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 March 31, 2011





o
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   000-51006





HARBIN ELECTRIC, INC.


(Exact name of registrant as specified in its charter)





Nevada
98-0403396(State or other jurisdiction ofincorporation or organization)
(I.R.S. EmployerIdentification Number)





No. 9 Ha Ping Xi Lu, Ha Ping Lu Ji Zhong Qu


Harbin Kai Fa Qu, Harbin, People’s Republic of China 150060


(Address of principal executive offices) (Zip Code)





Telephone: 86-451-86116757


(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 past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes xNo o





Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes oNo o




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  o
Accelerated filer xNon-accelerated filer (Do not check if a smaller reporting company) o
Smaller reporting company o





Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes oNo x





APPLICABLE ONLY TO CORPORATE ISSUERS





State the number of shares outstanding of each of the issuer’s classes of common equity, as of May 9, 2011: 31,250,820 shares of common stock, par value $0.00001 per share.














TABLE OF CONTENTS





PagePart I. Financial InformationItem 1. Financial Statements

2Consolidated Balance SheetsAs of March 31, 2011 (Unaudited) and December 31, 2010

2Consolidated Statements of Operations and Other Comprehensive Income (Loss)For the Three Months Ended March 31, 2011 and 2010 (Unaudited)

3Consolidated Statements of Changes in Equity (Unaudited)

4Consolidated Statements of Cash FlowsFor the Three Months Ended March 31, 2011 and 2010 (Unaudited)

5Notes to the Consolidated Financial Statements (Unaudited)

6Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

31Item 3. Quantitative and Qualitative Disclosures About Market Risk

38Item 4. Controls and Procedures

39Part II. Other InformationItem 1. Legal Proceedings

40Item 1A. Risk Factors

41Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

48Item 3. Defaults Upon Senior Securities

48Item 4. (Removed and Reserved)

48Item 5. Other Information

48Item 6. Exhibits

48Signatures

49Index to Exhibits

50


1


PART I. FINANCIAL INFORMATION





Item 1. Financial Statements (Unaudited)




HARBIN ELECTRIC, INC. AND SUBSIDIARIES
  CONSOLIDATED BALANCE SHEETS
 AS OF MARCH 31, 2011 AND DECEMBER 31, 2010
  March 31,


December 31,2011


2010(Unaudited)ASSETSCURRENT ASSETS:Cash and cash equivalents

$
122,826,445


$
98,753,870Restricted cash


15,516,875



1,061,900Notes receivable


8,670,460



1,845,883Accounts receivable, net


80,398,060



85,899,332Inventories, net


55,888,992



62,843,556Other assets, current


3,032,428



2,501,695Advances on inventory purchases


22,670,251



15,893,866Total current assets


309,003,511



268,800,102PLANT AND EQUIPMENT, net


183,934,350



173,074,138OTHER ASSETS:Debt issuance costs, net


455,137



496,804Advances on plant and equipment purchases


36,128,919



48,830,831Advances on intangible assets


3,912,302



3,645,361Goodwill


55,209,362



54,919,738Other intangible assets, net


22,796,478



23,147,079Other assets, non-current


3,710,119



1,403,326Total other assets


122,212,317



132,443,139Total assets

$
615,150,178


$
574,317,379LIABILITIES AND SHAREHOLDERS' EQUITYCURRENT LIABILITIES:Notes payable - short term

$
31,033,750


$
2,123,800Accounts payable


21,605,725



26,881,540Short term loans


30,615,900



29,490,480Customer deposits


20,082,582



14,621,882Accrued liabilities and other payables


12,806,811



17,934,047Taxes payable


9,947,773



8,205,807Amounts due to original shareholders


762,500



758,500Total current liabilities


126,855,041



100,016,056LONG TERM LIABILITIES:Long term loans


50,250,000



50,070,000Warrant liability


1,960,285



1,526,530Total liabilities


179,065,326



151,612,586COMMITMENTS AND CONTINGENCIESSHAREHOLDERS' EQUITY:Common Stock, $0.00001 par value, 100,000,000 shares authorized,31,250,820 shares issued and outstanding as of March 31, 2011and December 31, 2010


312



312Paid-in-capital


218,323,640



218,212,343Retained earnings


145,481,692



136,149,513Statutory reserves


34,602,860



33,129,367Accumulated other comprehensive income


34,809,336



32,360,515Total shareholders' equity


433,217,840



419,852,050NONCONTROLLING INTERESTS


2,867,012



2,852,743Total liabilities and shareholders' equity

$
615,150,178


$
574,317,379
  The accompanying notes are an integral part of these consolidated financial statements.
 2
  HARBIN ELECTRIC, INC. AND SUBSIDIARIES
  CONSOLIDATED STATEMENTS OF OPERATIONS AND OTHER COMPREHENSIVE INCOME (LOSS)
 FOR THE THREE MONTHS ENDED MARCH 31, 2011 AND 2010
 (Unaudited)
  2011


2010REVENUES

$
103,829,424


$
105,485,157COST OF SALES


73,625,636



69,743,087GROSS PROFIT


30,203,788



35,742,070RESEARCH AND DEVELOPMENT EXPENSE


3,878,528



594,195SELLING, GENERAL AND  ADMINISTRATIVE EXPENSES


10,073,382



7,416,758INCOME FROM OPERATIONS


16,251,878



27,731,117OTHER EXPENSE (INCOME)Other income, net


(1,121,201
)


(1,119,286
)Interest expense, net


1,923,950



1,646,923Change in fair value of warrants


433,755



234,078Total other  expense, net


1,236,504



761,715INCOME BEFORE PROVISION FOR INCOME TAXES


15,015,374



26,969,402PROVISION FOR INCOME TAXES


4,195,433



4,063,361NET INCOME BEFORE NONCONTROLLING INTEREST


10,819,941



22,906,041LESS: NET INCOME  ATTRIBUTABLE TO NONCONTROLLING INTEREST


14,269



2,352,353NET INCOME ATTRIBUTABLE TO CONTROLLING INTEREST


10,805,672



20,553,688OTHER COMPREHENSIVE INCOME (LOSS)Foreign currency translation adjustment


2,448,821



91,596Foreign currency translation adjustment attributable to noncontrolling interest


-



(802
)COMPREHENSIVE INCOME

$
13,254,493


$
20,644,482EARNINGS PER SHAREBasicWeighted average number of shares


31,250,820



31,067,471Earnings per share before noncontrolling interest

$
0.35


$
0.74Earnings per share attributable to controlling interest

$
0.35


$
0.66Earnings per share attributable to noncontrolling interest

$
-


$
0.08DilutedWeighted average number of shares


31,364,025



31,353,863Earnings per share before noncontrolling interest

$
0.34


$
0.73Earnings per share attributable to controlling interest

$
0.34


$
0.66Earnings per share attributable to noncontrolling interest

$
-


$
0.07
  The accompanying notes are an integral part of these consolidated financial statements.
  3
  HARBIN ELECTRIC, INC. AND SUBSIDIARIES
 CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY
 Common stock


Additional


Retained earnings


Accumulated otherPar


paid-in


Unrestricted


Statutory


comprehensive


NoncontrollingShares


value


capital


earnings


reserves


income (loss)


interest


TotalBALANCE, January 1, 2010


31,067,471


$
310


$
218,094,374


$
69,594,111


$
22,869,423


$
18,638,299


$
21,299,841


$
350,496,358Amortization of stock compensation










254,670



















254,670Net income














20,553,688











2,352,353



22,906,041Adjustment to statutory reserve














(2,302,999
)


2,302,999











-Foreign currency translation gain






















90,794



802



91,596-BALANCE, March 31, 2010 (Unaudited)


31,067,471



310



218,349,044



87,844,800



25,172,422



18,729,093



23,652,996



373,748,665Amortization of stock compensation










740,109



















740,109Exercise of stock warrants at $10.84


183,349



2



4,510,398



















4,510,400Noncontrolling interest in acquiree






























-Net income














56,261,658











80,058



56,341,716Adjustment to statutory reserve














(7,956,945
)


7,956,945











-Deconsolidation of subsidiaries






















23



(1,604,613
)


(1,604,590
)Acquisition of noncontrolling interest










(5,387,208
)










711



(22,134,423
)


(27,520,920
)Increase in noncontrolling interest


























2,882,353



2,882,353Foreign currency translation gain






















13,630,688



(23,628
)


13,607,060-BALANCE, December 31, 2010


31,250,820



312



218,212,343



136,149,513



33,129,367



32,360,515



2,852,743



422,704,793Amortization of stock compensation










111,297



















111,297Net income














10,805,672











14,269



10,819,941Adjustment to statutory reserve














(1,473,493
)


1,473,493











-Foreign currency translation gain






















2,448,821







2,448,821BALANCE, March 31, 2011 (Unaudited)


31,250,820


$
312


$
218,323,640


$
145,481,692


$
34,602,860


$
34,809,336


$
2,867,012


$
436,084,852
  The accompanying notes are an integral part of these consolidated financial statements.
  4
 
 HARBIN ELECTRIC, INC. AND SUBSIDIARIES
  CONSOLIDATED STATEMENTS OF CASH FLOWS
 FOR THE THREE MONTHS ENDED MARCH 31, 2011 AND 2010
 (Unaudited)
 2011


2010CASH FLOWS FROM OPERATING ACTIVITIES:Net income attributable to noncontrolling interest

$
14,269


$
2,352,353Net income attributable to controlling interest


10,805,672



20,553,688Consolidated net income


10,819,941



22,906,041Adjustments to reconcile net income to cash provided by (used in) operating activities:Depreciation


2,387,899



1,888,108Amortization of intangible assets


457,261



365,848Amortization of debt issuance costs


41,667



140,968Amortization of debt discount


-



910,535Provision for accounts receivable and other receivable


1,722,518



45,384Provision for inventory reserve


641,455



-Share-based compensation


111,297



254,669Loss on disposal of equipment


14,541



45,880Change in fair value of warrants


433,755



234,078Foreign exchange loss


180,000



-Change in operating assets and liabilitiesNotes receivable


(6,796,655
)


(104,501
)Accounts receivable


4,201,653



(11,637,766
)Inventories


6,690,949



(665,548
)Other assets, current


(609,383
)


1,044,592Advances on inventory purchases


(6,670,625
)


699,662Other assets, non-current


(2,303,088
)


371,477Accounts payable


(5,399,547
)


2,039,115Customer deposits


5,365,939



(786,773
)Other payables & accrued liabilities


(5,256,274
)


(1,599,798
)Taxes payable


2,695,385



1,192,964Net cash  provided by operating activities


8,728,688



17,344,935CASH FLOWS FROM INVESTING ACTIVITIES:Payment for advances on intangible assets


(246,905
)


-Payment for advances on equipment purchases


(5,528
)


22,623Purchase of intangible assets


-



(68,236
)Purchase of plant and equipment


(278,296
)


(1,466,942
)Disposal of plant and equipment


26,152



10,467Additions to construction-in-progress


(77,681
)


121,648Payment to original shareholders for acquisition


-



(27,938,951
)Net cash provided by (used in) investing activities


(582,258
)


(29,319,391
)CASH FLOWS FROM FINANCING ACTIVITIES:(Increase) decrease in restricted cash


(14,402,000
)


516,941Payment on notes payable


-



(3,800,000
)Proceeds from notes payable-short term


30,400,000



1,019,218Payment on notes payable-short term


(1,596,000
)


(2,053,100
)Proceeds from short term loan-bank


9,120,000



3,372,950Repayment of short term loan-bank


(8,056,000
)


(2,199,750
)Proceeds from short term loan-other


-



35,531Net cash provided by (used in) financing activities


15,466,000



(3,108,210
)EFFECTS OF EXCHANGE RATE CHANGE ON CASH


460,145



(2,637
)INCREASE (DECREASE) IN CASH


24,072,575



(15,085,303
)Cash and cash equivalents, beginning of period


98,753,870



92,902,400Cash and cash equivalents, end of period

$
122,826,445


$
77,817,097
  The accompanying notes are an integral part of these consolidated financial statements.


5


HARBIN ELECTRIC, INC. AND SUBSIDIARIES
  NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2011
 (UNAUDITED)
 
 Note 1 - Nature of Business
 
 Harbin Electric, Inc. (the “Company” or “Harbin Electric”) is a Nevada Corporation, incorporated on July 9, 2003. Through its subsidiaries, the Company designs, develops, engineers, manufactures, sells and services a wide array of electric motors including linear motors, specialty micro-motors, and industrial rotary motors, with focus on innovation, creativity, and value-added products.  Products are sold in China and to certain international markets.
 
 Recent development
 
 On October 10, 2010, our Board of Directors (the “Board”) received a non-binding proposal from Mr. Tianfu Yang (“Mr. Yang”) and Baring Private Equity Asia Group Limited (“Baring”) for Mr. Yang and an investment fund advised by Baring (the "Baring Fund") to acquire all of the outstanding shares of Common Stock of Harbin Electric not currently owned by Mr. Yang and his affiliates for $24.00 per share in cash, subject to certain conditions (“Going Private Proposal”). Mr. Yang owns 31.1% of our Common Stock. According to the proposal letter, Mr. Yang and Baring intended to form an acquisition vehicle for the purpose of completing the acquisition and that they intend to finance the acquisition with a combination of debt and equity capital. The proposal letter stated that Goldman Sachs (Asia) LLC (“Goldman”) is acting as financial advisor to the acquisition vehicle to be formed by Mr. Yang and Baring and that Goldman has informed Mr. Yang and Baring that it is highly confident that the underwriting and arranging of commitments for the debt financing needed to complete the transaction can be done. The proposal letter stated that the equity portion of the financing would be provided by Mr. Yang, the Baring Fund and related sources.
 
 On November 22, 2010, the Board received a new letter from Mr. Yang regarding his previously announced proposal to take the Company private (the “Yang Proposal”). In this letter, Mr. Yang advised the Board that, by mutual agreement, Mr. Yang and Baring Private Equity Asia Group Limited (“Baring”) had amended and restated their previously announced Consortium Agreement, pursuant to which they had agreed to work together exclusively on the Yang Proposal. The amended and restated agreement between Baring and Mr. Yang provides that Baring’s participation in the Yang Proposal will consist solely of a right (but not an obligation) to provide up to 10% of the financing for the transaction, in the form of debt and/or equity and that Mr. Yang will not be restricted from seeking alternative sources of financing, in the form of debt and/or equity, for the transaction. Mr. Yang further advised the Company that he intends to proceed with a proposal to take the Company private at the previously announced proposed price of $24.00 per share, that he would seek alternative sources of financing for the transaction, and that Goldman Sachs (Asia) LLC would continue to act as financial advisor to Mr. Yang in connection with the transaction.
 
 Pursuant to a Schedule 13D/A (the “Schedule 13D/A”) filed jointly on May 2, 2011 by Mr. Tianfu Yang, Hero Wave Investments Limited (“Hero”), Tech Full Electric Company Limited (“Tech Full”), Abax Lotus Ltd. (“Abax Lotus”), Abax Nai Xin A Ltd. (“Abax Nai Xin”), Abax Global Opportunities Fund (“Global Fund”), Abax Upland Fund LLC (“Upland”), Abax Arhat Fund (“Arhat”), Abax Claremont Ltd. (“Upland Managing Member”), Abax Global Capital (“AGC”), Abax Global Capital (Hong Kong) Limited (“Abax HK”), and Xiang Dong Yang (“Mr. Xiang Dong Yang”, collectively with Abax Lotus, Global Fund, Upland, Arhat, Upland Managing Member, AGC, AGC Asia 3, Abax HK and Abax Nai Xin, the “Abax Parties”) with the Securities and Exchange Commission on May 2, 2011 (Mr. Yang, Hero, Tech Full and the Abax Parties are collectively referred to herein as the “Reporting Persons”), the Reporting Persons disclosed that on April 20, 2011, Mr. Tianfu Yang and AGC (acting on behalf of certain funds it manages and/ or advises), on behalf of themselves, submitted a proposal (the “Proposal”) to the Special Committee of the Company’s board of directors for the acquisition of all of the Publicly Held Shares (as defined below) for US$24.00 per share (the “Proposed Transaction”). According to the Schedule 13D/A, financing for the Proposed Transaction will include both debt and equity components, as well as rollover equity from certain members of the management and certain Abax Parties (the “Rollover Commitments”). AGC and Abax HK, on behalf of certain of the funds and/or entities that they manage or advise, will also provide equity and debt financing through certain such funds in connection with the Proposed Transaction, and the Abax Parties may bring in one or more additional third party investors to fund a portion of such equity and/ or debt financing.
 
 6
 
 HARBIN ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2011
 (UNAUDITED)
 Our Board of Directors has formed a special committee of independent directors to evaluate and consider this proposal and any other alternative proposals or other strategic alternatives that may be available to the Company. Since being formed, the Special Committee has engaged legal and financial advisors. The Special Committee’s process is ongoing and the Special Committee intends to continue with its work, including evaluating any proposal presented by Mr. Yang as well as other proposals which the Company may receive, for as long as the Special Committee, in consultation with its advisors, deems necessary.
 
 Note 2 - Summary of Significant Accounting Policies
 
 Basis of presentation
 
 The consolidated financial statements of Harbin Electric Inc. reflect the activities of the following subsidiaries.  All material intercompany transactions have been eliminated.
  Place incorporated

Ownership

percentageAdvanced Electric Motors, Inc. (“AEM”)

Delaware, USA


100
%Harbin Tech Full Electric Co., Ltd. (“HTFE”)

Harbin, China


100
%Advanced Automation Group, LLC (“AAG”)

Delaware, USA


51
%Advanced Automation Group Shanghai Co., Ltd. (“SAAG”)

Shanghai, China


51
%Shanghai Tech Full Electric Co., Ltd. (“STFE”)

Shanghai, China


100
%Weihai Tech Full Simo Motor Co., Ltd. (“Weihai”)

Weihai, China


100
%Xi’an Tech Full Simo Motor Co., Ltd. (“Simo Motor”)

Xi’an, China


100
%
 
 The accompanying consolidated financial statements include the accounts of all directly and indirectly owned subsidiaries listed above.
 
 The interim unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States, or GAAP, for interim financial information and with the instructions to Securities and Exchange Commission, or SEC, Form 10-Q and Article 10 of SEC Regulation S-X and consistent with the accounting policies stated in the Company’s 2010 Annual Report on Form 10-K. Certain information and note disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. Therefore, these financial statements should be read in conjunction with our audited consolidated financial statements and notes thereto for the year ended December 31, 2010, included in our Annual Report on Form 10-K filed with the SEC.
 
 The interim consolidated financial statements included herein are unaudited; however, they contain all normal recurring accruals and adjustments that, in the opinion of management, are necessary to present fairly our consolidated financial position as of March 31, 2011 and 2010, and our consolidated results of operations and cash flows for the three months ended March 31, 2011 and December 31, 2010. The results of operations for the three months ended March 31, 2011 are not necessarily indicative of the results to be expected for future quarters or the full year.
 
 Use of estimates
 
 The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions about future events. These estimates and the underlying assumptions affect the reported amounts of assets, liabilities, revenue and expenses, and disclosures about contingent assets and liabilities. Such estimates and assumptions by management affect accrued expenses, the valuation of accounts receivable, inventories, and long-lived assets, legal contingencies, lives of plant and equipment, lives of intangible assets, business combinations, goodwill, calculation of warranty accruals, taxes, share-based compensation and others.
 
 7
 HARBIN ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2011
 (UNAUDITED)
  Although the Company regularly assesses these estimates, actual results could materially differ. The Company bases its estimates on historical experience and various other assumptions that it believes to be reasonable under the circumstances.
 
 Foreign currency transactions
 
 Our reporting currency is the US dollar.  The functional currency of PRC subsidiaries is the Chinese Renminbi (“RMB”). Our results of operations and financial position of the PRC subsidiaries are translated to United States dollars using the end of period exchange rates as to assets and liabilities and weighted average exchange rates as to revenues, expenses and cash flows. Capital accounts are translated at their historical exchange rates when the capital transaction occurred. The resulting currency translation adjustments are recorded as a component of accumulated other comprehensive income (loss) within stockholders’ equity.  As a result, translation adjustments amounts related to assets and liabilities reported on the consolidated statement of cash flows will not necessarily agree with changes in the corresponding consolidated balances on the balance sheet. Transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the functional currency are included in the results of operations as incurred.
 
 Translation adjustments resulting from this process amounted to a gain of $2,448,821 and $91,596 for the three months ended March 31, 2011 and 2010, respectively. The balance sheet amounts with the exception of equity at March 31, 2011 and December 31, 2010 were translated at 6.56 RMB to $1.00 and 6.59 RMB to $1.00, respectively.  The equity accounts were stated at their historical exchange rate.  The average translation rates applied to the revenues, expenses and cash flows statement amounts for the three months ended March 31, 2011 and 2010 were 6.58 RMB to $1.00, and 6.84 RMB to $1.00, respectively.
 
 Transaction losses of $192,733 and $2,682 were recognized which were included in the other income for the three months ended March 31, 2011 and 2010, respectively.
 
 Concentration of risks
 
 The Company considers all highly liquid investments with original maturities of three months or less at the time of purchase to be cash equivalents, for cash flow statement purposes.  Cash includes cash on hand and demand deposits in accounts maintained with state owned banks within the PRC and with banks in the United States. The Company maintains balances at financial institutions which typically exceed Federal Deposit Insurance Corporation insured limits for the banks located in the United States. Balances at financial institutions or state owned banks within the PRC are not insured. As of March 31, 2011 and December 31, 2010, the Company had deposits in excess of federally insured limits totaling $122,078,755 and $98,989,404, respectively. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant risks on its cash in bank accounts.
 
 No customer accounted for more than 10% of the net revenue for the three months ended March 31, 2011 and 2010.
 
 One vendor provided approximately 13% of the Company’s purchases of raw materials for the three months ended March 31, 2011. The Company’s accounts payable to this vendor was $0 at March 31, 2011.  No vendor accounted for more than 10% of the Company’s purchases of raw materials for the three months ended March 31, 2010.
 
 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 the North America and Western Europe. These include risks associated with, among others, the political, economic and legal environments and foreign currency exchange. 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.
  8
 
 HARBIN ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2011
 (UNAUDITED)
 Restricted cash
 
 Restricted cash represents amounts set aside by the Company in accordance with the Company’s debt agreements with certain financial institutions.  These cash amounts are designated for the purpose of paying down the principal amounts owed to the financial institutions, and these amounts are held at the same financial institutions with which the Company has debt agreements in the PRC.  Due to the short-term nature of the Company’s debt obligations to these banks, the corresponding restricted cash balances have been classified as current in the consolidated balance sheets.
 
 Notes receivable
 
 Notes receivable arose from sale of goods and represent commercial drafts issued by customers to the Company that were guaranteed by banks of the customers.  Notes receivables are interest-free with maturity dates of three or six months from date of issuance. The Company has the ability to submit request for payment to the customer’s bank earlier than the scheduled payment date, but will incur an interest charge and a processing fee.
 
 Accounts receivable
 
 Accounts receivable are presented net of an allowance for bad debts account. The Company maintains reserves for potential credit losses on accounts receivable. Management reviews the composition of accounts receivable and analyzes historical bad debts, customer concentrations, customer credit worthiness, current economic trends and changes in customer payment patterns to evaluate the adequacy of these reserves. The estimated loss rate is based on our historical loss experience and also contemplates current market conditions. Delinquent account balances are written-off after management has determined that the likelihood of collection is not probable, and known bad debts are written off against allowance for doubtful accounts when identified.
 
 Inventories
 
 Inventories are valued at the lower of cost or market value, as determined on a first-in, first-out basis, using the weighted average method. Management compares the cost of inventories with the market value and an allowance is made for writing down the inventories to its market value, if lower than cost. On an ongoing basis, inventories are reviewed for potential write-down for estimated obsolescence or unmarketable inventories equal to the difference between the costs of inventories and the estimated net realizable value based upon forecasts for future demand and market conditions. When inventories are written-down to the lower of cost or market, they are not marked up subsequently based on changes in underlying facts and circumstances.  Inventories are composed of raw material for manufacturing electrical motors, work in process and finished goods within the Company’s warehouse premise or consigned at a customer site. The inventory allowance is made when the inventory’s market value is lower than the cost. The recovery of the reserve is only made through sale or disposition of such inventory items.
 
 Plant and equipment
 
 Plant and equipment are stated at cost, net of depreciation. Expenditures for maintenance and repairs are charged to earnings as incurred; additions, renewals and betterments are capitalized. When assets are retired or otherwise disposed of, the related cost and accumulated depreciation are removed from the respective accounts, and any gain or loss is included in operations. Depreciation of plant and equipment is provided using the straight-line method for substantially all assets with estimated lives as follows:
 
 Estimated Useful LifeBuildings
20-40  yearsVehicle
5-10  yearsOffice equipment
5-6  yearsProduction equipment
10-12  years
  9
 HARBIN ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2011
 (UNAUDITED)
 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 placed into service. Maintenance, repairs and minor renewals are charged directly to expense as incurred. Major additions and betterment to buildings and equipment are capitalized. Interest incurred during construction is capitalized into construction in progress. All other interest is expensed as incurred.
 
 The Company recognizes an impairment loss when estimated cash flows generated by those assets are less than the carrying amounts of the asset. Based on management review, the Company believes that there were no impairments as of March 31, 2011.
 
 Goodwill and other intangible assets
 
 Goodwill – the excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed shall be recognized as goodwill.  Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis in the fourth quarter or more frequently if there are indicators of impairment. For purposes of our goodwill impairment test, a two-step test is used to identify the potential impairment and to measure the amount of goodwill impairment, if any. The first step is to compare the fair value of the reporting unit with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, goodwill is considered not impaired. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any. Under step two, the impairment loss is measured by comparing the implied fair value of the reporting unit goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess.
 
 General intangibles other than goodwill
 
 Intangible assets that are acquired individually or as part of a group of assets, other than those acquired in a business combination are initially recorded at their fair value. The cost of a group of assets acquired in a transaction is allocated to the individual assets based on their relative fair values. Goodwill does not arise in such a transaction. Intangible assets that are acquired in a business combination are accounted for in accordance with ASC Topic 805,Business Combinations. The costs of intangible assets that are developed internally, as well as the costs of maintaining or restoring intangible assets that have indeterminate lives or that are inherent in a continuing business and related to the entity as a whole, are expensed as incurred.
 
 The accounting for intangible assets, other than goodwill, subsequent to acquisition is based on the asset’s useful life. The useful life of the intangible asset is the period over which the asset is expected to contribute directly or indirectly to the entity’s future cash flows. An asset for which no legal, regulatory, contractual, competitive, economic, or other factors limit its useful life is considered to have an indefinite useful life.
 
 The Company evaluates intangible assets for impairment, at least annually and whenever events or changes in circumstances indicate that the assets might be impaired.  We perform our annual impairment test in the fourth quarter.
 
 Our impairment test consists of a comparison of the fair value of the intangible asset with its carrying amount. If the carrying amount of an intangible asset exceeds its fair value, an impairment loss is recognized in an amount equal to the excess.  As of March 31, 2011, management believes there was no impairment.
 Accounting for long-lived assets
 
 Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. We assess the recoverability of the assets based on the undiscounted future cash flow the assets are expected to generate and recognize an impairment loss when estimatedundiscounted future cash flow expected to result from the use of the asset plus net proceeds expected from disposition of the asset, if any, are less than the carrying value of the asset. When we identify an impairment, we reduce the carrying amount of the asset to its estimated fair value based on a discounted cash flow approach or, when available and appropriate, to comparable market values.  As of March 31, 2011, management believes there was no impairment.
 
 10
 
 HARBIN ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2011
 (UNAUDITED)
  Stock-based compensation
 
 We record share-based compensation expense based upon the grant date fair value of share-based awards. The value of the award is principally recognized as expense ratably over the requisite service periods. We use the Black-Scholes Merton (“BSM”) option-pricing model, which incorporates various assumptions including volatility, expected life and interest rates to determine fair value. The Company’s expected volatility assumption is based on the historical volatility of Company’s stock. The expected life assumption is primarily based on the simplified method of the terms of the options. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of grant.
 
 The Company is required to measure the cost of the equity instruments issued in exchange for the receipt of goods or services from other than employees at the estimated fair market value of the consideration received or the estimated fair value of the equity instruments issued, whichever is more reliably determinable. The value of equity instruments issued for consideration other than employee services is determined on the earlier of a performance commitment or completion of performance by the provider of goods or services.
 
 Stock compensation expense is recognized based on awards expected to vest.  GAAP requires forfeitures to be estimated at the time of grant and revised in subsequent periods, if necessary, when actual forfeitures differ from those estimates.  There were no estimated forfeitures as the Company has a short history of issuing options and the actual forfeitures during the history of issuing options were minimal.
 
 Revenue recognition
 
 The Company recognizes sales when title and risk of ownership are passed to the customer (which is at the date of shipment), when a formal arrangement exists, the price is fixed or determinable, no other significant obligations exist and collectability is reasonably assured. For products that are required to be examined by customers, sales revenue is recognized after the customer examination is passed. Payments received before all of the relevant criteria for revenue recognition are satisfied, are recorded as customer deposits.
 
 In addition, revenue recognition could be negatively impacted by returns. For our linear motor and specialty micro-motor businesses, our products are custom products which are customer specific, and no returns are allowed. We warrant our product for repair, only in the event of defects for two years from the date of shipment.  We charge such costs to cost of goods sold. For our industrial rotary motor business, our products are standardized products and returns are allowed within three days upon receipt of products by customers. We provide product warranty for repair one year from the date of shipment. Historically, the returns and defects have not been material. Should returns increase in the future it would be necessary to adjust the estimates, in which case recognition of revenues could be delayed.
 
 The Company also provides after-sale services to our customers. Service revenue is recognized as services are rendered, the customers have approved the completion of the services and invoices have been issued and collectability is reasonably assured. Customer billings for services not yet rendered are deferred and recognized as revenue as the services are rendered and the associated deferred revenue is included in current liabilities or long-term liabilities, as appropriate.
 
 The Company recognizes revenues with regards to the sales of consigned inventories when the title and risks of ownership have been transferred to customers; customers provide a persuasive evidence to notify the Company, and upon receipt of the notification form from customers. The Company also performs periodic inventory counts to confirm the inventory quantities held on consignment.
 
 11
 
 HARBIN ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2011
 (UNAUDITED)
  Customers who purchase industrial rotary motors are divided into two major categories: distributors and non-distributors. Non-distributors consist of OEM users, traders and end users. Except for the annual sales target for distributors, the sales arrangements are the same with distributors and non-distributors.
 
 Distributors are committed to annual purchase target and entitled to a sales rebate. The Company periodically provides incentive offers to its distributors to encourage purchases. Such offers include inducement offers (e.g., offers for future discounts subject to its annual purchase target), and other similar offers. Inducement offers, when accepted by customers, are treated as a reduction to purchase price based on estimated future redemption rates. Redemption rates are estimated using the Company’s historical experience for similar inducement offers. Inducement offers are presented as a net amount in “net sales.”
 
 Shipping and handling costs are included in selling, general and administrative costs and totaled $1,459,368 and $832,415 for the three months ended March 31, 2011 and 2010, respectively.
 
 Income taxes
 
 The Company utilizes the asset and liability method of accounting for income taxes, under which deferred taxes are determined based on the temporary differences between the financial statement and tax basis of assets and liabilities using tax rates expected to be in effect during the years in which the basis differences reverse. A valuation allowance is recorded when it is more likely than not that some of the deferred tax assets will not be realized.  GAAP also requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. As of January 1, 2007, income tax positions must meet a more-likely-than-not recognition threshold to be recognized.  A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded.
 
 Under this method, deferred income taxes are recognized for the tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at each period end based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized.  Deferred tax assets of $380,565 and $377,727 mainly due to the temporary differences of commission expenses and warranty expenses between the financial statement and tax basis were recorded at March 31, 2011 and December 31, 2010, respectively. The deferred tax assets (see Note 12 for more discussion) were included in the Consolidated Balance Sheets under other assets, net. The deferred tax activity consisted of the following:
 
 AmountDeferred tax assets at January 1, 2010

$
-Additions to deferred tax assets


-Decrease of deferred tax assets


-Effect of foreign currency translation


-Deferred tax assets at March 31, 2010 (unaudited)


-Additions to deferred tax assets


368,365Decrease of deferred tax assets


-Effect of foreign currency translation


9,362Deferred tax assets at December 31, 2010


377,727Additions to deferred tax assets


43,396Decrease of deferred tax assets


(42,552
)Effect of foreign currency translation


1,994Deferred tax assets at March 31, 2011 (unaudited)

$
380,565
 
 12
 
 HARBIN ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2011
 (UNAUDITED)
 
 Penalties and interest incurred related to underpayment of income tax are classified as income tax expense in the year incurred.  No significant penalties or interest relating to income taxes have been incurred during the three months ended March 31, 2011 and 2010.  GAAP also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosures and transition.
 
 The charge for taxation is based on the results for the reporting period as adjusted for items, which are non-assessable or disallowed.  It is calculated using tax rates that have been enacted or substantively enacted by the balance sheet date.
 
 The Company’s operating subsidiaries located in PRC are subject to PRC income tax. Under the Income Tax Laws of PRC, a company is generally subject to income tax at an effective rate of 25% on income reported in the statutory financial statements after appropriated tax adjustments. The PRC government provides reduced tax rates for productive foreign investment enterprises in the Economic and Technological Development Zones and for enterprises engaged in production or business operations in the Special Economic Zones.  These preferential tax rates are generally graduated, starting at 0% and increasing to the standard EIT rate of 25% over time. HTFE was granted a 10% preferential tax rate from 2008 to 2010 due to its located in a specially designated economic region. This 10% preferential tax rate expired on December 31, 2010. While applying for the next level of 15% preferential tax treatment, HTFE is currently using 25% standard income tax rate until the application is approved. STFE was income tax exempt from 2008 to 2009 and was granted a preferential income tax rate of 11% in 2010 and 12% in 2011 due to its located in an economic development zone.  Simo Motor enjoyed a 15% preferential tax rate from 2009-2010 as it is located in the Province of Shaanxi which is in the mid-west region of China, and qualified for the government’s “Go-West” program. This “Go-West” preferential tax rate expired on December 31, 2010. However, Simo Motor also qualifies for a 15% preferential tax rate applying to enterprises in high/new technology industries singled out for special support by the State and therefore is subject to a 15% EIT rate in 2011. Weihai has been subject to 25% standard income tax rate.
 
 The Company’s subsidiaries were paying the following tax rate for the three months ended March 31:
 
 2011

(Unaudited)


2010

(Unaudited)Subsidiaries

Income Tax Exemption


Effective Income Tax Rate


Income Tax Exemption


Effective Income Tax RateHTFE


-



25
%


15
%


10
%Weihai


-



25
%


-



25
%STFE


13
%


12
%


14
%


11
%Simo Motor


10
%


15
%


10
%


15
%
 
 The following table reconciles the U.S. statutory rates to the Company’s effective tax rate for the three months ended March 31:
 
 2011

(Unaudited)


2010

(Unaudited)U.S. Statutory rates


34.0
%


34.0
%Foreign income not recognized in USA


-34.0



-34.0China income taxes


25.0



25.0Tax exemption


-0.9



-16.4Other items (a)


3.8



6.5Effective income taxes


27.9
%


15.1
%
  13
  HARBIN ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2011
 (UNAUDITED)
  (a)  The 3.8% represents the $2,642,668 of expenses incurred by the Company, and its US subsidiaries AEM and AAG that are not subject to PRC income tax for the three months ended March 31, 2011.
 
 The 6.5% represents the $1,765,674 of expenses incurred by the Company, and its US subsidiaries AEM and AAG that are not subject to PRC income tax for the three months ended March 31, 2010.
 
 The estimated tax savings for the three months ended March 31, 2011 and 2010 amounted to $163,133 and $3,120,440, respectively. The net effect on earnings per share attributable to controlling interest had the income tax been applied would decrease earnings per share from $0.35 to $0.34 for the three months ended March 31, 2011, $0.66 to $0.57 for the three months ended March 31, 2010.
 
 Harbin Electric, AEM and AAG were organized in the United States and have incurred net operating losses for income tax purposes for the three months ended March 31, 2011.  The net operating loss carry forwards for United States income taxes for Harbin Electric and AEM amounted to approximately $36.7 million which may be available to reduce future years’ taxable income. 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 net change in the valuation allowance for the three months ended March 31, 2011 was an increase of approximately $0.7 million. Management will review this valuation allowance periodically and make adjustments accordingly. AAG started to use the net operating loss carry forwards from previous years in the amount of $168,421 to reduce its taxable income generated in 2011. The remaining carry forwards will expire, if not utilized, starting from 2027 through 2030.
 
 The Company has cumulative undistributed earnings of foreign subsidiaries of approximately $252 million as of March 31, 2011, which is included in consolidated retained earnings and will continue to be indefinitely reinvested in international operations.  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
 
 Sales revenue represents the invoiced value of goods, net of a value-added tax (“VAT”). All of the Company’s products that are sold in the PRC are subject to a Chinese value-added tax at a rate of 17% of the gross sales price. This VAT may be offset by VAT paid by the Company on raw materials and other materials included in the cost of producing their finished product. The Company recorded VAT Payable and VAT receivable net of payments in the financial statements. The VAT tax return is filed offsetting the payables against the receivables.
 
 VAT on sales and VAT on purchases amounted to $19,288,580 and $12,849,885 for the three months ended March 31, 2011, respectively.  VAT on sales and VAT on purchases amounted to $17,983,171 and $11,313,713 for the three months ended March 31, 2010, respectively.  Sales and purchases are recorded net of VAT collected and paid as the Company acts as an agent for the government.
 
 Advertising costs
 
 The Company expenses the cost of advertising as incurred in selling, general and administrative costs. The Company incurred $32,284 and $32,449 for the three months ended March 31, 2011 and 2010, respectively.
 
 Research and development costs
 
 Research and development costs are expensed as incurred.  The costs of material and equipment that are acquired or constructed for research and development activities and have alternative future uses are classified as plant and equipment and depreciated over their estimated useful lives. The Company’s total research and development expenses for the three months ended March 31, 2011 and 2010 are $3,878,528 and $594,195, respectively.
  14
  HARBIN ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2011
 (UNAUDITED)
 In March 2010, the Company entered into a research and development contract with a research institute to develop the linear motor automated control system. The total contracted amount was $4.8 million with a 3-year term. For the three months ended March 31, 2011, $3,145,385 was incurred and expensed as research and development costs.
 
 Noncontrolling interest
 
 The Company owns 100% of Simo Motor. The 0.05% of noncontrolling interest was indirectly from Simo Motor’s subsidiary Qishan Simo Moulding Co, Ltd.  Effective July 1, 2010, 49% of AAG and SAAG was owned by noncontrolling interests, Shelton Technology, LLC, a Michigan limited liability company.
 
 Fair value of financial instruments
 
 The Company measures and reports its financial assets and liabilities on a fair value basis in accordance with ASC Topic 820,“Fair Value Measurements and Disclosures” (“ASC 820”). ASC 820 defines fair value as the price that would be received to sell an asset or the price paid to transfer a liability (the exit price) in the principal and most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. ASC 820 requires the classification of assets and liabilities carried at fair value using a three-tier hierarchy based upon observable and unobservable inputs as follows:
 
 Level 1: Quoted market prices in active markets for identical assets or liabilities
 
 Level 2: Observable market based inputs that are corroborated by market data
 
 Level 3: Unobservable inputs that are not corroborated by market data
 
 As of March 31, 2011 and December 31, 2010, the Company has 183,348 warrants outstanding. The fair value of the outstanding warrants was approximately $1.96 million and $1.53 million, respectively.  The Company recognized a total of $433,755 loss and a total of $234,078 loss from the change in fair value of the warrants for the three months ended March 31, 2011 and 2010, respectively.
 
 These common stock purchase warrants do not trade in an active securities market, and as such, we estimate the fair value of these warrants using the BSM using the following assumptions:
  March 31, 2011


December 31, 2010(Unaudited)Annual dividend yield


-



-Expected life (years)


1.42



1.67Risk-free interest rate


0.55
%


0.51
%Expected volatility


54
%


61
%
  Expected volatility is based primarily on historical volatility. Historical volatility was computed using daily pricing observations for recent periods that correspond to the term of the warrants. We believe this method produces an estimate that is representative of our expectations of future volatility over the expected term of these warrants. We have no reason to believe future volatility over the expected remaining life of these warrants likely to differ materially from historical volatility. The expected life is based on the remaining term of the warrants. The risk-free interest rate is based on U.S. Treasury securities according to the remaining term of the warrants.
  15
  HARBIN ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2011
 (UNAUDITED)
  Carrying Value

as of

March 31,

2011

Fair Value Measurements at March 31, 2011 Using

Fair Value Hierarchy(Unaudited)

Level 1

Level 2

Level 3Fair value of warrant liabilities

$
1,960,285



$
1,960,285
  Other than the warranty liabilities, the Company did not identify any assets and liabilities that are required to be presented on the balance sheet at fair value.
 
 Recent accounting pronouncements
 
 In April 2010, the FASB issued ASU 2010-13, Compensation -Stock Compensation (Topic 718): Effect of Denominating the Exercise Price of a Share-Based Payment Award in the Currency of the Market in Which the Underlying Equity Security Trades. This updateprovides amendments to Topic 718 to clarify that an employee share-based payment award with an exercise price denominated incurrency of a market in which a substantial porting of the entity’s equity securities trades should not be considered to contain acondition that is not a market, performance or service condition. Therefore, an entity would not classify such an award as a liability ifit otherwise qualifies as equity. The amendments in this ASU are effective for fiscal years, and interim periods within those fiscalyears, beginning on or after December 15, 2010. The Company’s adoption of this ASU did not have a material impact on itsconsolidated financial statements.
 
 In September 2010, the FASB issued Accounting Standard Update 2010-25, Plan Accounting—Defined Contribution Pension Plans (Topic 962): Reporting Loans to Participants by Defined Contribution Pension Plans. This ASU clarifies how loans to participantsshould be classified and measured by defined contribution plans and how International Financial Reporting Standards compare tothese provisions. The amendments in this update are effective for fiscal years ending after December 15, 2010. The Company’sadoption of this ASU did not have a material impact on its consolidated financial statements.
 
 In December 2010, the FASB issued Accounting Standard Update 2010-28, Intangibles—Goodwill and Other (Topic 350): When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts. This ASU modifiedStep 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For those reporting units, an entityis required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. For publicentities, the amendments in the ASU are effective for fiscal years, and interim periods within those years, beginning after December15, 2010. The Company`s adoption of this ASU did not have a material impact on its consolidated financial statements.
 
 In December 2010, the FASB issued Accounting Standard Update 2010-29, Business Combinations(Topic 805): Disclosure of Supplementary Pro Forma Information for Business Combinations. This ASU specifies that, if a public entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business combination(s) that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. ASU 2010-29 is effective prospectively for business combinations where the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010. The Company`s adoption of this ASU did not have a material impact on its consolidated financial statements.
 
 Reclassifications
 
 Certain prior period amounts have been reclassified to conform to the current period presentation. These reclassifications have no effect on net income or cash flows.
  16
  HARBIN ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2011
 (UNAUDITED)
  Note 3 – Disposal of subdivisions
 
 Effective April 1, 2010, Simo Motor, a PRC subsidiary of the Company, sold its equity interests in its three subsidiaries, Tianjin Simo Electric Co., Ltd. (“Tianjin Simo”), Xi’an Simo Science and Technology Development Co., Ltd. (“Science and Technology”) and Xi’an Simo Imports and Exports Co., Ltd. (“Imports and Exports”), to certain shareholders of these three subsidiaries.  As a result of the foregoing dispositions, Simo Motor no longer owns any of the outstanding equity of these three subsidiaries.
 
 Note 4 – Acquisition of the noncontrolling interests
 
 Effective April 1, 2010, Simo Motor, a PRC subsidiary of the Company, acquired all of the equity interests in its four subsidiaries, Tech Full Lamination Co., Ltd. (“Lamination”), Xi’an Simo A’Da Motor Co., Ltd. (“A’Da Motor”), Xi’an Tech Full Simo Moulds Co., Ltd. (“Moulds”) and Xi’an Tech Full Simo Transportation Co., Ltd. (“Transportation”). As a result of the above acquisitions, Simo Motor now owns 100% of the outstanding equity of these four subsidiaries.
 
 Note 5 – Supplemental disclosure of cash flows
 
 The Company prepares its statements of cash flows using the indirect method as defined under the ASC Topic 230. The following information relates to non-cash investing and financing activities for the three months ended March 31, 2011 and 2010.
 
 Total interest paid amounted to $1,333,209 and $872,884 for the three months ended March 31, 2011 and 2010, respectively.
 
 Total income tax paid amounted to $3,148,890 and $3,078,707 for the three months ended March 31, 2011 and 2010, respectively.
 
 For three months ended March 31, 2011, other payable in the amount of $17,279, and notes receivable in the amount of $4,157 were used for plant and equipment purchases. Other receivables in the amount of $98,758 were used for increase for construction-in-progress. Other payables in the amount of $23,100 were reduced against proceeds from disposal of equipment. Construction-in-progress in the amount of $745,522 was transferred into plant and equipment. Advances on plant and equipment purchases in the amount of $6,024,672 and $5,895,547 were transferred into construction-in-progress and plant and equipments, respectively.
 
 For the three months ended March 31, 2010, notes receivable in the amount of $98,871 was transferred as payment for purchase of equipment. Equipment in the amount of $243,100 was transferred as payment to accounts payable for $170,866 and as payment to other payables for the amount of $72,234.
 
 Note 6 – Accounts receivable
 
 Accounts receivable consisted of the following:
 
 March 31,


December 31,2011


2010(Unaudited)Accounts receivable

$
89,667,029


$
93,392,999Less: allowance for bad debts


(9,268,969)



(7,493,667)Accounts receivable, net

$
80,398,060


$
85,899,332
  17
  HARBIN ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2011
 (UNAUDITED)
 The following table consists of allowance for bad debts:
 Allowance for bad debts at January 1, 2010

$
114,475Increase in allowance


45,384Negative provisions for allowance


-Accounts receivable write off


-Effect of foreign currency translation


(106)Allowance for bad debts at March 31, 2010 (Unaudited)


159,753Increase in allowance


7,640,918Negative provisions for allowance


(233,660)Accounts receivable write off


-Effect of foreign currency translation


(73,344
)Allowance for bad debts at December 31, 2010

$
7,493,667Increase in allowance


1,777,709Negative provisions for allowance


(44,931)Accounts receivable write off


(2,686)Effect of foreign currency translation


45,210Allowance for bad debts at March 31, 2011 (Unaudited)

$
9,268,969
 
 For the Simo Motor acquisition, the Company recorded acquired accounts receivables at the acquisition-date fair value. However, the fair value was disclosed on the Company’s Form 10K filing of 2009 with the original book value, reduced by a separate valuation allowance. Based on accounting guidance related to Business Combination, Paragraphs 805-20-30-1, a separate valuation allowance is not recognized for assets that are recorded at fair value at the acquisition date. Topic 805 requires assets, which include receivables and loans, to be measured at their acquisition-date fair value without a separate valuation allowance. As a result, the Company made a reclassification as follows as of December 31, 2009. No financial statement captions were impacted as only net numbers were stated on the balance sheet.
  December 31, 2009


Reclassification


December 31, 2009RevisedAccounts receivable

$
97,302,153


$
(3,864,793
)

$
93,437,360Less: allowance for bad debts


(3,979,268
)


3,864,793



(114,475
)Accounts receivable, net

$
93,322,885


$
-


$
93,322,885
  Note 7 – Inventories
 
 The following is a summary of inventories by major category:
 March 31,


December 31,2011


2010(Unaudited)Raw and packing materials

$
9,145,275


$
8,673,719Work in process


20,651,443



20,819,664Finished goods


29,005,406



29,252,978Finished goods - consignment


66,794



6,421,301Inventory valuation allowance


(2,979,926
)


(2,324,106
)Total inventories, net

$
55,888,992


$
62,843,556
  18
  HARBIN ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2011
 (UNAUDITED)
  As of March 31, 2011 and December 31, 2010, inventory valuation allowance amounted to $2,979,926 and $2,324,106, respectively.
 
 Allowance for inventory valuation at January 1, 2010

$
710,611Additional reserves


-Recovery of reserves


-Effect of foreign currency translation


-Allowance for inventory valuation at March 31, 2010 (Unaudited)


710,611Additional reserves


3,940,870Recovery of reserves


(2,340,118
)Effect of foreign currency translation


12,743Allowance for inventory valuation at December 31, 2010

$
2,324,106Additional reserves


824,085Recovery of reserves


(182,630
)Effect of foreign currency translation


14,365Allowance for inventory valuation at March 31, 2011 (Unaudited)

$
2,979,926
 
 For the Simo Motor acquisition, the Company recorded acquired inventory at the acquisition-date fair value. However, the fair value was disclosed on the Company’s Form 10K filing of 2009 with the original book value, reduced by a separate valuation allowance. Based on accounting guidance related to Business Combination, Paragraphs 805-20-30-1, a separate valuation allowances are not recognized for assets that are recorded at fair value at the acquisition date. Topic 805 requires assets, which include receivables and loans, to be measured at their acquisition-date fair value without a separate valuation allowance. As a result, the Company made a reclassification as follows as of December 31, 2009. No financial statement captions were impacted as only net numbers were stated on the balance sheet.
  December 31, 2009


Reclassification


December 31, 2009RevisedRaw and packing materials

$
11,826,804


$
(2,903,706
)

$
8,923,098Work in process


28,434,522



(3,258,327
)


25,176,195Finished goods


25,471,544



(2,024,219
)


23,447,325Finished goods - consignment


18,077,870



-



18,077,870Inventory valuation allowance


(8,896,863
)


8,186,252


$
(710,611
)Total inventory, net

$
74,913,877


$
-


$
74,913,877
  Note 8 – Advances on inventory purchases
 
 The Company makes advances to certain vendors for inventory purchases.  The advances on inventory purchases were $22,670,251 and $15,893,866 as of March 31, 2011 and December 31, 2010, respectively.
 
 19
 
 HARBIN ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2011
 (UNAUDITED)
 
 Note 9 – Plant and equipment
 
 The following table presents details of our property and equipment:
 
 March 31,


December 31,2011


2010(Unaudited)Buildings

$
91,512,835


$
90,434,596Office equipment


3,416,793



3,380,045Production equipment


52,118,080



45,564,179Vehicles


2,331,886



2,335,906Assets held for sale


45,960



46,071Construction in progress


48,811,285



43,172,049Total


198,236,839



184,932,846Less: accumulated depreciation


(14,302,489
)


(11,858,708
)Property and equipment, net

$
183,934,350


$
173,074,138
 
 Construction in progress represents labor costs, material, capitalized interest incurred in connection with the construction of the new plant facility in Shanghai and the construction and installation of manufacturing equipment in HTFE, Weihai and Simo Motor.  Construction in progress as of March 31, 2011, consisted of the following:
  No.

Project Description

March 31,

2011

Commencement

Date

Expected

completion

date(Unaudited)1

Building construction for STFE facility

$
6,530,623

5/13/2009

5/30/20112

Manufacturing machinery and equipment for STFE


35,026,374

12/12/2008

7/31/20113

Building construction and Manufacturing machinery and equipment for Weihai facility


7,087,049

8/20/2010

12/31/20114

Building construction and Manufacturing machinery and equipment for Simo facility


167,239

11/30/2010 & 12/29/2010

12/31/2011Total

$
48,811,285
 
 Depreciation expense for the three months ended March 31, 2011 and 2010 amounted to $2,387,899 and $1,888,108, respectively.
 
 For the three months ended March 31, 2011 and 2010, a total of $0 and $78,328 of interest were capitalized into construction in progress, respectively.
 
 Note 10 – Advances on non-current assets
 
 Advance for intangible assets
 
 The advances for intangible assets consisted of land use right prepayment. As of March 31, 2011 and December 31, 2010, advances for intangible assets amounted to $3,912,302 and $3,645,361, respectively.
 
 On September 8, 2006, HTFE entered into an agreement ("Land Use Agreement") with Shanghai Lingang Investment and Development Company Limited ("Shanghai Lingang") with respect to HTFE’s use of 40,800 square meters of State-owned land in the Shanghai Zhuqiao Airport Industrial Zone (the "Site").  The size of the land used by HTFE was later revised to a total of approximately 53,000 square meters. The term of the land use agreement is 50 years and the aggregate amount HTFE shall pay to Shanghai Lingang is approximately $6.28 million (RMB 42,840,000) ("Fee"), approximately 96.8% or $6.08 million (RMB 41,452,020) has been paid, as of March 31, 2011. HTFE shall register a Sino-foreign joint venture company at the location of Shanghai Lingang, with taxes payable at the same location. HTFE has agreed to compensate Shanghai Lingang for certain local taxes due to the local tax authority in connection with applicable tax generation requirements.
 
 20
 
 HARBIN ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2011
 (UNAUDITED)
  Advance on plant and equipment purchases
 
 The Company makes advances to certain vendors for equipments and construction projects.  The advances on equipment and construction amounted to $36,128,919 and $48,830,831 as of March 31, 2011 and December 31, 2010, respectively.
 
 Note 11 – Goodwill and other intangible assets
 
 Net intangible assets consist of the following at:
  March 31,

2011


December 31,

2010(Unaudited)Goodwill on 2008 Acquisition of Weihai

$
12,759,040


$
12,692,107Goodwill on 2009 Acquisition of Simo Motor


42,450,322



42,227,631Total goodwill


55,209,362



54,919,738Land use rights


17,888,216



17,794,376Patents


6,977,145



6,940,543Software


16,735



16,648Intellectual property


2,594,118



2,594,118Customer lists


288,235



288,235Total goodwill and other intangible assets


82,973,811



82,553,658Less: accumulated amortization


(4,967,971
)


(4,486,841
)Intangible assets, net

$
78,005,840


$
78,066,817
 
 Amortization expense for the three months ended March 31, 2011 and 2010 amounted to $457,261 and $365,848, respectively.
  The Company uses the purchase method of accounting for business combinations. Annual testing for impairment of goodwill is performed during the fourth quarter of each year unless events or circumstances indicate earlier impairment testing is required. No impairment loss was recognized for the three months ended March 31, 2011 and 2010. As a result of the disposition of the three subdivisions, effective April 1, 2010, Simo Motor no longer owns any of the outstanding equity of Tianjin Simo, Science and Technology, and Imports and Exports (see Note 3 for more discussion). Goodwill of these three subdivisions in the amount of $964,159 was included in the carrying amount of the reporting unit in determining the gain or loss on disposal.
  Weihai


Simo Motor


TotalGoodwill, as of January 1, 2010

$
12,273,778


$
41,799,976


$
54,073,754Disposal of subsidiaries


-



-



-Effect of foreign currency translation


-



-



-Goodwill, as of March 31, 2010 (unaudited)


12,273,778



41,799,976



54,073,754Disposal of subsidiaries


-



(964,159
)


(964,159
)Effect of foreign currency translation


418,329



1,391,814



1,810,143Goodwill, as of December 31, 2010


12,692,107



42,227,631



54,919,738Effect of foreign currency translation


66,933



222,691



289,624Goodwill, as of March 31, 2011 (unaudited)

$
12,759,040


$
42,450,322


$
55,209,362
 
 21
 
 HARBIN ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2011
 (UNAUDITED)
 
 Note 12 – Other assets
 
 Other assets, current consisted of the following:
 
 
 March 31,

2011


December 31, 2010(Unaudited)Other receivable, net

$
1,657,105


$
1,620,638Prepaid expenses


376,812



503,330Prepaid consulting service fee, current


617,946



-Deferred tax assets


380,565



377,727Total

$
3,032,428


$
2,501,695
 
 Other assets, non-current consisted of the following:
 
 March 31,

2011


December 31, 2010(Unaudited)Security deposit

$
1,500


$
1,500Long term deferred expenses


1,387,513



1,401,826Prepaid consulting service fee, non-current


2,321,106



-Total

$
3,710,119


$
1,403,326
 
 In February 2011, the Company entered into a consulting service agreement with a third party which agreed to provide advisory and consulting services to obtain financing in Chinese Capital Market for a period of 5 years from 2011 to 2015. The service fee is non-refundable and amounted to $3 million. For the three month ended March 31, 2011, $60,948 was amortized as professional fees. As of March 31, 2011, prepayment of $617,946 and $2,321,106 were included in current and non-current prepaid consulting service fee, respectively.
  Note 13 – Taxes payable
 
 Taxes payable consisted of the following:
 March 31,

2011


December 31,

2010(Unaudited)VAT tax payable

$
2,303,861


$
1,930,544Individual income tax withholding payable


88,801



84,965Corporation income tax payable


4,740,058



3,672,511Other miscellaneous tax payable


2,815,053



2,517,787Total

$
9,947,773


$
8,205,807
 
 22
 
 HARBIN ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2011
 (UNAUDITED)
 
 Note 14 – Financing
 
 On July 28, 2010, the Company entered into a Loan Agreement, dated July 28, 2010 (the “Loan Agreement”) with Abax Emerald Ltd., a Cayman Islands limited company (“Abax”), pursuant to which Abax agreed to provide the Company with up to $15,000,000 in loans (“Abax Loan”). The Abax Loan was to be made pursuant to one or more borrowings (each, an “Advance”) from time to time from the Closing Date (July 28, 2010) to the date falling on the expiration of five (5) months after the Closing Date upon delivering a notice from us to Abax. In lieu of payment of interest in cash on each Advance, the outstanding principal amount thereof accreted in value for the period commencing on the Borrowing Date (the date on which any Advance is made from us to Abax) for such Advance and ending on the day on which such Advance is repaid, at a rate equal to 10% per annum, computed as described in the Agreement. The loan agreement provided that the Company could voluntarily prepay any Advance (or portion thereof in an integral multiple of $100,000) at its accreted value at any time upon written notice to Abax. On the Maturity Date (six months after the date of the Agreement), we were obligated to repay the remaining outstanding loan not theretofore paid, together with all fees and other amounts payable under the Loan. On July 29, 2010, the Company received the $15 million loan from Abax. The loan was used to pay down certain debt and to support the Company’s capital expenditures and working capital. The Abax Loan was fully paid off on December 27, 2010.
 
 On November 22, 2010, the Company entered into a Term Loan Facility Agreement, dated November 22, 2010 (the “CDB Agreement”) with China Development Bank Corporation, Hong Kong Branch (“CDB”) pursuant to which CDB has agreed to provide a USD$35,000,000 loan facility (“Facility A”) and an RMB100,000,000 loan facility (“Facility B,” and collectively with Facility A, the “Facilities”) to the Company (the loans made under Facility A shall be referred to herein as “Facility A Loans” and the loans made under Facility B shall be referred to herein as “Facility B Loans”). The Facility A Loans and the Facility B Loans shall be made pursuant to one or more borrowings from time to time during the period of time from the date of the CDB Agreement to the date falling on the expiration of six (6) months after the date of the CDB Agreement upon delivering a utilization request from the Company to CDB. Interest on Facility A Loans shall be 3% per annum plus LIBOR (as defined in the CDB Agreement). Interest on Facility B Loans shall be 2.5% per annum plus SHIBOR (as defined in the CDB Agreement). The Company is required to repay the Facility A Loans in two (2) equal installments on (i) the date which falls twenty four (24) months after the first utilization date of any loan and (ii) the date which falls thirty six (36) months after the first utilization date of any loan. The Company is required to repay the Facility B Loans in two (2) equal installments on (i) the date which falls twenty four (24) months after the first utilization date of any loan and (ii) the date which falls thirty six (36) months after the first utilization date of any loan.
 
 The CDB Agreement provides that the Company may, upon not less than one month’s prior notice prepay on an Interest Payment Date (as defined in the CDB Agreement) or a Repayment Date (as defined in the CDB Agreement) all or part of any loan (but if in part, in an amount that is an integral multiple of UDS$500,000 in the case of a Facility A Loan or RMB 2,000,000 in the case of Facility B Loan). The CDB Agreement also provides that upon a Change of Control (as defined in the CDB Agreement) of the Company, CDB may, by not less than 30 days notice to the Company, cancel the Facilities and declare all outstanding loans, together with accrued interest and all other amounts to be immediately due and payable.
 
 The Company’s obligations under the CDB Agreement are secured by a pledge of shares of common stock of the Company owned by its Chairman and Chief Executive Officer, Tianfu Yang. On November 22, 2010, Mr. Yang entered into a Security and Pledge Agreement (the “Pledge Agreement”) with CDB, pursuant to which, Mr. Yang has agreed to pledge 7,000,000 shares of common stock to CDB to secure the loans. Under the Pledge Agreement, Mr. Yang may also be obliged to pledge to CDB, under certain circumstances, additional shares of common stock owned by him and, to the extent such additional shares are not sufficient, cash.
 
 Debt issuance costs of $500,000, resulting from the Term Loan Facility Agreement the Company entered into with CDB, are carried in other assets and are amortized over the life of the loan using the straight-line amortization method. A total of $41,667 was amortized to interest expense for the three months ended March 31, 2011. As of March 31, 2011, unamortized debt issuance costs totaled $455,137.
 
 23
 
 HARBIN ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2011
 (UNAUDITED)
 Note 15 -Short and long term loans
 
 The Company’s short term loans are comprised of the following:
 
 March 31,
2011


December 31,
2010(Unaudited)Short term loan – bank

$
30,591,500


$
29,369,120Short term loan – others


24,400



121,360Total short term loans

$
30,615,900


$
29,490,480
 
 Short term loans – bank
 March 31,
2011


December 31,
2010(Unaudited)Loan from Citic Bank in city of Wendeng, due from various dates from May to June 2011. Monthly interest-only payments at 5.310% per annum, secured by assets

$
3,202,500


$
3,185,700Loan from Commercial Bank in city of Weihai, due from various dates from August to September 2011. Monthly interest-only payments at 0.509% per annum, secured by assets


1,220,000



1,213,600Loan from Bank of Communications, due in December 2011. Benchmark interest rate up by 10%, approximate rate of 6.116% per annum, guaranteed loan


1,525,000



1,517,000Loan from Bank of Communications, due in June 2011. Benchmark interest rate up by 10%, approximate rate of 5.84% per annum, guaranteed loan


1,525,000



1,517,000Loan from Citic Bank, due in January through February 2012. Average interest from 8.48% per annum, secured by assets and guaranteed loan


4,575,000



6,523,100Loan from Citic Bank, due in December 2011. Average interest from 5.81% per annum, secured by assets and guaranteed loan


3,050,000



-Loan from China Merchant Bank, due various dates in June through September 2011. Monthly interest-only payments from 6.37% to 6.39% per annum, secured by assets and guaranteed by third party


8,540,000



8,495,200Loan from Bank of China. Monthly interest-only payment at 4% per annum, unsecured, and due upon demand.


854,000



849,520Loan from Bank of China, due in March 2012. Monthly interest-only payment at 6.06% per annum, secured by assets


4,575,000



-Loan from China Commercial Bank, due in November 2011. Monthly interest-only payment at 6.0% per annum, guaranteed loan


1,525,000



1,517,000Loan from Huaxia Bank in city of Xi’an, due various dates from February to March 2011.  Interest-only payments at 6.12% per annum, secured by assets.


-



4,551,000Short term loan - bank

$
30,591,500


$
29,369,120
  24
 
 HARBIN ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2011
 (UNAUDITED)
 The Company’s long term bank loan (see Note 14 for more discussion) as of March 31, 2011 and December 31, 2010 are as follows:
 
 March 31,

2011


December 31,

2010(Unaudited)Loan from China Development Bank (see Note 14 for detail discussion of the Term Loan Facility terms)

$
50,250,000


$
50,070,000$
50,250,000


$
50,070,000
 
 The above loans are secured by the Company's plants, buildings, land use rights and inventories located within PRC, with carrying net value as follows:
 
 March 31,

2011


December 31,

2010(Unaudited)Buildings in Xi’an, China

$
22,341,800


$
22,373,129Buildings in Weihai, China


2,178,295



2,166,868Land use rights in Xi’an and Weihai, China


12,266,888



1,122,435Inventories in Xi’an, China


9,288,529



9,102,000Total assets pledged as collateral for bank loans

$
46,075,512


$
34,764,432
 
 Net interest expense for the three months ended March 31 was comprised of the following:
 
 2011

(Unaudited)


2010

(Unaudited)Amortization of debt discount

$
-


$
910,535Amortization of debt issuance costs


41,667



140,968Interest expense


1,910,133



795,217Interest earned on cash deposits


(220,583
)


(202,479
)Foreign currency transaction loss


192,733



2,682Interest expense, net

$
1,923,950


$
1,646,923
 
 Note 16 – Due to original shareholders
 
 Due to original shareholders represent the amount that was unpaid for the acquisition of Weihai, which consisted of the following:
 March 31,

2011


December 31,

2010(Unaudited)Amount due to Weihai original shareholders

$
762,500


$
758,500$
762,500


$
758,500
 
 Amount due to Weihai original shareholders is due on demand.
 
 25
  HARBIN ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2011
 (UNAUDITED)
 Note 17 – Additional product sales information
 
 The Company has a single operating segment. The majority of the Company’s revenue was generated from domestic PRC sales.
 
 Summarized financial information concerning the Company’s revenues based on geographic areas for the three months ended March 31, 2011 and 2010 are as follows:
 
 2011

(Unaudited)


2010

(Unaudited)China

$
100,097,842


$
98,421,710International


3,731,582



7,063,447Total sales


103,829,424



105,485,157Cost of sales - China


71,035,425



65,280,189Cost of sales - International


2,590,211



4,462,898Total cost of sales


73,625,636



69,743,087Gross profit

$
30,203,788


$
35,742,070
 
 The following tables present the revenue and cost of sales by each major product line for the three months ended March 31, 2011 and 2010:
 
 RevenuesProduct Line

2011

(Unaudited)


2010

(Unaudited)Linear Motors and Related Systems

$
19,261,483


$
19,831,210Specialty Micro-Motors


15,532,331



16,244,714Rotary MotorsWeihai


21,769,699



22,468,338Xi’an


46,304,677



45,042,162Others


961,234



1,898,733Total

$
103,829,424


$
105,485,157
 
 Cost of SalesProduct Line

2011

(Unaudited)


2010

(Unaudited)Linear Motors and Related Systems

$
10,477,955


$
7,970,388Specialty Micro-Motors


10,549,510



10,034,233Rotary MotorsWeihai


19,232,429



19,604,859Xi’an


32,815,610



31,019,050Others


550,132



1,114,556Total

$
73,625,636


$
69,743,087
 
 26
 
 HARBIN ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2011
 (UNAUDITED)
 Note 18 – Commitments and contingencies
 
 Commitments
 
 The Company enters into non-cancelable purchase commitments with some of its vendors. As of March 31, 2011 and December 31, 2010, the Company was obligated under the non-cancelable commitments to purchase materials totaling to $ 9,768,422 and $12,000,496, respectively. These commitments are short-term and expire within one year. The Company has not experienced losses on these purchase commitments over the years.
 
 On August 25, 2010, the Company entered into an agreement with Shelton Technology, LLC.  Under the terms of the agreement, the Company is required to contribute a total of $1 million to AAG prior to December 31, 2011.
 
 On September 8, 2006, HTFE entered into an agreement (“Land Use Agreement”) with Shanghai Lingang Investment and Development Company Limited (“Shanghai Lingang”) with respect to HTFE’s lease and use of 40,800 square meters of State-owned land in the Shanghai Zhuqiao Airport Industrial Zone (the “Site”). The size of the land used by HTFE was later revised to a total of approximately 53,000 square meters. The term of the Land Use Agreement is 50 years and totaled $6.28 million (RMB 42.84 million) (“Fee”), approximately 96.8% or $6.08 million (RMB 41,556, 000) of which has been paid with the balance to be paid in installments.
 
 Contingencies
 
 Ten shareholder class action lawsuits were filed against the Company and/or certain officers and the members of its Board of Directors (the “Board”), in connection with the October 10, 2010 non-binding proposal made by the Company’s Chairman and Chief Executive Officer, Mr. Tianfu Yang, and Baring Private Equity Asia Group Limited to acquire all of the outstanding shares of the Company’s Common Stock not currently owned by Mr. Yang and his affiliates for $24.00 per share in cash, as further described in the Schedule 13D/A and Exhibits thereto filed on October 12, 2010 (the “Proposal”). Five actions were filed in Nevada state court (Carson City, Clark County, or Washoe County); two actions were filed in Nevada federal district court, and three actions were filed in New York state court. All of the actions assert claims against the Company and/or members of the Board for allegedly breaching their fiduciary duties in connection with the Proposal.
 
 Guarantee of Third-Party Indebtedness—No Liability Is Recorded
 
 As China only began its economic reform and development of a market economy in the 1980s, its credit evaluation system has had only a very short history and is far less sophisticated than that in the developed countries. Therefore, when an enterprise applies for a loan from a commercial bank, it is difficult for the bank to evaluate the credit risk of the applicant. As an alternative tool, it is a common practice in China for commercial banks to require the applicant find an unrelated third-party in its local economy to provide a loan guarantee for the applicant, which very much serves as a credit check for the bank. In return, and also to avoid risk of having to make payments under the guarantee, such guarantors often require the counterparty to provide similar guarantees on their own debt. Therefore, this type of guarantee is usually cross-guarantee.
  For mutual benefit, the Company reached agreements with one third party to provide such cross-guarantee on bank loans as of March 31, 2011.
  As of March 31, 2011, the Company is contingently liable as guarantor with respect to $3,050,000 of indebtedness of Baoji Zhongcheng Machinery Co. Ltd. (“Baoji”). The term of the guarantee is through April 2011 and is not extended. At any time through that date, should Baoji be over six months delinquent on its debt payments, the Company will be obligated to perform under the guarantee by primarily making the required payments, including late fees and penalties. The maximum potential amount of future payments that the Company is required to make under the guarantee is the entire default amount, not exceed the loan amount. Baoji is also contingently liable as guarantor for the Company with respect to $4,575,000 of indebtedness. The term of the guarantee is through June 2011.
 
 The Company has evaluated the guarantee and concluded that the likelihood of having to make payments under the guarantee is remote.
 
 27
 
 HARBIN ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2011
 (UNAUDITED)
 
 Note 19 – Earnings per share
 
 FASB requires presentation of basic and diluted earnings per share in conjunction with the disclosure of the methodology used in computing such earnings per share.  Basic earnings per share excludes dilution and is computed by dividing income available to common stockholders by the weighted average common shares outstanding during the period. Diluted earnings per share takes into account the potential dilution that could occur if securities or other contracts to issue common stock were exercised and converted into common stock. The following is a reconciliation of the basic and diluted earnings per share computations:
 
 For the three months ended March 31:2011

(Unaudited)


2010

(Unaudited)Net income before noncontrolling interest

$
10,819,941


$
22,906,041Less: Net income attributable to noncontrolling interest


14,269



2,352,353Net income attributable to controlling interest

$
10,805,672


$
20,553,688Weighted average shares used in basic computation


31,250,820



31,067,471Diluted effect of stock options and warrants


113,205



286,392Weighted average shares used in diluted computation


31,364,025



31,353,863Earnings per share - Basic:Net income before noncontrolling interest

$
0.35


$
0.74Less: Net income attributable to noncontrolling interest

$
-


$
0.08Net income attributable to controlling interest

$
0.35


$
0.66Earnings per share - Diluted:Net income before noncontrolling interest

$
0.34


$
0.73Less: Net income attributable to noncontrolling interest

$
-


$
0.07Net income attributable to controlling interest

$
0.34


$
0.66
 
 Except for 30,000 stock options at $20.02 per share, all stock options and warrants have been included in the diluted earnings per share calculation for the three months ended March 31, 2011.  All stock options and warrants have been included in the diluted earnings per share calculation for the three months ended March 31, 2010.
 
 Note 20 – Shareholders’ equity
 
 Statutory reserves
 
 The laws and regulations of the People’s Republic of China require that before a Sino-foreign cooperative joint venture enterprise distributes profits to its partners, it must first satisfy all tax liabilities, provide for losses in previous years, and make allocations in proportions determined at the discretion of the board of directors, after the statutory reserve.
 
 28
 
 HARBIN ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2011
 (UNAUDITED)
 Surplus reserve fund
 
 The Company is required to transfer 10%-15% of its net income, as determined in accordance with the PRC accounting rules and regulations, to a statutory surplus reserve fund until such reserve balance reaches 50% of the Company’s registered capital. The transfer to this reserve must be made before distribution of any dividend to shareholders. The Company will transfer at year end 10%-15% of the year’s net income determined in accordance with PRC accounting rules and regulations.
 
 For the three months ended March 31, 2011 and 2010, the Company transferred $1,473,493, and $2,302,999, respectively, representing 10% -15% of the net income generated by the Company’s subsidiaries located within PRC determined in accordance with PRC accounting rules and regulations, to this reserve. The remaining reserve to fulfill the 50% registered capital requirement amounted to approximately $37.2 million and $38.7 million as of March 31, 2011 and December 31, 2010, respectively.
 
 The surplus reserve fund is non-distributable other than during liquidation and can be used to fund previous years’ losses, if any, and may be utilized for business expansion or converted into share capital by issuing new shares to existing shareholders in proportion to their shareholding or by increasing the par value of the shares currently held by them, provided that the remaining reserve balance after such issue is not less than 25% of the registered capital.
 
 Warrants
 
 Following is a summary of warrant activity:
 
 Outstanding as of January 1, 2010


366,697Granted


-Forfeited


-Exercised


-Outstanding as of March 31, 2010 (Unaudited)


366,697Granted


-Forfeited


-Exercised


(183,349)Outstanding as of December 31, 2010


183,348Granted


-Forfeited


-Exercised


-Outstanding as of March 31, 2011 (Unaudited)


183,348
 
 Following is a summary of the status of warrants outstanding at March 31, 2011:
 
 Outstanding Warrants


Exercisable WarrantsExercise Price

Number of

Shares


Average

Remaining

Contractual

Life


Average

Exercise Price


Number of

Shares


Average

Remaining

Contractual

Life$10.84


183,348



1.42


$
10.84



183,348



1.42Total


183,348











183,348
 
 29
 
 HARBIN ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2011
 (UNAUDITED)
 Options
 
 On November 30, 2009, the Company granted options to an independent director to purchase an aggregate of 30,000 shares of the Company’s common stock, at an exercise price of $20.02 per share, the closing price of the Company’s common stock on November 30, 2009. The fair values of stock options granted to employees and the independent directors were estimated at the date of grant using the BSM with the following assumptions:
 
 Expected


Expected


Dividend


Risk Free


Grant DateLife


Volatility


Yield


Interest Rate


Fair ValueExecutives - 2007
3.0 yrs



77
%


0
%


4.50
%

$
15.60Directors - 2009
3.0 yrs



70
%


0
%


1.15
%

$
20.02
 
 Following is a summary of stock option activity:
 Options Outstanding


Weighted

Average

Exercise Price


Aggregate Intrinsic

ValueOutstanding as of December 31, 2009


355,000


$
13.97


$
2,333,600Granted


-



-



-Forfeited


-



-



-Exercised


-



-



-Outstanding as of March 31, 2010 (Unaudited)


355,000


$
13.97


$
2,706,350Granted


-



-



-Forfeited


-



-



-Exercised


-



-



-Outstanding as of December 31, 2010


355,000


$
13.97


$
1,199,900Granted


-



-



-Forfeited


(95,000
)


8.10



1,043,100Exercised


-



-



-Outstanding as of March 31, 2011 (Unaudited)


260,000


$
16.11


$
1,190,800
 
 Following is a summary of the status of options outstanding at March 31, 2011:
 
 Outstanding Options


Exercisable OptionsExercise Price

Number


Average Remaining Contractual Life


Average

Exercise Price


Number


Average Remaining Contractual Life$15.60


230,000



1.71


$
15.60



230,000



1.71$20.02


30,000



3.67


$
20.02



21,250



3.67Total


260,000











251,250
 
 On July 12, 2007, the Company’s CEO transferred 280,000 of his own shares to the Company employees and consultants. The shares vest over 5 to 10 years starting July 12, 2007. The Company valued the shares at $13.73 per share, based on the average price for the immediately preceding fifteen consecutive trading days before June 16, 2007, the date when the Company and HTFE entered into the asset purchase agreement with Harbin Taifu Auto Electric Co., Ltd., the trading price of the stock on the date of transfer, as a capital contribution totaling $3,844,904 by the CEO, the value was amortized over the vesting period.
 
 For the three months ended March 31, 2011 and 2010, stock compensation expense related to options issued amounted to $111,297 and $254,669, respectively.
 
 Note 21 – Employee pension
 
 Regulations in the People’s Republic of China require the Company to contribute to a defined contribution retirement plan for all employees. All Joint Venture employees are entitled to a retirement pension amount calculated based upon their salary at their date of retirement and their length of service in accordance with a government managed pension plan. The PRC government is responsible for the pension liability to the retired staff. The employee pension in Harbin generally includes two parts: the first part to be paid by the Company is 20% of the employees’ actual salary in the prior year. If the average salary falls below $1,165 for each individual, $1,165 will be used as the basis. The other part, paid by the employees, is 8% of actual salary with the same minimum requirement. The Company made contributions to employment benefits, including pension, of $1,018,974 and $213,763 for the three months ended March 31, 2011 and 2010, respectively.




30


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





INFORMATION REGARDING FORWARD LOOKING STATEMENTS





The following is management’s discussion and analysis of certain significant factors that have affected aspects of our financial position and results of operations during the periods included in the accompanying unaudited financial statements. You should read this in conjunction with the discussion under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the audited financial statements for the year ended December 31, 2010 included in our Annual Report on Form 10-K and the unaudited consolidated financial statements and notes thereto set forth in Item 1 of this Quarterly Report. In addition to historical information, this discussion and analysis contains forward-looking statements that relate to future events and expectations and, as such, constitute forward-looking statements. Forward-looking statements include those containing such words as “anticipates,” “believes,” “estimates,” “expects,” “hopes,” “targets,” “should,” “will,” “will likely result,” “forecast,” “outlook,” “projects” or similar expressions. Such forward-looking statements involve known and unknown risks, uncertainties, and other factors that may cause actual results, performance or achievements of the Company to be materially different from those expressed or implied in the forward-looking statements.





OVERVIEW





Harbin Electric, Inc. (“Harbin Electric” or the “Company”) is incorporated under the laws of the state of Nevada and, along with our wholly-owned subsidiaries, is headquartered in Harbin, China. We design, develop, manufacture, supply, and service a wide range of electric motors, with a focus on innovation, creativity, and value-added products. Our major product lines include linear motors, specialty micro-motors, and industrial rotary motors. Our products are purchased by a broad range of customers including those customers in the energy industry, factory automation, food processing, packaging industry, power generation systems, mass transportation and freight transportation systems, chemical, petrochemical, metallurgical, mining, textile, agricultural, and machinery industries. We primarily supply domestic markets in China and also certain international markets.





We currently operate the following four manufacturing facilities in China with an employee base of approximately 3,970 engineers, production technicians, and other employees:




·
Harbin Tech Full Electric Co., Ltd. (“Harbin Tech Full”) is located in the government-designated Development Zone in the city of Harbin with approximately 50,000 square meters of land and manufactures linear motors and linear motor integrated systems.
 
 ·
Shanghai Tech Full Electric Co., Ltd. (“Shanghai Tech Full”) is located in the Shanghai Zhuqiao Airport Industrial Zone with 40,800 square meters of land and manufactures specialty micro-motors.
 
 ·
Weihai Tech Full Simo Motor Co., Ltd. (“Weihai Tech Full Simo”) is located in Weihai with approximately 150,000 square meters of land and primarily manufactures small to medium sized industrial rotary motors.
 
 ·
Xi’an Tech Full Simo Motor Co., Ltd. (“Xi’an Tech Full Simo”) was acquired in October 2009 and manufactures primarily medium to large sized industrial rotary motors. Xi’an Tech Full Simo is located in Xi’an city’s Economy and Technology Development Zone and occupies approximately 200,000 square meters of land.
 
 We are subject to risks common to companies operating in China, including risks inherent in our distribution and commercialization efforts, uncertainty of foreign regulatory and marketing approvals and laws, reliance on key customers, enforcement of patent and proprietary rights, the need for future capital, and retention of key employees. We cannot provide assurance that we will generate revenues or achieve and sustain profitability in the future.





RECENT EVENTS





On October 10, 2010, our Board of Directors (the “Board”) received a non-binding proposal from Mr. Tianfu Yang (“Mr. Yang”) and Baring Private Equity Asia Group Limited (“Baring”) for Mr. Yang and an investment fund advised by Baring (the "Baring Fund") to acquire all of the outstanding shares of Common Stock of Harbin Electric not currently owned by Mr. Yang and his affiliates for $24.00 per share in cash, subject to certain conditions (“Going Private Proposal”). Mr. Yang owns 31.1% of our Common Stock. According to the proposal letter, Mr. Yang and Baring intended to form an acquisition vehicle for the purpose of completing the acquisition and that they intend to finance the acquisition with a combination of debt and equity capital. The proposal letter stated that Goldman Sachs (Asia) LLC (“Goldman”) is acting as financial advisor to the acquisition vehicle to be formed by Mr. Yang and Baring and that Goldman has informed Mr. Yang and Baring that it is highly confident that the underwriting and arranging of commitments for the debt financing needed to complete the transaction can be done. The proposal letter stated that the equity portion of the financing would be provided by Mr. Yang, the Baring Fund and related sources.





On November 22, 2010, the Board received a new letter from Mr. Yang regarding his previously announced proposal to take the Company private (the “Yang Proposal”). In this letter, Mr. Yang advised the Board that, by mutual agreement, Mr. Yang and Baring Private Equity Asia Group Limited (“Baring”) had amended and restated their previously announced Consortium Agreement, pursuant to which they had agreed to work together exclusively on the Yang Proposal. The amended and restated agreement between Baring and Mr. Yang provides that Baring’s participation in the Yang Proposal will consist solely of a right (but not an obligation) to provide up to 10% of the financing for the transaction, in the form of debt and/or equity and that Mr. Yang will not be restricted from seeking alternative sources of financing, in the form of debt and/or equity, for the transaction. Mr. Yang further advised the Company that he intends to proceed with a proposal to take the Company private at the previously announced proposed price of $24.00 per share, that he would seek alternative sources of financing for the transaction, and that Goldman Sachs (Asia) LLC would continue to act as financial advisor to Mr. Yang in connection with the transaction.




31





Our Board of Directors has formed a special committee of independent directors to evaluate and consider this proposal and any other alternative proposals or other strategic alternatives that may be available to the Company. Since being formed, the Special Committee has engaged legal and financial advisors. The Special Committee’s process is ongoing and the Special Committee intends to continue with its work, including evaluating any proposal presented by Mr. Yang as well as other proposals which the Company may receive, for as long as the Special Committee, in consultation with its advisors, deems necessary.





Pursuant to a Schedule 13D/A (the “Schedule 13D/A”) filed jointly by Mr. Tianfu Yang, Hero Wave Investments Limited (“Hero”), Tech Full Electric Company Limited (“Tech Full”), Abax Lotus Ltd. (“Abax Lotus”), Abax Nai Xin A Ltd. (“Abax Nai Xin”), Abax Global Opportunities Fund (“Global Fund”), Abax Upland Fund LLC (“Upland”), Abax Arhat Fund (“Arhat”), Abax Claremont Ltd. (“Upland Managing Member”), Abax Global Capital (“AGC”), Abax Global Capital (Hong Kong) Limited (“Abax HK”), and Xiang Dong Yang (“Mr. Xiang Dong Yang”, collectively with Abax Lotus, Global Fund, Upland, Arhat, Upland Managing Member, AGC, AGC Asia 3, Abax HK and Abax Nai Xin, the “Abax Parties”) with the Securities and Exchange Commission on May 2, 2011 (Mr. Yang, Hero, Tech Full and the Abax Parties are collectively referred to herein as the “Reporting Persons”), the Reporting Persons disclosed that on April 20, 2011, Mr. Tianfu Yang and AGC (acting on behalf of certain funds it manages and/ or advises), on behalf of themselves, submitted a proposal (the “Proposal”) to the Special Committee of the Company’s board of directors for the acquisition of all of the Publicly Held Shares(as defined below) through a Nevada corporation wholly owned by Tech Full for US$24.00 per share (the “Proposed Transaction”). According to the Schedule 13D/A, financing for the Proposed Transaction will include both debt and equity components, as well as rollover equity from certain members of the management and certain Abax Parties (the “Rollover Commitments”). AGC and Abax HK, on behalf of certain of the funds and/or entities that they manage or advise, will also provide equity and debt financing through certain such funds in connection with the Proposed Transaction, and the Abax Parties may bring in one or more additional third party investors to fund a portion of such equity and/ or debt financing.  With respect to the Rollover Commitments, certain members of management, including Mr. Tianfu Yang, Tianli Yang, Zedong Xu, Suofei Xu and Lanxiang Gao, have committed to roll all of their shares of Common Stock into Tech Full in connection with the Proposed Transaction. In addition, Abax Lotus and Abax Nai Xin have also committed to roll over all of their shares of Common Stock into Tech Full in connection with the Proposed Transaction. According to the Schedule 13D/A, the Reporting Persons anticipate that approximately US$463.8 million will be expended in acquiring 18,525,436 outstanding shares of Common Stock owned by shareholders of the Company other than certain senior managers of the Company (the “Rollover Shareholders”) and the Reporting Persons (“Publicly Held Shares”). This amount includes (a) the estimated funds required by Reporting Persons to (i) purchase the Publicly Held Shares, (ii) pay for the outstanding options to purchase Common Stock, and (iii) pay for the outstanding warrants to purchase Common Stock, and (b) the estimated transaction costs associated with the purchase of the Publicly Held Shares.




According to the Schedule 13D/A, in connection with the Proposal, AGC and Abax HK, on behalf of certain of the funds and/or entities that they manage or advise, issued on April 20, 2011 a financing commitment letter and committed to provide equity and debt financing of an aggregate amount of up to US$63.8 million. The source of funds for such equity and debt financing will come from the investors in such funds. In addition, the Abax Parties may bring in one or more additional third party investors to fund a portion of such equity and/ or debt financing.





In addition, according to the Schedule 13D/A, on April 29, 2011, Tech Full received a debt commitment letter (the “Debt Commitment Letter”) issued by China Development Bank Corporation (“CDB”) for a US$400,000,000 term loan facility to fund the proposed purchase of the Publicly Held Shares, subject to execution of mutually acceptable definitive documents for the facility. CDB’s commitment under the Debt Commitment Letter will terminate on April 2, 2012 unless CDB receives a written confirmation prior to the expiration date.





There can be no assurance that any definitive agreement will be executed with respect to the Proposed Transaction or that this or any other transaction will be approved or consummated. See Part II, Item 1A. “Risk Factors” of this Quarterly Report on Form 10-Q.





CRITICAL ACCOUNTING POLICIES AND ESTIMATES





We believe that the application of the following accounting policies, which are important to our financial position and results of operations, require significant judgments and estimates on the part of management. Our critical accounting policies and estimates present an analysis of the uncertainties involved in applying a principle, while the accounting policies note to the financial statements (Note 2) describe the method used to apply the accounting principle.





Accounts Receivable





Accounts receivable are presented net of an allowance for bad debts account. The Company maintains reserves for potential credit losses on accounts receivable. Management reviews the composition of accounts receivable and analyzes historical bad debts, customer concentrations, customer credit worthiness, current economic trends, and changes in customer payment patterns to evaluate the adequacy of these reserves. The estimated loss rate is based on our historical loss experience and also considerations of current market conditions. Delinquent account balances are written-off after management has determined that the likelihood of collection is not probable, and known bad debts are written off against allowance for doubtful accounts when identified.





32





Inventories





Inventories are valued at the lower of cost or market value, as determined on a first-in, first-out basis, using the weighted average method. Management compares the cost of inventories with the market value and an allowance is made for writing down the inventories to its market value, if lower than cost. On an ongoing basis, inventories are reviewed for potential write-down for estimated obsolescence or unmarketable inventories equal to the difference between the costs of inventories and the estimated net realizable value based upon forecasts for future demand and market conditions. When inventories are written-down to the lower of cost or market, they are not marked up subsequently based on changes in underlying facts and circumstances.  Inventories are composed of raw material for manufacturing electrical motors, work in process and finished goods within the Company’s warehouse premise or consigned at a customer site. The inventory allowance is made when the inventory’s market value is lower than the cost. The recovery of the reserve is only made through sale or disposition of such inventory items.





Revenue Recognition





The Company recognizes sales when title and risk of ownership are passed to the customer (which is at the date of shipment), when a formal arrangement exists, the price is fixed or determinable, no other significant obligations exist and collectability is reasonably assured. For products that are required to be examined by customers, sales revenue is recognized after the customer examination is passed. Payments received before all of the relevant criteria for revenue recognition are satisfied, are recorded as customer deposits.





In addition, revenue recognition could be negatively impacted by returns. For our linear motor and specialty micro-motor businesses, our products are custom products which are customer specific, and no returns are allowed. We warrant our product for repair, only in the event of defects for two years from the date of shipment.  We charge such costs to cost of goods sold. For our industrial rotary motor business, our products are standardized products and returns are allowed within three days upon receipt of products by customers. We provide product warranty for repair one year from the date of shipment. Historically, the returns and defects have not been material. Should returns increase in the future it would be necessary to adjust the estimates, in which case recognition of revenues could be delayed.





The Company also provides after-sale services to our customers. Service revenue is recognized as services are rendered, the customers have approved the completion of the services and invoices have been issued and collectability is reasonably assured. Customer billings for services not yet rendered are deferred and recognized as revenue as the services are rendered and the associated deferred revenue is included in current liabilities or long-term liabilities, as appropriate.





The Company recognizes revenues with regards to the sales of consigned inventories when the title and risks of ownership have been transferred to customers; customers provide a persuasive evidence to notify the Company, and upon receipt of the notification form from customers. The Company also performs periodic inventory counts to confirm the inventory quantities held on consignment.





Customers who purchase industrial rotary motors are divided into two major categories: distributors and non-distributors. Non-distributors consist of OEM users, traders and end users. Except for the annual sales target for distributors, the sales arrangements are the same with distributors and non-distributors.





Distributors are committed to annual purchase target and entitled to a sales rebate. The Company periodically provides incentive offers to its distributors to encourage purchases. Such offers include inducement offers (e.g., offers for future discounts subject to its annual purchase target), and other similar offers. Inducement offers, when accepted by customers, are treated as a reduction to purchase price based on estimated future redemption rates. Redemption rates are estimated using the Company’s historical experience for similar inducement offers. Inducement offers are presented as a net amount in “net sales.”





Stock-Based Compensation





We record share-based compensation expense based upon the grant date fair value of share-based awards. The value of the award is principally recognized as expense ratably over the requisite service periods. We use the Black-Scholes Merton (“BSM”) option-pricing model, which incorporates various assumptions including volatility, expected life and interest rates to determine fair value. The Company’s expected volatility assumption is based on the historical volatility of Company’s stock. The expected life assumption is primarily based on the simplified method of the terms of the options. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of grant.





The Company is required to measure the cost of the equity instruments issued in exchange for the receipt of goods or services from other than employees at the estimated fair market value of the consideration received or the estimated fair value of the equity instruments issued, whichever is more reliably determinable. The value of equity instruments issued for consideration other than employee services is determined on the earlier of a performance commitment or completion of performance by the provider of goods or services.





33





Stock compensation expense is recognized based on awards expected to vest.  GAAP requires forfeitures to be estimated at the time of grant and revised in subsequent periods, if necessary, when actual forfeitures differ from those estimates.  There were no estimated forfeitures as the Company has a short history of issuing options and the actual forfeitures during the history of issuing options were minimal.





Fair Value of Financial Instruments





On January 1, 2008, the Company began recording financial assets and liabilities subject to recurring fair value measurement at the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. On January 1, 2009, the Company began recording non-recurring financial as well as all non-financial assets and liabilities subject to fair value measurement under the same principles. These fair value principles prioritize valuation inputs across three broad levels. The three levels are defined as follows:





-
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.





Recent Accounting Pronouncement





In April 2010, the FASB issued ASU 2010-13, Compensation -Stock Compensation (Topic 718): Effect of Denominating the Exercise Price of a Share-Based Payment Award in the Currency of the Market in Which the Underlying Equity Security Trades. This updateprovides amendments to Topic 718 to clarify that an employee share-based payment award with an exercise price denominated incurrency of a market in which a substantial porting of the entity’s equity securities trades should not be considered to contain acondition that is not a market, performance or service condition. Therefore, an entity would not classify such an award as a liability ifit otherwise qualifies as equity. The amendments in this ASU are effective for fiscal years, and interim periods within those fiscalyears, beginning on or after December 15, 2010. The Company’s adoption of this ASU did not have a material impact on itsconsolidated financial statements.





In September 2010, the FASB issued Accounting Standard Update 2010-25, Plan Accounting—Defined Contribution Pension Plans (Topic 962): Reporting Loans to Participants by Defined Contribution Pension Plans. This ASU clarifies how loans to participantsshould be classified and measured by defined contribution plans and how International Financial Reporting Standards compare tothese provisions. The amendments in this update are effective for fiscal years ending after December 15 2010. The Company’sadoption of this ASU did not have a material impact on its consolidated financial statements.





In December 2010, the FASB issued Accounting Standard Update 2010-28, Intangibles—Goodwill and Other (Topic 350): When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts. This ASU modifiedStep 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For those reporting units, an entityis required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. For publicentities, the amendments in the ASU are effective for fiscal years, and interim periods within those years, beginning after December15, 2010. The Company’s adoption of this ASU did not have a material impact on its consolidated financial statements.





In December 2010, the FASB issued Accounting Standard Update 2010-29, Business Combinations(Topic 805): Disclosure of Supplementary Pro Forma Information for Business Combinations. This ASU specifies that, if a public entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business combination(s) that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. ASU 2010-29 is effective prospectively for business combinations where the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010. The Company’s adoption of this ASU did not have a material impact on its consolidated financial statements.





RESULTS OF OPERATIONS





Revenues





For the first quarter of 2011, total revenues were $103.8 million, down slightly compared to $105.5 million in the first quarter of 2010. Marginally lower sales in linear motors and specialty micro motors were partially offset by slightly higher sales in industrial rotary motors. In the linear motor product line, sales were down $0.6 million year-over-year. Lower sales volume in oil pumps (75 units in the first quarter of 2011, compared with 105 units in the first quarter of 2010, a $1.4 million decrease in sales) and in propulsion systems for coal transportation trains (a $1.4 million decrease) were largely offset by higher volumes in other linear motors. In the specialty micro motor product line, sales declined by $0.7 million. A decrease in sales volume of existing products was partially compensated by sales of new products. Rotary motor sales at Xi’an Tech Full Simo were up $1.3 million driven by higher volumes, while rotary motor sales at Weihai Tech Full Simo were down $0.7 million due to lower volumes. Sales of other products dropped $0.9 million due to lower volume.




34




The following table presents the revenue contribution by percentage for each major product line in the first quarter of 2011 in comparison with the first quarter of 2010.





Percent of Total RevenuesProduct Line


1Q11



1Q10Linear Motors and Related Systems


18.5
%


18.8
%Specialty Micro-Motors


15.0
%


15.4
%Rotary Motors


65.6
%

64.0
%Weihai


21.0
%


21.3
%Xi’an


44.6
%


42.7
%Others


0.9
%


1.8
%Total


100
%


100
%





Net Income





The Company recorded a net income attributable to controlling interest of $10.8 million, or $0.34 per diluted share in the first quarter of 2011, compared with a net income attributable to controlling interest of $20.6 million, or $0.66 per diluted share in the same period of 2010. The net income attributable to controlling interest was 47.4% lower than in the first quarter of 2010 primarily due to the following factors:





1.
Lower gross profit margin (see section titled “Gross Profit Margin”);


2.
Higher research & development expenses (see section titled “Operating Expenses”);


3.
Higher selling, general and administrative expenses (see section titled “Operating Expenses”);


4.
Higher other expenses including expense related to change in fair value of warrant ($0.4 million and $0.2 million in the first quarter of 2011 and 2010, respectively) and net interest expense ($1.9 million and $1.6 million in the first quarter of 2011 and 2010, respectively); and


5.
Higher income tax rate (see section titled “Income Tax”).





The net profit margin (net income attributable to controlling interest as a percentage of total revenues) was 10.4% and 19.5% in the first quarter of 2011 and 2010, respectively.





Gross Profit Margin





The following table presents the average gross profit margin by product line for the three months ended March 31, 2011, compared with the same period in 2010.





Gross Profit MarginProduct Line


1Q11



1Q10Linear Motors and Related Systems


45.6
%


59.8
%Specialty Micro-Motors


32.1
%


38.2
%Rotary Motors


23.5
%

25.0
%Weihai


11.7
%


12.7
%Xi’an


29.1
%


31.1
%Others


42.8
%


41.3
%Corporate Average


29.1
%


33.9
%





The decline in overall gross margin was primarily due to margin decline in linear motors and specialty micro-motors. Higher raw material costs and labor costs contributed to higher cost of goods sold across all product lines.




In linear motors, margin compression was mainly attributable to the following factors in addition to higher raw material and labor costs:





1.
Changes in product mix. Sales volume of higher margin products – oil pumps and propulsion systems for coal transportation trains – declined in the first quarter of 2011 compared with the same period a year ago, while sales volume of lower margin products increased.





2.
Lower unit selling prices for some products. In order to expand our customer base and gain market share, we lowered the selling prices for some products.





35





In the specialty micro motors, lower gross margin was primarily attributable to the following factors in addition to higher raw material and labor costs:





1.
Several new products were added compared to the first quarter of last year. New product launch generally experiences higher manufacturing costs at the start-up stage due to higher costs associated with training of workforce, more test runs, and smaller orders, which resulted in reduced production efficiency.





2.
Changes in product mix. Sales volume of existing higher-margin products declined while sales volume of new lower-margin products increased.





Gross margin in rotary motors remained relatively stable year-over-year, driven by improved manufacturing efficiency offset by higher raw material and labor costs.





Operating Expenses





Research and development (R&D) expenses increased to $3.9 million in the three months ended March 31, 2011 from $0.6 million in the three months ended March 31, 2010. As technology and R&D are the Company’s long term strategic focus, we have been making every effort to enhance our R&D projects and invest in product and technology development in order to capture additional market share and position the Company well for further growth. The $3.9 million R&D expense in the first quarter of 2011 was primarily associated with a new development project to develop an automated control system for linear servo motors. This development project was initiated in March 2010 in collaboration with a research institute. It has received extensive interest from potential customers. This project is near a successful completion and a total of $3.1 million was incurred during this quarter. We expect to launch the production of this newly developed linear servo motor during 2011.





In subsequent quarters this year, we expect R&D expenses to be lower and expect that total R&D expenses in the entire year will remain below 3% of total revenues.





Selling, general and administrative expenses (SG&A) amounted to $10.1 million and $7.4 million in first quarter of 2011 and 2010, respectively, or 9.7% and 7.0% as a percentage of each quarter’s total revenues. The year-over-year increase in SG&A primarily reflected the following contributors:





1.
Xi’an Tech Full Simo recorded $1.7 million incremental provision for bad debts in the first quarter of 2011 versus in the first quarter of 2010 reflecting the accounts receivable aging analysis.





2.
Expenses in the first quarter of 2011 related to the Going Private Proposal submitted by the Company’s Chairman and Chief Executive Officer, Mr. Tianfu Yang (see section titled “Recent Events”) totaled approximately $0.9 million. This amount included legal fees associated with the class action law suits (see Part II, Item 1 “Legal Proceedings”), fees associated with legal and financial advisors for the Special Committee of the Board of Directors, and other related expenses. The Company expects to recover some of the legal expenses related to the class action law suits pursuant to its insurance policy.





3.
Shipping and handling costs increased to $1.5 million from $0.8 million in the same quarter of last year. The higher shipping and handling costs were mainly attributable to higher fuel costs and further geographical expansion of our customer base.





Operating profits were $16.3 million and $27.7 million in the first quarter of 2011 and 2010, respectively, with the operating margin at 15.7% and 26.3%, respectively.





Other Income (net)





Other income remained stable at $1.1 million year over year. Other income mainly consisted of income from recycling scrap materials and selling production waste.





Interest expense (net)





Net interest expense was $1.9 million in the first quarter of 2011, compared with $1.6 million in the first quarter of 2010. Net interest expense in the first quarter of 2011 mainly included $1.9 million interest expense, $0.2 million of foreign currency transaction loss and $0.2 million interest income. Net interest expense in the first quarter of 2010 mainly included $1.1 million amortization of debt discount and debt issuance cost, $0.8 million interest expense and $0.2 million interest income.





See Note 15 for a breakdown of interest expense.





Income Taxes





The income tax provision was $4.2 million and $4.1 million in the first quarter of 2011 and 2010, respectively.


36


The corporate income tax rates in 2011 for some of our PRC subsidiaries are higher than in 2010 due to expiration of the previous preferential tax rates approved by the government. Harbin Tech Full was subject to a 10% preferential tax rate in 2010 and this preferential tax treatment expired at the end of 2010. Harbin Tech Full is in the process of applying for a new preferential income tax rate from the Chinese government. Management believes that it is highly likely that Harbin Tech Full will be approved for a 15% preferential income tax rate for 2011. However, the approval process may take six months or longer. For the first quarter of 2011, before obtaining government approval, management of Harbin Tech Full used a 25% standard income tax rate to calculate the provision for income tax. The 25% income tax rate for Harbin Tech Full has caused the provision for income tax at Harbin Tech Full significantly higher in the first quarter of 2011 than in the first quarter of 2010. The 10% preferential tax rate as opposed to the 25% standard rate resulted in a $1.6 million saving on tax in the first quarter of 2010. Shanghai Tech Full was subject to an 11% preferential tax rate in 2010 and is granted a 12% preferential tax rate in 2011. Xi’an Tech Full Simo remains at a 15% preferential tax rate in 2011. Weihai Tech Full has been subject to the standard 25% tax rate.





LIQUIDITY AND CAPITAL RESOURCES





Overview





A major factor in the Company’s liquidity and capital resource planning is its generation of operating cash flow, which is strongly dependent on the demand for our products.  This is supplemented by our financing activities in the capital markets including potential debt and equity, which support major acquisitions and capital investments for business growth.





Our liquidity position remains adequate, with $122.8 million in cash and cash equivalents as of March 31, 2011, compared with $98.8 million as of December 31, 2010. Cash provided by operating activities totaled $8.7 million in the current quarter, compared with $17.3 million in the first quarter of 2010. The decreases are mainly due to a decrease in operating earnings and an increase in cash used for inventory purchases and cash used to reduce notes receivables. Net cash provided by financing activities totaled $15.5 million, mainly from increased bank notes, partially offset by an increase in restricted cash amount required by the banks. Capital spending from operations for the current quarter was approximately $0.3 million.





At March 31, 2011, several items under our current assets and current liabilities including restricted cash, accounts receivable, inventories, advance on inventory purchase, notes payable - short term, and customer deposits changed significantly in the first quarter of 2011. The $14.4 million increases in restricted cash were due to the $28.8 million increases in short-term notes payable provided by the bank. Banks in general requires a 50% restricted cash amount to secure the notes payable. Accounts receivables decreased by $4.2 million, and $1.7 million were reserved on accounts receivable allowance. Inventories decreased by $6.7 million mainly due to reduction of inventory held in consignment. Advance on inventory purchases were increased by $6.7 million in preparation for anticipated higher production activities. Customers increased deposits by $5.4 million to secure current selling price in anticipation of an increase in future selling price.





Cash Position





As of March 31, 2011, we had cash and cash equivalents of $122.8 million. The following table provides detailed information about our net cash flow for this quarter, compared to the first quarter of 2010.





Three Months Ended March 31,2011


2010Net cash provided by operating activities

$
8,728,688


$
17,344,935Net cash used in investing activities


(582,258
)


(29,319,391
)Net cash provided by financing activities


15,466,000



(3,108,201
)Effect of exchange rate changes on cash


460,145



(2,637
)INCREASE (DECREASE) IN CASH

$
24,072,575


$
(15,085,303
)





Operating Activities





The major components of cash provided by operating activities are consolidated net income (net income attributable to both controlling and non-controlling interest) adjusted for non-cash income and expense items and changes in operating assets and liabilities.





Net cash provided by operating activities was $8.7 million in the first quarter of 2011, as compared to net cash provided by operating activities of $17.3 million in the first quarter of 2010. The decrease is mainly due to decreases in operating earnings, increases in cash used for inventory purchases, and cash used to reduce notes receivable.





Investing Activities





Our main uses of cash for investing activities during the first quarter of 2011 were for equipment purchase. Capital spending by operations for the current quarter was approximately $0.3 million. Generally, capital spending in the first quarter is seasonally lower as major capital spending usually starts in the second quarter after Chinese New Year. The Company expects the capital spending to go up in the subsequent quarters of the year when we continue to invest in upgrading the manufacturing capabilities, improving production efficiency, and expanding the capacity.


37


Financing Activities





Net cash provided by financing activities totaled $15.5 million during the quarter, mainly from increased bank notes, partially offset by the increases in restricted cash required by the banks. In the first quarter of 2010, cash was used to repay debt.





On November 22, 2010, the Company entered into a Term Loan Facility Agreement, dated November 22, 2010 (the “CDB Agreement”) with China Development Bank Corporation, Hong Kong Branch (“CDB”) pursuant to which CDB has agreed to provide a USD$35,000,000 loan facility (“Facility A”) and an RMB100,000,000 loan facility (“Facility B,” and collectively with Facility A, the “Facilities”) to the Company (the loans made under Facility A shall be referred to herein as “Facility A Loans” and the loans made under Facility B shall be referred to herein as “Facility B Loans”). The Facility A Loans and the Facility B Loans shall be made pursuant to one or more borrowings from time to time during the period of time from the date of the CDB Agreement to the date falling on the expiration of six (6) months after the date of the CDB Agreement upon delivering a utilization request from the Company to CDB. Interest on Facility A Loans shall be 3% per annum plus LIBOR (as defined in the CDB Agreement). Interest on Facility B Loans shall be 2.5% per annum plus SHIBOR (as defined in the CDB Agreement). The Company is required to repay the Facility A Loans in two (2) equal installments on (i) the date which falls twenty four (24) months after the first utilization date of any loan and (ii) the date which falls thirty six (36) months after the first utilization date of any loan. The Company is required to repay the Facility B Loans in two (2) equal installments on (i) the date which falls twenty four (24) months after the first utilization date of any loan and (ii) the date which falls thirty six (36) months after the first utilization date of any loan.





The CDB Agreement provides that the Company may, upon not less than one month’s prior notice prepay on an Interest Payment Date (as defined in the CDB Agreement) or a Repayment Date (as defined in the CDB Agreement) all or part of any loan (but if in part, in an amount that is an integral multiple of UDS$500,000 in the case of a Facility A Loan or RMB 2,000,000 in the case of Facility B Loan). The CDB Agreement also provides that upon a Change of Control (as defined in the CDB Agreement) of the Company, CDB may, by not less than 30 days notice to the Company, cancel the Facilities and declare all outstanding loans, together with accrued interest and all other amounts to be immediately due and payable.





The Company’s obligations under the CDB Agreement are secured by a pledge of shares of common stock of the Company owned by its Chairman and Chief Executive Officer, Tianfu Yang. On November 22, 2010, Mr. Yang entered into a Security and Pledge Agreement (the “Pledge Agreement”) with CDB, pursuant to which, Mr. Yang has agreed to pledge 7,000,000 shares of common stock to CDB to secure the loans. Under the Pledge Agreement, Mr. Yang may also be obliged to pledge to CDB, under certain circumstances, additional shares of common stock owned by him and, to the extent such additional shares are not sufficient, cash.





The Company has maintained compliance with the covenants pursuant to the CDB Agreement.





Contractual Obligations





On September 8, 2006, HTFE entered into an agreement (“Land Use Agreement”) with Shanghai Lingang Investment and Development Company Limited (“Shanghai Lingang”) with respect to HTFE’s lease and use of 40,800 square meters of State-owned land in the Shanghai Zhuqiao Airport Industrial Zone (the “Site”). The term of the land use agreement is 50 years. In June 2009, the Land Use Agreement was revised with the land size increased to a total of approximately 53,000 square meters. The aggregate amount HTFE shall pay to Shanghai Lingang is approximately $6.28 million (RMB42.84 million) ("Fee"), approximately 96.8% or $6.1 million (RMB 41.56 million) had been paid as of March 31, 2011 with the balance payable in installments.





On August 25, 2010, the Company entered into an agreement with Shelton Technology, LLC.  Under the terms of the agreement, the Company is required to contribute a total of $1 million to AAG prior to December 31, 2011.





The Company enters into non-cancelable purchase commitments with some of its vendors. As of March 31, 2011 and December 31, 2010, the Company was obligated under the non-cancelable commitments to purchase materials totaling to $9,768,422 and $12,000,496, respectively. These commitments are short-term and expire within one year. The Company has not experienced losses on these purchase commitments over the years.





Off-balance Sheet Arrangements





We do not have any off balance sheet arrangements.





Item 3. Quantitative and Qualitative Disclosures about Market Risk





Information relating to quantitative and qualitative disclosures about market risk is provided in the Company’s 2010 Annual Report on Form 10-K, which information is incorporated herein by reference. There have been no material changes in the Company’s exposure to market risk since December 31, 2010.




38




Item 4. Controls and Procedures





(a) Evaluation of Disclosure Controls and Procedures





We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed pursuant to the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules, regulations and related forms, and that such information is accumulated and communicated to our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure.





Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, the Company conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of March 31, 2011, as such term is defined in Exchange Act Rules 13a-15(e) and 15d-15(e). Based on this evaluation, our principal executive officer and principal financial officer have concluded that during the period covered by this report, the Company’s disclosure controls and procedures are effective as of such date at a reasonable assurance level to ensure that information required to be disclosed by us in our Exchange Act reports is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.





(b) Changes in Internal Control over Financial Reporting





There have been no changes in our internal control over financial reporting that occurred during the first quarter of 2011 covered by this Quarterly Report that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.


39


PART II. OTHER INFORMATION





Item 1.Legal Proceedings





Ten shareholder class action lawsuits were filed against the Company and/or certain officers and the members of its Board of Directors (the “Board”), in connection with the October 10, 2010 non-binding proposal made by the Company’s Chairman and Chief Executive Officer, Mr. Tianfu Yang, and Baring Private Equity Asia Group Limited to acquire all of the outstanding shares of the Company’s Common Stock not currently owned by Mr. Yang and his affiliates for $24.00 per share in cash, as further described in the Schedule 13D/A and Exhibits thereto filed on October 12, 2010 (the “Proposal”). Five actions were filed in Nevada state court (Carson City, Clark County, or Washoe County); two actions were filed in Nevada federal district court; and three actions were filed in New York state court. All of the actions assert claims against the Company and/or members of the Board for allegedly breaching their fiduciary duties in connection with the Proposal, as described further below.





On or about October 19, 2010, the Company became aware that the first of the shareholder class actions had been filed against the Company and its Board members in connection with the Proposal. Plaintiffs allege, among other things, that the proposed buyout price and the process of evaluating the Proposal are unfair and inadequate. Plaintiffs seek, among other relief, to enjoin defendants from consummating the Proposal and to direct defendants to exercise their fiduciary duties to obtain a transaction that is in the best interests of the Company’s shareholders.





The Company has moved, or will move, to dismiss, transfer, or stay Plaintiffs’ actions. The Company has reviewed the allegations contained in the complaints and believes they are without merit.  The Company intends to defend the litigation vigorously.





The pending cases are listed below.





Kay Hurewitz v. Harbin Electric, Inc. et al., No. 10-OC-00489-1B (“Hurewitz”), filed in the First Judicial District Court of the State of Nevada in and for Carson City on October 13, 2010. The complaint named the Company and Board members Tianfu Yang, Ching Chuen Chan, Boyd Plowman, David Gatton, Yunyue Ye, and Lanxiang Gao as defendants.





Bertrand Sellier v. Harbin Electric, Inc. et al., No. 3:10-CV-00645 (“Bertrand”), filed in the United States District Court for the District of Nevada on October 13, 2010. The complaint named the Company and Board members Tianfu Yang, Ching Chuen Chan, Boyd Plowman, David Gatton, Yunyue Ye, and Lanxiang Gao as defendants. The plaintiff has filed a notice of voluntary dismissal of his action without prejudice.





Norfolk County Retirement System v. Harbin Electric, Inc. and Tianfu Yang (“Norfolk”), No. 10-35327, filed in the Supreme Court of the State of New York, Suffolk County on October 15, 2010. The complaint named the Company and Tianfu Yang as defendants.





Luis Necuze v. Harbin Electric, Inc. et al., No. A-10-627425 (“Necuze”), filed in the Eighth Judicial District Court for the State of Nevada in and for Clark County on October 15, 2010. The complaint named the Company, Board members Tianfu Yang, Ching Chuen Chan, Boyd Plowman, David Gatton, Yunyue Ye, and Lanxiang Gao, and Baring Private Equity Asia Group, Ltd. as defendants.





Jacqueline Elliott v. Harbin Electric, Inc. et al., No. A-10-627656-C (“Elliott”), filed in the Eighth Judicial District Court for the State of Nevada in and for Clark County on October 19, 2010. The complaint named the Company and Board members Tianfu Yang, Ching Chuen Chan, Boyd Plowman, David Gatton, Yunyue Ye, and Lanxiang Gao as defendants.





George Yun v. Harbin Electric, Inc. et al., No. 10-39805 (“Yun”), filed in the Supreme Court of the State of New York, Suffolk County) on October 22, 2010. The complaint named the Company and Board members Tianfu Yang, Ching Chuen Chan, Boyd Plowman, David Gatton, Yunyue Ye, and Lanxiang Gao as defendants.





Randolph Fisher v. Harbin Electric, Inc. et al., No. 10-OC-00498-1B (“Fisher”), filed in the First Judicial District Court for the State of Nevada in and for Carson City on October 22, 2010. The complaint named the Company and Board members Tianfu Yang, Ching Chuen Chan, Boyd Plowman, David Gatton, Yunyue Ye, and Lanxiang Gao as defendants.





Gerald Gould v. Tianfu Yang, No. 10-40004 (“Gould”), filed in the Supreme Court of the State of New York Suffolk County on October 25, 2010. The complaint named Tianfu Yang as a defendant.





Mark Rosen v. Harbin Electric, Inc. et al., No. 11-OC-00036-1B (“Rosen”), filed in the Second Judicial District Court for the State of Nevada in and for Washoe County on October 28, 2010. The complaint named the Company, Board members Tianfu Yang, Ching Chuen Chan, Boyd Plowman, David Gatton, Yunyue Ye, and Lanxiang Gao, and Baring Private Equity Asia Group, Ltd. as defendants. Plaintiff voluntarily dismissed the Company from this action and moved to transfer the action to the Eighth Judicial District Court of the State of Nevada in and for Carson City, which motion was granted.





Patrick Sweeney v. Harbin Electric, Inc. et al., No. 3:10-CV-00685 (“Sweeney”), filed in the United States District Court for the District of Nevada on November 11, 2010. The complaint named the Company and Board members Tianfu Yang, Ching Chuen Chan, Boyd Plowman, David Gatton, Yunyue Ye, and Lanxiang Gao as defendants.





The Company's motions to transfer the Carson City actions to Clark County, were granted. As a result, the Hurewitz, Fisher, and Rosen actions have been transferred to Clark County and consolidated with, Necuze and Elliott actions pending there.





40





Plaintiff Sellier voluntarily dismissed his federal district court action. The Sweeney action is the only remaining Nevada action that has not been transferred to Clark County. The Company has moved to dismiss or stay the Sweeney action, which motion is pending.





The New York actions (Yun, Gould and Norfolk) have been consolidated. Plaintiffs’ counsel thereafter filed a consolidated amended complaint naming only the Company and Tianfu Yang as defendants. The Company and Mr. Yang have moved to dismiss or, in the alternative, to stay the New York action.





Item 1A. Risk Factors





An investment in our common stock is very risky. You should carefully consider the risk factors described below before making an investment decision. If any of the following risks actually occurs, our business, financial condition or operating results could be materially and adversely affected. In such case, the trading price of our common stock could decline, and you may lose all or part of your investment. Additional risks and uncertainties not currently foreseeable to us may also impair our business operations.





GENERAL RISKS RELATING TO OUR BUSINESS





Our rapid growth may strain our resources.





Our revenues in the first quarter of 2011 declined slightly compared to the first quarter of 2010. Our revenues increased by 91% for the year ended December 31, 2010 versus the year ended December 31, 2009, and 85% in 2009 over 2008. However, it is unlikely that we will maintain such growth in the long term and cannot assure any growth of our business for any period. Our rapid expansion will place significant strain on our management and our operational, accounting, and information systems. We expect that we will need to continue to improve our financial controls, operating procedures, and management information systems. We will also need to effectively hire, train, motivate, and manage our employees. Our failure to manage our growth could disrupt our operations and ultimately prevent us from generating the profits we expect.





Our debt may constrict our operations, and cash flows and capital resources may be insufficient to make required payments on our indebtedness and future indebtedness.





As of March 31, 2011, we had a $35 million loan facility and an RMB100 million (approximately $15 million) loan facility under a Term Loan Facility Agreement with China Development Bank Corporation Hong Kong Branch as lender (“CDB”). Additionally, our PRC subsidiaries had a total of approximately $30.6 million short term loans outstanding as of March 31, 2011. These loans were obtained from local PRC banks and unrelated third parties.  These obligations could have important consequences to you. For example, they could:





·
reduce the availability of our cash flow to fund future working capital, capital expenditures, acquisitions and other general corporate purposes;





·
limit our ability to obtain additional financing for working capital, capital expenditures, and other general corporate requirements;





·
increase our vulnerability to general adverse economic and industry conditions;





·
require us to sell assets to reduce indebtedness or influence our decisions about whether to do so;





·
expose us to interest rate fluctuations because the interest rates for the two loan facilities are variable; and





·
place us at a competitive disadvantage compared to competitors that may have proportionately less debt.





In addition, our ability to make scheduled payments or refinance our obligations depends on our successful financial and operating performance, cash flows, and capital resources, which in turn depend upon prevailing economic conditions and certain financial, business, and other factors, many of which are beyond our control. If our cash flows and capital resources are insufficient to fund our debt obligations, we may be forced to reduce or delay capital expenditures, sell material assets or operations, obtain additional capital, restructure our debt, or declare bankruptcy. In the event that we are required to dispose of material assets or operations to meet our debt service and other obligations, the value realized on such assets or operations will depend on market conditions and the availability of buyers. Accordingly, we may be forced to sell at an unfavorable price. We may be unable to obtain financing or sell assets on satisfactory terms, or at all, which could cause us to default on our debt service obligations and be subject to foreclosure on such loans.





Additionally, we could incur additional indebtedness in the future and, if new debt is added to our current debt levels, the risks above could intensify.





41





Covenants in the CDB Agreement may restrict our ability to engage in or enter into a variety of transactions.





The Term Loan Facility Agreement (the “CDB Agreement”), dated as of November 22, 2010, between us and CDB   as lender, contains various covenants that may limit our discretion in operating our business. In particular, we are limited in our ability to, among other things, create liens on our assets, merge, consolidate, transfer substantially all of our assets, give guarantees or indemnities, engage in any transaction that results in Mr. Yang and certain of his affiliates being the beneficial owner of less than 30% of our outstanding common stock, and engage in certain transactions that result in a change in the majority of our Board of Directors from those in office on the date of the CDB Agreement. These covenants could have an adverse effect on our business by limiting our ability to take advantage of financing, merger and acquisition or other corporate opportunities.





A covenant in the CDB Agreement may cause the facility be cancelled upon 30 days notice at the discretion of the Lender.





Pursuant to the CDB Agreement, if a Change of Control of our company occurs, at the discretion of CDB, the facilities may be cancelled and all outstanding amounts under such facilities may become immediately due and payable with no less than 30 days notice.  For purposes of the CDB Agreement, a Change of Control shall be deemed to occur if (i) our chairman and chief executive officer, Mr. Tianfu Yang, ceases to be the beneficial owner, directly or indirectly, of at least thirty percent of our outstanding capital stock, (ii) we merge, consolidate, sell substantially all of our assets in a transaction other than with Mr. Tianfu Yang and certain of his affiliates, (iii) individuals who on the date of the CDB Agreement constitute our Board of Directors  (together with any  new directors  whose election  or appointment by such board or whose nomination for election by our shareholders is approved by a vote of not less than three-fourths of the directors then still in office who are either directors on the date of the CDB Agreement or whose election or nomination for election has been previously so approved) cease for any reason to constitute a majority of our Board of Directors then in office or (iv) our shareholders approve a plan of liquidation or dissolution.





A default in our Term Loan Facility Agreement may cause CDB to foreclose on the pledge of common stock made by Mr. Yang as security for our obligations under the Term Loan Agreement, which could result in a change of control of our company.





Our obligations under the CDB Agreement are secured by a pledge of shares of common stock of the Company owned by its Chairman and Chief Executive Officer, Tianfu Yang.  On November 22, 2010, Mr. Yang entered into a Security and Pledge Agreement (the “Pledge Agreement”) with CDB, pursuant to which, Mr. Yang agreed to pledge 7,000,000 shares of common stock to CDB to secure the loans.  Under the Pledge Agreement, Mr. Yang may also be obliged to pledge to CDB, under certain circumstances, additional shares of common stock owned by him and, to the extent such additional shares are not sufficient, cash.  In the event that we were to default on the CDB Agreement and CDB were to foreclose on the shares pledged by Mr. Yang and cause such shares to be sold in order to satisfy our obligations under the CDB Agreement, this could result in a change of control of our company.





Our success depends on our management team and other key personnel, the loss of any of whom could disrupt our business operations.





Our future success will depend in substantial part on the continued service of the members of our senior management. The loss of the services of one or more of our key personnel could impede implementation of our business plan and result in reduced profitability. We do not carry key person life insurance on any of our officers or employees. Our future success will also depend on the continued ability to attract, retain and motivate highly qualified technical sales and marketing customer support.





Because of the rapid growth of the economy in China, competition for qualified personnel is intense. We cannot assure you that we will be able to retain our key personnel or that we will be able to attract, assimilate or retain qualified personnel in the future.





We depend on the supply of raw materials and key component parts, and any adverse changes in such supply or the costs of raw materials may adversely affect our operations.





One vendor provided approximately 13% of the Company’s purchases of raw materials for the three months ended March 31, 2011. The Company’s accounts payable to this vendor was $0 at March 31, 2011. No vendor accounted for more than 10% of the raw material purchases for the three months ended March 31, 2010. Any material change in the spot and forward rates could have a material adverse effect on the cost of our raw materials and on our operations. In addition, if we need alternative sources for key component parts for any reason, these component parts may not be immediately available to us. If alternative suppliers are not immediately available, we will have to identify and qualify alternative suppliers, and production of these components may be delayed. We may not be able to find an adequate alternative supplier in a reasonable time period or on commercially acceptable terms, if at all. Shipments of affected products have been limited or delayed as a result of such problems in the past, and similar problems could occur in the future. An inability to obtain our key source supplies for the manufacture of our products might require us to delay shipments of products, harm customer relationships or force us to curtail or cease operations.


42





We may experience material disruptions to our manufacturing operation.





While we seek to operate our facilities in compliance with applicable rules and regulations and take measures to minimize the risks of disruption at our facilities, a material disruption at one of our manufacturing facilities could prevent us from meeting customer demand, reduce our sales and/or negatively impact our financial results. Any of our manufacturing facilities, or any of our machines within an otherwise operational facility, could cease operations unexpectedly due to a number of events, including:




·
unscheduled maintenance outages;





·
prolonged power failures;





·
an equipment failure;





·
disruptions in the transportation infrastructure including roads, bridges, railroad tracks;





·
fires, floods, earthquakes, or other catastrophes; and





·
other operational problems.





We may not be able to adequately protect and maintain our intellectual property, which could weaken our competitive position.





Our success will depend on our ability to continue to develop and market electric motor products. We have been granted 20 patents in China relating to linear motor and automobile specialty micro-motor applications. No assurance can be given that such patents will not be challenged, invalidated, infringed or circumvented, or that such intellectual property rights will provide a competitive advantage to us. The implementation and enforcement of PRC intellectual property laws historically have not been vigorous or consistent, primarily because of ambiguities in the PRC laws and a relative lack of developed enforcement mechanisms. Accordingly, intellectual property rights and confidentiality protections in the PRC are not as effective as in the United States and other countries. Policing the unauthorized use of proprietary technology is difficult and expensive, and we might need to resort to litigation to enforce or defend patents issued to us or to determine the enforceability, scope and validity of our proprietary rights or those of others. Such litigation will require significant expenditures of cash and management efforts and could harm our business, financial condition and results of operations. An adverse determination in any such litigation will impair our intellectual property rights and may harm our business, competitive position, business prospects and reputation. In addition, since we have chosen to secure patents only in China, we may not be in a position to protect our inventions and technology in other countries in which we sell our product, which could result in increased competition and lower pricing for our products.





RISKS RELATING TO DOING BUSINESS IN THE PEOPLE’S REPUBLIC OF CHINA





China’s economic policies could adversely affect our business.





Substantially all of our assets are located in China and substantially all of our revenues are derived from our operations in China. Accordingly, our results of operations and prospects are subject, to a significant extent, to economic, political and legal developments in China.





While China’s economy has experienced significant growth in the past 30 years, it has been uneven, both geographically and among various sectors of the economy. The Chinese government has implemented various measures to encourage economic growth and guide the allocation of resources. Some of these measures benefit the overall economy of China, but may also have a negative effect on us. For example, our operating results and financial condition may be adversely affected by government control over capital investments or changes in tax regulations.





The economy of China has been changing from a planned economy to a more market-oriented economy. In recent years the Chinese government has implemented measures emphasizing market forces for economic reform, reduction of state ownership of productive assets, and establishment of corporate governance in business enterprises; however, a substantial portion of productive assets in China are still owned by the Chinese government. In addition, the Chinese government continues to play a significant role in regulating industry development by imposing industrial policies. It also exercises significant control over China’s economic growth through the allocation of resources, controlling payment of foreign currency-denominated obligations, setting monetary policy, and providing preferential treatment to particular industries or companies.





PRC laws and regulations governing our current business operations are sometimes vague and uncertain and any changes in such laws and regulations may harm our business.





There are substantial uncertainties regarding the interpretation and application of PRC laws and regulations including, but not limited to, the laws and regulations governing our business, and the enforcement and performance of our arrangements with customers in the event of the imposition of statutory liens, death, bankruptcy and criminal proceedings. We are considered foreign persons or foreign funded enterprises under PRC laws and, as a result, we are required to comply with PRC laws and regulations. These laws and regulations are sometimes vague and may be subject to future changes, and their official interpretation and enforcement may involve substantial uncertainty. The effectiveness of newly enacted laws, regulations or amendments may be delayed, resulting in detrimental reliance. New laws and regulations that affect existing and proposed future businesses may also be applied retroactively. We cannot predict what effect the interpretation of existing or new PRC laws or regulations may have on our business.





43




Inflation in the PRC could negatively affect our profitability and growth.





The PRC economy has experienced rapid growth. Rapid economic growth could lead to growth in the money supply and rising inflation. If prices for our products rise at a rate that is insufficient to compensate for the rise in the cost of supplies, it may harm our profitability. In order to control inflation in the past, the PRC government has imposed controls on bank credit, limits on loans for fixed assets and restrictions on state bank lending. Such policies can lead to a slowing of economic growth. Rises in interest rates by the central bank would likely slow economic activity in China which could, in turn, materially increase our costs and also reduce demand for our products.





PRC regulations relating to mergers, offshore companies, and Chinese stockholders, if applied to us, may limit our ability to operate our business as we see fit.





Regulations govern the process by which we may participate in an acquisition of assets or equity interests. Depending on the structure of the transaction, the new regulation will require Chinese parties to make a series of applications and supplemental applications to various government agencies. In some instances, the application process may require the presentation of economic data concerning a transaction, including appraisals of the target business and evaluations of the acquirer, which are designed to allow the government to assess the transaction. Government approvals will have expiration dates by which a transaction must be completed and reported to the government agencies. Compliance with the new regulations is likely to be more time consuming and expensive than in the past and the government can now exert more control over the combination of two businesses. Accordingly, due to the PRC regulations, our ability to engage in business combination transactions in China through our Chinese subsidiaries has become significantly more complicated, time consuming and expensive, and we may not be able to negotiate transactions that are acceptable to us or sufficiently protective of our interests in a transaction.





If preferential tax concessions granted by the PRC government change or expire, our financial results and results of operations would be materially and adversely affected.





Our results of operation may be adversely affected by changes to or expiration of preferential tax concessions that our Chinese subsidiaries currently enjoy. The statutory tax rate generally applicable to domestic Chinese companies is generally 25%. The PRC government provides reduced tax rates for productive foreign investment enterprises in the Economic and Technological Development Zones and for enterprises engaged in production or business operations in the Special Economic Zones.  These preferential tax rates are generally graduated, starting at 0% and increasing to the standard EIT rate of 25% over time.  Harbin Tech Full was granted a 10% preferential tax rate from 2008 to 2010 due to its located in a specially designated economic region. This 10% preferential tax rate expired on December 31, 2010. While applying for the next level of 15% preferential tax treatment, Harbin Tech Full is currently using 25% standard income tax rate until the application is approved. Shanghai Tech Full was subject to an 11% preferential tax rate in 2010 and is granted a 12% preferential tax rate in 2011. Xi’an Tech Full Simo remains at a 15% preferential tax rate in 2011. Weihai Tech Full has been subject to the standard 25% tax rate. As a result, the estimated tax savings for the three months ended March 31, 2011 and 2010 amounted to $163,133 and $3,120,440, respectively. Tax laws in China are subject to interpretations by relevant tax authorities. Preferential tax rates may not remain in effect or may change, in which case we may be required to pay the higher income tax rate generally applicable to Chinese companies, or such other rate as is required by the laws of China.





Fluctuation in the value of the RMB may have a material adverse effect on your investment.





The value of RMB against the U.S. dollar and other currencies may fluctuate and is affected by, among other things, changes in political and economic conditions. Our revenues and costs are mostly denominated in RMB. Any significant fluctuation in value of RMB may materially and adversely affect our cash flows, revenues, earnings and financial position, and the value of our stock in U.S. dollars. For example, an appreciation of RMB against the U.S. dollar would make any new RMB denominated investments or expenditures more costly to us, to the extent that we need to convert U.S. dollars into RMB for such purposes. In addition, the depreciation of significant U.S. dollar denominated assets could result in a charge to our income statement and a reduction in the value of these assets.





Very limited hedging transactions are available in China to reduce our exposure to exchange rate fluctuations. We do not have any hedging transactions in an effort to reduce our exposure to foreign currency exchange risk. While we may enter into hedging transactions in the future, the availability and effectiveness of these transactions may be limited, and we may not be able to successfully hedge our exposure at all. In addition, our foreign currency exchange losses may be magnified by PRC exchange control regulations that restrict our ability to convert RMB into foreign currencies.





We must comply with the Foreign Corrupt Practices Act.





We are required to comply with the United States Foreign Corrupt Practices Act, which prohibits U.S. companies from engaging in bribery or other prohibited payments to foreign officials for the purpose of obtaining or retaining business. Foreign companies, including some of our competitors, are not subject to these prohibitions. Corruption, extortion, bribery, pay-offs, theft and other fraudulent practices occur from time-to-time in mainland China. If our competitors engage in these practices, they may receive preferential treatment from personnel of some companies, giving our competitors an advantage in securing business or from government officials who might give them priority in obtaining new licenses, which would put us at a disadvantage. Although we inform our personnel that such practices are illegal, we cannot assure you that our employees or other agents will not engage in such conduct for which we might be held responsible. If our employees or other agents are found to have engaged in such practices, we could suffer severe penalties.





44





The Chinese government exerts substantial influence over the manner in which we must conduct our business activities.





Our ability to operate in China may be harmed by changes in its laws and regulations, including those related to taxation, environmental regulations, land use rights, property and other matters. We believe that our operations in China are in material compliance with all applicable legal and regulatory requirements. However, the central or local governments of these jurisdictions may impose new, stricter regulations or interpretations of existing regulations that would require additional expenditures and efforts on our part to ensure our compliance with such regulations and interpretations. Government actions in the future, including any decision not to continue to support recent economic reforms and to return to a more centrally planned economy or regional or local variations in the implementation of economic policies, could have a significant effect on economic conditions in China or particular regions thereof, and could require us to divest ourselves of any interest we then hold in Chinese properties.





We are subject to environmental laws and regulations in the PRC.





We are subject to environmental laws and regulations in the PRC. Any failure by us to comply fully with such laws and regulations will result in us being subject to penalties and fines or being required to pay damages. Although we believe we are currently in compliance with the environmental regulations in all material respects, any change in the regulations may require us to acquire equipment or incur additional capital expenditure or costs in order to comply with such regulations. Our profits will be adversely affected if we are unable to pass on such additional costs to our customers.





We may have difficulty establishing adequate management, legal and financial controls in the PRC.





The PRC historically has been deficient in Western style management and financial reporting concepts and practices, as well as in modern banking, computer and other control systems. We may have difficulty in hiring and retaining a sufficient number of qualified employees to work in the PRC. As a result of these factors, we may experience difficulty in establishing management, legal and financial controls, collecting financial data and preparing financial statements, books of account and corporate records and instituting business practices that meet Western standards.





If we fail to maintain an effective system of internal control over financial reporting, we may be unable to accurately report our financial results or prevent fraud, and investor confidence and the market price of our common stock may be adversely affected.





We and our independent registered public accounting firm, in connection with management's assessment of and the audit of our internal control over financial reporting as of December 31, 2010, identified five material weaknesses in our internal control over financial reporting. The material weakness identified were attributable to Xi’an Simo, a former State-Owned-Enterprise ("SOE") the Company acquired in October 2009, which rendered our internal control over financial reporting ineffective on the consolidated level.  Despite significant improvements achieved in its internal control systems, due to its very short history of being part of a U.S. public company, large size, many subsidiaries located away from its headquarters, and limited time to integrate it with the Company, material weaknesses in its internal control over financial reporting were not completely eliminated at Xi’an Simo as of December 31, 2010. The material weaknesses identified by the management at Xi’an Simo are described below.





·
Control activities related to bank reconciliation – At Xi’an Simo, the bank reconciliation for various bank accounts were not prepared accurately which impacted the valuation and existence of the cash in bank as of December 31, 2010.·
Control activities related to the reconciliation and classification of notes receivable – At Xi’an Simo, notes receivables endorsed as payment to third parties were not properly recorded, resulting in a discrepancy between the physical notes receivables on hand and the general ledger. Additionally, the improper classifications of transactions has impacted the completeness, and valuation of accounts payable / advance to suppliers and notes receivable balances at the year ended December 31, 2010 at Xi’an Simo.





·
Control activities related to the calculation of provision of income tax – At Xi’an Simo, due to ambiguities in the PRC tax rules, the temporary and permanent differences in tax amounts were not properly identified.·
Control activities related to valuation of inventory allowance – At Xi’an Simo, slow moving inventories that had not been used over a year were not properly evaluated for inventory allowance.·
Control activities related to inventory recording –– At Xi’an Simo, inventory movement between manufacturing facilities and sales entities were not timely and properly recorded on the general ledger.





A "material weakness" is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company's annual or interim financial statements will not be prevented or detected on a timely basis. We have taken measures and plan to continue to take measures to remedy these deficiencies. However, the implementation of these measures may not fully address the control deficiencies in our internal control over financial reporting. Our failure to address any control deficiency could result in inaccuracies in our financial statements and could also impair our ability to comply with applicable financial reporting requirements and related regulatory filings on a timely basis. Moreover, effective internal control over financial reporting is important to prevent fraud. As a result, our business, financial condition, results of operations and prospects, as well as the trading price of our common stock, may be materially and adversely affected.





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It will be extremely difficult to acquire jurisdiction and enforce liabilities against our officers, directors and assets based in the PRC.





Because most of our executive officers and several of our directors, including our chairman of the Board of Directors, are Chinese citizens, it may be difficult, if not impossible, to acquire jurisdiction over these persons in the event a lawsuit is initiated against us and/or our officers and directors by a stockholder or group of stockholders in the United States. Also, because the majority of our assets are located in the PRC, it would also be extremely difficult to access those assets to satisfy an award entered against us in the U.S. court.





The legal system in China has inherent uncertainties that may limit the legal protections available in the event of any claims or disputes with third parties.





The legal system in China is based on written statutes. Prior court decisions may be cited for reference but have limited precedential value. Since 1979, the central government has promulgated laws and regulations dealing with economic matters such as foreign investment, corporate organization and governance, commerce, taxation and trade. As China’s foreign investment laws and regulations are relatively new and the legal system is still evolving, the interpretation of many laws, regulations and rules is not always uniform and enforcement of these laws, regulations and rules involve uncertainties, which may limit the remedies available in the event of any claims or disputes with third parties. In addition, any litigation in China may be protracted and result in substantial costs and diversion of resources and management attention.





RISKS ASSOCIATED WITH OUR COMMON STOCK





There can be no assurance that any agreement will be executed with respect to the Proposal made by Mr Yang, the Abax Parties and certain of their affiliates or that this or any other transaction will be approved or consummated. The absence of a proposal to acquire our common stock would likely have an effect on the market price of our common stock.





On October 10, 2010, our Board of Directors received a proposal from its Chairman and Chief Executive Officer, Mr. Tianfu Yang (“Mr. Yang”) and Baring Private Equity Asia Group Limited (“Baring”) for Mr. Yang and an investment fund advised by Baring (the "Baring Fund") to acquire all of the outstanding shares of Common Stock of Harbin not currently owned by Mr. Yang and his affiliates in a going private transaction for $24.00 per share in cash, subject to certain conditions. Mr. Yang owns 30.9% of our Common Stock. The proposal letter stated that Mr. Yang and Baring intended to form an acquisition vehicle for the purpose of completing the acquisition and that they intended to finance the acquisition with a combination of debt and equity capital. The proposal letter also stated that Goldman Sachs (Asia) LLC (“Goldman”) is acting as financial advisor to the acquisition vehicle to be formed by Mr. Yang and Baring and that Goldman had informed Mr. Yang and Baring that it is highly confident that the underwriting and arranging of commitments for the debt financing needed to complete the transaction can be done. The proposal letter further stated that the equity portion of the financing would be provided by Mr. Yang, the Baring Fund and related sources.





On October 10, 2010, our Board of Directors formed a special committee of independent directors (the “Special Committee”) to evaluate and consider this proposal and any other alternative proposals or other strategic alternatives that may be available to the Company. The public announcement of the receipt of this proposal affected our stock price.





On November 22, 2010, Mr. Yang submitted to our Board a non-binding modification letter (the “Modification Letter”) modifying the proposal presented to the Board on October 10, 2010.  The Modification Letter stated that Mr. Yang would no longer have an exclusive relationship with Baring, thereby allowing Mr. Yang to pursue alternative financing for the proposed going private transaction; and that Baring would have the opportunity (but not the obligation) to provide up to 10% of the financing for the proposed going private transaction.  The Modification Letter stated that it was the intent of Mr. Yang that the alternative financing would be in place by the time the definitive transaction agreement was executed.





Since being formed, the Special Committee has engaged legal and financial advisors.  The Special Committee’s process is ongoing and the Special Committee intends to continue with its work, including evaluating any proposal presented by Mr. Yang as well as other proposals which the Company may receive, for as long as the Special Committee, in consultation with its advisors, deems necessary.





According to a Schedule 13D/A (the “Schedule 13D/A”) filed jointly by Mr. Tianfu Yang, Hero,, Tech Full  and the Abax Parties, on May 2,2011, on April 20, 2011, Mr. Tianfu Yang and AGC (acting on behalf of certain funds it manages and/ or advises), on behalf of themselves, submitted a Proposal, to the Special Committee of the Company’s board of directors for the acquisition of all of the Publicly Held Shares through a Nevada corporation wholly owned by Tech-Full  for US$24.00 per share. According to the Schedule 13D/A, financing for the Proposed Transaction will include both debt and equity components, as well as rollover equity from certain members of the management and certain Abax Parties. AGC and Abax HK, on behalf of certain of the funds and/or entities that they manage or advise, will also provide equity and debt financing through certain such funds in connection with the Proposed Transaction, and the Abax Parties may bring in one or more additional third party investors to fund a portion of such equity and/ or debt financing.





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With respect to the Rollover Commitments, certain members of management, including Mr. Tianfu Yang, Tianli Yang, Zedong Xu, Suofei Xu and Lanxiang Gao, have committed to roll all of their shares of Common Stock into Tech Full in connection with the Proposed Transaction. In addition, Abax Lotus and Abax Nai Xin have also committed to roll over all of their shares of Common Stock into Tech Full in connection with the Proposed Transaction.





According to the Schedule 13D/A, in connection with the Proposal, AGC and Abax HK, on behalf of certain of the funds and/or entities that they manage or advise, issued on April 20, 2011 a financing commitment letter and committed to provide equity and debt financing of an aggregate amount of up to US$63.8 million. The source of funds for such equity and debt financing will come from the investors in such funds. In addition, the Abax Parties may bring in one or more additional third party investors to fund a portion of such equity and/ or debt financing.





In addition, according to the Schedule 13D/A, on April 29, 2011, Tech Full received a debt commitment letter (the “Debt Commitment Letter”) issued by China Development Bank Corporation (“CDB”) for a US$400,000,000 term loan facility to fund the proposed purchase of the Publicly Held Shares, subject to execution of mutually acceptable definitive documents for the facility. CDB’s commitment under the Debt Commitment Letter will terminate on April 2, 2012 unless CDB receives a written confirmation prior to the expiration date.





There can be no assurance that any definitive agreement will be executed with respect to the Proposed Transaction or that this or any other transaction will be approved or consummated. The absence of a proposal to acquire our common stock, or changes in the proposal, as well as the commencement of the litigation regarding the proposal described herein in “Legal Proceedings” would likely have an effect on the market price of our common stock.





Our common stock may be affected by limited trading volume and may fluctuate significantly.





Our common stock is traded on the Nasdaq Global Select Market. Although an active trading market has developed for our common stock, there can be no assurance that an active trading market for our common stock will be sustained. Failure to maintain an active trading market for our common stock may adversely affect our stockholders’ ability to sell our common stock in short time periods, or at all. In addition, sales of substantial amounts of our common stock in the public market could harm the market price of our common stock. Our common stock has experienced, and may experience in the future, significant price and volume fluctuations, which could adversely affect the market price of our common stock.





We do not anticipate paying cash dividends on our common stock in the foreseeable future.





We do not anticipate paying cash dividends in the foreseeable future. Presently, we intend to retain all of our earnings, if any, to finance development and expansion of our business. The Indenture pursuant to which the Notes were issued prohibits us from paying any dividends on our capital stock while the Notes remain outstanding. PRC capital and currency regulations may also limit our ability to pay dividends. Consequently, the only opportunity for investors to achieve a positive return on your investment in us will be if the market price of our common stock appreciates.





Our directors and officers control approximately one third of our common stock and, as a result, they may exercise some voting control and be able to take actions that may be adverse to your interests.





Our directors and executive officers, directly or through entities that they control, beneficially owned, as a group, approximately 34.98% of our issued and outstanding common stock as of March 31, 2011. This concentration of share ownership may adversely affect the trading price of our common stock because investors often perceive a disadvantage in owning shares in a company with one or several controlling stockholders. Furthermore, our directors and officers, as a group, have the ability to significantly influence the outcome of all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions, such as mergers, consolidations or the sale of substantially all of our assets. This concentration of ownership may have the effect of delaying or preventing a change of control, including a merger, consolidation or other business combination involving us, or discouraging a potential acquirer from making a tender offer or otherwise attempting to obtain control.





Your percentage ownership in us may be diluted by future issuances of capital stock, which could reduce your influence over matters on which stockholders vote.





Subject to any applicable stockholder approval requirements imposed by the Nasdaq Stock Market, our board of directors has the authority to issue all or any part of our authorized but unissued shares of common stock. Issuances of common stock would reduce your influence over matters on which our stockholders vote.




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





None.





Item 3.Defaults upon Senior Securities





None.





Item 4.(Removed and Reserved)





Item 5.Other Information





Item 6.Exhibits.





The exhibits listed on the Exhibit Index are being furnished with this report.




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SIGNATURES





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





Harbin Electric, Inc.Date: May 10, 2011
By:
/s/ Tianfu YangTianfu YangChief Executive Officer, Director and Chairman of the Board(Principal Executive Officer)





Date: May 10, 2011
By:
/s/ Zedong XuZedong XuChief Financial Officer(Principal Financial and Accounting Officer)







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EXHIBIT INDEX





Exhibits:





Exhibit Number

Description

Method of Filing31.1

Certification by the Chief Executive Officer pursuant to Rule 13a-14(a) or 15d-14(a)

Filed herewith as Exhibit 31.1.31.2

Certification by the Chief Financial Officer pursuant to Rule 13a-14(a) or 15d-14(a)

Filed herewith as Exhibit 31.2.32.1

Certification of the Chief Executive Officer and the Chief Financial Officer pursuant 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Filed herewith as Exhibit 32.1.




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