UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549







FORM 10-Q








(Mark One)


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





For the quarterly period ended: June 30, 2012


or


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: 333-172135





CHINA INDUSTRIAL STEEL INC.


(Exact name of registrant as specified in its charter)





Maryland

27-1847645(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification No.)





110 Wall Street, 11th Floor, New York, NY 10005


(Address of principal executive offices) (Zip Code)





1-646-328-1502


(Registrant’s telephone number, including area code)








(Former name, former address and former fiscal year, if changed since last report)





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


Yes x  No 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 x  No 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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.





Large accelerated filer
o

Accelerated filer
oNon-accelerated filer
x
(Do not check if a smaller reporting company)
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 o  No x




APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY


PROCEEDINGS DURING THE PRECEDING FIVE YEARS:





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





APPLICABLE ONLY TO CORPORATE ISSUERS:





Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 73,620,391 shares of common stock are issued and outstanding as of August 1, 2012.





Table of Contents




TABLEOF CONTENTS





PART I – FINANCIAL INFORMATION
PageITEM 1. FINANCIAL STATEMENTS
F-1ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
3ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
14ITEM 4. CONTROLS AND PROCEDURES
14PART II – OTHER INFORMATIONITEM 1. LEGAL PROCEEDINGS
16ITEM 1A. RISK FACTORS
16ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
16ITEM 3. DEFAULTS UPON SENIOR SECURITIES
16ITEM 4. MINE SAFETY DISCLOSURES
16ITEM 5. OTHER INFORMATION
16ITEM 6. EXHIBITS
17SIGNATURES
18








Table of Contents




PART I – FINANCIAL INFORMATION





ITEM1 FINANCIAL STATEMENTS.





CHINA INDUSTRIAL STEEL INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (IN US DOLLARS) (UNAUDITED)


June 30,


December 31,2012


2011ASSETSCurrent Assets:Cash

$
226,961


$
1,737,495Bank notes receivable


698,919



2,342,186Accounts receivables, net


12,115,630



20,862,269Inventories, net


13,803,390



16,139,936Advances to suppliers, net


2,151,348



3,215,680VAT and other taxes recoverable


22,624,414



21,612,482Advances to related parties


118,087,616



77,416,285Total Current Assets


169,708,278



143,326,333Machinery and Equipment, Net


86,048,878



84,410,398Machinery and Equipment - acquired from related parties, Net


91,067,914



98,514,249Total Machinery and Equipment, Net


177,116,792



182,924,647Other Assets:Restricted cash


7,240,860



5,402,600Land use rights and buildings under capital leases


5,224,956



5,613,105Total Other Assets


12,465,816



11,015,705TOTAL ASSETS

$
359,290,886


$
337,266,685LIABILITIES AND STOCKHOLDERS' EQUITYCurrent Liabilities:Accounts payable

$
90,138,703


$
23,095,827Accounts payable - related parties


426,409



184,447Accrued liabilities


2,384,275



2,622,224Taxes payables


536,212



1,868,886Bank and private loans payable


26,114,319



34,640,200Bank notes payable


5,981,580



3,019,100Equipment loan payable - related parties


3,896,141



11,562,752Current obligations under capital leases - related parties


614,009



597,258Short term loan payable - related party


787,050



1,747,900Advances from customers


30,338,502



13,257,487Total Current Liabilities


161,217,200



92,596,081Long Term Liabilities:Equipment loan payables - related parties


-



51,093,694Obligation under capital leases - related parties


5,878,122



6,254,954Total Long Term Liabilities


5,878,122



57,348,648TOTAL LIABILITIES


167,095,322



149,944,729Commitments and ContingenciesStockholders' Equity:Series A Convertible Preferred Stock, $0.0001 par value, 10,000,000 shares authorized, none issued and outstanding


-



-Blank Check Preferred Stock, $0.0001 par value, 10,000,000 shares authorized, none issued and outstanding


-



-Common stock, $0.0001 par value, 980,000,000 authorized, 73,620,391 and 73,542,058 issued and outstanding at June 30, 2012 and December 31, 2011, respectively


7,362



7,354Paid-in capital


16,417,235



16,299,744Statutory reserves


6,530,869



6,530,869Retained earnings


156,744,078



150,189,517Accumulated other comprehensive income


12,496,020



14,294,472Total Stockholders' Equity


192,195,564



187,321,956TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY

$
359,290,886


$
337,266,685
 
 The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
 
 F-1
 Table of Contents
 
 CHINA INDUSTRIAL STEEL INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (IN US DOLLARS) (UNAUDITED)
 Three Months Ended June 30,


Six Months Ended June 30,2012


2011


2012


2011RevenuesSales to customers

$
141,355,618


$
195,513,869


$
312,794,486


$
383,038,685Sales to related parties


4,216,751



21,285,432



9,806,531



21,285,432Total Revenues


145,572,369



216,799,301



322,601,017



404,324,117Cost of RevenueCost of Revenue - non-related parties


75,016,983



26,715,484



124,906,457



48,852,768Cost of Revenue - related parties


66,098,486



175,674,549



184,413,577



330,635,538Total Cost of Revenue


141,115,469



202,390,033



309,320,034



379,488,306Gross Profit


4,456,900



14,409,268



13,280,983



24,835,811Selling and General and Administrative ExpensesSelling and General and Administrative Expenses - non-related parties


295,977



412,040



1,361,056



859,287Selling and General and Administrative Expenses - related parties


705,826



216,799



882,909



403,449Total Selling and General and Administrative Expenses


1,001,803



628,839



2,243,965



1,262,736Income From Operations


3,455,097



13,780,429



11,037,018



23,573,075Other Income (Expenses)Interest income


2,120



8,328



54,609



8,543Interest expense - bank and private borrowings


(921,177
)


(124,846
)


(1,866,085
)


(574,596
)Interest expense - related parties


(323,521
)


(1,133,459
)


(1,286,589
)


(2,198,775
)Total Other Income (Expenses)


(1,242,578
)


(1,249,977
)


(3,098,065
)


(2,764,828
)Income from operation before income tax


2,212,519



12,530,452



7,938,953



20,808,247Provision for income tax


364,002



1,826,243



1,384,392



2,971,264Net Income


1,848,517



10,704,209



6,554,561



17,836,983Earnings Per Share - Basic and Diluted

$
0.03


$
0.15


$
0.09


$
0.24Weighted Average Shares Outstanding - Basic and Diluted


73,595,428



73,542,058



73,568,597



73,159,247Other Comprehensive Income:Foreign currency translation (loss) gain


(1,678,398
)


1,931,889



(1,798,452
)


3,013,380Comprehensive Income

$
170,119


$
12,636,098


$
4,756,109


$
20,850,363
 The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
 
 F-2
 Table of Contents
 
 CHINA INDUSTRIAL STEEL INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN US DOLLARS) FOR THE SIX MONTHS ENDED JUNE 30, 2012 AND 2011 (UNAUDITED)
 2012


2011Cash Flows from Operating Activities:Net Income

$
6,554,561


$
17,836,983Adjustments to Reconcile Net Income toNet Cash Provided by Operating Activities:(Reduction) provision for allowance for doubtful accounts receivable


(121,036
)


74,519Provision for allowance for forfeited advances to suppliers


567,649



-Depreciation


12,556,451



11,438,068Amortization of land use rights and buildings under capital leases


337,241



326,280Common stock issued for services


117,499



-Changes in operating assets and liabilities:Decrease (increase) in accounts receivables


8,715,479



(1,888,761
)Increase in accounts receivables - related party


-



(6,592,987
)Decrease (increase) in bank notes receivable


1,629,647



(2,483,432
)Decrease in inventories


2,196,447



646,119Decrease in advances to suppliers


473,630



593,039Increase in VAT and other taxes recoverable


(1,220,842
)


(1,945,616
)(Increase) decrease in advances to related parties


(83,568,612
)


1,109,474Increase (decrease) in accounts payable


67,605,548



(4,135,073
)Increase (decrease) in accounts payable - related parties


244,946



(4,387,802
)Decrease in accrued liabilities


(214,459
)


(1,929,345
)Increase in bank notes payable


3,006,180



2,908,466Increase (decrease) in advances from customers


17,293,865



(1,947,810
)(Decrease) increase in taxes payables


(1,321,917
)


1,360,111Net Cash Provided by Operating Activities


34,852,277



10,982,233Cash Flows from Investing Activities:Capital expenditures


(8,442,814
)


(11,517,158
)Net Cash Used in Investing Activities


(8,442,814
)


(11,517,158
)Cash Flows from Financing ActivitiesProceeds from bank and private loans


34,159,698



-Repayment of bank loans


(42,402,960
)


-Proceeds from short term loan - related parties


2,667,589



1,209,310Repayment of short term loan - related parties


(3,616,909
)


-Repayment of equipment loans - related party


(16,513,794
)


-Payment of obligation under capital lease - related parties


(297,351
)


(267,488
)Deposit of restricted cash


(1,898,640
)


(2,908,466
)Repayment of employee loans


-



(714,782
)Proceeds from private placement


-



310,951Net Cash Used in Financing Activities


(27,902,367
)


(2,370,475
)Effect of Exchange Rate Changes on Cash


(17,630
)


240,026Net Decrease in Cash and Cash Equivalents


(1,510,534
)


(2,665,374
)Cash - Beginning of the Year


1,737,495



4,061,412Cash - End of the Year

$
226,961


$
1,396,038Supplemental Cash Flow Information:Interest Paid

$
568,232


$
3,148,976Income taxes

$
2,624,548


$
1,901,184Supplemental Schedule of Non-Cash Investing Activities:Repayment of equipment loan payable - related party offset by previous advances to the same related party

$
(41,958,329
)

$
-
 The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
 
 F-3
 Table of Contents
 
 CHINA INDUSTRIAL STEEL INC. AND SUBSIDIARIES
 NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
 1.
Organization and Basis of Presentation
 
 Organization
 
 China Industrial Steel inc. (“CIS”) was incorporated January 27, 2010 under the laws of the State of Maryland. On February 5, 2010, CIS formed a wholly-owned subsidiary, Northern Steel Inc. (“Northern”), under the laws of the State of Colorado to facilitate the Company’s operations in China.
 
 On July 15, 2010, Northern formed its wholly owned foreign enterprise in Handan City, Hebei Province, China, Nuosen (Handan) Trading Co., Ltd (“Nuosen”), under the laws of China. Nuosen is a management company to manage operations in China.
 
 Handan Hongri Metallurgy Co., Ltd. (“Hongri”) is a Chinese company located at Handan City, Hebei Province, China. Hongri was incorporated under the Chinese laws on March 7, 2007 with registered capital of Reminbi (“RMB”) 90,489,999 (approximately $12 million US dollars). Hongri is primarily engaged in the business of manufacturing and selling steel plate, steel bars, steel wires and steel billets for domestic customers.
 
 Hebei Wu’an Yuanbaoshan Industry Group Co., Ltd (“YBS Group”) is an enterprise incorporated and existing within the territory of China. YBS Group owns 70% equity interest of Hongri.
 
 Fakei Investment (Hong Kong) Ltd (“Fakei”) is an enterprise incorporated in Hong Kong. Fakei owns 30% equity interest of Hongri.
 
 On August 1, 2010, CIS, through Northern and its wholly owned foreign enterprise, Nuosen, entered into Entrusted Management Agreement, Exclusive Option Agreement, and Covenants Agreement (collectively, the “Entrusted Agreements”) with Hongri and shareholders of Hongri, YBS Group and Fakei. The effect of the Entrusted Agreements is to cede control of management and economic benefits of Hongri to Nuosen. As a consideration, CIS issued 44,083,529 restricted shares of its common stock, par value $0.0001, to Karen Prudente, a nominee and trustee for the shareholders of YBS Group entering into the Entrusted Agreements with Nuosen. CIS also issued 17,493,463 restricted shares of its common stock to the shareholders of Fakei in consideration for Fakei entering into the Entrusted Agreements with Nuosen.
 
 The Entrusted Agreements empower CIS, through Northern and Nuosen, with the ability to control and substantially influence Hongri’s daily operations and financial affairs, appoint its senior executives and approve all matters requiring shareholders’ approval. As a result of these Entrusted Agreements, which obligate CIS to absorb a majority of expected losses of Hongri and enable CIS to receive a majority of expected residual returns from Hongri and because CIS has the power to direct the activities of Hongri that most significantly impact Hongri’s economic performance, CIS, through its wholly-owned subsidiaries, accounts for Hongri as its Variable Interest Entity (“VIE”) under ASC 810-10-05-8A. Accordingly, CIS consolidates Hongri’s operating results, assets and liabilities.
 On August 10, 2010, Mr. Liu Shenghong, the Chairman of the Board of Directors and one of the shareholders of YBS Group and several other shareholders of YBS Group (each of them, a “Purchaser”) have entered into call option agreements, (collectively, the “Call Option Agreements”), with the major shareholder, Karen Prudente, pursuant to which they are entitled to purchase up to 100% of the issued and outstanding shares from Karen Prudente at a price of $0.0001 per 100 shares for a period of five years as outlined in the Call Option Agreements: the Option may be exercised, in whole or in part, in accordance with the following schedule: 34% of the Option Shares subject to the Option shall vest and become exercisable on January 1, 2012; 33% of the Option Shares subject to the Option shall vest and become exercisable on January 1, 2013 and 33% of the Option Shares subject to the Option shall vest and become exercisable on January 1, 2014. 34% of the Option Shares became exercisable after December 31, 2011. The shareholders did not exercise these Option Shares as of the date of this report. According to the above mentioned Call Option Agreements, Karen Prudente would transfer all restricted shares of the Company’s common stock that she received to the shareholders of YBS Group subject to the terms and conditions thereunder and entrust the shareholders of YBS Group with her voting rights in the Company.
 
 F-4
 Table of Contents
 
 For accounting purposes, the above transactions were accounted for in a manner similar to a reverse merger or recapitalization, since the former equity shareholders of Hongri now effectively own a majority of CIS’ common stock immediately following the transactions. Consequently, the assets and liabilities and historical operations reflected in the consolidated financial statements prior to the transactions are those of Hongri and are recorded at the historical cost of Hongri, and the consolidated financial statements after completion of the transactions include the assets and liabilities of CIS, Northern, Nuosen, and Hongri (collectively, CIS or the “Company”), historical operations of Hongri, and operations of CIS, Northern, Nuosen and Hongri from the date of the transaction.
 
 CIS through Hongri, its operating company in China, produces and sells steel plates, steel bars, steel wires and steel billets. The Company currently has an aggregate production capacity of 2.3 million metric tons of steel per year from its headquarters on approximately 1,000 acres in Handan City, Hebei Province, China. Most of the Company’s products are domestically sold in China.
 
 Basis of Presentation
 
 The accompanying unaudited condensed consolidated financial statements include the accounts of the Company. All significant intercompany balances and transactions have been eliminated in consolidation.
 
 The condensed consolidated financial statements have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) and reflect all adjustments (consisting of normal recurring adjustments unless otherwise indicated) which, in the opinion of management, are necessary for a fair presentation of the results for the interim periods presented.
 
 Certain information in footnote disclosures normally included in the financial statements prepared in conformity with accounting principles generally accepted in the United States of America has been condensed or omitted pursuant to such principles and the financial results for the periods presented may not be indicative of the full year’s results. The Company believes the disclosures are adequate to make the information presented not misleading.
 
 These financial statements should be read in conjunction with the Company’s audited financial statements and notes thereto for the year ended December 31, 2011 included in the Company’s Annual Report on Form 10K filed in March 2012.
 
 2.
Summary of Significant Accounting Policies
 
 Use of Estimates
 
 In preparing the unaudited condensed consolidated financial statements in conformity with U.S. GAAP, management makes estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the dates of the unaudited consolidated financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Significant estimates, required by management, include bad debt allowance, recoverability of long-lived assets and the valuation of inventories.  Actual results could differ from those estimates.
 
 Fair Value of Financial Instruments
 
 The Company’s financial instruments consist of bank notes receivable, accounts receivable, net, advances to suppliers, VAT tax recoverable, advance to related parties, current portion of equipment loan payables and accrued interest payable, bank notes payable, accounts payable, accrued liabilities, VAT and other tax payables, bank and private loans payable, advances from customers, and accounts payable - related parties.  The fair value of these financial instruments approximate their carrying amounts reported in the balance sheets due to their short-term maturity or by comparison to other instruments with similar terms.
 
 F-5
 Table of Contents
 
 The Company evaluated the fair value of the equipment loans payable – related parties, net of current portion at December 31, 2011, and determined that the book value of equipment loans payable approximated the fair market value based on information available as of December 31, 2011.
 
 Inventories
 
 Inventories are stated at the lower of cost, as determined on a weighted average basis, or market. Costs of inventories include the purchase price and related manufacturing costs incurred in bringing the products to their present location and condition. Market value is determined by reference to sales prices or to management’s estimates based on prevailing market conditions. Management writes down the inventories to market value if it is below cost and also regularly evaluates the composition of its inventories to identify slow-moving and obsolete inventories to determine if a valuation allowance is required.
 
 Advances to Suppliers and Related Parties
 
 In order to ensure a steady supply of raw materials, the Company is required from time to time to make cash advances when placing its purchase orders. Management regularly evaluates the balance of advances and will record a reserve if necessary.
 
 See Note 11 for advances to related parties in the normal course of business.
 
 Advances from Customers
 
 Customer advances consist of amounts received from customers relating to the sales of the Company’s steel products. The Company recognizes these funds as a current liability until the revenue can be recognized.
 
 Revenue Recognition
 
 Revenue is recognized when all of the following have occurred: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) the price is fixed or determinable, and (iv) the ability to collect is reasonably assured. These criteria are generally satisfied by the Company at the time of delivery, which is the point when risk of loss and title passes to the customer. Revenue is reported net of all value added taxes. The Company does not routinely permit customers to return products and historically, customer returns have been immaterial.
 
 Foreign Currency Translation
 
 The Company’s financial information is presented in U.S. dollars. The functional currency of the US parent company and US subsidiaries is the US dollar. The functional currency of the Company’s subsidiaries in the PRC is the RMB. Subsidiary transactions, which are denominated in currencies other than RMB, are translated into RMB at the exchange rate quoted by the People’s Bank of China prevailing at the dates of the transactions. Exchange gains and losses resulting from transactions denominated in a currency other than the RMB are included in statements of income as foreign currency transaction gain or loss.
 
 The unaudited consolidated financial statements of the Company have been translated into U.S. dollars in accordance with ASC 830, “Foreign Currency Matters”. The financial information is first prepared in RMB and then is translated into U.S. dollars at period-end exchange rates for assets and liabilities and average exchange rates for revenue and expenses. Capital accounts are translated at their historical exchange rates when the capital transactions occurred. The effects of foreign currency translation adjustments are included as a component of accumulated other comprehensive income (loss) in stockholders’ equity.
 
 F-6
 Table of Contents
 
 The foreign exchange rates used in the translation were as follows:
 
 Three Months Ended


Six Months Ended


Year EndedJune 30,


June 30,


December 31,2012


2011


2012


2011


2011RMB/US$ exchange rate

$
0.1574


$
0.1547


$
0.1574


$
0.1547


$
0.1589Average RMB/US$ exchange rate


0.1580



0.1538



0.1582



0.1528



0.1547
 
 The RMB is not freely convertible into foreign currency and all foreign exchange transactions must take place through authorized institutions. No representation is made that the RMB amounts could have been, or could be, converted into U.S. dollars at the rates used in translation.
 
 Cash flows from the Company’s operations are calculated based upon the local currencies using the average translation rate. As a result, amounts related to assets and liabilities reported on the statements of cash flows will not necessarily agree with changes in the corresponding balances on the balance sheets.
 
 Comprehensive Income (Loss)
 
 Comprehensive income (loss) is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. Accumulated other comprehensive income (loss) arose from changes in foreign currency exchange rates.
 
 Net Income Per Share
 
 Basic net income per share is computed on the basis of the weighted average number of common shares outstanding during the period.
 
 Diluted net income per share is computed similarly to basic net income per share except that it includes the dilutive securities (warrants) outstanding and potential dilution that could occur if dilutive securities were converted. Such securities (2,580,022 warrants at $4.50 per share and 1,000 warrants at $2.00 per share), had an anti-dilutive effect and, as such, were excluded from the calculation for all periods presented.
 
 Risks and Uncertainties
 
 The operations of the Company are located in the PRC. Accordingly, the Company’s business and financial condition may be influenced by the political, economic, and legal environments in the PRC, as well as by the general state of the PRC economy. The Company’s operations in the PRC are subject to special considerations and significant risks not typically associated with companies in North America and Western Europe. These include risks associated with, among others, the political, economic and legal environment and foreign currency exchange. The Company’s results may be adversely affected by changes in the political, regulatory and social conditions in the PRC, and by changes in governmental policies or interpretations with respect to laws and regulations, anti-inflationary measures, currency conversion, remittances abroad, and rates and methods of taxation. The current management team (specifically the CEO) of the Company and the majority owner of the Company through YBS are also the majority owners of the controlled variable interest entity in the PRC, Handan Hongri Metallurgy Co. Ltd. (“Hongri”). The US parent company (or CIS) only controls Hongri through certain agreements which obligated CIS to absorb a majority of expected losses of Hongri or  enabled CIS  to receive a majority residual returns from Hongri and granted CIS the power to direct the activities of Hongri that most significantly impact Hongri’s economic performance. As such, there is a risk that the majority shareholders of the Company and, or Hongri could cancel these agreements. If such action was to be taken, the Company would no longer retain control of Hongri, the operating subsidiary. Although the Company has not experienced losses from these risks and believes that they are in compliance with existing laws and regulations including the organization and structure disclosed in Note 1, this may not be indicative of future results. In addition, the management of CIS currently intends to either reinvest or retain all of the income generated by Hongri for strategic expansion purposes and operations into the foreseeable future.
 
 F-7
 Table of Contents
 
 The Company has significant exposure to the fluctuation of raw materials and energy. The Company does not enter into any commodity contracts or other financial derivatives to hedge these risks.  In addition, the Company is subject to the cyclical nature of the steel industry and the current economic and political environment as it relates to steel production in China. There are many factors of the business which are impacted by prevailing market conditions, specifically, a change in the raw material and energy product pricing environment, rise or decline, will influence our inventory levels, purchasing decisions and will, ultimately, all have an impact on the Company’s gross profit and operating results. Management’s operational decisions are a direct response to the market and as such will change as market conditions change. However, an unfavorable cyclical impact and/or economic and political factors that could have a negative impact on our business can occur rapidly and be difficult for management to predict and mitigate.
 The Company provides credit in the normal course of business. Management continues to take appropriate actions to perform ongoing business and credit reviews of customers to reduce exposure to new and recurring customers who have been deemed to pose a high credit risk based on their commercial credit reports, the Company’s collection history, and perception of the risk posed by their geographic location. Concentration of credit risk with respect to accounts receivable is limited because a large number of geographically diverse customers make up the Company’s customer base.
 
 The Company is potentially exposed to risks of losses that may result from business interruptions, injury to others (including employees) and damage to property. These losses may be uninsured, especially due to the fact that the Company’s operations are in China, where business insurance is not readily available. As of June 30, 2012, the Company has not experienced any uninsured losses from injury to others or other losses.
 
 Recent Accounting Pronouncements
 
 In December 2011, the FASB issued ASU No. 2011-11, “Balance Sheet (Topic 210)—Disclosures about Offsetting Assets and Liabilities” (“ASU 2011-11”). The update requires entities to disclose information about offsetting and related arrangements of financial instruments and derivative instruments.  The ASU is effective for annual periods beginning on or after January 1, 2013 and interim periods therein. The Company is currently evaluating the impact this update will have on our consolidated financial statements.
 
 In December 2011, FASB issued ASU No. 2011−12, “Comprehensive Income - Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05”(“ASU 2011−12”).  Among the new provisions in ASU 2011-05 was a requirement for entities to present reclassification adjustments out of accumulated other comprehensive income by component in both the statement in which net income is presented and the statement in which other comprehensive income is presented (for both interim and annual financial statements); however this reclassification requirement is indefinitely deferred by ASU 2011-12 and will be further deliberated by the FASB at a future date. All other provisions of ASU 2011-5 were retrospectively adopted on January 1, 2012.
 
 3.
Bank Notes Receivable
 
 Bank notes receivable are highly liquid negotiable instruments issued by banks in the PRC on behalf of Hongri’s customers.  These notes typically have maturities between one to six months.  With these bank notes, The Company can: (a) redeem the notes for face value at maturity, (b) endorse the notes to the Company’s vendors as a form of payment instrument at full value, or (c) factor the notes to a bank.  In the event that the Company factors these notes to a bank, it will record as interest expense the difference between cash received and the face value of the note. The Company believes all of the notes are fully realizable and has not recorded any reserves as of June 30, 2012 and December 31, 2011, respectively.
 
 4.
Accounts Receivable
 
 Accounts receivable at June 30, 2012 and December 31, 2011 consisted of the following:
 
 2012


2011Accounts receivable

$
12,512,360


$
21,383,735Allowance for doubtful accounts


(396,730
)


(521,466
)Accounts receivable, net

$
12,115,630


$
20,862,269
 
 F-8
 Table of Contents
 5.
Inventories
 
 Inventories at June 30, 2012 and December 31, 2011 consisted of the following:
 
 2012


2011Raw materials

$
533,831


$
172,372Finished products


8,481,623



12,004,416Spare parts


4,787,936



3,963,148Total

$
13,803,390


$
16,139,936
 
 
 6.
Machinery and Equipment, Net
 
 Machinery and equipment stated at cost less accumulated depreciation at June 30, 2012 and December 31, 2011 consisted of the following:
 
 2012


2011Machinery and equipment

$
247,399,865


$
246,906,365Auxiliary facilities


3,000,027



3,028,424Transportation equipment


559,206



552,288Office equipment


34,978



34,087Electronic equipment


36,396



36,741Subtotal


251,030,472



250,557,905Accumulated depreciation


(82,351,189
)


(70,520,287
)Construction in progress


8,437,509



2,887,029Total

$
177,116,792


$
182,924,647
 7.
Restricted Cash
 
 Restricted cash consisted of the following at June 30, 2012 and December 31, 2011.
 
 2012


2011Bank deposit as part of collateral to bank notes payable

$
4,879,710


$
3,019,100Bank deposit as part of collateral to working capital loan


2,361,150



2,383,500Total

$
7,240,860


$
5,402,600
 
 Restricted cash represents required cash deposits by the bank as a part of collateral to bank notes payable and working capital loan (see Note 9). The Company has to maintain 100% or 50% of the balance of the bank notes payable to ensure future credit availability. The Company earns interest at a variable rate per month on this restricted cash.
 
 8.
Obligations Under Capital Leases – Related Parties
 
 The Company accounts for its related party leases with YBS and its affiliates as capital leases under ASC 840 because YBS has the ability to extend the length of the terms of all of the leases whenever they see fit. Therefore, the leases meet the requirement for capitalization of assets as the term is expected to be greater than 75% of the useful life of the asset. Typically, the terms of the lease are based on YBS’s costs. The value of the capitalized assets have been calculated to be the present value of all lease payments over the stated term using the Company’s bank borrowing rates. Should YBS extend any of the leases, the Company will re-calculate the value of the capitalized lease based on the renewed terms and record an additional asset upon the occurrence.
 
 F-9
 Table of Contents
 
 In December 2007, the Company entered into a lease agreement with YBS Group to lease 956 mu (approximately 157.5 acres) of land as its manufacturing site. The rent for the first three years was waived per lease agreement. The annual lease payment is RMB 1,434,450 (approximately $225,797) which commenced in 2011. The average lease payment is RMB 1,291,005 (approximately $203,217) per annum. The lease is set to expire on December 31, 2037. The present value of the total lease payments at inception was RMB 12,703,147 (approximately $1,999,602 at the current exchange rate), which was calculated with a discount rate of 7.83%, a PRC long term borrowing rate in December 2007.
 
 In November 2007, the Company entered into a lease agreement with YBS Group to lease the manufacturing building of Plate-Rolling I. The annual lease payment is RMB 3,522,211 (approximately $554,431) commencing on January 1, 2008. The lease is set to expire on December 31, 2017. The present value of the total lease payments at inception was RMB 23,816,623 (approximately $3,748,975 at the current exchange rate), which was calculated with a discount rate of 7.83%, a PRC long term borrowing rate in December 2007.
 
 In November 2007, the Company entered into a lease agreement with Hongrong, a related party, to lease the manufacturing building of Steel-Making I. The annual lease payment is RMB 1,210,716 (approximately $190,579) commencing on January 1, 2008. The lease is set to expire on December 31, 2017. The present value of the total lease payments at inception was RMB 8,186,666 (approximately $1,288,663 at the current exchange rate), which was calculated with a discount rate of 7.83%, a PRC long term borrowing rate in December 2007.
 
 In November 2009, the Company entered into a lease agreement with YBS Group to lease the manufacturing building of Steel-Making II. The annual lease payment is RMB 107,469 (approximately $16,917) commencing on January 1, 2010. The lease is set to expire on December 31, 2019. The present value of the total lease payments at inception was RMB 793,198 (approximately $124,857 at the current exchange rate), which was calculated with a discount rate of 5.94%, a PRC long term borrowing rate in December 2009.
 
 In November 2009, the Company entered into a lease agreement with Hongrong to lease the manufacturing building of Bar-Rolling III. The annual lease payment is RMB 758,503 (approximately $119,396) commencing on January 1, 2010. The lease is set to expire on December 31, 2019. The present value of the total lease payments at inception was RMB 5,598,552 (approximately $881,268 at the current exchange rate), which was calculated with a discount rate of 5.94%, a PRC long term borrowing rate in December 2009.
 
 As of June 30, 2012, future minimum rental payments applicable to the above non-cancelable capital leases with remaining terms in excess of one year were as follows:
 
 June 30,

Capital Leases2013

$
1,107,1192014


1,107,1192015


1,107,1192016


1,107,1192017


1,107,119Thereafter


5,342,117Total minimum lease payments


10,877,712Less amount representing interest


(4,385,581
)Present value of net minimum lease payments


6,492,131Less current obligations


(614,009
)Long-term obligations

$
5,878,122
 
 F-10
 Table of Contents
 9.
Bank Notes, Bank Loan Payable, Private Loan and Short Term Loan Payable – Related Party
 
 Bank Notes Payable
 
 The bank notes payable do not carry a stated interest rate, but carry a specific due date usually within six months. These notes are negotiable documents issued by financial institutions on the Company’s behalf to vendors. These notes can either be endorsed by the vendor to other third parties as payment, or prior to becoming due, they can factor these notes to other financial institutions. These notes are short-term in nature, as such; the Company does not calculate imputed interest with respect to them. These notes are collateralized by the Company’s restricted bank deposits. The Company has to maintain 100% of the balance of the bank notes payable to ensure future credit availability.
 
 Bank and Private Loan Payable
 
 Bank and private loans at June 30, 2012 and December 31, 2011 consisted of the following:
 
 2012


2011To Credit UnionInterest at 6.10%, payable March 29, 2012
(a)

$
-


$
3,019,100Interest at 13.12%, payable  September 19, 2012
(b)


2,990,790



3,019,100Interest at 7.93%, payable September 25, 2012
(c)


2,990,790



-To Raiffeisen Bank International AG Beijing BranchInterest at 7.93%, due by February 27, 2012
(e)


-



28,602,000Interest at 8.78%, due varied from July to August, 2012
(f)


18,889,200



-To a Private LoanInterest at 10.50%, payable January 10, 2013
(d)


1,243,539



-Total Short Term Bank Loans


$
26,114,319


$
34,640,200
 (a)
On September 30, 2011, the Company received a RMB 19,000,000 ($3,019,100) short-term borrowing from Credit Union. The loan was a “working capital” loan that bears interest at 6.10% per annum and was repaid on March 23, 2012.
 
 (b)
On September 22, 2011, the Company received a RMB 19,000,000 ($2,990,790, translated at June 30, 2012 exchange rate; $3,019,100 translated at December 31, 2011 exchange rate) short-term borrowing from Credit Union. The loan is a “working capital” loan that bears interest at 13.12% per annum and is due on September 19, 2012. The loan is secured by the equipment of Hongrong, a related party.
 
 (c)
On March 26, 2012, the Company received a RMB 19,000,000 ($2,990,790) short-term borrowing from Credit Union. The loan is a “working capital” loan that bears interest at 7.93% per annum and is due on September 25, 2012. The loan is secured by the equipment of Hongri.
 
 Total value of equipment secured for above mentioned bank loans is RMB 70,967,104 ($11,170,932).
 
 (d)
On January 20, 2012, the Company received a RMB 7,900,000 ($1,243,539) short-term borrowing from a private lender. The loan bore interest of 10.50% per annum and is due on January 10, 2013.
 
 (e)
On June 28, 2011, Hongri entered into a revolving loan agreement (the “Agreement”) with Raiffeisen Bank International AG Beijing Branch (“Raiffeisen”). The Agreement provides for a revolving credit facility in an aggregate principal amount of   RMB 180,000,000 (approximately $28,602,000 translated at the rate of December 31, 2011) which used as working capital. Each borrowing could not exceed 180 days or days the Bank agreed during the Agreement period.
 
 (f)
On August 24, 2011, Hongri deposited RMB 15,000,000 ($2,361,150) into Raiffeisen to execute the revolving loan agreement, which was recorded as restricted cash. On August 31, 2011, the Company received the first borrowing RMB 180,000,000 ($28,602,000) which was due by February 27, 2012. The Company repaid its outstanding balance as of February 24, 2012.  Upon the repayment, the Company acquired the second borrowing in the total amount of RMB 180,000,000 from Raiffeisen Bank. The second borrowing was due by varied from July to August 2012. On June 27, 2012, the Company repaid RMB 60,000,000 ($9,444,600, translated at the rate of June 30, 2012). The remaining balance of RMB 120,000,000 ($18,889,200) has been fully repaid as of August 9, 2012 (RMB 50,000,000 repaid in July and RMB 70,000,000 repaid in up through August 9).
 
 F-11
 Table of Contents
 
 Pursuant to the Agreement, borrowings will bear interest at 130% of the benchmark rates of similar loans published by the People’s Bank of China. Based on the current benchmark interest rate for a six months loan, the first borrowing bears the interest of 7.93% and the second borrowing bears the interest of 8.78%.  The interest is calculated on the daily basis and shall be paid on the 20th of the last month of each quarter. The borrowings are secured substantially by the following: all machinery and equipment of Hongri; inventories of  Hongri and Hongrong with a value of not less than RMB 75,000,000 (approximately $11,805,750); a security deposit of RMB 15,000,000 (approximately $2,361,150) into the Raiffeisen bank as a collateral; corporate guaranty from Hebei Wu’an Yuanbaoshan Industry Group Co., Ltd. (“YBS group”), a majority shareholder of Hongri; and personal guaranty from Mr. Beifang Liu, Chairman of YBS group and Mr. Shenghong Liu, Chairman and Chief Executive Officer of the Company.
 
 Short Term Loan Payable – Related Party
 
 During 2011, the Company borrowed RMB 11,000,000 from a related party, Mr. Maisheng Liu, a senior manager of the Company. During the six months ended June 30, 2012, the Company borrowed additional RMB 11,860,000 ($1,876,489) from Mr. Maisheng Liu and returned total of RMB 22,860,000 ($3,616,909) to Mr. Liu.
 On June 28, 2012, the Company borrowed RMB 1,000,000 ($157,410) from Mr. Beifang Liu, director of the Company, and RMB 4,000,000 ($629,640) from Mr. Maisheng Liu, brother of the CEO of the Company. These payables were interest free and due on demand.
 The weighted average short term loan balance consisting of financial institution and private loans and Binchang Liu, Beifang Liu and Maisheng Liu loans was $18,174,535 and $4,776,468 as of June 30, 2012 and 2011, , respectively. The weighted average interest rate for short term loan was 8.81% and 8.29% for the six months ended June 30, 2012 and 2011, respectively.
 
 10.
Taxes Payable
 
 Tax payables at June 30, 2012 and December 31, 2011 consisted of:
 
 2012


2011PRC corporation income tax

$
362,004


$
1,602,160Other taxes payable


174,208



266,726Total

$
536,212


$
1,868,886
 
 See Note 13.
 
 11.
Related Party Transactions
 
 Hongri is 70% owned by YBS Group,  a major shareholder of some other steel production related companies, mainly Hongrong Iron and Steel Co. Ltd. (“Hongrong”), Wu'an Baoye Coke Industrial Co. Ltd.(“Baoye”), Wu'an Yuanbaoshan Cement Plant (“Cement Plant”), Wu'an Yuanbaoshan Ore Treatment Plant (“Ore Treatment”), Wu'an Yuanbaoshan Industrial Group Go. Ltd - Gas Station and Wu’an Yeijin Iron Co. Ltd. (“Yeijin”). During the routine business process, Hongri purchases raw materials and supplies from these companies and advances to / or owes cash to these companies.
 
 F-12
 Table of Contents
 
 The relationships and the nature of related party transactions are summarized as follow:
 
 Name of Related Party

Owned by YBS and its major shareholders


Relationship

to Hongri

Nature of TransactionsHebei Wu'an Yuanbaoshan Industrial Group Co. Ltd. (“YBS Group”)

Self


70% parent

Services, information and public relationship, and coordinationWu'an Yuanbaoshan Industrial Group Co. Ltd - Gas Station


100
%

Affiliated company

Supplier of gasWu'an Hongrong Iron & Steel Co. Ltd (“Hongrong”)


67
%

Affiliated company

Supplier of molten ironWu'an Baoye Coke Industrial Co. Ltd. (“Baoye”)


49
%

Affiliated company

Supplier of cokeWu'an Yuanbaoshan Cement Plant


36
%

Affiliated company

Supplier of cementWu'an Yuanbaoshan Ore Treatment Plant


33
%

Affiliated company

Supplier of granularWu’an Yeijin Iron Co. Ltd


31
%

Affiliated company

Supplier of iron
 
 Consolidation is required when an entity holds a controlling interest in another entity (often in the form of control through voting interests) or if the entity meets the requirements of a variable interest entity (“VIE”). The Company has no direct control of the affiliated companies, noted above, through voting interests. However, because the Company has a variable interest in some of these affiliated companies via the supply relationships noted above (i.e. implied relationships), the Company is required to determine whether such affiliates are VIE’s and, if so, whether the Company is the primary beneficiary so that consolidation must occur. A VIE has the following characteristics in accordance with ASC 810-10-15-14:  insufficient equity investment at risk; equity lacking decision-making rights; equity with nonsubstantive voting rights; lacking the obligation to absorb an entity’s expected losses and lacking the right to receive an entity’s expected residual returns. The Company’s analysis concluded that such affiliates were not VIE’s because none of these characteristics are present.
 
 As of June 30, 2012 and December 31, 2011 advances to related parties and accounts payable - related parties consisted of:
 
 Advances to Related PartiesName of related parties

2012


2011YBS Group

$
-


$
21,075,317Hongrong


118,019,071



56,340,968Cement Plant


68,545



-Total Advances to Related Parties

$
118,087,616


$
77,416,285
 
 Accounts Payable - Related PartiesName of related parties


2012



2011YBS Group

$
(41,758
)

$
-Baoye


(381,531
)


(56,447
)Ore Treatment


(3,120
)


(3,149
)Cement Plant


-



(124,851
)Total Accounts Payable - Related Parties

$
(426,409
)

$
(184,447
)
 
 F-13
 Table of Contents
 The balance of advances to YBS group, a parent company, was $0 and $21,075,317 as of June 30, 2012 and December 31, 2011, respectively. YBS Group is a parent company. It provides various services to the subsidiary companies, such as market and industrial information, public relationship, various government agents’ relationship, coordination the production and purchase for subsidiaries and so on. Advances to YBS Group were in connection with the purchase of iron and supplementary materials used in Hongrong’s production, a motlen iron supplier of Hongri. The balance of advance to YBS Group will be returned or credited for YBS Group’s other services provided to the Company.
 
 YBS group charged a service fee based on applicable itemized expenses and fixed service fee. Commencing in 2010, YBS Group charged 0.1% of current year revenue of Hongri as a fixed service fee. Service fees consisted of management salaries, training, consultations, common areas charges and other fees. Management believes that 0.1% of revenue is a reasonable charge method. The Company estimated that this service fee would be similar or marginally higher if the same services had been provided by third parties. In addition to the fixed service fee, the Company will charge itemized services and expenses to the Company if such service and expenses are incurred. The services fees were $705,826 and $216,779 for the three months ended June 30, 2012 and 2011, respectively, and $882,909 and $403,449 for the six months ended June 30, 2012 and 2011, respectively. Among the second quarter services fees, $560,254 was an itemized expenses in connection with the refinancing of RMB 180 million loan from Raiffeisen Bank. Executive officers’ salaries were stand-alone expenses. Such expenses were $15,741 and $15,378 for the three months ended June 30, 2012 and 2011, respectively, and $31,620 and $30,649 for the six months ended June 30, 2012 and 2011, respectively.
 
 During six months ended June 30, 2012, the Company repaid its $41,958,329 equipment loans to YBS group by offsetting its previous and current advanced fund to YBS group.  In the same period, the Company also repaid $16,513,794 equipment loan to Hongrong by offsetting its current advanced fund to Hongrong.
 
 Purchases from related parties
 
 Hongri purchased raw materials from the above-mentioned related parties and had advances and accounts payable to these related parties in the routine business operations. It is a common practice in China that a vendor or supplier requires an advance payment before the shipment of merchandise. Company advance to the related parties enable these related parties to pay partial amounts in advance to their vendors or suppliers. Most of these advances related to the purchase of raw material and other supplies in routine business and were short term in nature. These advances are interest free. The balance of advances to Hongrong, the Company’s major molten iron supplier, was $118,019,071 and $56,340,968 as of June 30, 2012 and December 31, 2011, respectively.
 
 Accounts payable to related parties represents an unsettled amount in the normal course of business. These payables were short term in nature. Total payables to related parties was $426,409 and $184,447 as of June 30, 2012 and December 31, 2011, respectively.
 
 For the three months ended June 30, 2012, the Company purchased $62,387,883 (145,856 metric tons) molten iron and steel iron and $7,891,309 gas, electricity and other materials from Hongrong. For the six months ended June 30, 2012, the Company purchased $174,040,917 (403,752 metric tons) molten iron and steel iron and $12,877,915 gas, electricity and other materials from Hongrong. During the three and six months ended June 30, 2011, the Company purchased $178,091,530 (377,459 metric tons) and $330,086,201 (714,381 metric tons), respectively, of molten iron from Hongrong.
 
 F-14
 Table of Contents
 
 Sales to related parties
 
 During the three and six months ended in June 30, 2012, the Company’s sales of its products to YBS Group amounted to $1,897,474 and $4,211,704, respectively. During the three and six months ended June 30, 2011, the Company’s sales of its products to YBS Group amounted to $21,285,432 and $21,285,432, respectively. YBS acts as a distributor of steel products for the Company and all sales are final. The only right of return is for defective steel products and the Company has not experienced any returns in the past years of operations. The steel products are picked up directly by YBS’ customers at which time the Company recognizes the sale. The Company has determined these sales should be recorded on a gross basis based on the following analysis: upon shipment all risks of ownership transfer to YBS’ customers and the Company does not bare any additional risks and YBS has all of the collection risk from its customers.
 
 Accounts receivable from YBS Group were $0 as of June 30, 2012 and December 31, 2011, respectively.
 
 During the three and six months ended June 30, 2012, the Company sold $1,229,212 and $3,490,195 steel products to Hongrong, which were used in Hongrong’s blast furnace constructions. The Company also sold $1,090,065 and $2,095,645 by-products to Hongrong for the three and six months ended June 30, 2012, respectively, which were re-used in manufacturing of molten iron.
 
 During three and six months ended June 30, 2012, the Company sold $0 and $8,987 steel products to Baoye.
 
 Equipment purchased from related parties
 
 See Note 12 Equipment Loans Payable – Related Parties.
 
 Loan from related party
 
 See Note 9 Bank Notes, Bank Loan Payable and Short Term Loan Payable – Related Party
 
 Leases from related parties
 
 See Note 8 Obligations Under Capital Lease – Related Parties
 
 12.
Equipment Loans Payable – Related Parties
 
 Equipment loan payables – related parties at June 30, 2012 and December 31, 2011 consisted of:
 
 Equipment Loans Payable

2012


2011Equipment loan - YBS Group payable

$
3,896,141


$
46,071,679Equipment loan - Hongrong payable


-



16,584,767Total equipment loans payable


3,896,141



62,656,446Less: current portion


(3,896,141
)


(11,562,752
)Long-term payable

$
-


$
51,093,694
 
 On November 30, 2007, the Company purchased Plate-Rolling I production line and related auxiliary equipment from YBS Group at a price of RMB 191,163,559 (approximately $26,208,524 translated at the historical exchange rate), which was at cost, and carryover basis of YBS group. YBS Group provided a 10 year seller-financed loan to the Company to finance the purchase. The loan bears interest at 5% per annum, and has a fixed repayment schedule at RMB 17,973,455 (approximately $2,829,202 at the June 30, 2012 exchange rate) per annum (payable at the end of the year). On March 31, 2012 the Company repaid $16,511,998 equipment loan to YBS group by offsetting its previous advanced fund to YBS group. The remaining unpaid loan balance of $2,373,735 was paid on June 30, 2012 by offsetting its previous and current advanced fund to YBS group.
 
 F-15
 Table of Contents
 
 On November 30, 2009, the Company purchased Steel-Making II production line and related auxiliary equipment from YBS Group at a price of RMB 243,811,599 (approximately $35,718,399 at the historical exchange rate), which was at cost, and carryover basis of YBS Group. YBS Group provided a 10 year seller-financed loan to the Company to finance the purchase. The loan bears interest at 5% per annum, and has a fixed repayment schedule at RMB 24,380,000 (approximately $3,837,656 at June 30, 2012 exchange rate) per annum (payable at the end of the year). On June 30, 2012 the Company repaid $22,969,275 equipment loan to YBS group by offsetting its previous advanced fund to YBS group. The remaining unpaid loan balance is $3,896,141.
 
 On November 30, 2007, the Company purchased Steel-Making I production line and related auxiliary equipment from Hongrong at a price of RMB 326,028,440 ($44,698,499 translated at the historical exchange rate), which was at cost, and carryover basis of Hongrong. Hongrong provided a 10 year seller-financed loan to the Company to finance the purchase. The loan bears interest at 5% per annum, and has a fixed annual repayment schedule at RMB 30,414,021 (approximately $4,787,471 at June 30, 2012 exchange rate) per annum (payable at the end of the year). On March 31, 2012, the Company repaid the remaining $16,540,931 equipment loan balance to Hongrong by offsetting its current advanced fund to Hongrong.
 
 For the three and six months ended June 30, 2012, the Company recorded interest expense and paid interest totaling $366,766 and $941,140 to YBS Group, respectively. For the three months and six months ended June 30, 2011, the Company recorded interest expense and paid interest totalling $638,754 and $1,270,114 to YBS Group, respectively.
 
 For the three and six months ended June 30, 2012, the Company recorded interest expense and paid interest totaling $0 and $206,762 to Hongrong, respectively. For the three and six months ended June 30, 2011, the Company recorded interest expense and paid interest totalling $259,093 and $515,187) to Hongrong, respectively.
 
 13.
Income Tax
 
 The provision for income tax arose from income tax incurred and or paid to the Chinese tax agent.
 
 Hongri is subject to the PRC’s 25% standard enterprise income tax. However, in 2007, the Company applied for a foreign investment enterprise exemption, and the application was approved by the local tax authority. The Company is entitled to a tax holiday of full (100%) income tax exemption for two (2) years starting from the first profitable year of 2008 through 2009 and then a 50% reduction in income tax for additional three (3) years from the year of 2010 to 2012.
 
 Nuosen is subject to the PRC’s 25% standard enterprise income tax.
 
 Foreign pretax earnings were $2,378,265 and $12,744,502 for the three months ended June 30, 2012 and 2011, respectively, and $8,368,759 and $21,095,419 for the six months ended June 30, 2012 and 2011, respectively. Pretax earnings of a foreign subsidiary are subject to U.S. taxation when effectively repatriated. The Company provides income taxes on the undistributed earnings of non-U.S. subsidiaries except to the extent that such earnings are indefinitely invested outside the United States. At June 30, 2012, approximately $164,914,000 of accumulated unadjusted earnings of non-U.S. subsidiaries was indefinitely invested. At the existing U.S federal corporation income tax rate of 34%, an additional tax of $47,136,000 approximately would have to be provided if such earnings were remitted currently.
 
 F-16
 Table of Contents
 
 The following table reconciled the US statutory rates to the Company’s effective rate for the three and six months ended June 30, 2012 and 2011.
 
 Three Months Ended June 30,


Six Months Ended June 30,2012


2011


2012


2011US statutory tax rate


34.0
%


34.0
%


34.0
%


34.0
%Foreign income not recognized in US


-34.0
%


-34.0
%


-34.0
%


-34.0
%China income tax rate


12.5
%


12.5
%


12.5
%


12.5
%Non-deductible expenses


3.9
%


2.1
%


4.9
%


1.8
%Effective rate


16.4
%


14.6
%


17.4
%


14.3
%
 CIS and Northern were incorporated in the United States and have incurred net operating loss for income tax purpose in the past years and current period. As of June 30, 2012, the Companies had loss carry forwards of approximately $1,640,000 for U.S. income tax purposes available for offset against future taxable U.S. income expiring in 2030 and 2031. Management believes that the realization of the benefits from these losses appears uncertain due to the Company's limited operating history. Accordingly, a full deferred tax asset valuation allowance has been provided and no deferred tax asset benefit has been recorded. The valuation allowance as of June 30, 2012 and December 31, 2011 were approximately $557,000 and $411,000, respectively.
 
 The Company did not have any significant temporary differences relating to deferred tax liabilities as of June 30, 2012 and December 31, 2011.
 
 The Company files income tax returns with U.S. Federal Government and the states of Maryland and Colorado. With few exceptions, the Company is subject to U.S. federal and Maryland state income tax examinations by tax authorities for years on or after 2007 and for years on or after 2006 by Colorado tax authorities. The Company’s foreign subsidiaries also file income tax returns with the National Tax Bureau (with its branches in Handan) and other taxes and surcharges with the Local Tax Bureaus (Hubei Provincial Tax Bureau and Handan Municipal Tax Bureau). The Company is subject to tax examinations by these foreign tax authorities for years from 2007 to 2009.
 
 The Company evaluated its tax positions, and as of June 30, 2012 and December 31, 2011. No uncertain tax position has been identified.
 
 14.
Commitments and Contingencies
 
 In the normal course of business, the Company is subject to contingencies, including legal proceedings and claims arising out of the normal course of businesses that relate to a wide range of matters, including among others, product liability. The Company records accruals for such contingencies based upon the assessment of the probability of occurrence and where determinable, an estimate of the liability. Management may consider many factors in making these assessments including past history, scientific evidence and the specifics of each matter. Management has not become aware of any product liability claims arising from any incident over the years.
 
 As of June 30, 2012 and December 31, 2011, the Company had no pending litigation.
 
 15.
Major Customers and Vendors
 
 For the three months ended June 30, 2012 and 2011, there were two (2) major customers that accounted for approximately 33% and 40% of the Company’s total sales, respectively. Each of major customer accounted 18% and 15% of total sales for three months ended June 30, 2012, and 21% and 19% of total sales for the three months ended June 30, 2011, respectively.
 
 F-17
 Table of Contents
 
 For the six months ended June 30, 2012 and 2011, there were two (2) major customers that accounted for approximately 38% and 39% of the Company’s total sales, respectively. Each of major customer accounted 20% and 18% of total sales for six months ended June 30, 2012, and 21% and 18% of total sales for the six months ended June 30, 2011, respectively.
 
 For three months ended June 30, 2012, 52% of the total Company’s purchase was from Hongrong, and 41% of the total purchase was from an unrelated party. For the comparable period of 2011, 97% of the total purchases were from Hongrong. No purchase from other vendors was over 5%.
 
 For six months ended June 30, 2012, 64% of the total Company’s purchase was from Hongrong, and 32% of the total purchase was from an unrelated party. For the comparable period of 2011, 98% of the total purchases were from Hongrong. No purchase from other vendors was over 5%.
 
 16.
Major Products Lines
 
 The Company operates in one industry segment and in one geographic region, which is the PRC. Revenues and costs of goods sold by major products for the three and six months ended June 30, 2012 and 2011 consisted of:
 
 Three Months Ended June 30,


Six Months Ended June 30,Revenues

2012


2011


2012


2011Steel plates

$
101,296,170


$
171,365,525


$
165,592,905


$
297,463,703Steel bars/steel wires


42,007,530



929,023



104,954,351



929,023Steel billets


-



38,942,893



47,067,680



96,141,828Byproducts and others


2,268,669



5,561,860



4,986,081



9,789,563Total Revenues

$
145,572,369


$
216,799,301


$
322,601,017


$
404,324,117
 
 Three Months Ended June 30,


Six Months Ended June 30,Costs of Revenue


2012



2011



2012



2011Steel plates

$
101,522,232


$
165,336,000


$
167,211,256


$
289,034,679Steel bars/steel wires


39,060,294



923,762



98,669,634



923,762Steel billets


-



36,130,271



42,308,554



89,529,865Others


194,465



-



792,112



-Total Cost of Revenue

$
140,776,991


$
202,390,033


$
308,981,556


$
379,488,306
 
 Three Months Ended June 30,


Six Months Ended June 30,Gross Profit Margin


2012



2011



2012



2011Steel plates


-0.22
%


3.52
%


-0.98
%


2.83
%Steel bars/steel wires


7.02
%


0.57
%


5.99
%


0.57
%Steel billets


-



7.22
%


10.11
%


6.88
%Total Gross Profit Margin


3.29
%


6.65
%


4.22
%


6.14
%
 
 F-18
 Table of Contents
 The Company sold 182,554 and 272,990 metric tons of steel plates for the three months ended June 30, 2012 and 2011, respectively. The Company sold 296,376 and 481,734 metric tons of steel plates for the six months ended June 30, 2012 and 2011, respectively.
 
 The Company sold 70,936 metric tons of steel wire for the three months ended June 30, 2012. There were no steel wire sales in the same period of 2011. Instead, the Company sold 1,653 metric tons of steel bars. The Company sold 181,571 metric tons of steel wire for the six months ended June 30, 2012. There were no steel wire sales in the same period of 2011. Instead, the Company sold 1,653 metric tons of steel bars.
 
 The Company sold 0 and 66,066 metric tons of steel billets for the three months ended June 30, 2012 and 2011, respectively. The Company sold 85,602 and 166,354 metric tons of steel billets for the six months ended June 30, 2012 and 2011, respectively.
 
 17.
Subsequent Events
 
 During July 2012, Hongri entered into a new revolving credit facility, which is to be used as working capital only, from Raiffeisen Bank International AG Beijing Branch (“Raiffeisen”). The new revolving credit facility provides an aggregate principal amount of RMB 120,000,000 ($18,889,200 translated at the rate of June 30, 2012). The credit facility bears interest rate of 7.3136% and due on September 28, 2012. As of August 10, 2012, the Company used RMB 84,000,000 ($13,222,440 translated at the rate of June 30, 2012) of total credit line.
 F-19
 Table of Contents


ITEM2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.




The following discussion should be read in conjunction with our financial statements and notes thereto included in this report.





On August 1, 2010, China Industrial Steel Inc. (“CIS” or the “Company”), through Northern Steel Inc. (“Northern”) and its wholly owned foreign enterprise, Nuosen (Handan) Trading Co., Ltd (“Nuosen”), entered into Entrusted Management Agreement, Exclusive Option Agreement, and Covenants Agreement (collectively, the “Entrusted Agreements”) with Handan Hongri Metallurgy Co., Ltd. (“Hongri”) and shareholders of Hongri, Hebei Wu’an Yuanbaoshan Industry Group Co., Ltd (“YBS Group”) and Fakei Investment (Hong Kong) Ltd (“Fakei”). The effect of the Entrusted Agreements is to cede control of management and economic benefits of Hongri to Nuosen. As a consideration, CIS issued 44,083,529 restricted shares of its common stock, par value $0.0001, to Karen Prudente, a nominee and trustee for YBS Group for entering into the Entrusted Agreements with Nuosen. CIS also issued 17,493,463 restricted shares of its common stock to Fakei in consideration for Fakei entering into the Entrusted Management Agreement with Nuosen.


The Entrusted Agreements empower CIS, through Northern and Nuosen, with the ability to control and substantially influence Hongri’s daily operations and financial affairs, appoint its senior executives and approve all matters requiring shareholders’ approval. As a result of these entrusted agreements, which obligate CIS to absorb a majority of expected losses of Hongri and enable CIS to receive a majority of expected residual returns from Hongri and because CIS has the power to direct the activities of Hongri that most significantly impact Hongri’s economic performance, CIS, through its wholly-owned subsidiaries, accounts for Hongri as its Variable Interest Entity (“VIE”) under ASC 810-10-05-8A. Accordingly, CIS consolidates Hongri’s operating results, assets and liabilities. The management of the Company currently intends reinvest all of the income of Hongri for strategic expansion purpose for the foreseeable future.





For accounting purposes, the above transactions were accounted for in a manner similar to a reverse merger or recapitalization, since the former equity shareholders of Hongri now effectively own a majority of CIS’ common stock immediately following the transactions. Consequently, the assets and liabilities and historical operations reflected in the consolidated financial statements prior to the transactions are those of Hongri and are recorded at the historical cost of Hongri. The consolidated financial statements after completion of the transactions include the assets and liabilities of CIS, Northern, Nuosen, and Hongri (collectively, CIS or the “Company”), historical operations of Hongri, and operations of CIS, Northern, Nuosen and Hongri from the date of the transaction. The 44,083,529 restricted shares of common stock issued to Karen Prudente and 17,493,463 restricted shares of common stock issued to Fakei were presented as of the beginning of the first period presented in the accompanying consolidated financial statements.





CIS through Hongri, its operating company in China, produces and sells steel plates, steel wires, steel bars and steel billets. The Company currently operates from its headquarters on approximately 1,000 acres in Handan City, Hebei Province, China. Most of the Company’s products are sold domestically in China.


The Company completed construction of steel production phase II in 2009, which increased steelmaking capacity to 2.3 million metric tons in 2009 from 1.3 million tons in 2008. Annualized production of steelmaking to total capacity utilization rate was approximately 40% and 62% for the three months ended June 30, 2012 and 2011, respectively. Annualized production of steelmaking to total capacity utilization rate was approximately 48% and 59% for the six months ended June 30, 2012 and 2011, respectively. The decrease in capacity utilization rate resulted from lacking of market demand.





In addition to steelmaking capacity, the Company currently has 2 million metric tons of steel rolling production capacity (including steel plate and steel bar production). Annualized production of steel rolling to total capacity utilization rate was approximately 50% and 55% for the three months ended June 30, 2012 and 2011, respectively. Annualized production of steel rolling to total capacity utilization rate was approximately 47% and 48% for the six months ended June 30, 2012 and 2011, respectively.




3
 Table of Contents





Due to the nature of its business, the Company has significant exposure to the fluctuation of raw materials and energy prices as part of its normal operations. There are many factors of our business which are impacted by prevailing market conditions, specifically, a change in the raw material and energy pricing environment will influence our inventory levels and purchasing decisions which will, ultimately, impact our realized gross margin. The Company’s management operational decisions are a direct response to the market and, as such, will change as market conditions change. The Company does not undertake any hedging strategies to mitigate the fluctuation of market price. Therefore, the fluctuation of commodity price will have a direct impact on our operations through the price change in local steel market.
 
 The steel industry has been facing various challenges nationally since 2008. In 2008, iron ore prices increased dramatically and cost of revenue increased accordingly. In 2009, the supply of steel products exceeded the demand for steel products and in general, inventories increased consequently. In 2010, the Chinese government announced new targets for consolidation in the steel industry to close out small size steel manufacturers nationally in order to clean up excessive production capacities and to increase efficiency of energy usage and reduce pollution. In 2011, the output of steel production in China increased 8.9%, which caused the surplus of steel inventory nationwide for 2012. At the end of June 2012, Chinese comprehensive price index of steel products, an index used for market demand, decreased 14.43% compared to the same period of 2011. During the six months ended June 2012, it was estimated by Association of Chinese Steel Industry that 34% of steel manufacturers were experiencing losses. The recovery of the steel market is still uncertain and will largely depend on the recovery of the world’s economy in the second half of 2012. The weakened steel industry had a material negative impact on the Company’s operation results for the three and six months ended June 30, 2012.
 
 The Company subcontracted Wu'an Hongrong Iron & Steel Co. Ltd (“Hongrong”), a related party, to process molten iron prior to February 2010. Beginning from February 2010, the Company terminated the subcontracting relationship with Hongrong and began purchasing processed molten iron from Hongrong at the prevailing market price in the local iron market, in accordance with a supply agreement. This change had no material impact on our gross profit since the subcontracting fees paid was commensurate with the gross profit of manufacturing molten iron in the local market.
 
 For the three months ended June 30, 2012, 52% of the Company’s total purchase was from Hongrong, and 41% of the total purchase was from an unrelated party. For the comparable period of 2011, 97% of the total purchases were from Hongrong. No purchase from other vendors was over 5%. For the six months ended June 30, 2012, 64% of the total Company’s purchase was from Hongrong, and 32% of the total purchase was from an unrelated party. For the comparable period of 2011, 98% of the total purchase was from Hongrong. No purchase from other vendors was over 5%. The decrease in purchase form Hongrong was mainly due to the maintenance of current blast furnace in Hongrong.
 
 For the three months ended June 30, 2012 and 2011, there were two (2) major customers that accounted for approximately 33% and 40% of the Company’s total sales, respectively. Each of the major customers accounted for 18% and 15% of the total sales for the three months ended June 30, 2012, and 21% and 19% of total sales for the three months ended June 30, 2011, respectively. For the six months ended June 30, 2012 and 2011, there were two (2) major customers that accounted for approximately 38% and 39% of the Company’s total sales, respectively. Each of the major customers accounted for 20% and 18% of total sales for six months ended June 30, 2012, and 21% and 18% of total sales for the six months ended June 30, 2011, respectively.


4
 Table of Contents





Results of Operations for the Three Months Ended June 30, 2012 and 2011





Comparison of Revenue for the Three Months Ended June 30, 2012 and 2011





2012


2011Products

Revenue


Quantity (Ton)


Revenue


Quantity (Ton)Steel plates

$
101,296,170



182,554


$
171,365,525



272,990Steel wires


42,007,530



70,936



-



-Steel bars


-



-



929,023



1,653Steel billets


-



-



38,942,893



66,066Byproducts


2,268,669



-



5,561,860



-Products Total

$
145,572,369



253,490


$
216,799,301



340,709


Total sales for the three months ended June 30, 2012 were $145,572,369, a decrease of $71,226,932, or 33%, compared to $216,799,301 in the comparable period in 2011. Approximately $13.3 million, or 19% of the decrease was due to a decrease in the average sales price and 81% was due to decrease in the quantity sold offset by the new steel wire products.
 
 Revenue from steel plates was $101,296,170 in the three months ended June 30, 2012, a decrease of $70,069,355, or 41% compared to $171,365,525 in the three months ended June 30, 2011. The Company sold 182,554 tons of steel plates in the three months ended June 30, 2012, a decrease of 90,436 ton or 33%, compared to 272,990 tons in the three months ended June 30, 2011. The Company reduced its production of steel plates in the quarter ended June 30, 2012 due to lack of market demand. The average unit sales price of steel plates was approximately $555 per ton during the three months ended June 30, 2012, a decrease of $73 per ton, or 12%, from $628 in the comparable period in 2011.
 
 In the third quarter of 2011, the Company modified steel bar production line to produce steel wires to adapt to the market demand. During three months ended June 30, 2012, the Company sold 70,936 metric tons of steel wires, which generated revenue of $42,007,530. There was no steel bar production in three months ended June 30, 2012. In the comparable period of 2011, the Company sold 1,653 metric tons of steel bars with revenue of $929,023.
 
 Revenue from steel billets was $0 in the three months ended June 30, 2012, compared to 66,066 metric tons and revenue of $38,942,893 in the comparable period of 2011. Steel billets are semi-finished products that can be used to produce steel plates, steel bars and steel wires with further processing, or sold directly on the market. The Company sold no steel billets in the three months ended June 30, 2012, which was mainly attributable to a relative low customer demand and down market condition.
 
 Byproducts consist of the reselling of offcuts of steel plates, steel drop and oxygen gas. Byproducts sales were $2,268,669 in the three months ended June 30, 2012, a decrease of $3,293,191, or 59%, compared to $5,561,860 in the comparable period of 2011. The Company does not sell its byproduct in its regular daily sales activities. The sales of byproducts depend on the market condition as byproducts may be reused as raw materials in our production.


Comparison of Cost of Revenue for the Three Months Ended June 30, 2012 and 2011





Costs of Revenue

2012


2011Steel plates

$
101,522,232


$
165,336,000Steel wires


39,060,294



-Steel bars


-



923,762Steel billets


-



36,130,271Others


532,943



-Total Cost of Revenue

$
141,115,469


$
202,390,033
  5
 Table of Contents
  Gross Profit Margin

2012


2011Steel plates


-0.22
%


3.52
%Steel wires


7.02
%


-Steel bars


-



0.57
%Steel billets


-



7.22
%Total Gross Profit Margin


3.06
%


6.65
%





Cost of revenue totaled $141,115,469 for the three months ended June 30, 2012, a decrease of $61,274,564, or 30% compared to $202,390,033 in the comparable period of 2011. Of the decreased cost of revenue, approximately $9 million or 15% of the decrease was due to the decrease in raw material prices. The remaining 85% of the decrease was due to a decrease in production quantities offset by the increase of cost of steel wires. Gross profit margin was 3.06% in the three months ended June 30, 2012, a decrease of 3.59 percentage points, compared to 6.65% in the same period of 2011. The decrease in gross profit margin resulted mainly from decreased sales price of steel products.
 
 The Company does not buy any commodity products to hedge the fluctuation of market price. However, the fluctuation of commodity prices will have a direct impact on our operation and operation results through the price changes in the local steel market. The average cost of revenue of steel plates was approximately $556 per ton in the three months ended June 30, 2012, a decrease of $50 per ton, or 8%, from $606 in the comparable period of 2011. The average cost of revenue of steel wires was approximately $551 per ton in the three months ended June 30, 2012. There was no sale of steel bars and steel billets during the three months ended June 30, 2012. In the comparable period of 2011, the average cost of revenue of steel billets was $547 per ton and the average costs of revenue of steel bars was $559 per ton. The Company actively manages the production volume and type of steel products manufactured to maximize net profit in response to the fluctuations in market conditions.
 
 Comparison of Operating Expenses for the Three Months Ended June 30, 2012 and 2011
 
 Selling, General and Administrative expenses consist of allowance for bad debts, selling expenses, professional service fees and other general and administrative expenses. Total operating expenses were $1,001,803 in the three months ended June 30, 2012, an increase of $372,964, or 59%, compared to $628,839 in the comparable period of 2011. Operating expenses – non related parties was $295,977 in the three months ended June 30, 2012, a decrease of $116,063, or 28%, compared to $412,040 in the comparable period of 2011. The decrease in operating expenses – non related parties was mainly attributable to $258,058 decrease in allowance for impairment of advance to suppliers, which was offset by $151,065 increase in allowance for doubtful accounts receivable. The Company made an allowance for potentially forfeited advances to suppliers based on aging commenced from the quarter ended March 31, 2012. The Company incurred $153,170 of professional service and consulting fees in the three months ended June 30, 2012, while such fees were $226,028 in the comparable period of 2011. The Company expects that professional service fees will increase as a result of the Company’s effort to be listed on the US security market.
 
 The operating expenses – related parties were $705,826 in the three months ended June 30, 2012, an increase of $489,027, or 226%, compared to $216,799 in the comparable period of 2011. The operating expenses – related parties represented service fees charged by YBS Group. YBS Group owns 70% of the equity interest of Hongri. It provides various services to its subsidiary companies, including market and industrial information, public relationship, various government agents’ relationship, coordination of recycling of byproducts among the subsidiaries and executive officers’ salaries. YBS group charged a service fee based on countable expenses and fixed service fees. Commencing in 2010, YBS Group charged a fixed service fee of 0.1% of Hongri’s revenue. Service fees consisted of management salaries, trainings, consultations, common area charges and other fees. The management believes that 0.1% of revenue is a reasonable fixed service fee charge and the Company estimates that the service fee would be similar or marginally higher if the services had been provided by third parties. In addition to the fixed service fee, YBS Group will charge itemized services and expenses to the Company if such services are provided and such expenses are incurred. Of the service fees charged for the quarter ended June 30, 2012, $560,254 was an itemized charge in connection with the refinancing of the RMB 180 million loan from Raiffeisen Bank. Executive officers’ salaries were stand-alone expenses. Such expenses were $15,741 and $15,378 for the three months ended June 30, 2012 and 2011, respectively.


6
 Table of Contents





Comparison of Other Expenses for the Three Months Ended June 30, 2012 and 2011
 
 Other expenses consist of interest expense and interest income. Total net other expenses were $1,242,578 in the three months ended June 30, 2012, compared to $1,249,977 in the comparable period of 2011. Interest expense for bank and private borrowings was $921,177 and $124,846 in the three months ended June 30, 2012 and 2011, respectively. The increase of interest expense for bank borrowings mainly resulted from the increase in short-term bank and private loan borrowings and the increase in interest rate. Other interest expense in connection with the related party loans was $323,521 and $1,133,459 in the three months ended June 30, 2012 and 2011, respectively. The decrease in interest expense – related parties resulted from repayments of equipment loans – related parties in the quarter ended June 30, 2012.
 
 Comparison of Income Tax for the Three Months Ended June 30, 2012 and 2011
 
 The income tax of $364,002 and $1,826,243 for the three months ended June 30, 2012 and 2011, respectively arose from foreign income tax incurred and/or paid to the Chinese tax authority. Hongri is subject to a 25% PRC  standard enterprise income tax. Hongri applied for foreign investment enterprise exemption, and the application was approved by the local tax authority in 2007. Hongri was entitled to a tax holiday of full (100%) income tax exemption starting from the first profitable year of 2008 through 2009 and then a 50% reduction in income tax for additional three (3) years commencing 2010. The reduced income tax rate is 12.5% for the years ended December 31, 2010, 2011 and 2012.
 
 Comparison of Net Income for the Three Months Ended June 30, 2012 and 2011
 
 Net income totaled $1,848,517 in the three months ended June 30, 2012, a decrease of $8,855,692, or 83%, compared to the net income of $10,704,209 in the comparable period of 2011. The decrease of net income was attributable primarily to a decrease in revenue, gross profit margin and an increase in selling, general and administrative expenses as discussed above.


Results of Operations for the Six Months Ended June 30, 2012 and 2011





Comparison of Revenue for the Six Months Ended June 30, 2012 and 2011





2012


2011Products

Revenue


Quantity (Ton)


Revenue


Quantity (Ton)Steel plates

$
165,592,905



296,376


$
297,463,702



481,734Steel wires


104,954,351



181,571



-



-Steel bars


-



-



929,023



1,653Steel billets


47,067,680



85,602



96,141,828



166,355Byproducts


4,986,081



-



9,789,564



-Products Total

$
322,601,017



563,549


$
404,324,117



649,742


Total sales for the six months ended June 30, 2012 were $322,601,017, a decrease of $81,723,100, or 20%, compared to $404,324,117 in 2011. Approximately $19.8 million, or 24% of the decrease was due to a decrease in average sales price and 76% was due to a decrease in quantity sold, offset by new steel wire product.
 
 Revenue from steel plates was $165,592,905 in the six months ended June 30, 2012, a decrease of $131,870,797, or 44% compared to $171,365,525 in the comparable period in 2011. The Company sold 296,376 tons of steel plates in the six months ended June 30, 2012, a decrease of 185,358 tons or 38%, compared to 481,734 tons in the comparable period of 2011. The Company reduced its production of steel plates in the six months ended June 30, 2012 due to lack of market demand. The average unit sales price of steel plates was approximately $559 per ton during the six months ended June 30, 2012, a decrease of $59 per ton, or 10%, from $617 in the comparable period in 2011.


7
 Table of Contents





In the third quarter of 2011, the Company modified steel bar production line to produce steel wires to adapt to the market demand. During the six months ended June 30, 2012, the Company sold 181,571 metric tons of steel wire, which generated revenue of $104,954,351. There was no steel bar production in the six months ended June 30, 2012. In the comparable period of 2011, the Company sold 1,653 metric tons of steel bars which generated revenue of $929,023.
 
 Revenue from steel billets was $47,067,680 in the six months ended June 30, 2012, a decrease of 49,074,148, or 51%, compared to $96,141,828 in the comparable period of 2011. The Company sold 85,602 metric tons of steel billets in the six months ended June 30, 2012, a decrease of 80,753 tons, or 49%, compared to 166,355 metric tons in the comparable period of 2011. Steel billets are semi-finished products that can be used to produce steel plates, steel bars and steel wires with further processing, or sold directly in the market. The Company sold less steel billets in the six months ended June 30, 2012, which was mainly attributable to a relative lower customer demand and down market condition.
 
 Byproducts consist of the reselling of offcuts of steel plates, steel drop and oxygen gas. Byproducts sales were $4,986,081 in the six months ended June 30, 2012, a decrease of $4,803,483, or 49%, compared to $9,789,564 in the comparable period of 2011. The Company does not sell its byproducts in its regular daily sales activities. The sales of byproducts depend on the market condition as byproducts may be reused as raw materials in our production.


Comparison of Cost of Revenue for the Six Months Ended June 30, 2012 and 2011




Costs of Revenue

2012


2011Steel plates

$
167,211,256


$
289,034,679Steel wires


98,669,634



-Steel bars


-



923,762Steel billets


42,308,554



89,529,865Others


1,130,590



-Total Cost of Revenue

$
309,320,034


$
379,488,306
  Gross Profit Margin


2012



2011Steel plates


-0.98
%


2.83
%Steel wires


5.99
%


-Steel bars


-



0.57
%Steel billets


10.11
%


6.88
%Total Gross Profit Margin


4.12
%


6.14
%





Cost of revenue totaled $309,320,034 for the six months ended June 30, 2012, a decrease of $70,168,272, or 18% compared to $379,488,306 in the comparable period of 2011. Approximately $14 million or 20% of the decrease was due to the decrease in raw material prices. The remaining 80% of the decrease was due to a decrease in production quantities, offset by the increase of cost of steel wires. Gross profit margin was 4.12% in the six months ended June 30, 2012, a decrease of 2.02 percentage points, compared to 6.14% in the same period of 2011. The decrease in gross profit margin resulted mainly from decreased sales price of steel products.
 The Company does not buy any commodity products to hedge the fluctuation of market price. However, the fluctuation of commodity prices will have a direct impact on our operation and operation results through the price changes in the local steel market. The average cost of revenue of steel plates was approximately $549 per ton in the six months ended June 30, 2012, a decrease of $35 per ton, or 6%, from $684 in the comparable period of 2011. The average cost of revenue of steel billets was $494 per ton in the six months ended June 30, 2012, a decrease of $44, or 8%, from $538 in the comparable period of 2011. The average cost of revenue of steel wires was approximately $543 per ton in the six months ended June 30, 2012. There was no sale of steel bars during the six months ended June 30, 2012. In the comparable period of 2011, the average cost of revenue of steel bars was $559 per ton. The Company actively manages the production volume and type of steel products manufactured to maximize net profit in response to the fluctuations in market conditions.


8
 Table of Contents





Comparison of Operating Expenses for the Six Months Ended June 30, 2012 and 2011
 
 Selling, General and Administrative expenses consist of allowance for bad debts, selling expenses, professional service fees and other general and administrative expenses. Total operating expenses were $2,243,965 in the six months ended June 30, 2012, an increase of 981,229, or 78%, compared to $1,262,736 in the comparable period of 2011. Operating expenses – non related parties was $1,361,056 in the six months ended June 30, 2012, an increase of $501,769, or 58%, compared to $859,287 in the comparable period of 2011. The increase in operating expenses – non related parties was mainly attributable to $567,649 increase in allowance for impairment of advance to suppliers, which was offset by $194,601 decrease in allowance for doubtful accounts receivable. The Company made an allowance for potentially forfeited advances to suppliers based on aging commenced from 2012. The Company incurred $423,765 professional service and consulting fees in the six months ended June 30, 2012, such fees were $307,478 in the comparable period of 2011. The Company expects that professional service fees will increase continually as a result of the Company’s effort to be listed in the US security market.
 
 The operating expenses – related parties were $882,909 in the six months ended June 30, 2012, an increase of $479,460, or 119%, compared to $403,449 in the comparable period of 2011. The operating expenses – related parties represented service fees charged by YBS Group. YBS Group owns 70% of the equity interst of Hongri. It provides various services to its subsidiary companies, such as market and industrial information, public relationship, various government agents’ relationship, coordination of recycling of byproducts among the subsidiaries and executive officers’ salaries. YBS group charged a service fee based on countable expenses and fixed service fee. Commencing in 2010, YBS Group charged a fixed service fee of 0.1% of Hongri’s revenue. Service fees consisted of management salaries, trainings, consultations, common areas charges and other fees. The management believes that 0.1% of revenue is a reasonable fixed service fee. The Company estimated that service fee would be similar or marginally higher than current charged fees if the services had been provided by third parties. In addition to the fixed service fee, YBS Group will charge itemized services and expenses to the Company if such services are provided and such expenses are incurred. Of the service fees charged in the six months ended June 30, 2012, $560,254 was an itemized charge in connection with the refinancing of RMB 180 million loan from Raiffeisen Bank. Executive officers’ salaries were stand-alone expenses. Such expenses were $31,620 and $30,649 for the six months ended June 30, 2012 and 2011, respectively.
 
 Comparison of Other Expenses for the Six Months Ended June 30, 2012 and 2011
 
 Other expenses consist of interest expense and interest income. Total net other expenses were $3,098,065 in the six months ended June 30, 2012, compared to $2,764,828 in the comparable period of 2011. Interest expense for bank and private borrowings was $1,866,085, an increase of $1,291,489, or 225%, compared to $574,596 in the six months ended June 30, 2012 and 2011, respectively. The increase of interest expense for bank and private loan borrowings mainly resulted from the increase in short-term bank and private loan borrowings and in increase in interest rate. Other interest expense in connection with the related party loans was $1,286,589 and $2,198,775 in the six months ended June 30, 2012 and 2011, respectively. The decrease in interest expense – related parties resulted from repayments of equipment loans – related parties in 2012.
 
 Comparison of Income Tax for the Six Months Ended June 30, 2012 and 2011
 
 The provision for income tax of $1,384,392 and $2,971,264 for the six months ended June 30, 2012 and 2011, respectively and arose from foreign income tax incurred and/or paid to the Chinese tax authority. Hongri is subject to a 25% PRC standard enterprise income tax. Hongri applied for foreign investment enterprise exemption, and the application was approved by the local tax authority in 2007. Hongri was entitled to a tax holiday of full (100%) income tax exemption starting from the first profitable year of 2008 through 2009 and then a 50% reduction in income tax for additional six (3) years commencing 2010. The reduced income tax rate is 12.5% for the years ended December 31, 2010, 2011 and 2012.
 
 Comparison of Net Income for the Six Months Ended June 30, 2012 and 2011
 
 Net income totaled $6,554,561 in the six months ended June 30, 2012, a decrease of $11,282,422, or 63%, compared to the net income of $17,836,983 in the comparable period of 2011. The decrease of net income was attributable primarily to decrease in revenue, gross profit margin and an increase in selling, general and administrative expenses and interest expense as discussed above.




9
 Table of Contents





Liquidity and Capital Resources





The cash flow generated from our operations has been sufficient to support our daily operations currently. However, it may not be enough to support our operation in the future if weak market continues. The Company is facing rigorous challenges in the coming quarter and the remaining of 2012, including unfavorable steel industry cycles, unforeseeable recovery of world economy and uncertainty of political environment resulting from change of leadership in China. All those factors may have a negative impact on our operation results and cash flows. Management will continuously monitor these negative factors and to determine the production based on the demand of market, cash on hand and available credit facilitates. In addition, the Company plans to add a new production line to produce a coated steel product, known as Galvalume, which is primarily used in the automotive and home appliance industries. To implement this expansion strategy, it is estimated that the Company will need at least $80 million. Management believes that the Company’s available cash will not be sufficient to fund its expansion and therefore, will look for external sources such as debt or equity financings. However, there is no assurance that any such required funds from external sources will be available on attractive terms or that they will not have a significant dilutive effect on the Company’s existing stockholders. If such required funds from outside sources are limited, or not available, then the Company will adjust its expansion plan accordingly.
 Relevant PRC statutory laws and regulations restrict certain payments, such as dividends, loans or advances, from the Companies’ registered capital. Such restricted capital amounted to approximate $15,244,000 as of June 30, 2012. The Company is also required to allocate a portion of its after-tax profits to the statutory reserve. Annual appropriations to the statutory reserve are required to be at least 10% of the enterprise’s after-tax net income determined under Chinese GAAP. When the surplus reserves account balance is equal to or greater than 50% of the Company’s paid-in capital, no further allocation to the surplus reserve account is required. As of June 30, 2012, the Company’s reserved fund totaled $6,530,869. In addition, our ability to use revenue generated in RMB to fund any future business activities outside of China or to make dividend or other payments in U.S. dollars is limited due to the regulations of PRC’s currency exchange. We cannot be certain that the Chinese regulatory authorities will not impose more stringent restrictions on the convertibility of the RMB in the future.
 
 The Company currently intends to retain all earnings, if any, for use in its business operations. We have no plan to repurchase our common stock, or declare any dividends in the near future.
 
 The Company will have obligations to pay expenses in US dollars in connection with its status as a public company listed in the US security market, such as audit, legal, contracted CFO and other SEC filing related service fees. These service fees are usually wired to the Company’s US bank account or paid to vendors directly from China, which is allowed under the current PRC regulations. Other than these service fees, the Company has no significant obligations outside the PRC currently. The Company had cash of $226,961 and $1,737,495 as of June 30, 2012 and December 31, 2011, respectively. Most of the Company’s funds are kept in financial institutions in China, which do not provide insurance for deposits.
 
 It has been the intent of the management to accelerate repayments of equipment loans due to the related parties. During the six months ended June 30, 2012, the Company repaid $41,958,329 equipment loans to YBS group by offsetting its advances to related parties in the previous year. The Company repaid $16,513,794 equipment loans to Hongrong by offsetting its advances to related parties in the current year. The remaining equipment loan balance is $3,896,141.
 
 The Company’s advances to related parties were $118,087,616 as of June 30, 2012, an increase of $40,671,331, or 53%, compared to $77,416,285 as of December 31, 2011. The increase in advances to related parties resulted mainly from advance to Hongrong, the Company’s major molten iron supplier. The advance to Hongrong was $118,019,071 as of June 30, 2012; an increase of $61,678,103 compared $56,340,968 as of December 31, 2011. Most of these advances related to the purchase of raw materials and other supplies in routine business and were short term in nature. The balance of advances to Hongrong approximated 76 days of cost of production at the current production level. Hongrong has a new blast furnace ready for production when market demand is up. Therefore, the Company’s advances to Hongrong have been increased.


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The Company’s accounts payable was $90,138,703 at June 30, 2012, an increase of 67,042,876, compared $23,095,827 at December 31, 2011. The increase in accounts payable resulted mainly from increased payable balance to one new major iron pig supplier of the Company. The payable to such supplier amounted $67,366,645 and $0 at June 30, 2012 and December 31, 2011, respectively. Currently, the accounts payable balance is interest free and the Company has no specific terms of accounts payable with this vendor. The Company will pay this payable from cash generated from its operation, or through a debt financing, if needed after taking into consideration the impact of the advances to related parties, the advances from customers and current debt requirements.  We anticipate that the increase in our advanced payments to related parties, which are substantially used for future inventory procurement, will have the effect of reducing cash outflows for inventory purchases in the remaining of 2012.  Thus, a significant portion of the cash generated from revenue will be used substantially for operating expenses and reductions of operating liabilities.





Net cash provided by operating activities was $34,852,277 and $10,982,233 in the six months ended June 30, 2012 and 2011, respectively. The decrease in net cash provided by operating activities in 2012 was mainly due to the following facts: (i) a $11,282,422 decrease in net income ($6,554,561 in the six months ended June 30, 2012 and $17,836,983 in the six months ended June 30, 2011); (ii) a $10,604,240 positive change in accounts receivable ($8,715,479 decrease in accounts receivable in the six months ended June 30, 2012, $1,888,761 increase in accounts receivable in the six months ended June 30, 2011) resulted from more subsequent collections in 2012; (iii) a $6,592,987 positive change in accounts receivable from related parties ($0 in accounts receivable – related parties in the six months ended June 30, 2012, $6,592,987 increase in the six months ended June 30, 2011) resulted from no accounts receivable from related parties in the six months ended June 30, 2012; (iv) a $4,113,079 positive change in bank notes receivable ($1,629,647 decrease in the six months ended June 30, 2012 and $2,483,432 increase in the six months ended June 30, 2011) resulted from reduced amount of bank notes receivable in the six months ended June 30, 2012; (v) a $1,550,328 positive change in inventories ($2,196,447 decrease in inventories in the six months ended June 30, 2012 compared to $646,119 decrease in inventories in the six months ended June 30, 2011) resulted from the Company purchasing molten iron from Hongrong, a related party, beginning from February 2010 instead of outsourcing the production and consequently reduced related inventories; (vi) a $84,678,086 negative change in advances to related parties ($83,568,612 increase in advance to related parties in the six months ended June 30, 2012 and $1,109,474 decrease in advance to related parties in the six months ended June 30, 2011) resulted from the Company’s expectation for increasing demand of molten iron from Hongrong in the second half of 2012; (vii) a $68,740,621 positive change in accounts payable ($67,605,548 increase in accounts payable in the six months ended June 30, 2012 compared to $4,135,073 decrease in accounts payable in the six months ended June 30, 2011) resulted from the Company purchased 24% of its total purchase from a third party vendor, a pig iron suppler during the six months ended June 30, 2012; (viii) a $4,632,748 positive change in accounts payable to related parties ($244,946 increase in the six months ended June 30, 2012 compared to $4,387,802 decrease in the six months ended June 30, 2011) resulted from less accounts payables to related parties paid off in 2012 than in the six months ended June 30, 2011; (ix) a $1,714,886 positive change in accrued expenses ($214,459 decrease in the six months ended June 30, 2012 compared to $1,929,345 decrease in the six months ended June 30, 2011) resulted from more paid off and less accrued in 2011 than in the six months ended June 30, 2012; and (x) a $19,241,675 positive change in advances from customers ($17,293,865 increase in the six months ended June 30, 2012 compared to $1,947,810 increase in the six months ended June 30, 2011) resulted from more customer deposits in 2012.


Net cash used in investing activities was $8,442,814 and $11,517,158, respectively, in six months ended June 30, 2012 and 2011. Those expenditures were primarily related to the replacement, or modification of current production lines equipment.





Net cash used in financing activities was 27,902,367 in six months ended June 30, 2012. On June 28, 2011, Hongri entered into a revolving loan agreement (the “Agreement”) with Raiffeisen Bank International AG Beijing Branch (“Raiffeisen”). The Agreement provides for a revolving credit facility in an aggregate principal amount of RMB 180,000,000 which shall be used as working capital. On August 24, 2011, Hongri deposited RMB 15,000,000 ($2,320,500) into Raiffeisen to execute the revolving loan agreement, which was recorded as restricted cash. On August 31, 2011, the Company received the first borrowing RMB 180,000,000 ($28,479,600) which was due by February 27, 2012. From the beginning of February, 2012, the Company started to repay it and paid off all the balance as of February 24, 2012. Subsequent to the repayment, the Company acquired the second borrowing in the total amount of RMB 180,000,000 ($28,479,600) from Raiffeisen Bank and the second borrowing will be due by July 31, 2012. The Company repaid RMB 60,000,000 ($9,493,200) in June 2012. The remaining balance is repaid in July and August 2012. The Company repaid RMB 19,000,000 ($3,006,180) to Credit Union and acquired same amount $3,006,180 from Credit Union. The Company received a short term loan of RMB 9,000,000 ($1,423,980) from Credit Union and returned this short term loan in April 2012. During six months ended June 30, 2012, the Company repaid equipment loans of $16,513,794 to Hongrong. The Company received $2,667,589 short term loan from related parties and returned $3,616,909 to related parties. The Company made $1,898,640 deposit to bank as additional collateral for bank notes payable. The Company paid $297,351 to obligation under capital lease in 2012.





Net cash used in financing activities was $2,370,475 in six months ended June 30, 2011. During 2011, the Company received $1,209,310 proceeds from a related party, Mr. Binchang Liu, a senior manager of the Company. The borrowings from Mr. Liu are payable on demand and bear interest at 7% per annum. The Company also received $310,951 from private placement closed on January 28, 2011 (“PP1”) and private placement closed on February 7, 2011 (“PP2”). The Company paid $2,908,466 deposit to a bank as collateral to bank notes payable. The Company also repaid $714,782 employee loan and $267,488 to obligation under capital lease – related parties.




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Short-term Borrowings





Bank and Private Loan Payable





Bank and private loans at June 30, 2012 and December 31, 2011 consisted of the following:





2012


2011To Credit UnionInterest at 6.10%, payable March 29, 2012
(a)

$
-


$
3,019,100Interest at 13.12%, payable  September 19, 2012
(b)


2,990,790



3,019,100Interest at 7.93%, payable September 25, 2012
(c)


2,990,790



-To Raiffeisen Bank International AG Beijing BranchInterest at 7.93%, due by February 27, 2012
(e)


-



28,602,000Interest at 8.78%, due varied from July to August, 2012
(f)


18,889,200



-To a Private LoanInterest at 10.50%, payable January 10, 2013
(d)


1,243,539



-Total Short Term Bank Loans


$
26,114,319


$
34,640,200


(a)
On September 30, 2011, the Company received a RMB 19,000,000 ($3,019,100) short-term borrowing from Credit Union. The loan was a “working capital” loan that bears interest at 6.10% per annum and was repaid on March 23, 2012.





(b)
On September 22, 2011, the Company received a RMB 19,000,000 ($2,990,790, translated at June 30, 2012 exchange rate and $3,019,100 translated at December 31, 2011 exchange rate) short-term borrowing from Credit Union. The loan is a “working capital” loan that bears interest at 13.12% per annum and is due on September 19, 2012. The loan is secured by the equipment of Hongrong, a related party.





(c)
On March 26, 2012, the Company received a RMB 19,000,000 ($2,990,790) short-term borrowing from Credit Union. The loan is a “working capital” loan that bears interest at 7.93% per annum and is due on September 25, 2012. The loan is secured by the equipment of Hongri.





Total value of equipment secured for above mentioned bank loans is RMB 70,967,104 ($11,170,932).





(d)
On January 20, 2012, the Company received a RMB 7,900,000 ($1,243,539) short-term borrowing from a private lender. The loan bore interest of 10.50% per annum and is due on January 10, 2013.





(e)
On June 28, 2011, Hongri entered into a revolving loan agreement (the “Agreement”) with Raiffeisen Bank International AG Beijing Branch (“Raiffeisen”). The Agreement provides for a revolving credit facility in an aggregate principal amount of   RMB 180,000,000 (approximately $28,602,000 translated at the rate of December 31, 2011) which used as working capital. Each borrowing could not exceed 180 days or days the Bank agreed during the Agreement period.





(f)
On August 24, 2011, Hongri deposited RMB 15,000,000 ($2,361,150) into Raiffeisen to execute the revolving loan agreement, which was recorded as restricted cash. On August 31, 2011, the Company received the first borrowing RMB 180,000,000 ($28,602,000) which was due by February 27, 2012. The Company repaid its outstanding balance as of February 24, 2012.  Upon the repayments, the Company acquired the second borrowing in the total amount of RMB 180,000,000 from Raiffeisen Bank. The second borrowing was due varied from July to August, 2012. On June 27, 2012, the Company repaid RMB 60,000,000 ($9,444,600, translated at the rate of June 30, 2012). The remaining balance of RMB 120,000,000 ($18,889,200) has been fully repaid as of August 9, 2012 (RMB 50,000,000 repaid in July and RMB 70,000,000 repaid in up through August 9).




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Pursuant to the Agreement, borrowings will bear interest at 130% of the benchmark rates of similar loans published by the People’s Bank of China. Based on the current benchmark interest rate for a six months loan, the first borrowing bears the interest of 7.93% and the second borrowing bears the interest of 8.78%.  The interest is calculated on the daily basis and shall be paid on the 20th of the last month of each quarter. The borrowings are secured substantially by the following: (i) all machineries and equipment of Hongri; (ii) inventories of  Hongri and Hongrong with a value of not less than RMB 75,000,000 (approximately $11,805,750); (iii) a security deposit of RMB 15,000,000 (approximately $2,361,150) into the Raiffeisen bank as a collateral; (iv) corporate guaranty from Hebei Wu’an Yuanbaoshan Industry Group Co., Ltd. (“YBS group”), a majority shareholder of Hongri; and (v) personal guaranty from Mr. Beifang Liu, Chairman of YBS group and Mr. Shenghong Liu, Chairman and Chief Executive Officer of the Company.
 
 Short Term Loan Payable – Related Party
 
 During 2011, the Company borrowed RMB 11,000,000 from a related party, Mr. Maisheng Liu, a senior manager of the Company. During the six months ended June 30, 2012, the Company borrowed additional RMB 11,860,000 ($1,876,489) from Mr. Maisheng Liu and returned an aggregate amount of RMB 22,860,000 ($3,616,909) to Mr. Liu.
 
 On June 28, 2012, the Company borrowed RMB 1,000,000 ($157,410) from Mr. Beifang Liu, director of the Company, and RMB 4,000,000 ($629,640) from Mr. Maisheng Liu, brother of the CEO of the Company. These payables were interest free and due on demand.
 
 The weighted average short term loan balance consisting of financial institution and private loans and the loans from Binchang Liu, Beifang Liu and Maisheng Liu was $18,174,535 and $4,776,468 as of June 30, 2012 and 2011, respectively. The weighted average interest rate for short term loan was 8.81% and 8.29% for the six months ended June 30, 2012 and 2011, respectively.


Critical Accounting Policies and Estimates





In Note 2 to the audited consolidated financial statements for the years ended December 31, 2011 and 2010 included in the Form 10K filed on March 29, 2012, the Company discusses those accounting policies that are considered to be significant in determining the results of operations and its financial position. The Company believes that the accounting principles utilized by it conform to accounting principles generally accepted in the United States of America (U.S. GAAP).





Off-Balance Sheet Arrangements





The Company has not entered into any off-balance sheet financing arrangements and has not established any special purpose entities. The Company has not guaranteed any debt or commitments of other entities or entered into any options on non-financial assets.





Contractual Obligations





As of June 30, 2012, our significant contractual obligations were as follows:





Less than

One Year


One to

Three Years


Three to

Five Years


More Than

Five Years


TotalEquipment loans

$
3,896,141


$
-


$
-


$
-


$
3,896,141Capital Leases


614,009



1,370,767



1,586,035



2,921,320



6,492,131Interest on Capital Leases


493,110



843,471



628,203



2,420,800



4,385,584Interest on Equipment loans


194,807



-



-



-



194,807$
5,198,067


$
2,214,238


$
2,214,238


$
5,342,120


$
14,968,663




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ITEM3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.





Foreign Exchange Risk





While our reporting currency is the US dollar, almost all of our consolidated revenues and consolidated costs and expenses are denominated in RMB. All of our assets are denominated in RMB except for some cash and cash equivalents and accounts receivables. As a result, we are exposed to foreign exchange risk as our revenues and results of operations may be affected by fluctuations in the exchange rate between US dollar and RMB. If the RMB depreciates against the US dollar, the value of our RMB revenues, net income and assets as expressed in our US dollar financial statements will decline.  If the RMB appreciates against the US dollar, the value of our RMB revenues, net income and assets as expressed in US dollars will increase. We have not entered into any hedging transactions in an effort to reduce our exposure to foreign exchange risk.





Inflation Risk





According to the National Bureau of Statistics of China, the change in Consumer Price Index in China was -0.7%, 3.3% and 5.4% in 2009, 2010 and 2011 respectively. In recent years, the PRC has not experienced significant inflation, and thus inflation has not had a material impact on our results of operations. Although we are generally able to pass along minor incremental cost inflation to our customers, a high rate of inflation in the future may have an adverse effect on our ability to maintain current levels of gross margin and selling and distribution, general and administrative expenses as a percentage of net revenues if the sales prices of our products do not increase to cope with these increased costs.





Higher Interest Rate Risk





The Company may borrow more loans from bank in addition to other source of fund to support its expansion. We are exposed to higher interest rate risk arising from short-term borrowings. The interest rate in China is higher than that of in the US. The interest rate may go higher under the pressure of inflation. Our future interest expense will fluctuate in line with changes of borrowing rates.





ITEM4. CONTROLS AND PROCEDURES.





Disclosure Controls and Procedures





As required by paragraph (b) of Rules 13a-15 or 15d-15 under the Exchange Act, our management, with the participation of our principal executive and principal financial officer evaluated our company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act) as of the end of the period covered by this report on Form 10-Q. Disclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in our company's reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission's rules and forms. Disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed in our company's reports filed under the Exchange Act is accumulated and communicated to our principal executive officer and our principal accounting officer, as appropriate, to allow timely decisions regarding required disclosure. Based on their evaluation, management concluded that as of the period covered by this quarterly report on Form 10-Q, these disclosure controls and procedures were not effective.




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Plan for Remediation of Material Weaknesses





As financial conditions permit, we plan to take the following actions to improve our internal control over financial reporting, including actions to remediate those material weaknesses identified.





1.
Recruit qualified staff for internal control positions and develop a suitable internal control system. to provide effective oversight of our internal control over financial reporting.





2.
Conduct an equity level risk assessment by the end of this year.





3.
Look to engage the services of qualified consultants with China GAAP, U.S. GAAP and SEC reporting experience to support our financial reporting and SOX compliance requirements, including assistance with the following:





o
Remediating identified material weaknesses;





o
Monitoring our internal control over financial reporting on an ongoing basis;





o
Managing our period-end financial closing and reporting processes; and





o
Identifying and resolving non-routine or complex accounting matters.





Our management will continue to monitor and evaluate the effectiveness of its disclosure controls and procedures, as well as its internal control over financial reporting, on an ongoing basis, and is committed to taking further action and implementing additional improvements, as necessary and as funds allow.  However, our management cannot guarantee that the measures taken or any future measures will remediate the material weaknesses identified or that any additional material weaknesses or significant deficiencies will not arise in the future due to a failure to implement and maintain adequate internal control.





Changes in Internal Control over Financial Reporting





During the period ended June 30, 2012, there were no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect our internal control over financial reporting.





Certifications





Certifications with respect to disclosure controls and procedures and internal control over financial reporting under Rules 13a-14(a) or 15d-14(a) of the Exchange Act are attached to this quarterly report on Form 10-Q.





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PART II – OTHER INFORMATION








ITEM 1. LEGAL PROCEEDINGS.





None.





ITEM1A. RISK FACTORS.





Information about risk factors for the three months ended June 30, 2012, does not differ materially from that set forth in Part I, Item 1A of the Company’s 2011 Annual Report on Form 10-K.





ITEM2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.





None.





ITEM3. DEFAULTS UPON SENIOR SECURITIES.





None.





ITEM4. MINE SAFETY DISCLOSURES





Not applicable.





ITEM5. OTHER INFORMATION.





None.




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ITEM6. EXHIBITS.





Exhibits required by Item 601 of Regulation S-K:





Exhibit Index





3.1
Articles of Incorporation filed with the Secretary of State of the State of Maryland on January 27, 2010 (1)3.2
Bylaws of the Company (3)10.1
Financial Advisory Agreement, dated 8, 2008, entered into between the Company and Friedland Capital Inc. (2)10.2
Entrusted Management Agreement, by and among Fakei, YBS Group, Hongri Metallurgy and Nuosen (1)10.3
Exclusive Option Agreement, by and among Nuosen, Fakei, YBS Group and Hongri Metallurgy (2)10.4
Covenant Letter (2)10.5
Call Option Agreement (2)10.6
Molten Iron Purchase Contract (1)21.1
List of subsidiaries (1)31.1
Certification of the Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002*31.2
Certification of the Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002*32.1
Certification of the Principal Executive Officer pursuant to U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002*32.2
Certification of the Principal Financial Officer pursuant to U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002*101.INS
XBRL Instance Document**101.SCH
XBRL Taxonomy Extension Schema**101.CAL
XBRL Taxonomy Extension Calculation Linkbase**101.DEF
XBRL Taxonomy Extension Definition Linkbase**101.LAB
XBRL Taxonomy Extension Label Linkbase**101.PRE
XBRL Extension Presentation Linkbase**





(1)  Previously filed with the Registration Statement on Form S-1 (File No. 333-172135) filed with the Securities and Exchange Commission on February 9, 2011 and incorporated by reference herein.


(2)  Previously filed with the Registration Statement on Form S-1/A filed with the Securities and Exchange Commission on May 6, 2011, and incorporated by reference herein.


(3)  Previously filed with the Registration Statement on Form S-1/A filed with the Securities and Exchange Commission on September 22, 2011, and incorporated by reference herein.





* Filed herewith.





** Pursuant to Rule 405(a)(2) of Regulation S-T, the registrant is relying upon the applicable 30-day grace period for the initial filing of its first Interactive Data File required to contain detail-tagged footnotes or schedules. The registrant intends to file the required detail-tagged footnotes or schedules by the filing of an amendment to this Quarterly Report on Form 10-Q within the 30-day period.


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SIGNATURES





Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its In accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.





CHINA INDUSTRIAL STEEL INC.Dated:  August 14, 2012
By:
/s/ Liu ShenghongLiu ShenghongChief Executive Officer and Chairman(Chief Executive Officer)By:
/s/ Xiaolong ZhouXiaolong ZhouChief Financial Officer(Principal Accounting and Financial Officer)





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