB 16.6 million) for 50 years that expire in 2054.

 

Other than the land use rights that General Steel (China) acquired in 2001, the Company amortizes the land use rights over their 50 year term.

  

Entity  Original Cost   Expires in 
   (in thousands)     
General Steel (China)  $3,856    2050 & 2053 
Longmen Joint Venture  $24,097    2048 & 2052 
Maoming Hengda  $2,697    2054 

 

15
 

 

Mining right

 

Mining rights are capitalized at cost when acquired, including amounts associated with any value beyond proven and probable reserves, and amortized to operations as depletion expense using the units-of-production method over the estimated proven and probable recoverable tons. Longmen Joint Venture has iron ore mining rights amounting to $2.4 million (RMB 15.0 million), which is amortized over the estimated recoverable reserve of 4.2 million tons.

  

(l)Investments in unconsolidated entities

 

Entities in which the Company has the ability to exercise significant influence, but does not have a controlling interest, are accounted for using the equity method. Significant influence is generally considered to exist when the Company has an ownership interest in the voting stock between 20% and 50%, and other factors, such as representation on the Board of Directors, voting rights and the impact of commercial arrangements, are considered in determining whether the equity method of accounting is appropriate. The Company accounts for investments with ownership less than 20% using the cost method.

 

The table below summarizes Longmen Joint Venture’s investment holdings as of September 30, 2014 and December 31, 2013.

 

Unconsolidated entities  Year
acquired
   September 30,
2014
Net investment
(In thousands)
   Owned
%
   December 31,
2013
Net investment
(In thousands)
   Owned
%
 
Xi’an Delong Powder Engineering Materials Co., Ltd.   2007   $1,130    24.1   $1,215    24.1 

 

The table below summarizes General Steel (China)’s investment holding (see Note 2(a) - Basis of presentation) as of September 30, 2014 and December 31, 2013.

 

Unconsolidated entities  Year
acquired
   September 30,
2014
Net investment
(In thousands)
   Owned
%
   December 31,
2013
Net investment
(In thousands)
   Owned
%
 
Tianwu General Steel Material Trading Co., Ltd.   2010   $15,612    32.0   $15,728    32.0 

 

Total investment income in unconsolidated subsidiaries amounted to $0.03 million and $0.05 million for the three months ended September 30, 2014 and 2013, respectively, and $0.1 million and $0.1 million for the nine months ended September 30, 2014 and 2013, respectively, which was included in “Income from equity investments” in the condensed consolidated statements of operations and comprehensive (loss) income.

 

(m)Revenue recognition

 

Sales are recognized at the date of shipment to customers when a formal arrangement exists, the price is fixed or determinable, the delivery is completed, the Company has no other significant obligations and collectability is reasonably assured. Payments received before all of the relevant criteria for revenue recognition are met are recorded as customer deposits. Sales represent the invoiced value of goods, net of value-added tax (VAT). All of the Company’s products sold in the PRC are subject to a Chinese value-added tax at a rate of 13% or 17% of the gross sales price. This VAT may be offset by VAT paid by the Company on raw materials and other materials included in the cost of producing the finished product.

 

The Company infrequently engages in trading transactions in which the Company acts as an agent between the suppliers and the customers. The trading arrangements are such that the suppliers are the primary obligors, the Company does not have any general inventory risk, physical inventory loss risk or credit risk, and the Company does not have latitude in establishing price. Sales and cost of goods sold from these trading arrangements are recorded at the net amount in accordance with ASC 605-45.

 

(n)Recently issued accounting pronouncements

 

In June 2014, FASB issued Accounting Standards Update (ASU) No. 2014-12 Compensation – Stock Compensation (Topic 718), Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period. The amendments stipulate that a performance target in a share-based payment that affects vesting and that could be achieved after the requisite service period should be accounted for as a performance condition under Accounting Standards Codification (ASC) 718, Compensation — Stock Compensation. As a result, the target is not reflected in the estimation of the award’s grant date fair value. Compensation cost should be recognized over the required service period, if it is probable that the performance condition would be achieved. The amendments in this Accounting Standards Update are effective for annual periods beginning after December 15, 2015 and interim periods within those annual periods. Early adoption is permitted. The Company does not expect the adoption of ASU 2014-12 to have a material impact on the Company’s condensed consolidated financial statements.

 

16
 

 

In August 2014, FASB issued Accounting Standards Update (ASU) No. 2014-15 Preparation of Financial Statements - Going Concern (Subtopic 205-40), Disclosure of Uncertainties about an Entity's Ability to Continue as a Going Concern. Under generally accepted accounting principles (GAAP), continuation of a reporting entity as a going concern is presumed as the basis for preparing financial statements unless and until the entity's liquidation becomes imminent. Preparation of financial statements under this presumption is commonly referred to as the going concern basis of accounting. If and when an entity's liquidation becomes imminent, financial statements should be prepared under the liquidation basis of accounting in accordance with Subtopic 205-30, Presentation of Financial Statements-Liquidation Basis of Accounting. Even when an entity's liquidation is not imminent, there may be conditions or events that raise substantial doubt about the entity's ability to continue as a going concern. In those situations, financial statements should continue to be prepared under the going concern basis of accounting, but the amendments in this Update should be followed to determine whether to disclose information about the relevant conditions and events. The amendments in this Accounting Standards Update are effective for the annual period ending after December 15, 2016, and for annual periods and interim periods thereafter. Early application is permitted. The Company does not expect the adoption of ASU 2014-15 to have material impact on the Company’s condensed consolidated financial statements, although there may be additional disclosures upon adoption.

 

In November 2014, the FASB issued Accounting Standard Update (ASU) No. 2014-16, Derivatives and Hedging (Topic 815): Determining Whether the Host Contract in a Hybrid Financial Instrument Issued in the Form of a Share Is More Akin to Debt or to Equity, to clarify how current U.S. GAAP should be interpreted in evaluating the economic characteristics and risks of a host contract in a hybrid financial instrument that is issued in the form of a share. Specifically, the amendments clarify that an entity should consider all relevant terms and features, including the embedded derivative feature being evaluated for bifurcation, in evaluating the nature of the host contract. The assessment of the substance of the relevant terms and features should incorporate a consideration of: (1) the characteristics of the terms and features themselves; (2) the circumstances under which the hybrid financial instrument was issued or acquired; and (3) the potential outcomes of the hybrid financial instrument, as well as the likelihood of those potential outcomes. The amendments in this ASU apply to all entities that are issuers of, or investors in, hybrid financial instruments that are issued in the form of a share. The amendments in this ASU are effective for annual reporting periods beginning after December 15, 2015, including interim periods within that reporting period. Early adoption is permitted. The Company does not expect the adoption of ASU 2014-16 to have a material impact on the Company’s condensed consolidated financial statements.

 

Note 3 – Loans receivable (including related parties)

 

Loans receivable represent amounts the Company expects to collect from third parties and related parties upon maturity.

 

The Company had the following loan receivable due within one year as of: 

 

   September 30, 2014   December 31, 2013 
   (in thousands)   (in thousands) 
Loan to third party; due on demand and non-interest bearing.  $14,625   $- 
Total loan receivable  $14,625   $- 

 

The Company had the following loan receivable – related party due within one year as of:

 

   September 30, 2014   December 31, 2013 
   (in thousands)   (in thousands) 
Loan to Teamlink Investment Co., Ltd; due in June, July and December 2014; interest rate is 4.75%  $-   $4,540 
Total loan receivable – related party  $-   $4,540 

 

See Note 18 “Related party transactions and balances” for the nature of the relationship of related parties.

 

Total interest income for the loans amounted to $0.1 million and $0.1 million for the three months ended September 30, 2014 and 2013, respectively.

 

Total interest income for the loans amounted to $0.2 million and $0.2 million for the nine months ended September 30, 2014 and 2013, respectively.

 

17
 

 

Note 4 – Accounts receivable (including related parties), net

 

Accounts receivable, including related party receivables, net of allowance for doubtful accounts consists of the following:  

 

   September 30, 2014   December 31, 2013 
   (in thousands)   (in thousands) 
Accounts receivable  $9,209   $5,131 
Less: allowance for doubtful accounts   (728)   (1,053)
Accounts receivable – related parties   2,153    2,942 
Net accounts receivable  $10,634   $7,020 

 

Changes in the allowance for doubtful accounts are as follows:

 

   September 30, 2014   December 31, 2013 
   (in thousands)   (in thousands) 
Beginning balance  $1,053   $1,367 
Charge to expense   -    96 
Less: recovery   (317)   (449)
Exchange rate effect   (8)   39 
Ending balance  $728   $1,053 

 

Note 5 – Inventories

 

Inventories consist of the following:

 

   September 30, 2014   December 31, 2013 
   (in thousands)   (in thousands) 
Supplies  $22,459   $21,040 
Raw materials   157,872    164,301 
Finished goods   86,762    42,977 
Less: allowance for inventory valuation   (17,076)   (15,397)
Total inventories  $250,017   $212,921 

 

Raw materials consist primarily of iron ore and coke at Longmen Joint Venture. The cost of finished goods includes direct costs of raw materials as well as direct labor used in production. Indirect production costs at normal capacity such as utilities and indirect labor related to production such as assembling, shipping and handling costs for purchasing are also included in the cost of inventory.

 

The Company values its inventory at the lower of cost or market, determined on a weighted average method, or net realizable value. As of September 30, 2014 and December 31, 2013, the Company had provided allowance for inventory valuation in the amounts of $17.1 million and $15.4 million, respectively.

 

Changes in the allowance for inventory valuation are as follows:

 

   September 30, 2014   December 31, 2013 
   (in thousands)   (in thousands) 
Beginning balance  $15,397   $9,585 
Addition   17,099    15,194 
Less: write-off   (15,304)   (9,757)
Exchange rate effect   (116)   375 
Ending balance  $17,076   $15,397 

 

Note 6 – Advances on inventory purchases

 

Advances on inventory purchases are monies deposited or advanced to outside vendors or related parties on future inventory purchases. Most of the Company’s vendors require a certain amount of money to be deposited with them as a guarantee that the Company will complete its purchases on a timely basis.

 

This amount is refundable and bears no interest. The Company has legally binding contracts with its vendors, which require the deposit to be returned to the Company or netted against accounts payable due to its vendors to the extent there are unpaid balances when the contract ends. The inventory is normally delivered within one month after the monies have been advanced. The total outstanding amount, including advances to related parties, was $171.3 million and $127.9 million as of September 30, 2014 and December 31, 2013, respectively.

 

18
 

 

Note 7 – Plant and equipment, net

 

Plant and equipment consist of the following:

 

   September 30, 2014   December 31, 2013 
   (in thousands)   (in thousands) 
Buildings and improvements  $311,562   $274,402 
Machinery   657,680    667,093 
Machinery under capital lease   625,196    623,895 
Transportation and other equipment   23,177    22,991 
Construction in progress   294,062    11,412 
Subtotal   1,911,677    1,599,793 
Less: accumulated depreciation   (395,668)   (327,886)
Total  $1,516,009   $1,271,907 

 

Construction in progress consisted of the following as of September 30, 2014:

 

Construction in progress  Value   Completion  Estimated
additional cost to
complete
 
description  (In thousands)   date  (In thousands) 
Equipment updates   1,992   December 2014   12,869 
Sintering machine construction   84,831   November 2014   59,875 
#5 blast furnace construction   185,354   December 2014   32,709 
Reconstruction of miscellaneous factory buildings   5,649   September 2015   5,242 
Project materials   2,139       - 
Others   14,097       - 
Total  $294,062      $110,695 

  

The Company is obligated under a capital lease for the iron and steel making facilities, including one sintering machine, two converters, two blast furnaces and some auxiliary systems that expire on April 30, 2031. During 2013 and 2014, Longmen Joint Venture entered into a number of capital lease agreements for energy-saving equipment installed throughout the steel production line. The Company is obligated under the capital lease for the equipment upon the confirmation of the energy-saving rate between the Company and its vendors.

 

The carrying value of assets acquired under the capital lease consists of the following:

 

   September 30, 2014   December 31, 2013 
   (in thousands)   (in thousands) 
Machinery  $625,196   $623,895 
Less: accumulated depreciation   (99,777)   (77,086)
Carrying value of leased assets  $525,419   $546,809 

  

The Company assessed the recoverability of all of its remaining long lived assets at September 30, 2014 and December 31, 2013, respectively, and such assessment did not result in any impairment charges.

 

Depreciation expense for the three months ended September 30, 2014 and 2013 amounted to $23.7 million and $21.6 million, respectively, and for the nine months ended September 30, 2014 and 2013, amounted to $71.0 and $64.1 million, respectively. These amounts include depreciation of assets held under capital leases for the three months ended September 30, 2014 and 2013, which amounted to $7.7 million and $7.1 million, respectively, and for the nine months ended September 30, 2014 and 2013, amounted to $23.3 and $21.2 million, respectively.

 

Note 8 – Intangible assets, net

 

Intangible assets consist of the following:

 

   September 30, 2014   December 31, 2013 
   (in thousands)   (in thousands) 
Land use rights  $30,650   $30,884 
Mining right   2,441    2,459 
Software   1,049    743 
Subtotal   34,140    34,086 
Less:          
Accumulated amortization – land use rights   (8, 931)    (8,498)
Accumulated amortization – mining right   (1,396)   (1,320)
Accumulated amortization – software   (692)   (561)
Subtotal   (11,019)   (10,379)
Intangible assets, net  $23,121   $23,707 

 

19
 

 

The gross amount of the intangible assets amounted to $34.1 million and $34.1 million as of September 30, 2014 and December 31, 2013, respectively. The remaining weighted average amortization period is 32.9 years as of September 30, 2014.

 

Total amortization expense for the three months ended September 30, 2014 and 2013 amounted to $0.1 million and $0.2 million, respectively, and for the nine months ended September 30, 2014 and 2013, amounted to $0.6 million and $0.7 million, respectively.

 

Total depletion expense for the three months ended September 30, 2014 and 2013 amounted to $0.04 million and $0.02 million, respectively, and for the nine months ended September 30, 2014 and 2013, amounted to $0.1 million and $0.1 million, respectively.

 

The estimated aggregate amortization and depletion expenses for each of the five succeeding years is as follows:

 

Year ending  Estimated
amortization and
depletion expenses
   Gross carrying
amount
 
   (in thousands)   (in thousands) 
September 30, 2015  $966    22,155 
September 30, 2016   966    21,189 
September 30, 2017   966    20,223 
September 30, 2018   966    19,257 
September 30, 2019   966    18,291 
Thereafter   18,291    - 
Total  $23,121      

 

Note 9 – Debt

 

Short-term notes payable

 

Short-term notes payable are lines of credit extended by banks. Banks in turn issue the Company a bank acceptance note, which can be endorsed and assigned to vendors as payments for purchases. The notes payable are generally payable within three to six months. This short-term note payable is guaranteed by the bank for its complete face value. The banks do not charge interest on these notes, but usually charge a transaction fee of 0.05% of the notes value. In addition, the banks usually require the Company to deposit either a certain amount of cash at the bank as a guarantee deposit, which is classified on the balance sheet as restricted cash, or provide notes receivable as security, which are classified on the balance sheet as restricted notes receivable. Restricted cash as a guarantee for the notes payable amounted to $371.0 million and $399.4 million as of September 30, 2014 and December 31, 2013, respectively. Restricted notes receivable as a guarantee for the notes payable amounted to $26.0 million and $231.7 million as of September 30, 2014 and December 31, 2013, respectively.

 

The Company had the following short-term notes payable as of:

 

   September 30, 2014   December 31, 2013 
   (in thousands)   (in thousands) 
General Steel (China): Notes payable to various banks in China, due various dates from December 2014 to January 2015. Restricted cash required of $8.1 million and $16.4 million as of September 30, 2014 and December 31, 2013, respectively; guaranteed by third parties. These notes payable were either repaid or renewed subsequently on the due dates.  $8,125   $29,466 
Longmen Joint Venture: Notes payable to various banks in China, due various dates from October 2014 to September 2015. $362.9 million restricted cash and $26.0 million notes receivable are secured for notes payable as of September 30, 2014, and comparatively $383.0 million restricted cash and $231.7 million notes receivable secured as of December 31, 2013, respectively; some notes are further guaranteed by third parties. These notes payable were either repaid or renewed subsequently on the due dates.   776,198    988,364 
Total short-term notes payable  $784,323   $1,017,830 

 

20
 

 

Short-term loans

 

Short-term loans represent amounts due to various banks, other companies and individuals, including related parties, normally due within one year. The principal of the loans are due at maturity but can be renewed at the bank’s option. Accrued interest is due either monthly or quarterly.

 

Short term loans due to banks, related parties and other parties consisted of the following as of:

 

Due to banks

 

   September 30,
2014
   December 31, 2013 
   (in thousands)   (in thousands) 
General Steel (China): Loans from various banks in China, due various dates from November 2014 to August 2015. Weighted average interest rate was 7.2% per annum and 7.2% per annum as of September 30, 2014 and December 31, 2013, respectively; some are guaranteed by third parties and related parties. These loans were either repaid or renewed subsequently on the due dates.  $43,713   $34,229 
Longmen Joint Venture: Loans from various banks in China, due various dates from December 2014 to July 2015. Weighted average interest rate was 6.9% per annum and 6.3% per annum as of September 30, 2014 and December 31, 2013, respectively; some are guaranteed by third parties, accounts receivable, restricted cash or notes receivables. $82.5 million and $163.9 million restricted notes receivable were secured for the loans as of September 30, 2014 and December 31, 2013, respectively; $12.2 million and $0 restricted cash were secured for the loans as of September 30, 2014 and December 31, 2013, respectively; These loans were either repaid or renewed subsequently on the due dates.   204,576    267,688 
Total short-term loans - bank  $248,289   $301,917 

 

Due to unrelated parties

 

   September 30, 2014   December 31, 2013 
   (in thousands)   (in thousands) 
Longmen Joint Venture: Loans from various unrelated companies and individuals, due various dates from December 2014 to September 2015, and weighted average interest rate was 5.6% per annum and 5.2% per annum as of September 30, 2014 and December 31, 2013, respectively. These loans were either repaid or renewed subsequently on the due dates.  $37,899   $22,720 
Longmen Joint Venture: Loans from financing sales.   16,264    33,124 
Maoming Hengda: Loans from one unrelated party and one related party, due on demand, none interest bearing.   6,177    6,223 
Total short-term loans – others  $60,340   $62,067 

 

The Company had various loans from unrelated companies amounting to $60.3 million and $62.1 million as of September 30, 2014 and December 31, 2013, respectively. Of the $60.3 million, $6.2 million of loans carry no interest, $16.3 million of financing sales are subject to interest rates ranging between 4.6% and 9.6%, and the remaining $37.9 million are subject to interest rates ranging from 5.0% to 14.4%. All short term loans from unrelated companies are payable on demand and unsecured.

 

As part of its working capital management, Longmen Joint Venture has entered into a number of sale and purchase back contracts ("contracts") with third party companies and Longmen Joint Venture’s subsidiaries, Yuxin and Yuteng. According to the contracts, Longmen Joint Venture sells rebar to the third party companies at a certain price, and within the same month, Yuxin and Yuteng will purchase back the rebar from the third party companies at a price of 4.6% to 9.6% higher than the original selling price from Longmen Joint Venture. Based on the contract terms, Longmen Joint Venture is paid in advance for the rebar sold to the third party companies and Yuxin and Yuteng are given a credit period of several months to one year from the third party companies. There is no physical movement of the inventory during the sale and purchase back arrangement. The margin of 4.6% to 9.6% is determined by reference to the bank loan interest rates at the time when the contracts are entered into, plus an estimated premium based on the financing sale amount, which represents the interest charged by the third party companies for financing Longmen Joint Venture through the above sale and purchase back arrangement. The revenue and cost of goods sold arising from the above transactions are eliminated and the incremental amounts paid by Yuxin and Yuteng to purchase back the goods are treated as financing costs in the consolidated financial statements.

 

21
 

 

 

Total financing sales for the three months ended September 30, 2014 and 2013 amounted to $259.7 million and $166.2 million, respectively, and for the nine months ended September 30, 2014 and 2013, amounted to $719.3 million and $519.5 million, respectively, which are eliminated in the Company’s consolidated financial statements. The financial cost related to financing sales for the three months ended September 30, 2014 and 2013 amounted to $1.4 million and $1.1 million, respectively, and for the nine months ended September 30, 2014 and 2013, amounted to $3.1 million and $4.2 million, respectively.

 

Short term loans due to related parties

 

   September 30,
2014
   December 31,
2013
 
   (in thousands)   (in thousands) 
General Steel China: Loans from Yangpu Capital Automobile, due on demand, and interest rate is 10% per annum.  $668   $1,458 
Longmen Joint Venture: Loan from Shaanxi Coal and Chemical Industry Group Co., Ltd., due on demand, and interest rate is 7.0% per annum.   5,467    28,216 
Longmen Joint Venture: Loan from Shaanxi Steel Group due on various dates from November 2014 to July 2015, and interest rate is 8.0% per annum.   95,875    49,110 
Longmen Joint Venture: Loans from financing sales.   121,450    47,909 
Total short-term loans - related parties  $223,460   $126,693 

  

Long-term loans due to related party

 

   September 30, 2014   December 31, 2013 
   (in thousands)   (in thousands) 
Longmen Joint Venture: Loans from Shaanxi Steel Group, due on various dates through November 2015 and interest rate is 5.6% per annum.  $72,124   $72,657 
Less: Current maturities of long-term loans – related party   (67,249)   (53,013)
Long-term loans - related party  $4,875   $19,644 

 

Total interest expense, net of capitalized interest, amounted to $4.0 million and $8.2 million for the three months ended September 30, 2014 and 2013, respectively.

 

Total interest expense, net of capitalized interest, amounted to $21.6 million and $26.7 million for the nine months ended September 30, 2014 and 2013, respectively.

 

Capitalized interest included in construction in progress amounted to $1.3 million and $1.3 million for the three months ended September 30, 2014 and 2013, respectively. 

 

Capitalized interest included in construction in progress amounted to $2.1 million and $2.1 million for the nine months ended September 30, 2014 and 2013, respectively. 

 

Note 10 – Customer deposits

 

Customer deposits represent amounts advanced by customers on product orders. The product normally is shipped within one month after receipt of the advance payment, and the related sale is recognized in accordance with the Company’s revenue recognition policy. As of September 30, 2014 and December 31 2013, customer deposits amounted to $300.5 million and $152.7 million, respectively, including deposits received from related parties, which amounted to $113.7 million and $64.9 million, respectively.

 

Note 11 – Deposits due to sales representatives

 

Longmen Joint Venture entered into agreements with various entities to act as the Company’s exclusive sales agent in a specified geographic area.  These exclusive sales agents must meet certain criteria and are required to deposit a certain amount of money with the Company. In return the sales agents receive exclusive sales rights in a specified area and at discounted prices on products they order. These deposits bear no interest and are required to be returned to the sales agent once the agreement is terminated. The agreement is normally entered/or renewed on an annual basis. Termination of the agreement can be mutually agreed to by both parties at any time. The Company had $32.2 million and $26.3 million in deposits due to sales representatives, including deposits due to related parties, as of September 30, 2014 and December 31, 2013, respectively.

 

22
 

 

Note 12 – Warrants

 

The Company had 3,900,871 common stock warrants outstanding, which were issued in connection with $40 million of convertible notes issued by the Company in 2007. The warrants, which were accounted for as a derivative liability at fair value, expired unexercised on May 13, 2013.   

 

Note 13 - Supplemental disclosure of cash flow information

 

Interest paid, net of amounts capitalized, amounted to $12.6 million and $11.5 million for the nine months ended September 30, 2014 and 2013, respectively.

 

The Company paid income taxes of $0.1 million and $0.3 million during the nine months ended September 30, 2014 and 2013, respectively.

 

During the nine months ended September 30, 2014 and 2013, the Company had receivables of $0.01 million and $1.0 million, respectively, as a result of the disposal of equipment that had not been collected.

 

During the nine months ended September 30, 2014 and 2013, the Company converted $0.05 million and $1.0 million of equipment, respectively, into inventory productions.

 

During the nine months ended September 30, 2014 and 2013, the Company used $2.4 million and $37.3 million of inventory, respectively, in plant and equipment construction.

 

The Company had $57.4 million notes receivable from financing sales loans to be converted to cash as of September 30, 2014.

 

During the nine months ended September 30, 2014, the Company incurred $208.3 million of accounts payable for the purchase of equipment and construction in progress.

 

During the nine months ended September 30, 2014 and 2013, one of the Company’s unconsolidated entities declared a dividend and the Company is entitled to a dividend of $0.2 million and $0.2 million, respectively, which has not yet been collected.

  

During the nine months ended September 30, 2014, the Company acquired $5.9 million of equipment through capital leases.

 

During the nine months ended September 30, 2013, the Company offset $ 64.2 million of accounts payable to related party as loan receivable – related party repayment.

 

During the nine months ended September 30, 2013, the Company offset $ 119.9 million of advance on inventory purchases and other receivables to related parties as short-term loan repayments.

 

During the nine months ended September 30, 2013, the Company reclassified $ 3.8 million of refundable advances on inventory purchase – related parties to other receivables – related parties.

 

Note 14 - Deferred lease income

 

To compensate the Company for the costs and economic losses incurred during construction of the iron and steel making facilities owned by Shaanxi Steel, which are leased by the Longmen Joint Venture, Shaanxi Steel reimbursed Longmen Joint Venture $11.4 million (RMB 70.1 million) in the fourth quarter of 2010 for the value of assets dismantled and rent under a 40-year property sub-lease that was entered into by the parties in June 2009 (the "Longmen Sub-lease"), and $29.8 million (RMB 183.1 million) for the reduced production efficiency caused by the construction. In addition, in 2010 and 2011, Shaanxi Steel reimbursed Longmen Joint Venture $14.6 million (RMB 89.5 million) and $14.5 million (RMB 89.3 million), respectively, for trial production costs related to the new equipment.

 

During the period from June 2010 to March 2011, as construction progressed and certain of the assets came online, Longmen Joint Venture used the assets free of charge to produce saleable units of steel products during this period. As such, the cost of using these assets and therefore the fair value of the free rent received was imputed with reference to what the depreciation charge would have been on these assets had they been owned or under capital lease to Longmen Joint Venture during the free use period. This cost of $7.1 million (RMB 43.9 million) was deferred and is being recognized over the term of the land sub-lease similar to the other charges and credits related to the construction of these assets.

 

The deferred lease income is amortized to income over the remaining term of the 40-year land sub-lease. For the three months ended September 30, 2014 and 2013, the Company recognized $0.5 million and $0.5 million, respectively. For the nine months ended September 30, 2014 and 2013, the Company recognized $1.6 million and $1.6 million, respectively. As of September 30, 2014 and December 31, 2013, the balance of deferred lease income amounted to $75.2 million and $77.4 million, respectively, of which $2.2 million and $2.2 million represents amounts to be amortized within one year. See Note 18 – Related party transactions and balances (m) – Deferred lease income for details.

 

23
 

 

Note 15 - Capital lease obligations

 

Iron and steel production facilities

 

On April 29, 2011, the Company’s subsidiary, Longmen Joint Venture entered into a Unified Management Agreement with Shaanxi Steel and Shaanxi Coal under which Longmen Joint Venture uses new iron and steel making facilities including one sintering machine, two converters, two blast furnaces and other auxiliary systems constructed by Shaanxi Steel. As the 20-year term of the agreement exceeds 75% of the assets’ useful lives, this arrangement is accounted for as a capital lease. The ongoing lease payments are comprised of two elements: (1) a monthly payment of $2.3 million (RMB 14.6 million), based on Shaanxi Steel’s cost to construct the assets, to be paid over the term of the Unified Management Agreement of 20 years and (2) 40% of any remaining pre-tax profits from the Asset Pool which includes Longmen Joint Venture and the newly constructed iron and steel making facilities. In February 2014, Shaanxi Steel agreed that it will not demand capital lease payments from Longmen Joint Venture until February 2017. The profit sharing component does not meet the definition of contingent rent because it is based on future revenue and was therefore considered part of the financing for the capital leased assets. The initial fair value of the profit sharing liability was included in determining the value of the leased assets at inception. The profit sharing liability is accounted for separately from the monthly lease payments and is accounted for as a derivative liability at fair value, with changes in the fair value charged or credited to income each period. See Note 2(h) – “Financial instruments” and Note 16 – “Profit sharing liability”.

 

Energy-saving equipment

 

During 2013 and 2014, the Company’s subsidiary, Longmen Joint Venture, entered into capital lease agreements for energy-saving equipment to be installed throughout the production chain. Under these agreements, Longmen Joint Venture uses the energy-saving equipment for which the vendors are responsible for the design, purchase, installation, and on-site testing, as well as the ownership rights to the equipment during the lease periods. The lease periods, which vary between four to six years, begin upon the completion of the equipment installation, testing, and the issuance of the energy-saving rate reports to be agreed upon by both the vendors and Longmen Joint Venture. As the ownership rights of the equipment transfer to Longmen Joint Venture at the end of the lease periods, these agreements are accounted for as capital leases.

 

The minimum lease payments are based on the energy cost saved during the lease periods, which is determined by the estimated annual equipment operating hours per the lease agreements. If the actual annual equipment operating hours are less than the estimated amount, the lease periods may be extended, subject to further negotiation and agreement between the Company and the vendors. If the actual annual equipment operating hours exceed the estimated amount, the Company is obligated to make additional lease payments based on the additional energy cost saved during the lease period and will recognize the additional lease payments as contingent rent expense. For the three and nine months ended September 30, 2014 and 2013, no contingent rent expense was incurred under these lease agreements.

 

Presented below is a schedule of estimated minimum lease payments on the capital lease obligations for the next five years as of September 30, 2014:

 

Year ending September 30,  Capital Lease Obligations
Minimum Lease Payments
 
   (in thousands) 
2015  $8,320 
2016   5,804 
2017   188,812 
2018   32,510 
2019   29,957 
Thereafter   331,209 
Total minimum lease payments   596,612 
Less: amounts representing interest   (201,172)
Ending balance  $395,440 

 

The above amounts do not include the profit sharing liability, which is accounted for separately as a derivative instrument at fair value.

 

Interest expense for the three months ended September 30, 2014 and 2013 on the capital lease obligations was $5.2 million and $5.1 million, respectively.

 

Interest expense for the nine months ended September 30, 2014 and 2013 on the capital lease obligations was $16.0 million and $15.3 million, respectively.

 

24
 

 

Note 16 – Profit sharing liability

 

The profit sharing liability component of the capital lease obligation was recognized initially at its estimated fair value at the lease commencement date and included in the initial measurement and recognition of the capital lease, in addition to the fixed payment component of the minimum lease payments. The profit sharing liability is accounted for separately from the fixed portion of the capital lease obligation (see Note 15 - “Capital lease obligation”) and is accounted for as a derivative instrument in accordance with ASC 815-10-15-83. The estimated fair value of the profit sharing liability is reassessed at the end of each reporting period, with any change in fair value charged or credited to income as “Change in Fair Value of Profit Sharing Liability”. See Note 2(h) – “Financial instruments” for details.

 

Payments to Shaanxi Steel for the profit sharing liability are not required until net cumulative profits are achieved. Based on the performance of the Asset Pool, no profit sharing payment was made from inception to date.

 

Note 17 – Taxes

 

Income tax

 

Significant components of the provision for income taxes on earnings and deferred taxes on net operating losses from operations for the three and nine months ended September 30, 2014 and 2013 are as follows: 

 

(In thousands)  Three months ended
September 30, 2014
   Three months ended
September 30, 2013
 
Current  $93   $25 
Deferred   -    - 
Total provision for income taxes  $93   $25 

 

(In thousands)  Nine months ended
September 30, 2014
   Nine months ended
September 30, 2013
 
Current  $205   $201 
Deferred   -    - 
Total provision for income taxes  $205   $201 

 

Under the Income Tax Laws of the PRC, General Steel (China), Baotou Steel Pipe Joint Venture (located in Inner Mongolia province), Maoming Hengda (located in Guangdong province) and Tianwu Joint Venture (located in Tianjin Port Free Trade Zone) are subject to income tax at a rate of 25%.

 

Longmen Joint Venture is located in the Mid-West region of China and as such, qualifies for the “Go-West” tax rate of 15% promulgated by the government. In 2010, the Chinese government announced that the “Go-West” tax initiative would be extended for 10 years and thus the preferential tax rate of 15% will be in effect until 2020. This special tax treatment for Longmen Joint Venture will be evaluated on a year-to-year basis by the local tax bureau. The special tax treatment has not changed to date as a result of the evaluations by the local tax bureau.

 

Deferred tax assets – China

  

According to Chinese tax regulations, net operating losses can be carried forward to offset operating income for the next five years. The Group’s losses carry forwards of $531.8 million will begin to expire in 2015. The Chinese government recently announced several policies to curb the real estate price increases across the country, which led to a slowdown in demand for construction steel products. Additionally due to the continued global economic slowdown and the overcapacity issues in China's steel market, management expected there would be a sustained increase in margin pressure in the next five years until all the existing but outdated steel capacity across the whole industry is eliminated. Management took into consideration this potential negative impact on average selling price and gross margin of its products, re-performed an operating forecast for the next five years and concluded that the beginning-of-the-year balance of deferred tax assets mainly relating to the net operating loss carry forward may not be fully realizable due to the reduction in the projection of income to be available in the next 5 years. Management therefore decided to provide a 100% valuation allowance for the deferred tax assets. The valuation allowance as of September 30, 2014 and December 31, 2013 was $101.0 million and $97.6 million, respectively. Management will review this valuation allowance periodically and make adjustments as warranted. Temporary differences represent tax and book differences for various items, such as receivable allowances, inventory allowances, impairments on fixed assets and deferred lease income.

 

Movement of valuation allowance:

 

   September 30, 2014   December 31, 2013 
   (in thousands)   (in thousands) 
Beginning balance  $97,569   $72,891 
Current period addition   4,567    23,293 
Current period reversal   (214)   (1,206)
Exchange difference   (721)   2,591 
Ending balance  $101,201   $97,569 

 

25
 

 

Deferred tax assets – U.S.

 

General Steel Holdings, Inc. was incorporated in the United States and has incurred net operating losses for income tax purposes for the nine months ended September 30, 2014. The net operating loss carry forwards for United States income taxes amounted to $3.0 million, which may be available to reduce future years’ taxable income. These carry forwards will expire, if not utilized, starting from 2026 through 2033. Management believes that the realization of the benefits from these losses appears uncertain due to the Company’s limited operating history and continuing losses for United States income tax purposes. Accordingly, the Company has provided a 100% valuation allowance on the deferred tax asset benefit to reduce the asset to zero. The valuation allowance as of September 30, 2014 was $1.0 million. The net change in the valuation allowance for the nine months ended September 30, 2014 was $0.3 million. Management will review this valuation allowance periodically and make adjustments as warranted.

 

The Company has no cumulative proportionate retained earnings from profitable subsidiaries as of September 30, 2014. Accordingly, no provision has been made for U.S. deferred taxes related to future repatriation of these earnings, nor is it practicable to estimate the amount of income taxes that would have to be provided if we concluded that such earnings will be remitted in the future.

 

Value added tax

 

Enterprises or individuals who sell commodities, engage in repair and maintenance or import and export goods in the PRC are subject to a value added tax in accordance with PRC laws. The value added tax (“VAT”) standard rates are 13% to 17% of the gross sales price. A credit is available whereby VAT paid on the purchases of semi-finished products or raw materials used in the production of the Company’s finished products can be used to offset the VAT due on sales of the finished product. As of September 30, 2014 and December 31, 2013, the Company had $4.8 million and $3.5 million in value added tax credits which are available to offset future VAT payables, respectively.

 

Sales and purchases are recorded net of VAT collected and paid as the Company acts as an agent for the government for VAT collection. VAT on sales and VAT on purchases amounted to $217.6 million and $210.8 million, respectively, for the three months ended September 30, 2014 and $ 160.5 million and $156.2 million, respectively, for the three months ended September 30, 2013. VAT on sales and VAT on purchases amounted to $549.1 million and $537.2 million, respectively, for the nine months ended September 30, 2014 and $513.7 million and $494.4 million, respectively, for the nine months ended September 30, 2013. 

 

Taxes payable consisted of the following: 

 

   September 30, 2014   December 31, 2013 
   (in thousands)   (in thousands) 
VAT taxes payable  $1,731   $2,211 
Income taxes payable   256    173 
Other taxes   1,943    2,244 
Totals  $3,930   $4,628 

 

Note 18 – Related party transactions and balances

 

Related party transactions

 

a.  Capital lease

 

As disclosed in Note 15 – “Capital lease obligations”, Longmen Joint Venture entered into a capital lease arrangement on April 29, 2011, with Shaanxi Coal and Shaanxi Steel, which are related parties of the Group. The following is an analysis of the leased assets under the capital lease:

 

   September 30, 2014   December 31, 2013 
   (in thousands)   (in thousands) 
Machinery  $601,398   $605,839 
Less: accumulated depreciation   (97,602)   (76,740)
Carrying value of leased assets  $503,796   $529,099 

 

26
 

 

b.  The following chart summarizes sales to related parties for the three and nine months ended September 30, 2014 and 2013. 

 

Name of related parties  Relationship  Three months ended
September 30, 2014
   Three months ended
September 30, 2013
 
      (in thousands)   (in thousands) 
Long Steel Group  Noncontrolling shareholder of Longmen Joint Venture  $45,200   $63,793 
Shaanxi Yuchang Trading Co., Ltd  Significant influence by Long Steel Group*   -    1,081 
Shaanxi Haiyan Trade Co., Ltd  Significant influence by Long Steel Group*   22,126    85 
Shaanxi Shenganda Trading Co., Ltd  Significant influence by Long Steel Group*   22,216    19,866 
Shaanxi Steel  Majority shareholder of Long Steel Group   734    979 
Shaanxi Coal and Chemical Industry Group Co., Ltd.  Shareholder of Shaanxi Steel   14,406    7,951 
Shaanxi Long Steel Group Baoji Steel Rolling Co., Ltd  Subsidiary of Long Steel Group   1,998    9 
Shaanxi Junlong Rolling Co., Ltd  Investee of Long Steel Group   -    1,782 
Total     $106,680   $95,546 

 

*Long Steel Group has the ability to significantly influence the operating and financial decisions of the entity through equity ownership either directly or through key employees, commercial contractual terms, or the ability to assign management personnel.

 

Name of related parties  Relationship  Nine months ended
September 30, 2014
   Nine months ended
September 30, 2013
 
      (in thousands)   (in thousands) 
Long Steel Group  Noncontrolling shareholder of Longmen Joint Venture  $115,150   $226,754 
Sichuan Yutai Trading Co., Ltd  Significant influence by Long Steel Group   -    72 
Shaanxi Yuchang Trading Co., Ltd  Significant influence by Long Steel Group   -    21,491 
Shaanxi Haiyan Trade Co., Ltd  Significant influence by Long Steel Group   22,946    15,681 
Shaanxi Shenganda Trading Co., Ltd  Significant influence by Long Steel Group   69,919    56,545 
Shaanxi Steel  Majority shareholder of Long Steel Group   1,831    2,390 
Shaanxi Coal and Chemical Industry Group Co., Ltd.  Shareholder of Shaanxi Steel   35,795    22,577 
Shaanxi Long Steel Group Baoji Steel Rolling Co., Ltd  Subsidiary of Long Steel Group   13,733    2,122 
Shaanxi Junlong Rolling Co., Ltd  Investee of Long Steel Group   8,888    33,075 
Total     $268,262   $380,707 

 

Sales to related parties in trading transactions, which were netted against the corresponding cost of goods sold, amounted to $49.2 million and $141.1 million for the three and nine months ended September 30, 2014, respectively. See Note 2(m) Revenue Recognition for details.

 

27
 

 

c. The following charts summarize purchases from related parties for the nine months ended three and nine months ended September 30, 2014 and 2013.

 

Name of related parties  Relationship  Three months
ended
September 30,
2014
   Three months
ended
September 30,
2013
 
      (in thousands)   (in thousands) 
Long Steel Group  Noncontrolling shareholder of Longmen Joint Venture  $27,649   $101,606 
Hancheng Haiyan Coking Co., Ltd  Noncontrolling shareholder of Long   Steel Group   41,690    31,331 
Xi’an Pinghe Metallurgical Raw
Material Co., Ltd
  Noncontrolling shareholder of Long Steel Group   32,536    1,181 
Shaanxi Junlong Rolling Co., Ltd  Investee of Long Steel Group   -    1 
Shaanxi Huafu New Energy Co., Ltd  Significant influence by the Long Steel Group   7,636    10,529 
Beijing Daishang Trading Co., Ltd.  Noncontrolling shareholder of Longmen Joint Venture’s subsidiary   -    1,726 
Tianjin General Quigang Pipe Co., Ltd  Partially owned by CEO through indirect shareholding**   5,090    - 
Maoming Shengze Trading Co., Ltd.  Partially owned by CEO through indirect shareholding   16,764    - 
Shaanxi Coal and Chemical Industry Group Co., Ltd.  Shareholder of Shaaxi Steel   13,441    - 
Others  Entities either owned or have significant influence by our affiliates or management   -    64 
Total     $144,806   $146,438 

 

**The CEO referred to herein is the chief executive officer of General Steel Holdings, Inc. 

 

Name of related parties  Relationship  Nine months ended
September 30, 2014
   Nine months ended
September 30, 2013
 
      (in thousands)   (in thousands) 
Long Steel Group  Noncontrolling shareholder of Longmen Joint Venture  $279,925   $376,104 
Hancheng Haiyan Coking Co., Ltd  Noncontrolling shareholder of Long   Steel Group   125,957    148,322 
Xi’an Pinghe Metallurgical Raw
Material Co., Ltd
  Noncontrolling shareholder of Long Steel Group   38,456    13,678 
Shaanxi Long Steel Group Baoji
Steel Rolling Co., Ltd
  Subsidiary of Long Steel Group   -    53 
Shaanxi Junlong Rolling Co., Ltd  Investee of Long Steel Group   -    212 
Shaanxi Huafu New Energy Co., Ltd  Significant influence by the Long Steel Group   21,857    28,618 
Beijing Daishang Trading Co., Ltd.  Noncontrolling shareholder of Longmen Joint Venture’s subsidiary   -    6,635 
Tianwu General Steel Material Trading Co., Ltd.  Investee of General Steel (China)   83,649    - 
Tianjin General Quigang Pipe Co., Ltd  Partially owned by CEO through indirect shareholding   13,618    - 
Tianjin Hengying Trading Co., Ltd  Partially owned by CEO through indirect shareholding   45,604    - 
Maoming Shengze Trading Co., Ltd.  Partially owned by CEO through indirect shareholding   16,764    - 
Shaanxi Coal and Chemical Industry Group Co., Ltd.  Shareholder of Shaaxi Steel   14,385    - 
Others  Entities either owned or have significant influence by our affiliates or management   140    300 
Total     $640,355   $573,922 

 

28
 

 

Related party balances

 

a.Loans receivable – related parties:

 

Name of related parties  Relationship  September 30, 2014   December 31, 2013 
      (in thousands)   (in thousands) 
Teamlink Investment Co., Ltd  Partially owned by CEO through indirect shareholding   -    4,540 
Total     $-   $4,540 

 

See Note 3 – loans receivable – related parties for loan details.

 

b.Accounts receivables – related parties:

 

Name of related parties  Relationship  September 30, 2014   December 31, 2013 
      (in thousands)   (in thousands) 
Long Steel Group  Noncontrolling shareholder of Longmen Joint Venture  $173   $548 
Tianjin Daqiuzhuang Steel Plates  Partially owned by CEO through indirect shareholding   19    19 
Shaanxi Steel  Majority shareholder of Long Steel Group   1,961    1,741 
Others      -    634 
Total     $2,153   $2,942 

  

c.Other receivables – related parties:

 

Other receivables - related parties are those nontrade receivables arising from transactions between the Company and its related parties, such as advances or payments made on behalf of these related parties.

 

Name of related parties  Relationship  September 30,
2014
   December 31, 2013 
      (in thousands)   (in thousands) 
Long Steel Group  Noncontrolling shareholder of Longmen Joint Venture  $16,549   $406 
Shaanxi Steel  Majority shareholder of Long Steel Group   1,137    46,439 
Tianjin General Quigang Pipe Co., Ltd  Partially owned by CEO through indirect shareholding   9,391    1,247 
Tianjin Dazhan Industry Co, Ltd  Partially owned by CEO through indirect shareholding   24,311    491 
Beijing Shenhua Xinyuan Metal Materials Co., Ltd.  Partially owned by CEO through indirect shareholding   5,840    4,901 
Tianjin Hengying Trading Co., Ltd.  Partially owned by CEO through indirect shareholding   13,299    - 
Victory Energy Resource Co., Ltd  Partially owned by CEO through indirect shareholding   1,131    - 
Others  Entities either owned or have significant influence by our affiliates or management   322    622 
Total     $71,980   $54,106 

 

29
 

 

d.Advances on inventory purchase – related parties:

 

Name of related parties  Relationship  September 30, 2014   December 31, 2013 
      (in thousands)   (in thousands) 
Long Steel Group  Noncontrolling shareholder of Longmen Joint Venture  $87   $9,123 
Shaanxi Shenganda Trading Co., Ltd.  Significant influence by Long Steel Group   -    25,607 
Tianjin Dazhan Industry Co., Ltd  Partially owned by CEO through indirect shareholding   11,721    10,343 
Tianjin Hengying Trading Co., Ltd  Partially owned by CEO through indirect shareholding   51,304    16,158 
Tianjin General Qiugang Pipe Co., Ltd  Partially owned by CEO through indirect shareholding   20,868    555 
Maoming Shengze Trading Co., Ltd  Partially owned by CEO through indirect shareholding   43,888    21,197 
Others  Entities either owned or have significant influence by our affiliates or management   31    20 
Total     $127,899   $83,003 

  

e. Accounts payable - related parties:

 

Name of related parties  Relationship  September 30,
2014
   December 31,
2013
 
      (in thousands)   (in thousands) 
Hancheng Haiyan Coking Co., Ltd  Noncontrolling shareholder of Longmen Joint Venture  $72,240   $58,163 
Long Steel Group  Noncontrolling shareholder of Longmen Joint Venture   106,480    134,758 
Shaanxi Coal and Chemical Industry Group Co., Ltd.  Shareholder of Shaanxi Steel   25,066    29,990 
Tianjin Dazhan Industry Co., Ltd  Partially owned by CEO through indirect shareholding   945    958 
Xi’an Pinghe Metallurgical Raw Material Co., Ltd  Noncontrolling shareholder of Long Steel Group   31,990    8,714 
Tianjin Hengying Trading Co., Ltd  Partially owned by CEO through indirect shareholding   -    1 
Henan Xinmi Kanghua Fire Refractory Co., Ltd  Noncontrolling shareholder of Longmen Joint Venture’s subsidiary   799    716 
Beijing Daishang Trading Co., Ltd  Noncontrolling shareholder of Longmen Joint Venture’s subsidiary   36    1,004 
Tianwu General Steel Material Trading Co., Ltd.  Investee of General Steel (China)   19,207    759 
Tianjin General Qiugang Pipe Co., Ltd.  Partially owned by CEO through indirect shareholding   8,136    - 
Others  Entities either owned or have significant influence by our affiliates or management   845    629 
Total     $265,744   $235,692 

 

f. Short-term loans - related parties:

 

Name of related parties  Relationship  September 30,
2014
   December 31,
2013
 
      (in thousands)   (in thousands) 
Shaanxi Steel  Majority shareholder of Long Steel Group  $95,875   $49,110 
Shaanxi Coal and Chemical Industry Group Co., Ltd  Shareholder of Shaanxi Steel   74,171    28,216 
Long Steel Group  Noncontrolling shareholder of Longmen Joint Venture   52,746    33,183 
Tianjin Hengying Trading Co., Ltd  Partially owned by CEO through indirect shareholding   -    8,178 
Tianjin Dazhan Industry Co., Ltd  Partially owned by CEO through indirect shareholding   -    6,548 
Yangpu Capital Automobile  Partially owned by CEO through indirect shareholding   668    1,458 
Total     $223,460   $126,693 

 

30
 

 

See Note 9 – Debt for the loan details.

 

g.Current maturities of long-term loans – related parties

 

Name of related party  Relationship  September 30, 2014   December 31, 2013 
      (in thousands)   (in thousands) 
Shaanxi Steel  Majority shareholder of Long Steel Group  $67,249   $53,013 
Total     $67,249   $53,013 

 

h.Other payables – related parties:

 

Other payables – related parties are those nontrade payables arising from transactions between the Company and its related parties, such as advances or payments from these related parties on behalf of the Group.

 

Name of related parties  Relationship  September 30,
2014
   December 31,
2013
 
      (in thousands)   (in thousands) 
Tianjin Hengying Trading Co, Ltd  Partially owned by CEO through indirect shareholding  $11,731   $380 
Long Steel Group  Noncontrolling shareholder of Longmen Joint Venture   71,671    43,636 
Shaanxi Steel  Majority shareholder of Long Steel Group   3,727    44,363 
Wendlar Investment & Management Group Co., Ltd  Common control under CEO   1,125    895 
Yangpu Capital Automobile  Partially owned by CEO through indirect shareholding   362    291 
Tianjin Dazhan Industry Co., Ltd  Partially owned by CEO through indirect shareholding   9,329    473 
Maoming Shengze Trading Co., Ltd  Partially owned by CEO through indirect shareholding   2,723    1,745 
Victory Energy Resource Co., Ltd  Partially owned by CEO through indirect shareholding   -    1,375 
Others  Entities either owned or have significant influence by our affiliates or management   807    921 
Total     $101,475   $94,079 

 

i.Customer deposits – related parties:

 

Name of related parties  Relationship  September 30, 2014   December 31, 2013 
      (in thousands)   (in thousands) 
Shaanxi Yuchang Trading Co., Ltd  Significant influence by Long Steel Group  $10   $10 
Shaanxi Coal and Chemical Industry Group Co., Ltd  Shareholder of Shaanxi Steel   386    - 
Long Steel Group  Noncontrolling shareholder of Longmen Joint Venture   17,282    15,038 
Shaanxi Junlong Rolling Co., Ltd  Investee of Long Steel Group   16    2,748 
Shaanxi Shenganda Trading Co., Ltd  Significant influence by Long Steel Group   -    275 
Tianwu General Steel Material Trading Co., Ltd.  Investee of General Steel (China)   95,798    46,521 
Shaanxi Haiyan Trade Co., Ltd  Significant influence by Long Steel Group   182    - 
Others      -    289 
Total     $113,674   $64,881 

 

31
 

 

j.Deposits due to sales representatives – related parties

 

Name of related parties  Relationship  September 30, 2014   December 31, 2013 
      (in thousands)   (in thousands) 
Gansu Yulong Trading Co., Ltd.  Significant influence by Long Steel Group  $1,073   $1,408 
Shaanxi Yuchang Trading Co., Ltd  Significant influence by Long Steel Group   585    589 
Shaanxi Haiyan Trading Co., Ltd.  Significant influence by Long Steel Group   650    - 
Total     $2,308   $1,997 

  

k. Long-term loans – related party:

 

Name of related party  Relationship  September 30, 2014   December 31, 2013 
      (in thousands)   (in thousands) 
Shaanxi Steel  Majority shareholder of Long Steel Group  $4,875   $19,644 
Total     $4,875   $19,644 

 

The Company also provided guarantees on related parties’ bank loans amounting to $151.4 million and $205.8 million as of September 30, 2014 and as of December 31, 2013, respectively.

 

l.Deferred lease income

 

   September 30, 2014   December 31, 2013 
   (in thousands)   (in thousands) 
Beginning balance  $77,444   $77,199 
Less: Lease income realized   (1,630)   (2,158)
Exchange rate effect   (566)   2,403 
Ending balance   75, 248    77,444 
Current portion   (2,171)   (2,187)
Noncurrent portion  $73,077   $75,257 

  

For the three months ended September 30, 2014 and 2013, the Company realized lease income from Shaanxi Steel, a related party, amounting to $0.5 million and $0.5 million, respectively.

 

For the nine months ended September 30, 2014 and 2013, the Company realized lease income from Shaanxi Steel, a related party, amounting to $1.6 million and $1.6 million, respectively.

 

m.Equity

 

On November 19, 2013, the Company sold its 28% equity interest in Tianwu, held by Yangpu Shengtong, to Tianjin Dazhan Industry Co., Ltd., a related party through indirect common ownership by the CEO, for $13.6 million (RMB 84.3 million) while retaining the 32% interest held by General Steel (China). As a result of this transaction, the Company met the criteria under ASC 810-10-40-4 to deconsolidate Tianwu as of the ownership disposal date and recognize a gain, which amounted to $1.0 million. After the deconsolidation of Tianwu, General Steel (China)’s 32% interest in Tianwu is accounted for as an equity method investment, which amounted to $15.6 million and $15.8 million as of September 30, 2014 and December 31, 2013, respectively.

 

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Note 19 – Equity

 

2014 Equity Transactions

 

On February 3, 2014, the Company granted 80,000 shares of common stock for investor relations consulting services under two service agreements dated January 14, 2014. The shares were valued at $1.01 per share, the quoted market price at the time the services were provided.

 

On August 21, 2014, the Company granted 80,000 shares of common stock for investor relations consulting services under two service agreements dated July 10, 2014. The shares were valued at $1.04 per share, the quoted market price at the time the services were provided.

 

Note 20 – Retirement plan

 

Regulations in the PRC require the Company to contribute to a defined contribution retirement plan for all employees. All the employees of the Company’s entities in China are entitled to a retirement pension amount calculated based upon their salary at their date of retirement and their length of service in accordance with a government managed pension plan. The PRC government is responsible for the pension liability to the retired staff. The Company’s entities in China are required to contribute based on the higher of 20% of the employees’ monthly base salary or 12% of the minimum social average salary of the city where the facilities are located. Employees are required to contribute 8% of their base salary to the plan. The minimum social average salary is announced by the local Social Security bureau and updated annually. Total pension expense incurred by the Company for the three months ended September 30, 2014 and 2013 amounted to $5.0 million and $2.3 million, respectively, and for the nine months ended September 30, 2014 and 2013 amounted to $10.8 million and $6.4 million, respectively.

 

Note 21 – Commitment and contingencies

 

Operating Lease Commitments

 

Total operating lease commitments for rental of offices, buildings, equipment and land use rights of the Company’s PRC subsidiaries as of September 30, 2014 is as follows:

 

Year ending June 30,  Minimum lease payment 
   (in thousands) 
2015  $871 
2016   566 
2017   566 
2018   566 
2019   566 
Years after   19,644 
Total minimum payments required  $22,779 

 

Total rental expense was $0.9 million and $0.8 million for the three months ended September 30, 2014 and 2013, respectively, and $2.4 million and $2.4 million for the nine months ended September 30, 2014 and 2013, respectively.

 

Contractual Commitments

 

Longmen Joint Venture has $110.7 million contractual obligations related to construction projects as of September 30, 2014 estimated to be fulfilled between November 2014 and September 2015.

 

Contingencies

 

As of September 30, 2014, Longmen Joint Venture provided guarantees to related parties’ and third parties’ bank loans, including lines of credit and others, amounting to $196.7 million.

 

Nature of guarantee  Guarantee
amount
   Guaranty Due Date
   (In thousands)    
Line of credit  $127,644   Various from December 2014 to September 2015
Three-party financing agreements   14,463   Various from April to June 2015
Confirming storage   41,600   Various from October 2014 to April 2015
Financing by the rights of goods delivery in future   13,000   October 2014
Total  $196,707    

 

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Name of parties being guaranteed  Guarantee
amount
   Guaranty Due Date
   (In thousands)    
Long Steel Group  $79,706   Various from December 2014 to September 2015
Hancheng Haiyan Coking Co., Ltd   25,350   Various from October 2014 to April 2015
Chengdu Zhongyi Steel Co., Ltd   8,125   March 2015
Shaanxi Fuping Steel Co., Ltd   3,088   June 2015
Xi’an Laisheng Logistics Co., Ltd   3,250   May 2015
Xi'an Kaiyuan Steel Sales Co., Ltd   6,500   January 2015
Shaanxi Longan Industry Co., Ltd.   8,125   December 2014
Hancheng Sanli Furnace Burden Co., Ltd.   16,250   March 2015
Tianjin Dazhan Industry Co., Ltd   20,313   Various from January to March 2015
Tianjin Hengying Trading Co., Ltd   26,000   Various from October 2014 to January 2015
Total  $196,707    

 

As of September 30, 2014, the Company did not accrue any liability for the amounts the Group has guaranteed for third parties and related parties because those parties are current in their payment obligations and the Company has not experienced any losses from providing guarantees. The Company has evaluated the debt guarantees and concluded that the likelihood of having to make payments under the guarantees is remote and that the fair value of the stand-ready obligation under these commitments is not material.

 

Note 22 – Segments

 

The Company’s chief operating decision maker evaluates performance and determines resource allocations based on a number of factors, the primary measure being income from operations of the Group’s four regional divisions in the PRC: Longmen Joint Venture in Shaanxi province, Maoming Hengda in Guangdong province, Baotou Steel Pipe Joint Venture in Inner Mongolia province and General Steel (China) & Tianwu Joint Venture in Tianjin City.

 

The Group operates in one business segment that includes four different divisions. These reportable divisions are consistent with the way the Company manages its business, each division operates under separate management groups and produces discrete financial information. The accounting principles applied at the operating division level in determining income from operations is generally the same as those applied at the consolidated financial statement level.

 

The following represents the results of division operations for the three months ended September 30, 2014 and 2013:

 

(In thousands)        
Sales:  2014   2013 
Longmen Joint Venture  $559,317   $606,444 
Maoming Hengda   1,122    252 
Baotou Steel Pipe Joint Venture   2,383    2,921 
General Steel (China) & Tianwu Joint Venture   20,335    4,236 
Total sales   583,157    613,853 
Interdivision sales   (20,335)   (3,758)
Consolidated sales  $562,822   $610,095 

 

Gross profit (loss):  2014   2013 
Longmen Joint Venture  $9,010   $8,122 
Maoming Hengda   (80)   (57)
Baotou Steel   178    160 
General Steel (China) & Tianwu Joint Venture   502   6 
Total gross profit (loss)   9,610    8,231 
Interdivision gross profit   -    - 
Consolidated gross profit (loss)  $9,610   $8,231 

 

Income (loss) from operations:  2014   2013 
Longmen Joint Venture  $9,746   $30,306 
Maoming Hengda   (248)   (719)
Baotou Steel   (30)   20 
General Steel (China) & Tianwu Joint Venture   841   (695)
Total income (loss) from operations   10,309    28,912 
Interdivision income (loss) from operations   -    - 
Reconciling item (1)   (2,406)   (1,177)
Consolidated income (loss) from operations  $7,903   $27,735 

 

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Net income (loss) attributable to General Steel Holdings, Inc.:  2014   2013 
Longmen Joint Venture  $(3,378)  $8,284 
Maoming Hengda   (318)   (694)
Baotou Steel   (24)   16 
General Steel (China) & Tianwu Joint Venture   2,595   (2,689)
Total net loss attributable to General Steel Holdings, Inc.   (1,125)   4,917 
Interdivision net income   -    - 
Reconciling item (1)   (2,365)   (1,116)
Consolidated net loss attributable to General Steel Holdings, Inc.  $(3,490)  $3,801 

 

Depreciation, amortization and depletion:  2014   2013 
Longmen Joint Venture  $22,960   $21,014 
Maoming Hengda   437    307 
Baotou Steel   64    62 
General Steel (China) & Tianwu Joint Venture   447    505 
Consolidated depreciation, amortization and depletion  $23,908   $21,888 

 

Finance/interest expenses:  2014   2013 
Longmen Joint Venture  $17,831   $20,591 
Maoming Hengda   1    1 
Baotou Steel   -    - 
General Steel (China) & Tianwu Joint Venture   1,588    2,249 
Interdivision interest expenses   -    - 
Reconciling item (1)   2    1 
Consolidated interest expenses  $19,422   $22,842 

 

Capital expenditures:  2014   2013 
Longmen Joint Venture  $5,096   $16,455 
Maoming Hengda   16    - 
Baotou Steel   1    - 
General Steel (China) & Tianwu Joint Venture   -    - 
Reconciling item (1)   -    - 
Consolidated capital expenditures  $5,113   $16,455 

 

 The following represents the results of division operations for the nine months ended September 30, 2014 and 2013:

 

(In thousands)        
Sales:  2014   2013 
Longmen Joint Venture  $1,740,645   $1,903,933 
Maoming Hengda   1,373    3,124 
Baotou Steel Pipe Joint Venture   3,028    3,902 
General Steel (China) & Tianwu Joint Venture   20,388    58,416 
Total sales   1,765,434    1,969,375 
Interdivision sales   (20,388)   (54,338)
Consolidated sales  $1,745,046   $1,915,037 

 

Gross profit (loss):  2014   2013 
Longmen Joint Venture  $15,020   $(23,704)
Maoming Hengda   (35)   188 
Baotou Steel   158    249 
General Steel (China) & Tianwu Joint Venture   -   29 
Total gross profit (loss)   15,143    (23,238)
Interdivision gross profit   -    - 
Consolidated gross profit (loss)  $15,143   $(23,238)

 

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Loss from operations:  2014   2013 
Longmen Joint Venture  $(21,420)  $20,558 
Maoming Hengda   (824)   (1,741)
Baotou Steel   (207)   (285)
General Steel (China) & Tianwu Joint Venture   (2,445)   (2,293)
Total loss from operations   (24,896)   16,239 
Interdivision loss from operations   -    - 
Reconciling item (1)   (4,539)   (3,504)
Consolidated loss from operations  $(29,435)  $12,735 

 

Net loss attributable to General Steel Holdings, Inc.:  2014   2013 
Longmen Joint Venture  $(49,489)  $(18,335)
Maoming Hengda   (978)   (1,681)
Baotou Steel   (165)   (227)
General Steel (China) & Tianwu Joint Venture   (3,118)   (9,373)
Total net loss attributable to General Steel Holdings, Inc.   (53,750)   (29,616)
Interdivision net income (loss)   -    - 
Reconciling item (1)   (4,323)   (3,298)
Consolidated net loss attributable to General Steel Holdings, Inc.  $(58,073)  $(32,914)

 

Depreciation, amortization and depletion:  2014   2013 
Longmen Joint Venture  $69,268   $62,295 
Maoming Hengda   899    933 
Baotou Steel   185    185 
General Steel (China) & Tianwu Joint Venture   1,344    1,542 
Consolidated depreciation, amortization and depletion  $71,696   $64,955 
           
Finance/interest expenses:  2014   2013 
Longmen Joint Venture  $69,952   $60,984 
Maoming Hengda   1    1 
Baotou Steel   -    - 
General Steel (China) & Tianwu Joint Venture   4,685    7,927 
Interdivision interest expenses   -    - 
Reconciling item (1)   98    3 
Consolidated interest expenses  $74,736   $68,915 

 

Capital expenditures:  2014   2013 
Longmen Joint Venture  $117,695   $60,461 
Maoming Hengda   48    2 
Baotou Steel   1    8 
General Steel (China) & Tianwu Joint Venture   82    3 
Reconciling item (1)   -    - 
Consolidated capital expenditures  $117,826   $60,474 

 

Total Assets as of:  September 30, 2014   December 31, 2013 
Longmen Joint Venture  $2,583,371   $2,573,212 
Maoming Hengda   27,154    29,211 
Baotou Steel Pipe Joint Venture   5,601    4,448 
General Steel (China) & Tianwu Joint Venture   223,517    121,883 
Interdivision assets   (73,311)   (34,213)
Reconciling item (2)   1,945    5,817 
Total Assets  $2,768,277   $2,700,358 

 

  (1) Reconciling item represents the unallocated income or expenses of the Company, arising from General Steel Investment Co., Ltd, Yangpu Shengtong Investment Co., Ltd and Qiu Steel for the three and nine months ended September 30, 2014 and 2013.

 

  (2) Reconciling item represents assets held at General Steel Holdings, Inc., General Steel Investment Co., Ltd, Yangpu Shengtong Investment Co., Ltd and Qiu Steel as of September 30, 2014 and December 31, 2013.

 

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Note 23 – Subsequent events

 

On July 14, 2014, the Company entered into a Subscription Agreement (the "Subscription Agreement") with Zuosheng Yu, the Company's Chief Executive Officer and a member of the Company's Board of Directors, relating to a private placement of the Company's common stock, par value $0.001 per share. On October 23, 2014, after certain closing conditions contained in the Subscription Agreement were satisfied, the transaction closed and the Company sold to Zuosheng Yu 5,000,000 shares of common stock at a purchase price of $1.50 per share (the "Purchase Price"), upon receipt of $7,500,000 in gross proceeds in accordance with the terms of the Subscription Agreement. The Purchase Price represents a 23% premium to the volume weighted average closing price of the Common Stock from March 5, 2014 to July 11, 2014, which ranged from $0.90 to $1.47 per share of common stock during the period. Upon completion of this transaction, Zuosheng Yu beneficially owned 44.7% of the Company’s common stock.

 

On September 30, 2014, Longmen Joint Venture entered into a short-term loan agreement with Shaanxi Steel, the majority shareholder of Long Steel Group, for $32.5 million (RMB 200.0 million) with annual interest rate of 7.6% and due on March 29, 2015. Longmen Joint Venture subsequently received the loan amount on October 8, 2014 and October 9, 2014.

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Note Regarding Forward-Looking Statements

 

The following discussion of the financial condition and results of operations should be read in conjunction with the unaudited condensed consolidated financial statements and related notes thereto. The following discussion contains forward-looking statements. General Steel Holdings, Inc. is referred to herein as “we,” “our,” “us” and “the Company.” The words or phrases “would be,” “will allow,” “expect to,” “intends to,” “will likely result,” “are expected to,” “will continue,” “is anticipated,” “estimate,” or similar expressions are intended to identify forward-looking statements. Such statements include those concerning our expected financial performance, our corporate strategy and operational plans. Actual results could differ materially from those projected in the forward-looking statements as a result of a number of risks and uncertainties, including: (a) those risks and uncertainties related to general economic conditions in the People’s Republic of China, including regulatory factors that may affect such economic conditions; (b) whether we are able to manage our planned growth efficiently and operate profitable operations, including whether our management will be able to identify, hire, train, retain, motivate and manage required personnel or that management will be able to successfully manage and exploit existing and potential market opportunities; (c) whether we are able to generate sufficient revenues or obtain financing to sustain and grow our operations; and (d) whether we are able to successfully fulfill our primary requirements for cash which are explained below under “Liquidity and Capital Resources.” Unless otherwise required by applicable law, we do not undertake, and we specifically disclaim any obligation, to update any forward-looking statements to reflect occurrences, developments, unanticipated events or circumstances after the date of such statement. Additional information regarding certain factors which could cause actual results to differ from such forward-looking statements include, but are not limited to, those described in Item 1A, “Risk Factors”, in our Annual Report on Form 10-K/A for the fiscal year ended December 31, 2013 filed with the SEC on August 19, 2014.

 

Third Quarter Highlights

 

The third quarter of 2014 was highlighted with the following:

 

  · Sales in the third quarter of 2014 decreased by 7.7% to $562.8 million, from $610.1 million in the third quarter of 2013, due to the decrease in the average selling price of our products despite the increase in sales volume. For the third quarter of 2014, sales volume of rebar in Shaanxi Longmen Iron and Steel Co., Ltd. (“Longmen Joint Venture”) totaled 1.44 million metric tons, an increase of 16.3%, compared with 1.24 million metric tons in the third quarter of 2013, with an average selling price of $388.1 per ton, as compared with $489.6 per ton in the third quarter of 2013.

 

  · Gross profit in the third quarter of 2014 was $9.6 million, or 1.7% of total revenue, compared with $8.2 million, or 1.3% of total revenue in the third quarter of 2013.
     
  · Total finance expense in the third quarter of 2014 was $19.4 million, as compared with $22.8 million for the same period in 2013. Finance expenses mainly consisted of interest expense on capital leases, which was $5.2 million and $5.1 million in the third quarter of 2014 and 2013, respectively, and interest expense on bank borrowings and discounted notes receivable, which was $14.2 million and $17.7 million in the second quarter of 2014 and 2013, respectively.

 

  · Loss per share was $(0.06) in the third quarter of 2014, compared to an income per share of $0.07 in the third quarter of 2013. The decrease of income in 2014 was mainly due to the decrease in the gain from the change in fair value of profit sharing liability, which led a decrease in the income from operations.

 

OVERVIEW

 

We were incorporated on August 5, 2002, in the State of Nevada. We are headquartered in Beijing, China and operate a portfolio of Chinese steel companies. We serve various industries and produce a variety of steel products including, but not limited to: reinforced bars (“rebar”), hot-rolled carbon, spiral-weld pipes and high-speed wire. Our current aggregate annual production capacity of crude steel products, consisting mainly of steel rebar, is 7 million metric tons. Our rebar products have a variety of demand drivers, such as rural income, infrastructure construction and energy consumption. Domestic economic conditions are also an overall demand driver for all our products.

 

Our vision is to become one of the largest and most profitable non-government controlled steel companies in the People’s Republic of China (“PRC”). Our mission is to grow our business organically, and through the acquisition of Chinese steel companies, increase profitability and efficiency by utilizing western management practices and advanced production technologies, and the infusion of capital resources.

 

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Our two-pronged growth strategy focuses on a combination of capacity expansion, as well as optimizing operating efficiencies and leverage.

 

  · We aim to grow revenue by increasing capacity and through continual cooperation and partnerships with leading state-owned enterprises (SOEs).

 

  · We aim to drive profitability through improved operational efficiencies and optimization of our cost structure.

 

Unless the context indicates otherwise, as used herein the terms “General Steel”, the “Company”, “we”, “our” and “us” all refer to General Steel Holdings, Inc. 

 

Steel-Related Subsidiaries and Raw Material Trading Company

 

We presently have controlling interests in four steel-related subsidiaries:

 

  · General Steel (China) Co., Ltd. (“General Steel (China)”);
  · Baotou Steel - General Steel Special Steel Pipe Joint Venture Company Limited (“Baotou Steel Pipe Joint Venture”);
  · Shaanxi Longmen Iron and Steel Co., Ltd. (“Longmen Joint Venture”);
  · Maoming Hengda Steel Co., Ltd. (“Maoming Hengda”).

 

Our Company, together with our subsidiaries, majority owned subsidiaries and variable interest entity, are referred to as the Group.

 

General Steel (China) Co., Ltd

 

General Steel (China), formerly known as “Tianjin Daqiuzhuang Metal Sheet Co., Ltd.” started operations in 1988.

 

On May 14, 2009, General Steel (China) changed its official name from “Tianjin Daqiuzhuang Metal Sheet Co., Ltd.” to better reflect its role as a merger and acquisition platform for steel company investments in China.  In some instances, General Steel (China) retains the use of the name “Daqiuzhuang Metal” for brand recognition purposes within the industry.

 

On May 1, 2011 General Steel (China) entered into a lease agreement with Tianjin Shuangjie Liansheng Rolled Steel Co., Ltd. (the “Lessee”), whereby General Steel (China) leased parts of the facilities its facility located at No. 1, Tonga Street, Daqiuzhuang Town, Jinghai County, Tianjin City to the Lessee for a monthly payment of $0.1 million (RMB 0.5 million). The lease expires in May 2021. Management evaluates the fair value of its long-term assets on an annual basis, or upon a triggering event which would require an assessment sooner, and is of the opinion that the fair value of the property, plant and equipment as supported by the operating lease approximates its current carrying value

 

Baotou Steel - General Steel Special Steel Pipe Joint Venture Company Limited

 

On April 27, 2007, General Steel (China) and Baotou Iron and Steel Group Co., Ltd. (“Baotou Steel”) entered into an Amended and Restated Joint Venture Agreement, amending the Joint Venture Agreement entered into on September 28, 2005, to increase General Steel (China)’s ownership interest in the related joint venture to 80%. The joint venture’s name is Baotou Steel - General Steel Special Steel Pipe Joint Venture Company Limited, a Chinese limited liability company (“Baotou Steel Pipe Joint Venture”). Baotou Steel Pipe Joint Venture obtained its business license from governmental authorities in the PRC on May 25, 2007, and commenced operations in July 2007. Baotou Steel Pipe Joint Venture has four production lines capable of producing 100,000 metric tons of double spiral-weld pipes primarily used in the energy sector to transport oil and steam. These pipes have a diameter ranging from 219mm to 1240mm, a wall thickness ranging from 6mm to 13mm, and a length ranging from 6m to 12m. Presently, Baotou Steel Pipe Joint Venture sells its products using an internal sales force to customers in the Inner Mongolia Autonomous Region and the northwest region of the PRC.

 

Shaanxi Longmen Iron and Steel Co., Ltd

 

Effective June 1, 2007, through General Steel (China) and Tianjin Qiu Steel Investment Co., Ltd. (“Qiu Steel”), a 99% owned subsidiary of General Steel (China), we entered into a Joint Venture Agreement with Shaanxi Longmen Iron & Steel Group Co., Ltd. (“Long Steel Group”) to form Shaanxi Longmen Iron and Steel Co., Ltd. (“Longmen Joint Venture”). Through General Steel (China) and Qiu Steel, we invested approximately $39.3 million in cash and collectively held a 60% ownership interest in Longmen Joint Venture until April 29, 2011, when a 20-year Unified Management Agreement (the “Unified Management Agreement”) was entered into between our Company, Longmen Joint Venture, Shaanxi Coal and Shaanxi Steel. Longmen Joint Venture was determined to be a Variable Interest Entity (“VIE”) and we are the primary beneficiary.

 

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Currently, Longmen Joint Venture has five branch offices, four consolidated subsidiaries and one entity in which it has a noncontrolling interest. It employs approximately 8,100 full-time workers.  In addition to steel production, Longmen Joint Venture operates transportation services through its Changlong Branch, located in Hancheng city, Shaanxi Province. Changlong Branch owns 177 vehicles and provides transportation services exclusively to Longmen Joint Venture.

 

Longmen Joint Venture’s rebar products are categorized within the steel industry as “longs” (in reference to their shape). Rebar is generally considered a regional product because its weight and dimension make it ill-suited for cost-effective long-haul ground transportation. By our estimates, the market demand for rebar in Shaanxi Province is six to eight million metric tons per year. Slightly more than half of this demand comes from Xi’an, the capital of Shaanxi Province, located 180km from Longmen Joint Venture’s main steel production site. Currently, we estimate that we have approximately a 72% share of the Xi’an market for rebar.

 

An established regional network of one hundred and twelve distributors, together with smaller distributors and eleven sales offices sell Longmen Joint Venture’s products. All products are sold under the registered brand name of “Yulong”, which has strong regional recognition and awareness. Rebar and billet products carry ISO 9001 and 9002 certification and other Longmen Joint Venture’s products have won national quality awards. Products produced at the facility have been used in the construction of the Yangtze River Three Gorges Dam, the Xi’an International Airport, the Xi’an city subway system and the Xi Luo Du and Xiang Jia Ba hydropower projects.

 

From June 2009 to March 2011, we worked with Shaanxi Steel to build new iron and steel making facilities, including two 1,280 cubic meter blast furnaces, two 120 metric ton converters, one 400 square meter sintering machine and some auxiliary systems.  As a result, Longmen Joint Venture incurred certain costs of construction as well as economic losses on suspended production of certain small furnaces and other equipment to accommodate the construction of the new equipment, on behalf of Shaanxi Steel. See Note 14 - “Deferred lease income” of the Notes to Condensed Consolidated Financial Statements included herein

 

On April 29, 2011, a 20-year Unified Management Agreement (“the Agreement”) was entered into between the Company, the Company’s 60%-owned subsidiary Shaanxi Longmen Iron and Steel Co., Ltd. (“Longmen Joint Venture”), Shaanxi Coal and Chemical Industry Group Co., Ltd. (“Shaanxi Coal”) and Shaanxi Iron and Steel Group (“Shaanxi Steel”). Shaanxi Steel is the controlling shareholder of Shaanxi Longmen Iron and Steel Group Co., Ltd (“Long Steel Group”) which is the non-controlling interest holder in Longmen Joint Venture, and Shaanxi Coal, a state owned entity, is the parent company of Shaanxi Steel. Under the terms of the Agreement, all manufacturing machinery and equipment of Longmen Joint Venture and the $605.8 million (or approximately RMB 3.7 billion) of the constructed iron and steel making facilities owned by Shaanxi Steel, which includes one 400 m 2 sintering machine, two 1,280 m 3 blast furnaces, two 120 ton converters and some auxiliary systems, are managed collectively as a single virtual asset pool (“Asset Pool”). Longmen Joint Venture manages the Asset Pool as the principal operating entity and is responsible for the daily operations of the new and existing facilities. The Agreement leverages each of the parties’ operating strengths, allowing Longmen Joint Venture to derive the greatest benefit from the cooperation and the newly constructed iron and steel making facilities. At the designed efficiency level, the facilities contribute three million tons of crude steel production capacity per year.

 

Longmen Joint Venture pays Shaanxi Steel for the use of the constructed iron and steel making facilities an amount equaling the depreciation expense on the equipment constructed by Shaanxi Steel as well as 40% of the pre-tax profit generated by the Asset Pool. The remaining 60% of the pre-tax profit is allocated to Longmen Joint Venture. As a result, the Company’s economic interest in the profit or loss generated by Longmen Joint Venture decreased from 60% to 36%. However, the overall capacity under the management of Longmen Joint Venture increased by three million tons, or 75%. The Agreement improved Longmen Joint Venture’s cost structure through sustainable and steady sourcing of key raw materials and reduced transportation costs. The distribution of profit is subject to a prospective adjustment after the first two years based on each entity’s actual investment of time and resources into the Asset Pool. There has been no adjustment to the Agreement from its inception to the present time nor intention to make future adjustment by the Company and Shaanxi Steel.

 

The parties to the Agreement established the Shaanxi Longmen Iron and Steel Unified Management Supervisory Committee ("Supervisory Committee") to ensure that the facilities and related resources are operated and managed according to the stipulations set forth in the Agreement. The Board of Directors of Longmen Joint Venture, of which the Company holds 4 out of 7 seats, requires a simple majority vote and remains the controlling decision-making body of Longmen Joint Venture and the Asset Pool. See Note 2(c) “Consolidation of VIE.”

 

The Agreement constitutes an arrangement that involves a lease which meets certain of the criteria of a capital lease and therefore the assets constructed by Shaanxi Steel are accounted for by Longmen Joint Venture as a capital lease. The profit sharing liability portion of the lease obligation, representing 40% of the pre-tax profit generated by the Asset Pool, is accounted for by Longmen Joint Venture as a derivative financial instrument at fair value. See Notes 2 “Summary of significant accounting policies”, 15 “Capital lease obligations” and 16 “Profit sharing liability”.

 

In November 2010, we brought online a 1,200,000 metric ton capacity rebar production line, which was renovated based on an existing 800,000 metric ton capacity rebar production line. In July 2011, we brought online a 1,000,000 metric ton capacity high speed wire production line. These two newly installed production lines were both relocated from the Maoming Hengda (as defined below) facility and consume less energy when running at maximum efficiency compared to our previous production line.

 

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Maoming Hengda Steel Co., Ltd

 

On June 25, 2008, through our subsidiary Qiu Steel, we paid approximately $7.1 million (RMB 50 million) in cash to purchase 99% of Maoming Hengda Steel Group, Ltd. (“Maoming Hengda”).  The total registered capital of Maoming Hengda is approximately $77.8 million (RMB 544.6 million).

 

Maoming Hengda’s core business was the production of rebar products used in the construction industry.  Located on 140 hectares (approximately 346 acres) in Maoming city, Guangdong Province, the Maoming Hengda facility previously had two production lines capable of annual production capacities of 1.8 million metric tons of 5.5mm to 16mm diameter high-speed wire and 12mm to 38mm diameter rebar. The products were sold through nine distributors which targeted customers in Guangxi Province and the western region of Guangdong. To take advantage of a stronger market demand in Shaanxi Province, between 2009 and 2010, we relocated the 1.8 million metric ton capacity rebar production line from Maoming Hengda's facility to Longmen Joint Venture.

 

In December 2010, we brought online a new 400,000 ton capacity rebar production line. On December 15, 2013, Maoming Hengda entered into a lease agreement with Zhongshan Baohua Rebar Factory, with which Maoming Hengda leased the 400,000 ton capacity rebar production line and various other buildings and equipment to Zhongshan Baohua Rebar Factory, for an annual payment of $1.2 million (RMB 7.2 million) for eight years between March 2014 and February 2022.

 

Production Capacity Information Summary by Subsidiary

 

 Annual Production

Capacity (metric tons)

  General Steel
(China) (1)
    Baotou Steel Pipe
Joint Venture
  Longmen Joint
Venture 
  Maoming
Hengda (1)
 
Crude Steel   -     -   7 million   -  
                     
Processing   400,000     100,000   5 million   400,000  
                     
Main Products   Hot-rolled sheet     Spiral-weld pipe   Rebar/High-speed wire   Rebar  
                     
Main Application   Light Agricultural vehicles     Energy transport   Infrastructure and construction   Infrastructure and construction  

 

  (1) The production facilities of General Steel (China) and Maoming Hengda currently are leased to unrelated parties.

 

Marketing and Customers

 

We sell our products primarily to distributors, and we typically collect payment from these distributors in advance.  Our marketing efforts are mainly directed toward those customers who have demanding requirements for on-time delivery, timeliness of customer services, and product quality.  We believe that these requirements, as well as product planning, are critical factors in our ability to serve this segment of the market.

 

Our revenue is dependent, in large part, on significant contracts with a limited number of large customers. For the three and nine months ended September 30, 2014, 16.0% and 16.9% of our sales were to five customers, respectively. We believe that revenue derived from our current and future large customers will continue to represent a significant portion of our total revenue.

 

Moreover, our success will depend in part upon our ability to obtain orders from new customers, as well as the financial condition and success of our customers and general economic conditions in China.

 

Demand for our Products

 

For the three months ended September 30, 2014 and 2013, rebar, our major product, comprised more than 99.4% of our sales. For the nine months ended September 30, 2014 and 2013, rebar, our major product, comprised more than 99.7% and 99.4% of our sales, respectively. Overall, domestic economic growth is an important driver of demand for our major product, especially from construction and infrastructure projects.

 

At Longmen Joint Venture, growth in regional construction and infrastructure projects drives demand for our products. According to the 12th Five Year National Economic and Social Development Plan (“NESDP”) (2011-2015), development of China’s western region is one of China’s top five economic priorities. Shaanxi Province, where Longmen Joint Venture is located, has been designated as a focal point for development in the Western region, and Xi’an, the provincial capital, has been designated as a focal point for this development in China. Longmen Joint Venture is 180 kilometers from Xi’an and it does not have a major competitor within a 250 km radius.

 

The Western region of China, where our major sales market is located, has experienced a higher rate of growth than other Chinese regions in recent years. Compared to an increase of 7.7% for the national GDP, a GDP increase of 11% was reported by Shaanxi Province in 2013 over the previous year. As the national GDP increased by 7.4% for the first nine months of 2014, Shaanxi Province reported a higher-than-national-average GDP growth of 9.6% in the same period. Additionally, according to Accounting and Corporate Finance Production Statistics in China, Sichuan Province also reported a GDP increase of 10%. We have a sales office in Chengdu City, Sichuan Province to meet the increasing demand for the production of steel.

 

According to the Shaanxi provincial government, the total fixed asset investment for the Shaanxi Province was $257.4 billion (RMB 1.59 trillion) for the year ended December 31, 2013, an increase of 24.1% over the same period in 2012.

 

41
 

  

At the end of June 2009, the State Council Office announced that it approved the Guanzhong-Tianshui Economic Zone development program. This program covers the development of two western provinces and seven cities from 2009 to 2020.

 

In addition, the Guanzhong-Tianshui Economic Zone will concentrate on the development of the Xi’an area. The metropolitan area construction program focuses on the cities of Xi’an, Xianyang, and their surrounding areas, covering up to 12,000 square kilometers, including the construction of railways, highways, subways, airport expansion and newly developed areas. Under this program, the Shaanxi provincial government has announced that it will build approximately 4,500 kilometers of railway with an investment of approximately $40 billion (RMB 260 billion) by 2015 and 8,080 kilometers of highway by 2020. The infrastructure and construction projects provide strong and stable demand for our steel products in this area, in which we have over 70% of the market share.

 

In January 2011, the Shaanxi provincial government announced that it will invest approximately $13 billion (RMB 80 billion) in the construction of hydro projects, which is three times the amount invested during the 11th Five Year National Economic and Social Development Plan. In addition to hydro projects, according to the central government, 16,000 kilometers of high speed railway will be built by 2020. 

 

In May 2011, the central government passed the Cheng-Yu Economic Zone Plan focusing on Chongqing City and Sichuan Province, covering 206,000 square kilometers, to further accelerate the development of the western region of China.  We anticipate that in the near future, the demand for our products will increase in those areas, and we expect that our expanded production capacity will be able to successfully meet the increase in demand. Furthermore, we have a sales office located in Chengdu to help facilitate such increased demand.

 

In February 2012, the government approved the Western Development 12th Five Year Plan, which continues the efforts to develop the Western areas. The Plan is centered on infrastructure and construction, highlighted by the development of economic zones, construction of roads/railway and hydro projects, which drive the local demand for steel products.

 

In February 2014, the National Development and Reform Commission (“NDRC”) announced nine focal points of the western development, which will speed up major infrastructure construction in the western areas, including the construction of railway, highway and hydro-projects.

 

We anticipate strong demand for our products driven by these and many other construction and infrastructure projects. We believe there will be sustained regional demand for several years as both the central and provincial governments continue to drive western region development efforts.

 

At Baotou Steel Pipe Joint Venture, energy sector growth, which spurs the need to transport oil, natural gas and steam, drives demand for spiral-weld steel pipe. Presently, demand is fueled by smaller pipeline projects and municipal energy infrastructure projects within the Inner Mongolia Autonomous Region.

 

Supply of Raw Materials

 

The primary raw materials we use for steel production are iron ore, coke, hot-rolled steel coil and steel billets.  Baotou Steel Pipe Joint Venture uses hot-rolled steel coil as its main raw material.  Longmen Joint Venture uses iron ore and coke as its main raw materials.  Iron ore is the main raw material used to produce hot-rolled steel coil and steel billets. Therefore, the prices of iron ore and coke are the primary raw material cost drivers for our products.

 

Iron Ore

 

Longmen Joint Venture has 7 million tons of annual crude steel production capacity. At Longmen Joint Venture, approximately 76% of production costs are associated with raw materials, with iron ore being the largest component.

  

According to the China Iron and Steel Association, approximately 60% of the Chinese domestic steel industry’s demand for iron ore must be filled by imports. At Longmen Joint Venture, we purchase iron ore from four primary sources: Mulonggou mine (owned by Longmen Joint Venture), Daxigou mine (owned by Long Steel Group, our partner in Longmen Joint Venture), surrounding local mines and mines located abroad.

 

Coke

 

Coke, produced from metallurgical coal (also known as coking coal), is our second most consumed raw material, after iron ore. It requires approximately 550kg to 600kg of coke to make one metric ton of crude steel.

 

Under the terms of the Unified Management Agreement, our partner, Shaanxi Coal, has committed to providing coke and coal to us at a cost not higher than the market price.

 

Our Longmen Joint Venture facility is located in the center of China’s coal belt. We source all coke used at Longmen Joint Venture from the town in which Longmen Joint Venture is located. This ensures a dependable local supply and minimum transportation costs.

 

42
 

  

The sources and/or our top five major suppliers of our raw materials for the three months ended September 30, 2014 are as follows:

 

Name of Major Supplier  Raw Material
Purchased
  % of Total Raw
Material
Purchased
   Relationship with
Company
Jiahui Mining Industry Co., Ltd.  Iron Ore   5.5%  Third Party
Shaanxi Haiyan Coal Chemical Industry Co., Ltd.  Coke   4.8%  Related Party
Shaaxi Longmen Coal Chemical Industry Co., Ltd  Coke   4.4%  Third Party
Long Steel Group  Iron Ore   2.4%  Related Party
Baotou Bangli Industry Co., Ltd.  Iron Ore   1.7%  Third Party
   Total   18.8%   

 

The sources and/or our top five major suppliers of our raw materials for the nine months ended September 30, 2014 are as follows:

 

Name of Major Supplier  Raw Material
Purchased
  % of Total Raw
Material
Purchased
   Relationship with
Company
Long Steel Group Import & Export Co., Ltd  Iron Ore   7.4%  Related Party
Shaanxi Longmen Coal Chemical Industry Co., Ltd  Coke   6.9%  Third Party
Shaanxi Haiyan Coal Chemical Industry Co., Ltd.  Coke   6.1%  Related Party
Long Steel Group  Iron Ore   5.0%  Related Party
Tianwu General Steel Material Trading Co., Ltd.  Iron Ore   4.1%  Related Party
   Total   29.5%   

 

Industry Environment

 

Despite demand growth experienced throughout the past years, the overall nationwide steelmaking capacity still exceeds steel demand. There is significant over-capacity in the Chinese steel sector which is putting pressure on operators’ profitability and has become the most significant challenge in the steel manufacturing business. Chinese crude steel production was 618 million tons from January to September in 2014, an increase of 2.34% compared with the same period last year, while the total consumption of crude steel reached 560 million tons from January to September in 2014, an decrease of 0.9% from the same period last year, according to the China Iron and Steel Association.

 

For steelmakers, operating performance depends on the volatility of the cost of raw materials. The shortage of these raw materials in the market has allowed suppliers of iron ore and metallurgical coal to rebuild the pricing mechanisms through the shift from annual to shorter-term price contracts. This has created numerous challenges for steelmakers as they must now deal with volatility in raw material prices, as well as maintain margins with fluctuating demand. Over the past few years, we have witnessed perseverance in steel prices that has given iron ore producers an opportunity to increase the prices in the next contract; however the reverse may not be true as steel companies cannot always pass on the rise in iron ore prices to end consumers due to the market overcapacity and fragmentation.

 

The Chinese central government has had a long-stated goal to consolidate 70% of domestic steel production among the top ten producers by 2020. Currently, there are over 500 crude steel producers throughout China, and the top ten producers account for approximately 48% of total national output. In April 2012, the central government announced its goal of reducing obsolete iron and steel capacities by 17.8 million tons in 2012 and successfully reached the goal and eliminated 20.2 million tons of obsolete iron and steel capacity. In April 2013, the central government published the industry target of eliminating 10.4 million tons of obsolete iron and steel capacities in 2013 and successfully eliminated 16.9 million tons of obsolete iron and steel capacity. In March 2014, the government reaffirmed its determination of industry consolidation, and announced that it plans to eliminate 27 million tons of obsolete iron and steel capacity in order to reach the industry goal of 12th five-year plan ahead of schedule in 2014. However, we continue to see a strong demand for our products and believe there are significant growth opportunities in the industry and market we serve and such consolidation is not expected to directly impact our Company.

 

 On July 12, 2010, the Ministry of Industry & Information Technology enacted the Steel Industry Admittance and Operation Qualifications standards. The new standards specify requirements for all aspects of steel production in China, which include: size of blast furnaces, size of converters, emission of waste water, dust per ton from steel production, quantity of coal used for each process in steel production and output capacity.  According to the new standards, blast furnaces under 450 cubic meters are targeted to be eliminated. These standards once again confirmed the central government’s determination to push forward the consolidation of this fragmented industry.  As the operational conditions become more stringent, more small and medium sized companies will likely aggressively look for valued partners which could lead to opportunities for high quality acquisitions for us.  We believe the above government policy will strengthen our position as an industry consolidator by creating qualified potential acquisition targets.

 

Since 2013, the government has exerted a more stringent environment protection policy on the steel industry. In January 2014, the Ministry of Industry and Information Technology of the People's Republic of China (the "MIIT") announced a List of Enterprises Fulfilling the Iron and Steel Industry Specification (the "List").  The List includes a highly-selected group of large and medium steel manufacturers that have met or exceeded more stringent national requirements and standards on product quality, environmental protection, energy consumption, workmanship and equipment, production scale, as well as work safety and social responsibility. The MIIT will collaborate with China's other governmental agencies to provide support to the List's members and to speed up the steel industry's restructuring and consolidation. Steel makers omitted from the List will most likely face higher electricity costs, more restrictive administrative measures, and adverse effects of forceful regulations intent on reducing the nation's overcapacity. Longmen Joint Venture, the major facility of General Steel, has been included on the List as the only enterprise in China’s Shaanxi Province.

43
 

  

Results of Operations for the Three and Nine Months Ended September 30, 2014

 

Sales

 

Three months ended September 30, 2014 compared with three months ended September 30, 2013

 

The following table sets forth sales and volume in metric tons.

 

   Three months ended         
   September 30, 2014   September 30, 2013   Change   Change 
in thousands, except metric
tons
  Volume   Sales   %   Volume   Sales   %   Volume
%
   Sales
%
 
                                 
Longmen Joint Venture   1,441,094   $559,317    99.4%   1,238,689   $606,446    99.4%   16.3%   (7.8)%
Others   5,436    3,505    0.6%   18,132    3,649    0.6%   (70.0)%   (3.9)%
Total Sales   1,446,530   $562,822    100.0%   1,256,821   $610,095    100.0%   15.1%   (7.7)%

 

Total sales for the three months ended September 30, 2014 decreased by 7.7% to $562.8 million from $610.1 million for the same period in 2013. The decrease in sales compared with the same period in 2013 was due to the decrease in the average selling price of our rebar products. Longmen Joint Venture comprised 99.4% and 99.4% of total sales for the third quarter of 2014 and 2013, respectively. Sales volume of rebar increased by 16.3% to 1.44 million metric tons, compared with 1.24 million metric tons in the same period in 2013. The average selling price of rebar decreased by 20.7% to approximately $388.1 per ton in the third quarter of 2014 compared with approximately $489.6 per ton in the same period of 2013.

 

Our product demands and prices had been rising in the first two quarters of 2012. As a result of the China and global steel industry over-capacity, Chinese economic control polices and the financial crisis, commodity prices declined significantly in the third quarter of 2012. With weakened demand, market forces kicked-in and the price of steel dropped substantially. As such, our sales prices have dropped since the third quarter of 2012, evidencing a continued decline. The over-capacity issue continued to impact our results during the year of 2013 and into 2014. Further, the gradual slowdown in the Chinese economic growth indirectly impacted our industry, and the selling price of our products continued to decrease during this period in comparison with the same period in 2013.

  

Our five major customers are distributors and collectively represented 16.0% of our total sales for the three months ended September 30, 2014 compared with 25.5% of our total sales for the three months ended September 30, 2013. As we are the largest supplier in Shaanxi Province, we maintain a good relationship with these five customers to stabilize our sales channel. 

 

Nine months ended September 30, 2014 compared with nine months ended September 30, 2013

 

The following table sets forth sales and volume in metric tons.

 

   Nine months ended         
   September 30, 2014   September 30, 2013   Change   Change 
in thousands, except metric
tons
  Volume   Sales   %   Volume   Sales   %   Volume
%
   Sales
%
 
                                 
Longmen Joint Venture   4,063,761   $1,740,645    99.7%   3,841,985   $1,903,933    99.4%   5.8%   (8.6)%
Others   7,472    4,401    0.3%   104,163    11,104    0.6%   (92.8)%   (60.4)%
Total Sales   4,071,233   $1,745,046    100.0%   3,946,148   $1,915,037    100.0%   3.2%   (8.9)%

 

Total sales for the nine months ended September 30, 2014 decreased by 8.9% to $1.7 billion from $1.9 billion for the same period in 2013. The decrease in sales compared with the same period in 2013 was predominantly due to the decreased average selling price. Longmen Joint Venture comprised 99.7% and 99.4% of total sales for the nine months ended September 30, 2014 and 2013, respectively. Sales volume of rebar increased by 5.8% to 4.06 million metric tons, compared with 3.84 million metric tons in the same period in 2013. The average selling price of rebar decreased by 13.6% to approximately $428.3 per ton in the nine months ended September 30, 2014 compared with approximately $495.6 per ton in the same period of 2013.

 

44
 

 

Our product demands and prices had been rising in the first two quarters of 2012. As a result of the China and global steel industry over-capacity, Chinese economic control polices and the financial crisis, commodity prices declined significantly in the third quarter of 2012. With weakened demand, market forces kicked-in and the price of steel dropped substantially. As such, our sales prices have dropped since the third quarter of 2012, evidencing a continued decline. The over-capacity issue continued to impact our results during the year of 2013 and into 2014. Further, the gradual slowdown in the Chinese economic growth indirectly impacted our industry, and the selling price of our products continued to decrease during this period in comparison with the same period in 2013.

 

Our five major customers are distributors and collectively represented 16.9% of our total sales for the nine months ended September 30, 2014 compared with 23.4% of our total sales for the nine months ended September 30, 2013. These five customers included related parties and major distributors owned by the central government. As we are the largest supplier in Shaanxi Province, we maintain a good relationship with these five customers to stabilize our sales channel. 

 

Cost of Goods Sold

 

Three months ended September 30, 2014 compared with three months ended September 30, 2013

 

   Three months ended         
   September 30, 2014   September 30, 2013   Change   Change 
in thousands, except metric
tons
  Volume   Cost of
Goods Sold
   %   Volume   Cost of
Goods Sold
   %   Volume
%
   Cost of
Goods Sold
%
 
                                 
Longmen Joint Venture   1,441,094   $550,307    99.5%   1,238,689   $598,324    99.4%   16.3%   (8.0)%
Others   5,436    2,905    0.5%   18,132    3,540    0.6%   (70.0)%   (17.9)%
Total Cost of Goods Sold   1,446,530   $553,212    100.0%   1,256,821   $601,864    100.0%   15.1%   (8.1)%

 

Our primary cost of goods sold is the cost of raw materials such as iron ore, coke, alloy and scrap steel. The costs of iron ore and coke accounted for 61.2% of our total cost of sales. The cost of goods sold decreased by 8.1% to $553.2 million in the third quarter of 2014 from $601.9 million in the same period of 2013. The decrease was mainly driven by the decreased unit costs of raw materials as a result of the decline in iron ore and coke purchase prices of 25.3% and 15.8%, respectively, for the three months ended September 30, 2014 compared with the same period in 2013. As such, the average costs of rebar manufactured decreased 20.9% to $381.9 per ton in the third quarter of 2014 from $483.0 per ton in the same period of 2013.

 

Nine months ended September 30, 2014 compared with Nine months ended September 30, 2013

 

   Nine months ended         
   September 30, 2014   September 30, 2013   Change   Change 
in thousands, except metric
tons
  Volume   Cost of
Goods Sold
   %   Volume   Cost of
Goods Sold
   %   Volume
%
   Cost of
Goods Sold
%
 
                                 
Longmen Joint Venture   4,063,761   $1,725,625    99.8%   3,841,985   $1,927,639    99.5%   5.8%   (10.5)%
Others   7,472    4,278    0.2%   104,163    10,636    0.5%   (92.8)%   (59.8)%
Total Cost of Goods Sold   4,071,233   $1,729,903    100.0%   3,946,148   $1,938,275    100.0%   3.2%   (10.8)%

 

Our primary cost of goods sold is the cost of raw materials such as iron ore, coke, alloy and scrap steel. The costs of iron ore and coke accounted for 70.3% of our total cost of sales. Cost of goods sold decreased by 10.8% to $1.7 billion in the nine months ended September 30, 2014 from $1.9 billion in the same period of 2013. The decrease was mainly driven by the decreased unit costs of raw materials as a result of the decline in iron ore and coke purchase prices of 13.2% and 17.1%, respectively, for the nine months ended September 30, 2014 compared with the same period in 2013. As such, the average costs of rebar manufactured decreased 15.4% to $424.6 per ton in the nine months ended September 30, 2014 from $501.7 per ton in the same period of 2013.

 

Gross Profit (Loss)

 

Three months ended September 30, 2014 compared with three months ended September 30, 2013

 

   Three months ended     
   September 30, 2014   September 30, 2013   Change 
in thousands, except metric
tons
  Volume   Gross Profit   Margin
%
   Volume   Gross Profit   Margin
%
   Gross Profit 
                             
Longmen Joint Venture   1,441,094   $9,010    1.6%   1,238,689   $8,122    1.3%   10.9%
Others   5,436    600    17.1%   18,132    109    3.0%   450.5%
Total Gross Profit   1,446,530   $9,610    1.7%   1,256,821   $8,231    1.3%   16.8%

 

45
 

  

Gross profit for the third quarter of 2014 was $9.6 million, or 1.7% of total sales, compared with $8.2 million, or 1.3% of total sales in the same period in 2013. The increase in gross margin percentage was mainly attributable to the percentage decrease in the costs of rebar manufactured of 20.9%, which was higher than the percentage decrease in the average rebar selling price of 20.7% compared with the same period of 2013.

  

Nine months ended September 30, 2014 compared with nine months ended September 30, 2013

 

   Nine months ended     
   September 30, 2014   September 30, 2013   Change 
in thousands, except metric
tons
  Volume   Gross
Profit
(Loss)
   Margin
%
   Volume   Gross
Profit
(Loss)
   Margin
%
   Gross
Profit
 
                             
Longmen Joint Venture   4,063,761   $15,020    0.9%   3,841,985   $(23,706)   (1.2)%   (163.4)%
Others   7,472    123    2.8%   104,163    468    4.2%   (73.7)%
Total Gross Profit (Loss)   4,071,233   $15,143    0.9%   3,946,148   $(23,238)   (1.2)%   (165.2)%

 

Gross profit for the nine months ended September 30, 2014 was $15.1 million, or 0.9% of total sales, compared with a gross loss of $23.2 million, or (1.2)% of total sales in the same period in 2013. The increase in gross margin percentage was mainly attributable to the percentage decrease in the costs of rebar manufactured of 15.4%, which was higher than the percentage decrease in the average rebar selling price of 13.6% compared with the same period of 2013.

 

Selling, General and Administrative Expenses (“SG&A”)

 

Three months ended September 30, 2014 compared with three months ended September 30, 2013

 

(in thousands)  Three months ended     
   September 30,
2014
   September 30,
2013
   Change % 
             
Selling, general and administrative expenses  $(16,434)  $(19,661)   (16.4)%
SG&A expenses as a percentage of total revenue   (2.9)%   (3.2)%     

 

SG&A expenses, such as travel expenses and transportation fees, entertainment, employee benefits, and training expenses decreased by 16.4% to $16.4 million for the three months ended September 30, 2014, compared with $19.7 million for the same period in 2013.

 

Selling expenses decreased by 7.6% to $6.7 million for the three months ended September 30, 2014 compared with $7.3 million in the same period of 2013. The decrease was mainly due to the decrease in sales tax expenses along with the 7.7% decrease in sales in the third quarter of 2014.

 

In addition, general and administrative (“G&A”) expenses were approximately $9.7 million and $12.4 million for three months ended September 30, 2014 and 2013, respectively. The 21.6% decrease was mainly due to the decrease in salary expenses, union expenses, employee education and training expenses, and depreciation expense in the third quarter of 2014 compared with the same period in 2013.

 

Nine months ended September 30, 2014 compared with Nine months ended September 30, 2013

 

(in thousands)  Nine months ended     
   September 30,
2014
   September 30,
2013
   Change % 
             
Selling, general and administrative expenses  $(56,336)  $(59,464)   (5.3)%
SG&A expenses as a percentage of total revenue   (3.2)%   (3.1)%     

 

SG&A expenses, such as travel expenses and transportation fees, entertainment, employee benefit, and training expenses decreased by 5.3% to $56.3 million for the nine months ended September 30, 2014, compared to $59.5 million for the same period in 2013.

 

Selling expenses increased by 0.6% to $24.7 million for nine months ended September 30, 2014 as compared to $24.6 million in the same period of 2013. The increase was mainly due to the increase in freight expenses as a result of the PRC government’s policy to increase freight train fees in early 2014.

 

In addition, general and administrative (“G&A”) expenses were approximately $31.6 million and $34.9 million for nine months ended September 30, 2014 and 2013, respectively. The 9.4% decrease was mainly due to the decrease in salary expenses and water treatment expenses.

 

46
 

  

Change in Fair Value of Profit Sharing Liability

 

Three months ended September 30, 2014 compared with three months ended September 30, 2013

 

(in thousands)  Three months ended     
   September 30,
2014
   September 30,
2013
   Change % 
                
Change in fair value of profit sharing liability  $14,727   $39,164    (62.4)%

 

Our profit sharing liability relates to equipment operated by Longmen Joint Venture under a capital lease arrangement. Part of the payments under the capital lease is a portion of our future operating profits. Our estimate of those future profit sharing payments are accounted for as a derivative liability at fair value. In 2013, we considered the recent changes in China’s economic situation, which included a new estimation and downgrade of 2014 GDP by major investment bankers in June 2013, and steel industry outlook reports issued for 2014. As a result, we re-evaluated our projected operating profit (loss) taking into consideration the macroeconomic events in China, as well as our most recent operating results. Due to the continued decrease in our rebar selling price, the market slow-down in the first quarter of 2013, and the lack of gross profit recovery as quickly as expected in 2012, we foresaw a greater downward trend in 2014 through 2016 than previously anticipated in 2012. As our projected profit (loss) decreased in 2013, the fair value of our profit sharing liability was reduced compared with our previous estimates in 2012 and we recognized a gain of $39.2 million in our income from operations for the three months ended September 30, 2013. In September 2014, Goldman Sachs published its latest global economic forecast, which showed a greater downgrade of China’s GDP growth rate from 2014 to 2017 than projected in prior year. Thus we re-evaluated our projected operating profit (loss) taking into consideration both the projected GDP downgrade in China and our recent operating results. As a result, we recognized a gain of $14.7 million on the change in the fair value of the profit sharing liability primarily due to the reduction in the fair value of profit sharing liability as a result of the change in estimate of future operating results.

 

Nine months ended September 30, 2014 compared with Nine months ended September 30, 2013

 

(in thousands)  Nine months ended     
   September 30,
2014
   September 30,
2013
   Change % 
                
Change in fair value of profit sharing liability  $11,758   $95,437    (87.7)%

 

As discussed above, our projected profit (loss) decreased in 2013, and as a result, the fair value of our profit sharing liability was reduced compared with our previous estimates in 2012 and we recognized a gain of $95.4 million in our income (loss) from operations for the nine months ended September 30, 2013. In 2014, the fair value of profit sharing liability was further reduced, and we recognized a gain of $11.8 million primarily as a result of the change in estimate of future operating results based on the downgraded GDP for China through 2017 published by Goldman Sachs in September 2014. Thus we recognized a gain on the change in the fair value of the profit sharing liability of $11.8 million.

 

Income (Loss) from Operations

 

Three months ended September 30, 2014 compared with three months ended September 30, 2013

 

(in thousands)  Three months ended     
   September 30,
2014
   September 30,
2013
   Change % 
                
Income from operations  $7,903   $27,734    (71.5)%

 

Income from operations for the three months ended September 30, 2014 was $7.9 million, compared to $27.7 million for the same period in 2013. The decrease in income from operations was predominantly due to the decrease in the gain from the change in fair value of the profit sharing liability, offset by the increase in gross profit and the decrease in SG&A expenses.

 

Nine months ended September 30, 2014 compared with Nine months ended September 30, 2013

 

(in thousands)  Nine months ended     
   September 30,
2014
   September 30,
2013
   Change % 
                
(Loss) income from operations  $(29,435)  $12,735    (331.1)%

  

47
 

 

Loss from operations for the nine months ended September 30, 2014 was $29.4 million, compared with an income of $12.7 million for the same period in 2013. The increase in the loss from operations was predominantly due to the decrease in the gain from the change in fair value of the profit sharing liability, offset by the increase in gross profit and the decrease in SG&A expenses.

 

Other Income (Expense)

 

Three months ended September 30, 2014 compared with three months ended September 30, 2013

 

(in thousands)  Three months ended     
   September 30,
2014
   September 30,
2013
   Change % 
             
Interest income  $2,767   $2,835    (2.4)%
Finance/interest expense   (14,194)   (17,721)   (19.9)%
Financing cost on capital lease   (5,228)   (5,121)   2.1%
(Loss) gain on disposal of equipment   (21)   17    (223.5)%
Income from equity investment   32    47    (31.9)%
Foreign currency transaction gain   3,146    322    877.0%
Lease income   542    542    0.0%
Other non-operating (expense) income, net   (18)   770    (102.3)%
Total other expense, net  $(12,974)  $(18,309)   (29.1)%

 

Total other expense, net, for the three months ended September 30, 2014 was $13.0 million, a 29.1% decrease compared with $18.3 million for the same period in 2013. The decrease was mainly a result of the $3.5 million decrease in finance/interest expense and $2.8 million increase in foreign currency transaction gain from the appreciation of our USD loans. The decrease in finance/interest expense was mainly a result of the decrease in the amount borrowed from third parties and related parties in the third quarter of 2014 compared with the same period in 2013.

 

Nine months ended September 30, 2014 compared with Nine months ended September 30, 2013

 

(in thousands)  Nine months ended     
   September 30,
2014
   September 30,
2013
   Change % 
             
Interest income  $10,025   $8,657    15.8%
Finance/interest expense   (58,753)   (53,577)   9.7%
Financing cost on capital lease   (15,983)   (15,338)   4.2%
Gain (loss) on disposal of equipment   (117)   113    (203.5)%
Income from equity investment   99    137    (27.7)%
Foreign currency transaction gain   1,329    448    (196.7)%
Lease income   1,630    1,613    1.1%
Other non-operating income, net   108    1,560    (93.1)%
Total other expense, net  $(61,662)  $(56,387)   9.4%

 

Total other expense, net, for the nine months ended September 30, 2014 was $61.7 million, a 9.4% increase compared with $56.4 million for the same period in 2013. The increase was mainly a result of the $5.2 million increase in finance/interest expense. The increase in finance/interest expense was mainly a result of the increase in finance charges from bank notes receivable redemptions prior to maturity offset by the decrease in the amount borrowed from third parties and related parties for the nine months ended September 30, 2014 compared with the same period in 2013. As a result, notes receivable early redemption expenses for the nine months ended September 30, 2014 amounted to $37.1 million, a $10.2 million or 37.9% increase from $26.9 million for the same period in 2013, and interest expense on loan borrowings for the nine months ended September 30, 2014 amounted to $21.6 million, a $5.1 million or 19.1% decrease from $26.7 million for the same period in 2013.

  

Income Taxes

 

For the three months ended September 30, 2014 and 2013, we had a total tax provision of $93,000 and $25,000, respectively, from our profitable subsidiaries. For the three months ended September 30, 2014, we evaluated the deferred tax assets of Longmen Joint Venture and Baotou Steel Pipe Joint Venture and concluded the net operating loss may not be fully realizable and thus we provided a 100% valuation allowance for the deferred tax assets. No deferred income tax provision was recorded for the three months ended September 30, 2014 as the deferred tax assets had been fully reserved.

 

For the three months ended September 30, 2014 and 2013, we had effective tax rates of (1.8)% and 0.3%, respectively.

 

48
 

 

For the nine months ended September 30, 2014 and 2013, we had a total tax provision of $205,000 and $201,000, respectively, from our profitable subsidiaries. For the nine months ended September 30, 2014, we evaluated the deferred tax assets of Longmen Joint Venture and Baotou Steel Pipe Joint Venture and concluded the net operating loss may not be fully realizable and thus we provided a 100% valuation allowance for the deferred tax assets. As a result, no deferred income tax provision was recorded for the nine months ended September 30, 2014 as the deferred tax assets had been fully reserved.

 

For the nine months ended September 30, 2014 and 2013, we had effective tax rates of (0.2)% and (0.5)%, respectively.

 

Net (Loss) Income

 

Three months ended September 30, 2014 compared with three months ended September 30, 2013

 

(in thousands)  Three months ended     
   September 30,
2014
   September 30,
2013
   Change % 
                
Net (loss) income  $(5,164)  $9,400    (154.9)%

 

Nine months ended September 30, 2014 compared with Nine months ended September 30, 2013

 

(in thousands)  Nine months ended     
   September 30,
2014
   September 30,
2013
   Change % 
                
Net Loss  $(91,302)  $(43,853)   108.2%

 

Net (Loss) Income Attributable to General Steel Holdings, Inc.

 

Three months ended September 30, 2014 compared with three months ended September 30, 2013

 

(in thousands)  Three months ended     
   September 30,
2014
   September 30,
2013
   Change % 
                
Net (loss) income  $(5,164)  $9,400    (154.9)%
Less: Net (loss) income attributable to the non-controlling interest   (1,674)   5,599    (129.9)%
Net (loss) income attributable to General Steel Holdings, Inc.  $(3,490)  $3,801    (191.8)%

 

Net loss attributable to us for the three months ended September 30, 2014 was $3.5 million compared with a net income of $3.8 million for the same period in 2013. The increase in net loss attributable to us for the three months ended September 30, 2014 was mainly a result of the $24.4 million decrease in the gain from the change in the fair value of our profit sharing liability offset by the $3.2 million decrease in SG&A expense and the $5.3 million decrease in other expenses, net.

 

We have subsidiaries in which we do not have a 100% ownership interest. Allocation of income or loss to these non-controlling interests is based on the percentage of their equity investment times the subsidiaries’ net income or loss.

 

Nine months ended September 30, 2014 compared with Nine months ended September 30, 2013

 

(in thousands)  Nine months ended     
   September 30,
2014
   September 30,
2013
   Change % 
                
Net loss  $(91,302)  $(43,853)   108.2%
Less: Net loss attributable to the non-controlling interest   (33,229)   (10,939)   203.8%
Net loss attributable to General Steel Holdings, Inc.  $(58,073)  $(32,914)   76.4%

 

Net loss attributable to us for the nine months ended September 30, 2014 was $58.1 million compared with $32.9 million for the same period in 2013. The increase in net loss attributable to us for the nine months ended September 30, 2014 was mainly a result of the $38.4 million increase in gross profit offset by an $83.7 million decrease in the gain from the change in the fair value of our profit sharing liability and a $5.2 million increase in finance/interest expense.

 

We have subsidiaries in which we do not have a 100% ownership interest. Allocation of income or loss to these non-controlling interests is based on the percentage of their equity investment times the subsidiaries’ net income or loss.

 

49
 

 

Liquidity and capital resources

 

As of September 30, 2014, our current liabilities exceeded our current assets by approximately $1.5 billion. Given our expected capital expenditure in the foreseeable future, we have comprehensively considered our available sources of funds as follows:

 

  · Financial support and credit guarantees from related parties; and
  · Other available sources of financing from domestic banks and other financial institutions given our credit history. 

 

Based on the above considerations, Management and our Board of Directors are of the opinion that we have sufficient funds to meet our working capital requirements and debt obligations as they become due for at least the next year from the reporting date. As a result, our unaudited condensed consolidated financial statements for the period ended September 30, 2014 have been prepared on a going concern basis.

 

As of September 30, 2014, we had cash and restricted cash aggregating $405.4 million, of which $383.3 million was restricted.

 

We believe our cash flows generated from operations and financing, which include customer prepayments and vendor financing, existing cash balances, and credit facilities will be adequate to finance our working capital requirements, fund capital expenditures, make required debt and interest payments, pay taxes, and support our operating strategies.

 

The steel business is capital intensive and we utilize leverage greater than our industry peers, which we believe enables us to generate revenue compared to our shareholder equity at a rate higher than our industry peers. We utilize leverage in the form of credit from banks, vendor financing and customer deposits and from other sources. This blended form of financing reduces our reliance on any single source.

 

Substantially all our operations are conducted in China and all of our revenues are denominated in Renminbi (“RMB”). RMB is subject to exchange control regulation in China, and, as a result, we may have difficulty distributing any dividends outside of China due to PRC exchange control regulations that restrict our ability to convert RMB into U.S. Dollars.

 

Under applicable PRC regulations, foreign-invested enterprises in China may pay dividends only out of their accumulated profits, if any, determined in accordance with PRC accounting standards and regulations. In addition, a foreign-invested enterprise in China is required to set aside at least 10% of its after-tax profit based on PRC accounting standards each year to its general reserves until the accumulative amount of such reserves reaches 50% of its registered capital. These reserves are not distributable as cash dividends. The board of directors of a foreign-invested enterprise has the discretion to allocate a portion of its after-tax profits to staff welfare and bonus funds, which may not be distributed to equity owners except in the event of liquidation. Under PRC law, RMB is currently convertible into U.S. Dollars under a company’s “current account,” which includes dividends, trade and service-related foreign exchange transactions, without prior approval of the State Administration of Foreign Exchange (SAFE), but is not convertible from a company’s “capital account,” which includes foreign direct investments and loans, without the prior approval of the SAFE.

 

We have previously raised money in the U.S. capital markets which provided the capital needed for our operations and for General Steel Investment Co, Ltd. (“General Steel Investment”). Thus the foreign currency restrictions and regulations in the PRC on dividend distributions will not have a material impact on the liquidity, financial condition and results of operations of General Steel Holdings, Inc. and General Steel Investment.

 

Although the steel industry is slowing down due to over-capacity issues in the PRC, in order for us to stay competitive, we continue to look for opportunities to improve the efficiency of our production lines. In addition to the renovation of an existing 800,000 metric ton capacity rebar production line that we brought online in November 2010, in July 2011, we also brought online a 1,000,000 metric ton capacity high speed wire production line. These two newly installed production lines were both relocated from our Maoming Hengda facility and will consume less energy when running at maximum efficiencies compared with our previous production line. In September 2012 we began the construction of a 900,000 metric ton capacity rebar production line, which was completed and put into production in September 2013. In March 2013, we began the construction of a 1,200,000 metric ton capacity rebar production line for the purpose of reducing our reprocessing cost and to increase our profit margin. The 1,200,000 metric ton capacity rebar production line was completed and put into production in February 2014. Any future facility expansion will require additional financing and/or equity capital and will be dependent upon the availability of financing arrangements and capital at the time.

 

Short-term Notes Payable

 

As of September 30, 2014, we had $784.3 million in short-term notes payable liabilities, which were secured by restricted cash of $371.0 million and restricted notes receivable of $26.0 million. These are lines of credit extended by banks for a maximum of six months and are used to finance working capital. The short-term notes payable must be paid in full at maturity and credit availability is continued upon payment at maturity. There are no additional significant financial covenants. We pay zero interest on this type of credit as this is a monetary tool used by China’s central bank to control liquidity over the Chinese monetary system. However, we are required to pay a transaction fee of 0.05% of the notes’ value. In addition, the banks usually require us to deposit either a certain amount of cash at the bank as a guarantee deposit or provide notes receivable as security.

 

50
 

 

Short-term Loans – Banks

 

As of September 30, 2014, we had $248.3 million in short-term bank loans. These were bank loans with a one year maturity and must be paid in full upon maturity. We believe our current creditors will renew their loans to us after our loans mature as they did in the past.

  

We are able to repay our short-term notes payables and short term bank loans upon maturity using available capital resources.

 

For more details about our debt, see Note 9 in our Notes to the unaudited condensed consolidated financial statements included in this report.

 

For more details about our related party debt financing, see Note 19 in our Notes to the unaudited condensed consolidated financial statements included in this report.

 

As part of our working capital management, Longmen Joint Venture has entered into a number of sale and purchase back contracts (“Contracts”) with third party companies and two 100% owned subsidiaries of Longmen Joint Venture, named Yuxin Trading Co., Ltd. (“Yuxin”) and Yuteng Trading Co., Ltd. (“Yuteng”). Pursuant to the Contracts, Longmen Joint Venture sells rebar to the third party companies at a certain price, and within the same month, Yuxin and Yuteng will purchase back the rebar from the third party companies at a price between 4.6% to 9.6% higher than the original selling price from Longmen Joint Venture. Based on the Contract terms, Longmen Joint Venture is paid in advance for the rebar sold to the third party companies and Yuxin and Yuteng are given a credit period of several months to one year for the purchase back of the inventory from the third party companies. There is no physical movement of the inventory during the sale and purchase back arrangement. The margin between 4.6% to 9.6% is determined by reference to the bank loan interest rates at the time when the Contracts are entered into, plus an estimated premium based on the financing sale amount, which represents the interest charged by the third party companies for financing Longmen Joint Venture through the above sale and purchase back arrangement. As such, the revenue and cost of goods sold arising from the above transactions are recorded on a net basis and the incremental amounts paid by Yuxin and Yuteng to purchase back the goods are treated as financing costs in the consolidated financial statements.

 

Total financing sales for the three months ended September 30, 2014 and 2013 amounted to $259.7 million and $166.2 million, respectively, which were eliminated in our consolidated financial statements. The financial cost related to financing sales for the three months ended September 30, 2014 and 2013 amounted to $1.4 million and $1.1 million, respectively.

 

Total financing sales for the nine months ended September 30, 2014 and 2013 amounted to $719.3 million and $519.5 million, respectively, which were eliminated in our consolidated financial statements. The financial cost related to financing sales for the Nine months ended September 30, 2014 and 2013 amounted to $3.1 million and $4.2 million, respectively.

 

Liquidity

 

Our accounts have been prepared in accordance with U.S. GAAP on a going concern basis. The going concern basis assumes that assets are realized and liabilities are extinguished in the ordinary course of business at amounts disclosed in the financial statements. Our ability to continue as a going concern depends upon aligning our sources of funding (debt and equity) with our expenditure requirements and repayment of the short-term debt facilities as and when they fall due.

 

The steel business is capital intensive and as a normal industry practice in PRC, we are highly leveraged. Debt financing in the form of short term bank loans, loans from related parties, financing sales, bank acceptance notes, and capital leases have been utilized to finance the working capital requirements and the capital expenditures of our Company. As a result, our debt to equity ratio as of September 30, 2014 and December 31, 2013 were (5.7) and (6.5), respectively. As of September 30, 2014, our current liabilities exceed current assets (excluding deferred lease income) by $1.5 billion.

 

Longmen Joint Venture, as our most important subsidiary, accounted for a majority of our total sales. As such, the majority of our working capital needs come from Longmen Joint Venture. Our ability to continue as a going concern depends heavily on Longmen Joint Venture’s operations, as well as its ability to obtain external financial supports, including but not limited to lines of credit from banks and vendor financing. If Longmen Joint Venture does not maintain a sufficient level of financial support by renewing its financing terms with existing financing sources or obtaining new sources of financial support, there may be an immediate negative impact on our operations and ability to continue as a going concern. Longmen Joint Venture has obtained different types of financial support, which include lines of credit from banks, vendor financing, financing sales, other financing and sales representative financing.

 

For more details and terms about our financial support, see Note 2(d) in our Notes to the unaudited condensed consolidated financial statements.

 

With the financial support from the banks and the companies discussed in Note 2(d) in our Notes to the unaudited condensed consolidated financial statements, management is of the opinion that we have sufficient funds to meet our future operations, working capital requirements and debt obligations until the end of September 30, 2015. The detailed breakdown of Longmen Joint Venture’s estimated cash flow items are listed below.

 

51
 

 

   Cash inflow (outflow)
(in millions)
 
   For the twelve months ending
September 30, 2015
 
Estimated current liabilities over current assets (excluding deferred lease income) as of September 30, 2014 (unaudited)  $(1,537.9)
Projected cash financing and outflows:     
Cash provided by lines of credit from banks   141.4 
Cash provided by vendor financing   893.8 
Cash provided by other financing   662.6 
Cash provided by sales representatives   32.2 
Cash projected to be used in operations in the twelve months ending September 30, 2015   (33.5)
Cash projected to be used for financing cost in the twelve months ending September 30, 2015   (58.0)
Net projected change in cash for the twelve months ending September 30, 2015  $100.6 

 

As a result, the unaudited condensed consolidated financial statements for the nine months ended September 30, 2014 have been prepared on a going concern basis.

 

Cash-flow

 

Operating Activities

 

Net cash provided by operating activities for the nine months ended September 30, 2014 and 2013 were $42.6 million and 14.0 million, respectively. This change was mainly due to the combination of the following factors:

 

  · The impact of some non-cash items included in net income (loss) of $72.0 million for the nine months ended September 30, 2014, compared with $(16.7) million in the same period in 2013. The non-cash items include the following:

 

  - Depreciation, amortization and depletion;
  - Change in fair value of derivative liabilities - warrants;
  - Change in fair value of profit sharing liability.
  - (Gain) loss on disposal of equipment and intangible assets;
  - Provision for doubtful accounts;
  - Reservation of mine maintenance fee;
  - Stock issued for service and compensation;
  - Amortization of deferred financing cost on capital lease;
  - Income from equity investments;
  - Foreign currency transaction gain; and
  - Deferred lease income.

 

  · The primary reasons for the material fluctuations in cash inflow were as follows:

 

  - Notes receivable: The decrease was mainly due to less notes receivable being received as a form of payment in the first nine months of 2014 compared with the same period in 2013;
  - Prepaid taxes: The decrease was mainly due to the decrease in prepaid VAT purchase taxes which was offset by the increase in VAT sales tax in the first nine months of 2014 compared with the same period in 2013;
  - Accounts payable - related parties: The increase in accounts payable - related parties was mainly due to Longmen Joint Venture making more purchases from related parties during the nine months ended September 30, 2014 compared with the same period in 2013. Pursuant to the supplier financing agreements signed between Longmen Joint Venture and its suppliers, those suppliers agreed not to demand certain cash payments for a certain period; and
  - Other payables and accrued liabilities, including related parties: The increase was mainly due to Longmen Joint Venture incurring more payables to third parties and related parties for cash flow purposes during the nine months ended September 30, 2014 compared with the same period in 2013.
  -

Customer deposits, including related parties: The increase in customer deposits, including related parties, was mainly due to our customers making more prepayments to us in the nine months ended September 30, 2014. These deposits were subsequently recognized as sales after September 30, 2014 in accordance with our sales recognition policy. 

 

  · The primary reasons for material fluctuations in cash outflow were as follows:

 

  - Accounts receivable: The increase was mainly due to more credit sales to both third parties and related parties were incurred that have not yet been collected for the nine months ended September 30, 2014 compared with the same period in 2013;
  - Other receivables, including related parties: The increase was mainly due to mainly due to less miscellaneous receivables were collected from third parties and related parties in the first nine months of 2014 compared with the same period in 2013;
  - Inventories: The increase was mainly due to more finished goods being produced than sold during the nine months ended September 30, 2014 compared to the same period in 2013 as a result of the 20.7% decrease in average rebar sales price;

 

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  - Advance on inventory purchases - related parties: The increase was mainly due to more advance payments made to related parties for raw material purchases to meet future production requirements. Advance payments are a prevailing requirement on iron ore purchases in the steel production industry; and
  - Accounts payable: The decrease in accounts payable was mainly due to Longmen Joint Venture making fewer purchases from third parties during the nine months ended September 30, 2014 compared with the same period in 2013.

 

Investing activities

  

Net cash used in investing activities was $104.6 million for the nine months ended September 30, 2014 compared with $146.6 million for the nine months ended September 30, 2013. Fluctuations in cash outflow between the two periods was mainly due to the increase in cash used for equipment and intangible asset purchases offset by the decrease in restricted cash along with the decrease in notes payable, which cash deposits were restricted for, for the nine months ended September 30, 2014 compared to the same period in 2013. Cash used for equipment and intangible asset purchases amounted to $117.8 million for the nine months ended September 30, 2014, compared with $75.3 million in the same period in 2013.

 

Financing activities

 

Net cash provided by financing activities was $51.1 million for the nine months ended September 30, 2014 compared with $146.8 million for the nine months ended September 30, 2013. Compared with the same period in 2013, the decrease of cash inflow from financing activities was mainly driven by the following:

 

  · Restricted notes receivable: We borrowed less notes payables to banks for the nine months ended September 30, 2014 compared with the same period in 2013 and thus required less notes receivable to be restricted;

  · Short term loans – others: We borrowed and repaid fewer loans from third parties during the nine months ended September 30, 2014 compared with the same period in 2013; and

  · Short term loans – related parties: We borrowed and repaid fewer loans from related parties during the nine months ended September 30, 2014 compared with the same period in 2013.
  · Deposits due to sales representatives, including related parties: We received more deposits from sales representatives during the nine months ended September 30, 2014 compared with the same period in 2013.

 

The cash inflow was offset by the following cash outflow:

 

·Short term notes payable: We borrowed less notes payables to banks to pay suppliers for the nine months ended September 30, 2014 compared with the same period in 2013 and repaid more notes payable from the banks during the quarter; and
·Short term loans - bank: We repaid more money to banks during the nine months ended September 30, 2014 as they became due compared with the same period in 2013 and borrowed more short term loans from banks during the quarter as we generated positive operating cash flows in 2014 allowing us to repay more short term bank loans than borrowed.

  

Impact of Inflation

 

We are subject to commodity price risks arising from price fluctuations in the market prices of our raw materials. We have generally been able to pass on cost increases through price adjustments. However, the ability to pass on these increases depends on market conditions influenced by the overall economic conditions in China. We manage our price risks through productivity improvements and cost-containment measures. We do not believe that inflation risk is material to our business or our financial position, results of operations or cash flows.

 

Compliance with Environmental Laws and Regulations

 

Longmen Joint Venture:

 

Together with our joint venture partners Long Steel Group and Shaanxi Steel, we have invested RMB 580 million in a series of comprehensive projects to reduce our waste emissions of coal gas, water, and solid waste. In 2005, we received ISO 14001 certification for our overall environmental management system. We have received several awards from the Shaanxi provincial government as a result of our increased effort in environmental protection.

 

We have spent in excess of $9.1 million (RMB 57 million) on a comprehensive waste water recycling and water treatment system. The 2,000 cubic meter/h treatment capacity systems were implemented at the end of 2005. In 2010, 1.08 metric tons of new water was consumed per metric ton of steel produced.

 

We have one 10,000 cubic meter coke-oven gas tank, one 50,000 cubic meter blast furnace coal gas tank and one 80,000 cubic meter converter furnace coal gas tank to collect the residual coal gas produced from our facility and that of surrounding enterprises. We also have spent $36.6 million (RMB 230 million) on a thermal power plant with two 25 Kilowatt generators that use the residual coal gas from the blast furnaces and converters as fuel to generate power.

 

53
 

 

We have several plants to further process solid waste generated from the steel making process into useful products such as construction materials, building blocks, porcelain tiles, curb tops, ornamental tiles, as well as other products.

 

In 2009, we treated and recycled about 6.8 million tons of waste water, 335,320 tons of slag, 130 million m³ of gas from the converters and 6.1 billion m³ of gas from the blast furnaces. We also reused 855,714 tons of hot steam and generated 433 million KWH of electricity.

 

During 2010 and 2012, more than $9.6 million (RMB 60 million) was spent on the technical upgrade and renovation of our converters and $0.88 billion (RMB 5.5 billion) was spent on the upgrade of the blast furnaces and sintering machines.

 

In 2012, we installed desulfidation equipment for two sintering machines, which started operating in June 2012.

 

In January 2014, Longmen Joint Venture was elected by the Ministry of Industry and Information Technology of the People's Republic of China (the "MIIT") as the only qualified enterprise in Shaanxi Priovince and was included in the MIIT's List of Enterprises Fulfilling the Iron and Steel Industry Specifications. This List includes a highly-selected group of large and medium steel manufacturers that have met or exceeded more stringent national requirements and standards on environmental protection and energy consumption.

 

Off-balance Sheet Arrangements

 

There were no off-balance sheet arrangements for the period ended September 30, 2014 that have or that, in the opinion of management, are likely to have a current or future material effect on our financial condition or results of operations.

 

Contractual Obligations and Commercial Commitments

 

We have certain fixed contractual obligations and commitments that include future estimated payments. Changes in our business needs, cancellation provisions, changing interest rates, and other factors may result in actual payments differing from the estimates. We cannot provide certainty regarding the timing and amounts of payments. Throughout our operating history, we have funded our contractual obligations and commercial commitments through financing arrangements and operating cash flow, including but not limited to, operating income, payments collected from customers in advance and stock issuances. We have presented in the tables below a summary of the most significant contractual obligations and commercial commitments, in order to assist in the review of this information within the context of our consolidated financial position, results of operations, and cash flows.

 

The following tables summarize our contractual obligations as of September 30, 2014 and the effect these obligations are expected to have on our liquidity and cash flows in future periods.

 

   Payment due by period     
       Less than             
Contractual obligations  Total   1 year   1-3 years   3- 5 years   5 years after 
   (in thousands)     
Notes payable  $784,323   $784,323   $-   $-   $- 
Bank loans (1)   248,289    248,289    -    -    - 
Other loans, including related parties   283,800    283,800    -    -    - 
Deposits due to sales representatives, including related parties   32,226    32,226    -    -    - 
Lease obligations   22,779    871    1,132    1,132    19,644 
Construction obligations - Longmen Joint Venture (2)   110,695    110,695    -    -    - 
Long term loan – Shaanxi Steel   72,124    67,249    4,875    -    - 
Capital lease obligations   395,440    6,825    136,548    28,137    223,930 
Profit sharing liability   149,363    -    -    -    149,363 
Total  $2,099,039   $1,534,278   $142,555   $29,269   $392,937 

 

  (1) Bank loans in the PRC are due either on demand or, more typically, within one year. These loans can be renewed with the banks subject to the bank’s credit reevaluation. These loans amount includes estimated interest payments as well as principal repayment.

 

  (2) Upon completion of the construction obligations – Longmen Joint Venture, if Longmen Joint Venture is unable to repay the obligation when due, Shaanxi Steel will support Longmen Joint Venture for such obligations.

 

As of September 30, 2014, Longmen Joint Venture guaranteed bank loans for related parties and third parties, including lines of credit, amounting to $196.7 million, as follows:

 

Nature of guarantee  Guarantee
amount
   Guaranty Due Date
   (In thousands)    
Line of credit  $127,644   Various from December 2014 to September 2015
Three-party financing agreements   14,463   Various from April to June 2015
Confirming storage   41,600   Various from October 2014 to April 2015
Financing by the rights of goods delivery in future   13,000   October 2014
Total  $196,707