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GURE > SEC Filings for GURE > Form 10-Q on 8-Nov-2012All Recent SEC Filings

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Form 10-Q for GULF RESOURCES, INC.


8-Nov-2012

Quarterly Report


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

Cautionary Note Regarding Forward-Looking Statements

The discussion below contains "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act, and Section 21E of the Exchange Act. We have used words such as "believes," "intends," "anticipates," "expects" and similar expressions to identify forward-looking statements. These statements are based on information currently available to us and are subject to a number of risks and uncertainties that may cause our actual results of operations, financial condition, cash flows, performance, business prospects and opportunities and the timing of certain events to differ materially from those expressed in, or implied by, these statements. These risks, uncertainties and other factors include, without limitation, those matters discussed in Item 1A of Part I of our 2011 Form 10-K. Except as expressly required by the federal securities laws, we undertake no obligation to update such factors or to publicly announce the results of any of the forward-looking statements contained herein to reflect future events, developments, or changed circumstances, or for any other reason. The following discussion should be read in conjunction with our consolidated financial statements and notes thereto appearing in our 2011 Form 10-K and Item 1A, "Risk Factors" for the year ended December 31, 2011.

Overview

Gulf Resources conducts operations through its two wholly-owned China subsidiaries, SCHC and SYCI. Our business is also reported in these three segments, Bromine, Crude Salt, and Chemical Products.

Through SCHC, we produce and sell bromine and crude salt. We are one of the largest producers of bromine in China, as measured by production output. Elemental bromine is used to manufacture a wide variety of brominated compounds used in industry and agriculture. Bromine is commonly used in brominated flame retardants, fumigants, water purification compounds, dyes, medicines, and disinfectants.

Through SYCI, we manufacture and sell chemical products that are used in oil and gas field exploration, oil and gas distribution, oil field drilling, wastewater processing, papermaking chemical agents and inorganic chemicals.

Our Corporate History

We were incorporated in Delaware on February 28, 1989. From November 1993 through August 2006, we were engaged in the business of owning, leasing and operating coin and debit card pay-per copy photocopy machines, fax machines, microfilm reader-printers and accessory equipment under the name "Diversifax, Inc.". Due to the increased use of internet services, demand for our services declined sharply, and in August 2006, our Board of Directors decided to discontinue our operations.

Upper Class Group Limited, incorporated in the British Virgin Islands in July 2006, acquired all the outstanding stock of SCHC, a company incorporated in Shouguang City, Shandong Province, PRC, in May 2005. At the time of the acquisition, members of the family of Mr. Ming Yang, our president and former chief executive officer, owned approximately 63.20% of the outstanding shares of Upper Class Group Limited. Since the ownership of Upper Class Group Limited and SCHC was then substantially the same, the acquisition was accounted for as a transaction between entities under common control, whereby Upper Class Group Limited recognized the assets and liabilities transferred at their carrying amounts.

On December 12, 2006, we, then known as Diversifax, Inc., a public "shell" company, acquired Upper Class Group Limited and SCHC. Under the terms of the agreement, the stockholders of Upper Class Group Limited received 13,250,000 (restated for the 2-for-1 stock split in 2007 and the 1-for-4 stock split in 2009) shares of voting common stock of Gulf Resources, Inc. in exchange for all outstanding shares of Upper Class Group Limited. Members of the Yang family received approximately 62% of our common stock as a result of the acquisition. Under accounting principles generally accepted in the United States, the share exchange is considered to be a capital transaction rather than a business combination. That is, the share exchange is equivalent to the issuance of stock by Upper Class Group Limited for the net assets of Gulf Resources, Inc., accompanied by a recapitalization, and is accounted for as a change in capital structure. Accordingly, the accounting for the share exchange is identical to that resulting from a reverse acquisition, except no goodwill is recorded. Under reverse takeover accounting, the post reverse acquisition comparative historical financial statements of the legal acquirer, Gulf Resources, Inc., are those of the legal acquiree, Upper Class Group Limited. Share and per share amounts stated have been retroactively adjusted to reflect the share exchange. On February 20, 2007, we changed our corporate name to Gulf Resources, Inc.

On February 5, 2007, we acquired SYCI, a company incorporated in PRC, in October 2000. Under the terms of the acquisition agreement, the stockholders of SYCI received a total of 8,094,059 (restated for the 2-for-1 stock split in 2007 and the 1-for-4 stock split in 2009) shares of common stock of Gulf Resources, Inc. in exchange for all outstanding shares of SYCI's common stock. Simultaneously with the completion of the acquisition, a dividend of $2,550,000 was paid to the former stockholders of SYCI. At the time of the acquisition, approximately 49.1% of the outstanding shares of SYCI were owned by Ms. Yu, Mr. Yang's wife, and the remaining 50.9% of the outstanding shares of SYCI were owned by SCHC, all of whose outstanding shares were owned by Mr. Yang and his wife. Since the ownership of Gulf Resources, Inc. and SYCI are substantially the same, the acquisition was accounted for as a transaction between entities under common control, whereby Gulf Resources, Inc. recognized the assets and liabilities of SYCI at their carrying amounts. Share and per share amounts have been retroactively adjusted to reflect the acquisition.

To satisfy certain ministerial requirements necessary to confirm certain government approvals required in connection with the acquisition of SCHC by Upper Class Group Limited, all of the equity interest of SCHC were transferred to a newly formed Hong Kong corporation named Hong Kong Jiaxing Industrial Limited ("Hong Kong Jiaxing") all of the outstanding shares of which are owned by Upper Class Group Limited. The transfer of all of the equity interest of SCHC to Hong Kong Jiaxing received approval from the local State Administration of Industry and Commerce on December 10, 2007.

As a result of the transactions described above, our corporate structure is linear. That is Gulf Resources owns 100% of the outstanding shares of Upper Class Group Limited, which owns 100% of the outstanding shares of Hong Kong Jiaxing, which owns 100% of the outstanding shares of SCHC, which owns 100% of the outstanding shares of SYCI.

On October 12, 2009 we completed a 1-for-4 reverse stock split of our common stock, such that for each four shares outstanding prior to the stock split there was one share outstanding after the reverse stock split. All shares of common stock referenced in this report have been adjusted to reflect the stock split figures. On October 27, 2009 our shares began trading on the NASDAQ Global Select Market under the ticker symbol "GFRE" and on June 30, 2011 we changed our ticker symbol to "GURE" to better reflection of our corporate name.

Our current corporate structure chart is set forth in the following diagram:

[[Image Removed]]

As a result of our acquisitions of SCHC and SYCI, our historical financial statements and the information presented below reflects the accounts of SCHC and SYCI. The following discussion should be read in conjunction with our consolidated financial statements and notes thereto appearing elsewhere in this report.

RESULTS OF OPERATIONS

The following table presents certain information derived from the consolidated statements of operations, cash flows and stockholders equity for the three-month and nine-month periods ended September 30, 2012 and 2011.

Comparison of the Three-Month Periods Ended September 30, 2012 and 2011



                                                      Three-Month              Three-Month
                                                      Period Ended             Period Ended
                                                   September 30, 2012       September 30, 2011       % Change
Net revenue                                       $         24,530,332     $         37,761,975             (35 )%
Cost of net revenue                               $        (17,099,890 )   $        (23,823,944 )           (28 )%
Gross profit                                      $          7,430,442     $         13,938,031             (47 )%
Sales, marketing and other operating expenses     $            (20,327 )   $            (20,116 )             1 %
Research and development costs                    $            (28,478 )   $            (33,565 )           (15 )%
Exploration cost                                  $                  -     $         (1,047,110 )          (100 )%
Write-off/Impairment on property, plant and
equipment                                         $           (130,143 )   $                  -               -
General and administrative expenses               $         (2,336,581 )   $         (5,459,069 )           (57 )%
Other operating income                            $            713,968     $          1,368,074             (48 )%
Income from operations                            $          5,628,881     $          8,746,245             (36 )%
Other income, net                                 $             13,661     $             17,647             (23 )%
Income before taxes                               $          5,642,542     $          8,763,892             (36 )%
Income taxes                                      $         (1,529,326 )   $         (3,179,546 )           (52 )%
Net income                                        $          4,113,216     $          5,584,346             (26 )%

Net revenue. Net revenue was $24,530,332 for three-month period ended September 30, 2012, a decrease of approximately $13.2 million (or 35%) as compared to the same period in 2011. This decrease was primarily attributable to the reduction of overall demand for all of our segment products, specifically, (i) revenue from the bromine segment decreased from $24,820,194 for the three-month period ended September 30, 2011 to $13,960,118 for the same period in 2012, a decrease of approximately 44%; (ii) revenue from the crude salt segment decreased from $2,455,307 for the three-month period ended September 30, 2011 to $2,360,905 for the same period in 2012, a decrease of approximately 4%; and (iii) revenue from the chemical products segment decreased from $10,486,474 for the three-month period ended September 30, 2011 to $8,209,309 for the same period in 2012, a decrease of approximately 22%.

                                                         Net Revenue by Segment
                                    Three-Month Period Ended                 Three-Month Period Ended           Percent Decrease
                                       September 30, 2012                       September 30, 2011               of Net Revenue
Segment                                                % of total                               % of total
Bromine                       $       13,960,118                57 %   $       24,820,194                66 %                 (44 )%
Crude Salt                    $        2,360,905                10 %   $        2,455,307                 6 %                  (4 )%
Chemical Products             $        8,209,309                33 %   $       10,486,474                28 %                 (22 )%
Total sales                   $       24,530,332               100 %   $       37,761,975               100 %                 (35 )%




Bromine and crude salt segments                                          Three-Month Period Ended                  Percentage Change
product sold in tonnes                                         September 30, 2012         September 30, 2011      Increase/(Decrease)
Bromine (excluded volume sold to SYCI)                                       4,815                      6,900                      (30 )%
Crude Salt                                                                  62,568                     66,014                       (5 )%




                                                     Three-Month Period Ended                  Percentage Change
Chemical products segment sold in tones    September 30, 2012         September 30, 2011      Increase/(Decrease)
Oil and gas exploration additives                        2,502                      3,890                      (36 )%
Paper manufacturing additives                              772                      1,075                      (28 )%
Pesticides manufacturing additives                         724                        610                       19 %
Wastewater treatment chemical additives                      -                          5                     (100 )%
Overall                                                  3,998                      5,580                      (28 )%

Bromine segment

The table below shows the changes in the average selling price and changes in the sales volume of bromine for three-month period ended September 30, 2012 from the same period in 2011.

                                                                   Three-Month Period
                                                                   Ended September 30,
Increase / (Decrease) in net revenue of bromine as a result of:       2012 vs. 2011
Decrease in average selling price                                 $          (4,085,582 )
Decrease in sales volume                                          $          (6,774,494 )
Total effect on net revenue of bromine                            $         (10,860,076 )

The decrease in net revenue from our bromine segment was mainly due to the decrease in both the sales volume and selling price of bromine. The sales volume of bromine decreased from 6,900 tonnes for the three-month period ended September 30, 2011 to 4,815 tonnes for the same period in 2012, a decrease of 30%. The major reason for the decrease in the sales volume of bromine was mainly attributable to the drop in overall demand for bromine as a result of the recent macro-economic tightening policy imposed by the PRC government beginning in the second half of 2011 to slow down the economy, which has affected our customers' industries.

Due to the drop in demand of bromine, since the second half of 2011, we needed to offer competitive selling prices to our customers to compete with other bromine manufacturers. The average selling price of bromine decreased from $3,597 per tonne for the three-month period ended September 30, 2011 to $2,900 per tonne for the same period in 2012, a decrease of 19%. The average selling price for this quarter further reduced by 17% as compared with the three-month period ended June 30, 2012 ($3,486 per tonne) in order to maintain the existing customers and sales level. We expect the average selling price of bromine will remain at current levels through the end of 2012 should the PRC government's macro-economic tightening policy remain in place.

Crude salt segment

The table below shows the changes in the average selling price and changes in the sales volume of crude salt for three-month period ended September 30, 2012 from the same period in 2011.

                                                                      Three-Month Period
                                                                      Ended September 30,
Increase / (Decrease) in net revenue of crude salt as a result of:       2012 vs. 2011
Increase in average selling price                                    $              34,687
Decrease in sales volume                                             $            (129,089 )
Total effect on net revenue of crude salt                            $             (94,402 )

The decrease in net revenue from our crude salt segment was mainly due to the decrease in sales volume of crude salt. The sales volume of crude salt decreased by 5% from 66,014 tonnes for the three-month period ended September 30, 2011 to 62,568 tonnes for the same period in 2012. Similar to the bromine segment, the decrease in the sales volume was a result of the macro-economic tightening policy imposed by the PRC government beginning in the second half of 2011 to slow down the economy. This policy resulted in, among other things, the decrease in the demand for crude salt for downstream production of chlorine alkali and use in chemical, food and beverage industries.

The average selling price of crude salt slightly increased from $37.19 per tonne for the three-month period ended September 30, 2011 to $37.73 per tonne for the same period in 2012, an increase of 1%. Despite the competitive selling prices we offered to our customers to compete with other crude salt manufacturers since the first quarter of 2011, the average selling prices maintained at $37 to $38 per tonne since the third quarter of 2011 as crude salt is a basic and elementary material for chemical industry with stable demand.

Chemical products segment

                                                 Product Mix of Chemical Products Segment                           Percent
                                     Three-Month Period Ended                 Three-Month Period Ended             Change of
                                        September 30, 2012                       September 30, 2011               Net Revenue
Chemical Products                                       % of total                               % of total
Oil and gas exploration
additives                      $       4,531,296                 55 %   $        6,589,900                63 %             (31 )%
Paper manufacturing
additives                      $         843,854                 10 %   $        1,402,234                13 %             (40 )%
Pesticides manufacturing
additives                      $       2,834,159                 35 %   $        2,478,345                24 %              14 %
Wastewater treatment
chemical additives                             -                  -                 15,995                 0 %            (100 )%
Total sales                    $       8,209,309                100 %   $       10,486,474               100 %             (22 )%

Net revenue from our chemical products segment decreased from $10,486,474 for the three-month period ended September 30, 2011 to $8,209,309 for the same period in 2012, a decrease of approximately 22%. The decrease was mainly attributable to the drop in demand for our oil and gas exploration additives and paper manufacturing additives. Our oil and gas exploration chemicals are the most popular products within the chemical products segment, which contributed $4,531,296 (or 55%) and $6,589,900 (or 63%) of our chemical segment revenue for the three-month periods ended September 30, 2012 and 2011, respectively, with a decrease of $2,058,604, or 31%. Net revenue from our paper manufacturing additives decreased from $1,402,234 for the three-month period ended September 30, 2011 to $843,854 for the same period in 2012, a decrease of approximately 40%. We believe that as result of the recent macro-economic tightening policy imposed by the PRC government to slow down the economy, the overall demand for chemical products was reduced, which resulted in a decrease in our volume of both oil and gas exploration additives and paper manufacturing additives sold, which decreased by 36% and 28%, respectively, for the three-month period ended September 30, 2012 as compared with the same period in 2011.

However, the effect of the decrease in sales volume was partially offset by the increase in sales volume of pesticides manufacturing additives, which increased by 19% for the three-month period ended September 30, 2012 as compared with the same period in 2011. Such increase in sales volume was mainly attributable to
(1) the PRC government continued to support expansion of agricultural related products, which supported the growth in sales of our pesticides manufacturing additives; and (2) we stopped production of our wastewater treatment chemical additives and in July 2011 we successfully converted the production equipment to pharmaceutical and agricultural chemical additives which contributed additional capacity.

The overall effect of the decrease in net revenue from our chemical products segment was also partially offset by the increase in the average selling price of our oil and gas exploration additives due to the continuing high price levels of oil. The average selling price per tonne for our oil and gas exploration additives increased by 7% for the three-month period ended September 30, 2012 as compared with the same period in 2011. The selling prices of the paper manufacturing additives and pesticides manufacturing additives, however, both recorded a decrease in their average selling prices by 16% and 4%, respectively, for the three-month period ended September 30, 2012 as compared with the same period in 2011, which are attributable to the change in product mix. For the pesticides manufacturing additives, the volume of lower pricing products sold, mainly Bromopropane, increased while the volume of higher pricing products sold, mainly Dibromo Aldehyde, decreased over the comparative periods. For the paper manufacturing additives, we also increased the sales volume of a new paper strengthening agent product with lower pricing since May 2012. All these change in product mix decreased the average selling price for the three-month period ended September 30, 2012.

The table below shows the changes in the average selling price and changes in the sales volume of major chemical products (excluded wastewater treatment chemical additives of $15,995 for three-month period ended September 30, 2011 as the production of such product line was stopped since July 2011) for three-month period ended September 30, 2012 from the same period in 2011.

Increase / (Decrease) in net revenue,               Oil and gas           Paper            Pesticides
for the three-month period ended September 30,      exploration       manufacturing       manufacturing
2012 vs. 2011, as a result of:                       additives          additives           additives           Total
Increase / (Decrease) in average selling price      $    373,957     $      (195,162 )   $      (100,649 )   $     78,146
Increase / (Decrease) in sales volume               $ (2,432,561 )   $      (363,218 )   $       456,463     $ (2,339,316 )
Total effect on net revenue of chemical products    $ (2,058,604 )   $      (558,380 )   $       355,814     $ (2,261,170 )

Cost of Net Revenue.



                                                        Cost of Net Revenue by Segment                               % Change
                                       Three-Month Period Ended                 Three-Month Period Ended            of Cost of
                                          September 30, 2012                       September 30, 2011              Net Revenue
Segment                                                   % of total                               % of total
Bromine                          $        9,770,880                57 %   $       15,003,570                63 %            (35 )%
Crude Salt                       $        1,474,142                 9 %   $        1,094,508                 5 %             35 %
Chemical Products                $        5,854,868                34 %   $        7,725,866                32 %            (24 )%
Total                            $       17,099,890               100 %   $       23,823,944               100 %            (28 )%

Cost of net revenue reflects mainly the raw materials consumed and the direct salaries and benefits of staff engaged in the production process, electricity, depreciation and amortization of manufacturing plant and machinery and other manufacturing costs. Our cost of net revenue was $17,099,890 for three-month period ended September 30, 2012, a decrease of $6,724,056 (or 28%) as compared to the same period in 2011. The decrease in overall cost of net revenue was mainly attributable to the decrease in volume of products sold, the decrease in purchase price of raw materials and price adjustment fund, a levy imposed by the local PRC government to our bromine and crude segments since January 2011 for the purpose of enhancing the local PRC government's ability to adjust the price and stabilize the market price of daily necessities and other important commodities, as compared to the last comparable period, which was partially offset by the increase in depreciation and amortization of manufacturing plant and machinery.

Bromine production capacity and utilization of our factories

The table below represents the annual capacity and utilization ratios for all of our bromine producing properties:

                                                               Annual Production             Utilization
                                                              Capacity (in tonnes)           Ratio (ii)
Three-month period ended September 30, 2011                                  41,547 (i)                66 %
Three-month period ended September 30, 2012                                  44,547                    48 %
Variance of the three-month periods ended September 30,
2012 and 2011                                                                 3,000 (iii)             (18 )%

(i) Annual production capacity for the three-month period ended September 30, 2011 was adjusted with the appraisal report carried out by an international appraisal firm, Grant Sherman Appraisal Limited, in October 2011.

(ii) Utilization ratio is calculated based on the annualized actual production volume in tonnes for the periods divided by the annual production capacity in tonnes.

(iii) The increase in 3,000 tonnes production capacity represents the management's estimated capacity of Factory No. 10 acquired in late December 2011.

Our utilization ratio decreased by 18% for the three-month period ended September 30, 2012 as compared with the same period in 2011. The decrease in utilization was mainly attributable to the drop in overall demand for bromine as a result of the macro-economic tightening policy imposed by the PRC government to slow down the economy, which reduced our sales and production volume since mid-2011.

In view of the trend of a decrease in the bromine concentration of the brine water being extracted at our production facilities as explained in 2011 Form 10-K, and in order to reduce the leakage rate and attempt to recover the annual production capacity of bromine and crude salt to a higher level in the future, we decided to carry out large scale enhancement work to replace all the eroded protective shells within a four year timeframe, which work commenced in the second quarter of 2011. In May through September 2012, we resumed and completed the second phase enhancement works to our existing bromine extraction and crude salt production facilities. The total cost of the second phase enhancement work to the extraction wells and protective shells to transmission channels and ducts in Factory No. 1 to 9 are approximately $12,786,791 and $8,125,659, respectively, which are capitalized as building and plant and machinery. We anticipated the next phase of enhancement works will be carried out in mid-2013.

Bromine segment

For the three-month period ended September 30, 2012, the cost of net revenue for the bromine segment was $9,770,880, a decrease of $5,232,690 or 35% over the same period in 2011. The most significant components of the costs of net revenue for the bromine segment were cost of raw materials and finished goods consumed . . .

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