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SORL > SEC Filings for SORL > Form 10-K on 1-Apr-2013All Recent SEC Filings

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Form 10-K for SORL AUTO PARTS INC


1-Apr-2013

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following is management's discussion and analysis of certain significant factors that have affected our financial position and operating results during the periods included in the accompanying consolidated financial statements, as well as information relating to the plans of our current management. This report includes forward-looking statements. Generally, the words "believes," "anticipates," "may," "will," "should," "expect," "intend," "estimate," "continue," and similar expressions or the negative thereof or comparable terminology are intended to identify forward-looking statements. Such statements are subject to certain risks and uncertainties, including the matters set forth in this report and other reports or documents we file with the Securities and Exchange Commission from time to time, which could cause actual results or outcomes to differ materially from those presented. Undue reliance should not be placed on these forward-looking statements, which speak only as of the date hereof. We undertake no obligation to update these forward-looking statements.

The following discussion and analysis should be read in conjunction with our consolidated financial statements and the related notes thereto and other financial information contained elsewhere in this Form 10K.

OVERVIEW

On May 10, 2004, we acquired all of the issued and outstanding equity interests of Fairford Holdings Limited, a Hong Kong limited liability company ("Fairford"). Until we acquired Fairford, we had only nominal assets and liabilities and limited business operations. Although Fairford became a wholly-owned subsidiary following the acquisition, because the acquisition resulted in a change of control, the acquisition was recorded as a "reverse merger" whereby Fairford is considered to be the accounting acquirer. As such, the following results of operations are those of Fairford.

Fairford was organized in Hong Kong as a limited liability company on November 3, 2003. Fairford owns 90% of the equity interest of Ruili Group Ruian Auto Parts Co., Ltd., a Sino-foreign joint venture (the "Joint Venture") established pursuant to the laws of China. The Joint Venture is a joint venture between our wholly-owned subsidiary, Fairford, and the Ruili Group.

The Ruili Group was incorporated in the PRC in 1987 to specialize in the development, production and sale of various kinds of automotive parts. Its headquarters are located in Ruian City of Wenzhou Area, one of the leading automotive parts manufacturing centers of China with more than 1400 auto parts manufacturing companies. Its major product lines include valves for air brake systems, auto metering products, auto electric products, anti-lock brake systems and retarders. Some of those products were developed and are manufactured through affiliated companies of Ruili Group. Due to its leading position in the industry, the Chairman of the Ruili Group, Mr. Xiao Ping Zhang, has been elected as the Chairman of Wenzhou Auto Parts Association, one of the leading auto parts trade associations in China. Mr. Zhang is also Chairman and Chief Executive Officer of the Company. The Joint Venture was established in the PRC as a Sino-foreign joint venture company with limited liability by the Ruili Group and Fairford. Fairford and Ruili Group contributed 90% and 10%, respectively, of the paid-in capital in the aggregate amount of approximately $43.4 million.

In connection with its formation, effective January 19, 2004 the Joint Venture acquired the business of the Ruili Group relating to the manufacture and sale of various kinds of valves for automotive brake systems and related operations (the "Transferred Business"). This was accomplished by the transfer from the Ruili Group to Fairford of the relevant assets and liabilities of the Transferred Business including trade receivables, inventories and machinery, and the assumption of short and long term borrowings, at a consideration of approximately $6.39 million.

The consideration was based on a valuation by an independent PRC valuation firm. Fairford then contributed these assets and liabilities as a capital contribution for its 90% interest in the Joint Venture. The Ruili Group also transferred inventory as its capital contribution for its 10% interest in the Joint Venture. The assets and liabilities transferred to the Joint Venture by Fairford and the Ruili Group represented all the relevant assets and liabilities of the Transferred Business.

Pursuant to the formation of the Joint Venture, on January 17, 2004, the Ruili Group and Fairford signed a binding Joint Venture agreement (the "JV Agreement"). Pursuant to the JV Agreement, the Board of Directors consists of three directors; Fairford has the right to designate two members of the board and the Ruili Group has the right to designate one member. The majority of the Board has decision making authority with respect to operating matters. As a result, our wholly-owned subsidiary, Fairford, maintains operating control over the Joint Venture.

The transactions were accounted for as a reverse spin-off in accordance with EITF 02-11 "Accounting for Spin-offs." Accordingly SORL Auto Parts, Inc. was deemed to be the "spinnor" for accounting purposes.

In December 2006, through Fairford, SORL invested a further approximately $32.67 million in its operating subsidiary- the Joint Venture. To maintain its 10% shareholding in the Joint Venture, the Ruili Group increased its capital investment by approximately $3.63 million. SORL Auto Parts, Inc. continues to hold a 90% controlling interest in the operating subsidiary.

As a result of the foregoing, through Fairford's 90% interest in the Joint Venture, the Company manufactures and distributes automotive brake systems and other key safety related components in China and internationally for use primarily in different types of vehicles, such as trucks and buses. There are 65 categories of valves with over 2,000 different specifications. Management believes that it is the largest manufacturer of automotive air brake systems for commercial vehicles in China.

On November 11, 2009, we entered into a joint venture agreement with MGR, a Hong Kong-based global auto parts distribution specialist firm, and with a Taiwanese investor. The new joint venture was named SORL International Holding, Ltd. (the "SIH"). SORL holds a 60% interest in the joint venture. SIH was primarily devoted to expanding SORL's international sales network in Asia-Pacific and creating a larger footprint in Europe, the Middle East and Africa with a target to create a truly global distribution network. Based in Hong Kong, SIH seeks to open up and establish channels of distribution in international markets with SORL's primary products, including spring brake chambers, clutch servos, air dryers, relay valves and hand brake valves.

On February 8, 2010, the Company sold 1,000,000 shares of its common stock to selected institutional investors at a price of $10.00 per share pursuant to a registered direct offering. This transaction provided net proceeds of approximately $9.4 million. On March 9, 2010, through Fairford, SORL invested $9.349 million in its operating subsidiary, the Joint Venture. To maintain its 10% shareholding in the Joint Venture, the Ruili Group increased its capital investment by $1.039 million. Accordingly, SORL continues to hold a 90% controlling interest in the operating subsidiary.

On August 31, 2010, the Company, through the Joint Venture, executed an Agreement to acquire the assets of the hydraulic brake, power steering, and automotive electrical operations of the Ruili Group (the "Seller", a related party under common control). As a result of this acquisition, the Company's product offerings expanded to both commercial and passenger vehicles' brake systems and other key safety-related auto parts. The purchase price was RMB 170 million, or approximately USD$25 million. The transaction was accounted for using the book value of assets acquired, consisting primarily of machinery and equipment, inventory, accounts receivable and patent rights, used or usable in connection with the acquired segment of the auto parts business of the Seller. The Company purchased the machinery and equipment, inventory, accounts receivable at book values of approximately $8.0 million, $8.0 million and $5.2 million, respectively. The Company did not acquire any of the assets of the Seller other than those in the segment of Seller's business described above. The excess of consideration over the carrying value of net assets received has been recorded as a decrease in the additional paid-in capital of the Company.

The acquisition was accounted for as a transaction between the entities under common control because the CEO of the Company owns 63% of the registered capital of Ruili Group Co., Ltd., and owns more than 50% of the outstanding common stock of SORL, together with his wife and brother. This results in the acquisition being accounted for using the historical costs of the financial statements of the Seller. The consolidated financial statements have been prepared as if the acquisition took place at the earliest time presented, that is, as of January 1, 2009. The asset purchase was deemed to be the acquisition of a business.

Overall financing cost has declined due to the lower benchmark interest rates and a gradually easing financial environment. In order to lower the Company's financing cost, on December 25, 2012, the Company reached an agreement with International Far Eastern Leasing Co., Ltd. to terminate a previous leasing agreement dated September 13, 2011 and to satisfy any unpaid principle under that agreement.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of financial statements in conformity with those accounting principles requires us to make judgments and estimates that affect the amounts reported in the consolidated financial statements and accompanying notes. Those judgments and estimates have a significant effect on the consolidated financial statements because they result primarily from the need to make estimates about the effects of matters that are inherently uncertain. Actual results could differ from those estimates. We periodically re-evaluate our judgments and estimates that are based upon historical experience and on various other assumptions that we believe to be reasonable under the circumstances.

We believe that the following critical accounting policies set forth below involve the most significant judgments and estimates used in the preparation of our consolidated financial statements. We evaluate these policies on an ongoing basis, based upon historical results and experience, consultation with experts, trends and other methods we consider reasonable in the particular circumstances, as well as our forecasts as to how these might change in the future.

WARRANTIES

Estimated product warranty expenses are accrued in cost of goods sold at the time the related sales are recognized. We base our estimate on historical trends of units sold and payment amounts, combined with our current understanding of the status of existing claims and discussions with our customers.

INVENTORIES

Inventories are stated at the lower of cost or net realizable value. Cost is calculated on the weighted-average basis and includes all costs to acquire and other costs incurred in bringing the inventories to their present location and condition. The Company evaluates the net realizable value of its inventories on a regular basis and records a provision for loss to reduce the computed weighted-average cost if it exceeds the net realizable value.

INCOME TAXES

Taxes are calculated in accordance with taxation principles currently effective in the PRC. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income or loss in the period that includes the enactment date. A valuation allowance is provided for the amount of deferred tax assets and liabilities that, based on available evidence, are not expected to be realized.

The Company increased its investment in the Joint Venture as a result of its financing in December, 2006. In accordance with the Income Tax Law of the People's Republic of China on Foreign-invested Enterprises and Foreign Enterprises, the Joint Venture was therefore eligible for additional preferential tax treatment. For the years 2007 and 2008, the Joint Venture was entitled to an income tax exemption on all pre-tax income generated by the company above its pre-tax income generated in the year 2006. Thereafter, the Joint Venture was entitled to a 50% exemption from the effective income tax rate on any pre-tax income above its 2006 pre-tax income, to be recognized in the years 2009, 2010 and 2011. However, the above tax exemption was superseded, as a result of the Joint Venture having been awarded the Chinese government's "High-Tech Enterprise" designation. The High-Tech Enterprise certificate is valid for three years and provides for a reduced tax rate for years 2009 through 2011. As a result, the Company's effective income tax rate is 15% for years 2009 through 2011. In 2012, the Joint Venture passed the re-assessment by the government, based on PRC income tax laws. Accordingly, it continues to be taxed at the 15% tax rate in 2012, 2013 and 2014.

REVENUE RECOGNITION

In accordance with the provisions of Staff Accounting Bulletin No. 103, revenue from the sale of goods is recognized when the risks and rewards of ownership of the goods have transferred to the buyer including factors such as when persuasive evidence of an arrangement exits, delivery has occurred, the sales price is fixed and determinable, and collection is probable. The Company generally records sales upon shipment of product to customers and transfer of title under standard commercial terms. Revenue consists of the invoice value for the sale of goods and services net of value-added tax ("VAT"), rebates and discounts and returns. The Company nets sales return in gross revenue, i.e., the revenue shown in the income statement is the net sales. The Company is subject to the following surtaxes, which are recorded as deductions from gross sales:
Education Tax and City Construction Tax.

The Company does not receive revenue for shipping and handling costs to customers. Shipping and handling expenses incurred by the Company are included in selling and administrative expenses in the accompanying consolidated statements of income.

CONCENTRATION OF CREDIT RISK

Financial instruments that potentially subject the Company to significant concentrations of credit risk consist primarily of accounts receivable. The Company performs ongoing credit evaluations with respect to the financial condition of its creditors, but does not require collateral. In order to determine the value of the Company's accounts receivable, the Company records a provision for doubtful accounts to cover probable credit losses. Management reviews and adjusts this allowance periodically based on historical experience and its evaluation of the collection of outstanding accounts receivable.

RESULTS OF OPERATIONS

REVENUE



Year ended December 31, 2012 as compared to year ended December 31, 2011:



                                                    Years Ended December 31,
                                                      Percent                   Percent
                                                        of                        of
                                                       Total                     Total
                Sales                     2012         sales        2011         sales
                                                   (U.S.  dollars in million)
Commercial vehicle brake systems, etc.   $ 152.2          79.2 %   $ 170.6          78.7 %
Passenger vehicle brake systems, etc.    $  40.0          20.8 %   $  46.2          21.3 %

Total                                    $ 192.2           100 %   $ 216.8           100 %

Total sales were $192,217,399 and $216,788,518 for the years ended December 31, 2012 and 2011, respectively, representing a decrease of $24.6 million or 11.3% year over year. The decrease was mainly due to the decreased sales to China OEM and international market.

The sales from commercial vehicle brake systems decreased by $18.4 million or 10.8%, to $152.2 million for the years ended December 31,2012, compared to $170.6 million for the same period of 2011.

The sales from passenger vehicle brake systems decreased by $6.2 million or 13.4%, to $40.0 million for the years ended December 31, 2012, compared to $46.2 million for the same period of 2011.

A breakdown of sales revenue for our three principal markets, Chinese domestic OEM market, Chinese domestic aftermarket and international markets, in 2012 and 2011 is as follows:

                                     Years Ended December 31,
                                    Percent of                   Percent of
                                      Total                                       Percentage
                        2012          sales          2011       Total sales         Change
                                             (U.S. dollars in million)
China OEM market       $  93.9             48.9 %   $ 115.1             53.1 %          -18.4 %
China Aftermarket      $  45.4             23.6 %   $  44.6             20.6 %            1.8 %
International market   $  53.0             27.6 %   $  57.1             26.3 %           -7.2 %

Total                  $ 192.2            100.0 %   $ 216.8            100.0 %          -11.3 %

Despite the overall growth of the output and sales of all the automobiles in China, the output and sales volume of commercial vehicles in China decreased 4.71% and 5.49% to 3.75 million units and 3.81 million units, respectively. Within the commercial vehicle sector in China, the sales of heavy-duty trucks decreased the most, by 27.8% in 2012 compared with the year of 2011. The decline of the overall sales of heavy-duty trucks in China in 2012 could be attributed to the deceleration of the growth in capital investment, domestic consumption and international trade, which resulted in the reduced demand for heavy-duty trucks in the construction of residential and commercial real estate development projects, infrastructure projects, as well as highway transportation of goods.

During year 2012, SORL made further inroads into construction equipment and expanded its market share in the bus market, which partially offset the effects of these declines. Our OEM sales for the year of 2012 declined 18.4% from 2011, to $93.9 million.

Considering that sales of heavy-truck parts contributes to a significant portion of our overall sales to the commercial vehicle sector, management considers our performance in 1912 in this sector relatively satisfactory in view of these difficult market conditions.

Our sales to the Chinese aftermarket increased by $0.8 million or 1.8%, to $45.4 million for the year of 2012, compared to $44.6 million for the year of 2011. The increased number of vehicles in service in China and the expiration of OEM warranties helped increase our aftermarket business. Sales of our new model products, applicable to both OEM and aftermarket, also grew for the year of 2012. We will continue with our strategies to further optimize our sales network, to help further penetrate into new markets. Accelerated urbanization and the Chinese government's increased support for public transportation favor expansion in the bus aftermarket.

Our export sales decreased by $4.1 million or 7.2%, to $53.0 million for the year of 2012, as compared to $57.1 million for the same period of 2011. The debt crisis in Europe and the currency depreciation in some countries caused some of our customers to reduce their inventories; also the instability of the situation in the Middle Eastern countries decreased the purchases of our customers from us.

We expect to take the following measures to ensure future growth in the international market:

(1) Enhance the Company brand image through industry exhibitions.

(2) Maintenance of our customer base and market position while penetrating new markets and capturing new customers.

(3) Building a stronger international marketing network with the focus on exploring high-value foreign markets, and active marketing to the large automotive chain stores that directly sell to end users.

(4) Further targeting the international OEM market by actively supporting initiatives that promote our overseas sales.

COST OF SALES AND GROSS PROFIT

Cost of sales for the year ended December 31, 2012 decreased to approximately $139.7 million from $156.8 million for the year ended December 31, 2011, a $17.1 million or approximately 10.9% decrease, slightly less than 11.3% year over year decrease in revenues.

Gross profit for the year ended December 31, 2012, decreased by approximately $7.5 million or 12.4% to $52.5 million from $60.0 million for the year ended December 31, 2011, as a result of the decreased sales.

Gross margin decreased by approximately 0.4%, from 27.7% in 2011 to 27.3% in 2012. Gross margin was affected by rising labor expenses, the appreciation of the Chinese currency, and higher raw material prices.

Cost of sales from commercial vehicle brake systems for the year ended December 31, 2012 were $110.6 million, a decrease of $9.3 million or 14.0%, from $121.8 million for the same period last year. The gross profit from commercial vehicle brake systems decreased by 14.6% to $41.6 million for the year ended December 31, 2012 from $48.7 million for the year of 2011. Gross margin from commercial vehicle brake systems decreased to 27.4% for the year ended December 31, 2012 from 28.6% in 2011. The decrease was primarily due to raising labor expenses, the appreciation of the Chinese currency, and higher raw material prices.

Cost of sales from passenger vehicle brake systems for the year ended December 31, 2012 were $29.1 million, a decrease of $5.8 million or 16.7% from $34.9 million for the same period in 2011. The gross profit from passenger vehicle brake systems decreased by 3.2% to $10.9 million for the year of 2012 from $11.3 million for the year of 2011. Gross margin from passenger vehicle brake systems increased to 27.3% for the year ended December 31, 2012 from 24.4% in 2011.

SELLING EXPENSES

Selling expenses were $15,330,507 for the year ended December 31, 2012, as compared to $14,290,988 for the year ended December 31, 2011, an increase of $1,039,519 or 7.3%. The increase was mainly due to the increased wages expense and packing expenses.As a percentage of sales revenue, selling expenses increased to 8.0% for the year ended December 31, 2012, as compared to 6.6% for the same period in 2011,and the percentage increase was also due to the decrease of our total sales.

GENERAL AND ADMINISTRATIVE EXPENSES

General and administrative expenses were $13,512,003 for the year ended December 31, 2012, as compared to $13,818,136 for the year ended December 31, 2011, a decrease of $0.3 million or 2.2%. The Company incurred fewer expenses as a result of reduced sales. As a percentage of sales revenue, general and administrative expenses increased to 7.0% for the year ended December 31, 2012, as compared to 6.4% for the same period in 2011, and the percentage increase was also due to the decrease of our total sales.

RESEARCH AND DEVELOPMENT EXPENSE

Research and development expense was $7,849,101 for the year ended December 31, 2012, as compared with $9,002,744 for the year ended December 31, 2011, a decrease of $1.2 million or 12.8%. The decrease was mainly due to decreased sales. The Company expects to continue to invest in new product development, particularly in upgrading traditional products and in developing electronically controlled products.

DEPRECIATION AND AMORTIZATION

Depreciation and amortization expense increased 2.5% to $7,405,347 for the year ended December 31, 2012, compared with depreciation and amortization expense of $7,224,777 for the year ended December 31, 2011.

The decrease in depreciation and amortization expense was primarily due to the addition of purchased production equipment.

FINANCIAL EXPENSES

Financial expenses mainly consist of interest expense and exchange loss. The financial expenses for the year ended December 31, 2012 decreased by $0.9 million to $2,360,966 from $3,217,155 for the same period of 2011, mainly due to less debt and discount expense.

OTHER INCOME

For the year ended December 31, 2012, other income was $3,047,072 compared with $1,567,950 for the year ended December 31, 2011, an increase of $1.5 million. The increase was mainly due to an increase in sales of raw material scrap for the year ended December 31, 2012.

INCOME TAX

The Joint Venture is registered in the PRC, and is therefore subject to state and local income taxes within the PRC at the applicable tax rate on the taxable income as reported in the PRC statutory financial The Joint Venture is registered in the PRC, and is therefore subject to state and local income taxes within the PRC at the applicable tax rate on taxable income as reported in the PRC statutory financial statements in accordance with relevant income tax laws.

The Company increased its investment in the Joint Venture as a result of its financing in December, 2006. In accordance with the Income Tax Law of the People's Republic of China on Foreign-invested Enterprises and Foreign Enterprises, the Joint Venture was eligible for additional preferential tax treatment for the years 2007 and 2008. In those years, the Joint Venture was entitled to an income tax exemption on all pre-tax income generated by the Company above its pre-tax income generated in the year 2006. This tax exemption was superseded as a result of the Joint Venture having been awarded the Chinese government's "High-Tech Enterprise" designation. The High-Tech Enterprise certificate is valid for three years and provides for a reduced tax rate for years 2009 through 2011. In 2012, the Joint Venture passed the re-assessment by the government, based on PRC income tax laws. Accordingly, it continues to be taxed at the 15% tax rate in 2012, 2013 and 2014.

Income tax expense of $2,005,125 and $2,664,052 was recorded for the year of 2012 and 2011, respectively.

NET INCOME ATTRIBUTABLE TO NON-CONTROLLING INTEREST IN SUBSIDIARIES

Non-controlling interest in subsidiaries represents a 10% non-controlling interest in Ruian and 40% non-controlling interest in SIH, in each case held by our Joint Venture Partners. Net income attributable to non-controlling interest in subsidiaries amounted to $1,458,672 and $1,631,135 for the years ended December 31, 2012 and 2011, respectively.

NET INCOME ATTRIBUTABLE TO STOCKHOLDERS

The net income attributable to stockholders for the year ended December 31, 2012 decreased by $3.9 million, to $12,804,938 from $16,671,819 for the year ended December 31, 2011 due to the factors discussed above. Earnings per share ("EPS"), both basic and diluted, for 2012 and 2011, were $0.66 and $0.86 per share, respectively.

FINANCIAL CONDITION

LIQUIDITY AND CAPITAL RESOURCES

OPERATING - Net cash provided from operating activities was $31,616,917 for the year ended December 31, 2012, as compared to $7,649,520 of net cash provided by operating activities for the year ended December 31, 2011, an increase of $24.0 million, primarily due to the increased cash inflow as a result of changes in accounts receivable and inventories.

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