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HGSH > SEC Filings for HGSH > Form 10-Q on 9-May-2014All Recent SEC Filings

Show all filings for CHINA HGS REAL ESTATE INC.

Form 10-Q for CHINA HGS REAL ESTATE INC.


9-May-2014

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION

The following discussion and analysis of financial condition and results of operations relates to the operations and financial condition reported in the unaudited condensed consolidated financial statements of China HGS Real Estate, Inc. for the three and six months ended March 31, 2014 and 2013 and should be read in conjunction with such financial statements and related notes included in this report.

As used in this report, the terms "Company," "we," "our," "us" and "HGS" refer to China HGS Real Estate, Inc. and its subsidiaries.

Preliminary Note Regarding Forward-Looking Statements.

We make forward-looking statements in Management's Discussion and Analysis of Financial Condition and Results of Operations and elsewhere in this report based on the beliefs and assumptions of our management and on information currently available to us. Forward-looking statements include information about our possible or assumed future results of operations which follow under the headings "Business Overview," "Liquidity and Capital Resources," and other statements throughout this report preceded by, followed by or that include the words "believes," "expects," "anticipates," "intends," "plans," "estimates" or similar expressions.

Forward-looking statements are subject to a number of risks and uncertainties that could cause actual results to differ materially from those expressed in these forward-looking statements, including the risks and uncertainties described below and other factors we describe from time to time in our periodic filings with the U.S. Securities and Exchange Commission (the "SEC"). We therefore caution you not to rely unduly on any forward-looking statements. The forward-looking statements in this report speak only as of the date of this report, and we undertake no obligation to update or revise any forward-looking statement, whether as a result of new information, future developments or otherwise. These forward-looking statements include, among other things, statements relating to:

our ability to sustain our project development

our ability to obtain additional land use rights at favorable prices;

the market for real estate in Tier 3 and 4 cities and counties;

our ability to obtain additional capital in future years to fund our planned expansion; or

economic, political, regulatory, legal and foreign exchange risks associated with our operations.

Business Overview

We conduct substantially all of our business through Shaanxi Guangsha Investment and Development Group Co., Ltd, in Hanzhong, Shaanxi Province. Since the initiation of our business, we have been focused on expanding our business in certain Tier 3 and Tier 4 cities and counties in China.

During 2013, the introduction of the cooling measures such as the "National Five" regulations has by far caused a temporary halt in land and property price appreciation. With uncertainties in the PRC government's credit tightening policies, the market for real estate sales in 2013 and 2014 remained challenging. Developers generally have been reducing inventory by adopting more aggressive sales tactics. On the other hand, real estate housing demands and sales remained stable. In general, property developers in the market, including the Company, recorded satisfactory sales growth.

China's urbanization, rising incomes and growing demand for a higher standard of living continues to create a strong housing need in the market. The Company believes that the demand from first-time buyers amid ongoing urbanization is expected to remain robust. The PRC government's continuous efforts to increase housing and land supply should be conducive to long-term healthy development of the property market.

For the three months ended March 31, 2014, our sales, gross profit and net income were $49,907,770, $15,507,808 and $13,448,579 respectively, representing an approximately 157.5%, 105.2% and 133.2% increase in sales, gross profit and net income from three months ended March 31, 2013, respectively. For the six months ended March 31, 2014, our sales, gross profit and net income were $64,048,333, $19,555,842 and $16,505,696 respectively, representing an approximately 110.8%, 39.5% and 46.4% increase in sales, gross profit and net income from the same period of last year, respectively. The significant increase in sales, gross profit and net income mainly resulted from sales of commercial units in the Yang Pearl Garden project, the delivery of two municipal roads to the local government and revenues from the Oriental Garden project under the percentage completion method.

The Company adopted the percentage of completion method in fiscal 2013 to account for real estate sales from large high rise residential projects with construction periods over 18 -24 months. Total revenue recognized under the percentage of completion method for the three and six months ended March 31, 2014 was $33,533,887 and $46,482,483 (2013- $Nil and $Nil), representing 67.2% and 72.6% of total revenue for the three and six months ended March 31, 2014, respectively. The related costs of these real estate sales was $22,046,651 and $30,634,703 (2013-$Nil and $Nil) for the three and six months ended March 31, 2014, representing 70.2% and 75.6% of the real estate costs in the same periods of last year, respectively. The gross profit before sales taxes from the percentage of completion method was $11,487,236 and 15,847,780 (2013-$Nil and $Nil), representing 74.1% and 81.0% of the total gross profits for the three and six months ended March 31, 2014, respectively. The adoption of the percentage of completion method does not have any impact on the Company's interim consolidated financial statements for the three and six months ended March 31, 2013, because the related conditions for revenue recognition under percentage of completion method was not met for the three and six months ended March 31, 2013.

For the six months ended March 31, 2014, our average selling price ("ASP") for real estate projects (excluding sales of parking spaces) located in Yang County was approximately $666.7 per square meter, an increase of 52.7% from the ASP of $436.7 per square meter for the six months ended March 31, 2013, due to more commercial units in Yang Pearl Garden project sold in the three months ended March 31, 2014 with an ASP of $817.2 per square meter. The ASP of our Hanzhong real estate projects (excluding sales of parking spaces) was approximately $774.1 per square meter, consistent from the ASP of $759.2 per square meter for the six months ended March 31, 2013.

Market Outlook

The Company expects the purchase restrictions and price ceiling policies to continue, which, however, should have less impact on the Company's products comparing to the premium real estate market in Tier 1 and Tier 2 cities. Our customers have a constant growth in their disposable income. With a lower housing price to family disposable income ratio and an increasing urbanization level, there is a growing demand for high quality residential housing. The Company expects to continuously focus on developing real estate properties in prime locations of Tier 3 and Tier 4 cities and counties. In this perspective, the Company is positive about the outlook for the local real estate market, as end-user demand stemming from rising disposable income and ongoing urbanization stays robust.

We intend to remain focused on our existing construction projects in Hanzhong city and Yang County, deepen our institutional sales network, enhance our cost and operational synergies and improve cash flows and strengthen our balance sheet. In this respect, in late fiscal 2013, we began the construction of the following large high rise residential projects in Hanzhong City and Yang County:

Oriental Pearl Garden

The project is located in downtown of Hanzhong City. It consists of 1 multi-layer residential building and 12 high-rise residential buildings with commercial shops on the first and second floors with an estimated GFA of 273,693 square meters. The Company started construction in the third quarter of fiscal 2012 and expects to complete the whole construction in 1-1.5 years. The pre-sale license was obtained in November 2013.

Mingzhu Beiyuan

The project is located in the south west part of Hanzhong City. It includes 17 high-rise residential buildings with an estimated GFA of 355,321 square meters. The Company started construction in the third quarter of fiscal 2012 and expects to complete the whole construction in 1-1.5 years. The pre-sale license was obtained in April 2013.

Yangzhou Pearl Garden

The Company is currently constructing 5 high-rise residential buildings and 1 multi-layer residential building with total GFA of 64,854 square meters in Yangzhou Pearl Garden located in Yang County. The related pre-sales licenses were obtained in February 2013. The construction is expected to be completed in 1-1.5 years.

Yangzhou Palace

The Company is currently constructing 9 high-rise residential buildings and 16 sub-high-rise residential and multi-layer residential buildings with total GFA of 285,244 square meters in Yangzhou Palace located in Yang County. The construction started in the fourth quarter of fiscal 2013. The related pre-sales license is expected to be obtained in later half of fiscal 2014. The construction is expected to be completed in 2-3 years.

Road Construction

In addition to the above residential projects, the Company was approved by the Hanzhong local government to construct two municipal roads with a total length of 1,064.09 meters. The budget for these two municipal roads was approximately $3 million and was approved by the Hanzhong Ministry of Finance. The Company completed and delivered these two roads to the local government on March 21, 2014 with an approved price of $3.18 million. The Company recognized such revenue during the three and six months ended March 31, 2014.

In September 2013, the Company entered into a framework agreement ("Liangzhou Agreement") with the Hanzhong local government on the Liangzhou Road reformation and expansion project (Liangzhou Road Project"). Pursuant to the agreement, the Company is contracted to reform and expand the Liangzhou Road, a commercial street in downtown Hanzhong City, with a total length of 2,080 meters and width of 30 meters and to resettle the existing residence in the Liangzhou road area. The original budgeted total of construction and related project cost ("Investment") is approximately $33 million in accordance with the Liangzhou Agreement. The Company, in return, is being compensated by the local government by having an exclusive right on acquiring at least 394.5 Mu land use rights in a specified location of Hanzhong City. The Company is also authorized by the local government to develop and manage the commercial and residential properties surrounding the Liangzhou Road project. The Company's Investment on the Liangzhou Road Project is treated as the Company's deposit on purchasing the related land use rights. The Liangzhou Road Project started during the end of 2013 and is expected to be completed by the end of 2014. The budgeted Investment project was extended during the quarter, because the local government included more area and resettlement residences in the project. As of March 31, 2014, the actual costs incurred by the Company was $33,326,399 and the incremental costs related to residence resettlement have been approved by the local government. The Company determined that the Investment in the Liangzhou Road Project in exchange for interests in future land use rights is a barter transaction with commercial substance.

Other road construction projects included a Yang County East 2nd Ring Road construction project. The Company was engaged by Yang County local government to construct East 2nd Ring Road with a total length of 2.15km and a budgeted price of approximately $27.3 million (or RMB168 million) which was approved by the local Yang County government in March 2014. The local government is required to repay the Company's project investment within 3 years with interest at the rate based on the commercial borrowing rate with similar terms as published by China Construction Bank. The local government also was allowed to refund to the Company by reducing local surcharges or taxes otherwise required in the real estate development.

We expect these initiatives will help us during this difficult period and better position us to capitalize on opportunities from a future market upturn.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these condensed consolidated financial statements requires us to make estimates and judgments that affect our reported assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We evaluate our estimates on an on-going basis and use them on historical experience and various other assumptions that are believed to be reasonable under the circumstances as the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates because of different assumptions or conditions.

We believe the following critical accounting policies affect our significant estimates and judgments used in the preparation of our condensed consolidated financial statements. These policies should be read in conjunction with Note 2 of the notes to unaudited condensed consolidated financial statements.

Revenue recognition

Percentage of Completion method

Real estate sales for the long term real estate projects are recognized under percentage completion method in accordance with the provisions of ASC 360-20-40D "Sale of Condominium Units". Revenue and profit from the sales of long term development properties is recognized by the percentage of completion method on the sale of individual units when all the following criteria are met:

a. Construction is beyond a preliminary stage.

b. The buyer is committed to the extent of being unable to require a refund except for non-delivery of the unit or interest.

c. Sufficient units have already been sold to assure that the entire property will not revert to rental property.

d. Sales prices are collectible.

e. Aggregate sales proceeds and costs can be reasonably estimated.

If any of the above criteria is not met, proceeds shall be accounted for as deposits until the criteria are met.

Under the percentage of completion method, revenues from condominium units sold and related costs are recognized over the course of the construction period, based on the completion progress of a project. In relation to any project, revenue is determined by calculating the ratio of incurred costs, including land use rights costs and construction costs, to total estimated costs and applying that ratio to the contracted sales amounts. Cost of sales is recognized by determining the ratio of contracted sales during the period to total estimated sales value, and applying that ratio to the incurred costs. Current period amounts are calculated based on the difference between the life-to-date project totals and the previously recognized amounts.

Revenue recognized to date in excess of amounts received from customers is classified as current assets under cost and earnings in excess of billings. Amounts received from customers in excess of revenue recognized to date are classified as current liabilities under billings in excess of cost and earnings.

Any changes in significant judgments and/or estimates used in determining construction and development revenue could significantly change the timing or amount of construction and development revenue recognized. Changes in total estimated project costs or losses, if any, are recognized in the period in which they are determined.

Full accrual method

Revenue from the sales of short term development properties, where the construction period is expected to 18 months or less is recognized by the full accrual method at the time of the closing of an individual unit sale. This occurs when title to or possession of the property is transferred to the buyer. A sale is not considered consummated until (a) the parties are bound by the terms of a contract, (b) all consideration has been exchanged, (c) any permanent financing for which the seller is responsible has been arranged, (d) all conditions precedent to closing have been performed, (e) the seller does not have substantial continuing involvement with the property, and (f) the usual risks and rewards of ownership have been transferred to the buyer. Further, the buyer's initial and continuing investment is adequate to demonstrate a commitment to pay for the property.

The Company provides "mortgage loan guarantees" only with respect to buyers who make down-payments of 30%-50% of the total purchase price of the property. The period of the mortgage loan guarantee begins on the date the bank approves the buyer's mortgage and we receives the loan proceeds in our bank account and ends on the date the "Certificate of Ownership" evidencing that title to the property has been transferred to the buyer. The procedures to obtain the Certificate of Ownership take six to twelve months (the "Mortgage Loan Guarantee Period"). If, after investigation of the buyer's income and other relevant factors, the bank decides not to grant the mortgage loan, our mortgage-loan based sales contract terminates and there will be no guarantee obligation. If, during the Mortgage Loan Guarantee Period, the buyer defaults on his or her monthly mortgage payment for three consecutive months, we are required to refund the loan proceeds back to the bank, although we have the right to keep the customer's deposit and resell the property to a third party. Once the Certificate of Property has been issued by the relevant government authority, our loan guarantee terminates. If the buyer then defaults on his or her mortgage loan, the bank has the right to take the property back and sell it and use the proceeds to pay off the loan. The Company is not liable for any shortfall that the bank may incur in this event. To date, no buyer has defaulted on his or her mortgage payments during the Mortgage Loan Guarantee Period and the Company has not had to refund any loan proceeds pursuant to its mortgage loan guarantees.

For municipal road construction projects, fees are generally recognized by the full accrual method at the time of the projects are completed.

Use of estimates

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes, and disclosure of contingent liabilities at the date of the consolidated financial statements. Estimates are used for, but not limited to, the assumptions and estimates used by management in recognizing development revenue under the percentage of completion method, the selection of the useful lives of property and equipment, provision necessary for contingent liabilities, fair values, revenue recognition, taxes, budgeted costs, share-based compensation and other similar charges. Management believes that the estimates utilized in preparing its consolidated financial statements are reasonable and prudent. Actual results could differ from these estimates.

Fair value of financial instruments

The Company follows the provisions of Accounting Standards Codification ("ASC") 820, Fair Value Measurements and Disclosures. It clarifies the definition of fair value, prescribes methods for measuring fair value, and establishes a fair value hierarchy to classify the inputs used in measuring fair value as follows:

Level 1-Inputs are unadjusted quoted prices in active markets for identical assets or liabilities available at the measurement date.

Level 2-Inputs are unadjusted quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, inputs other than quoted prices that are observable, and inputs derived from or corroborated by observable market data.

Level 3-Inputs are unobservable inputs which reflect the reporting entity's own assumptions on what assumptions the market participants would use in pricing the asset or liability based on the best available information.

The carrying amounts reported in the accompanying consolidated balance sheets for cash, restricted cash, advances to vendors, security deposits for land use rights, other current assets, accounts payable, other payables, customer deposits, accrued expenses and taxes payable approximate their fair value based on the short-term maturity of these instruments. The fair value of the long term customer, construction and security deposits approximate their carrying amounts because the deposits are received in cash. The carrying value of the long term bank loan approximates fair value because it has a variable rate of interest.

Real estate property development completed and under development

Real estate property consists of finished residential unit sites, commercial offices and residential unit sites under development. The Company leases the land for the residential unit sites under land use right leases with various terms from the PRC government. The cost of land use rights is included in the development cost and allocated to each project. Real estate property development completed and real estate property under development are stated at the lower of cost or fair value.

Expenditures for land development, including cost of land use rights, deed tax, pre-development costs, and engineering costs, exclusive of depreciation, are capitalized and allocated to development projects by the specific identification method. Costs are allocated to specific units within a project based on the ratio of the sales area of units to the estimated total sales area of the project (or phase of the project) multiplied by the total cost of the project (or phase of the project).

Cost of amenities transferred to buyers is allocated to specific units as a component of total construction cost. The amenity cost includes landscaping, road paving, etc. Once the projects are completed, the amenities are under control of the property management companies.

Real estate property development completed and real estate property under development are reclassified on the balance sheet into current and non-current portions based on the estimated date of construction completion and sales. The real estate property development completed classification is based on the estimated date that each property is expected to be sold within the Company's normal operating cycle of the business and the Company's sales plan. Real estate property development completed is classified as a current asset if the property is expected to be sold within the normal operating cycle of the business. Otherwise, it is classified as a non-current asset. Real estate property under development is classified as a current asset, if the property is reasonably expected to be completed within the Company's normal operating cycle of the business. Otherwise, it is classified as a non-current asset. The majority of real estate projects the Company has completed in the past were multi-layer or sub-high-rise real estate projects. The Company considers its normal operating cycle is 12 months.

In accordance with ASC 360, "Property, Plant and Equipment" ("ASC 360"), real estate property development completed and under development are subject to valuation adjustments when the carrying amount exceeds fair value. An impairment loss is recognized only if the carrying amount of the assets is not recoverable and exceeds fair value. The carrying amount is not recoverable if it exceeds the sum of the undiscounted cash flows expected to be generated by the assets. The Company reviewed all of its real estate projects for future losses and impairment by comparing the estimated future undiscounted cash flows for each project to the carrying value of such project. For the periods ended March 31, 2014 and September 30, 2013, the Company did not recognize any impairment for real estate property under development and completed.

RESULTS OF OPERATIONS

Three Months Ended March 31, 2014 compared to Three Months Ended March 31, 2013

Revenues



The following is a breakdown of revenue:



                                                                For three Months Ended
                                                                       March 31,
                                                                 2014             2013

Revenue recognized under full accrual method                 $ 16,373,883     $ 19,382,960
Revenue recognized under percentage of completion method       33,533,887                -
Total                                                        $ 49,907,770     $ 19,382,960

Revenues recognized under full accrual method

The following table summarizes our revenue generated by different projects:

                                         For three  Months Ended March 31,
                                        2014                          2013                        Variance
                                Revenue           %           Revenue           %            Amount           %

Mingzhu Garden (Mingzhu
Nanyuan & Mingzhu Beiyuan)    $  4,184,407         25.6 %   $  9,088,453         46.9 %   $ (4,904,046 )      (54.0 )%
Yangzhou Pearl Garden            9,005,623         55.0 %     10,289,763         53.1 %     (1,284,140 )      (12.5 )%
NanDajie (Mingzhu Xinju)                 -                         4,744          0.0 %         (4,744 )       (100 )%
Road construction                3,183,853         19.4 %              -                     3,183,853          100 %
Total Real Estate Sales
before Sales Tax              $ 16,373,883          100 %   $ 19,382,960          100 %   $ (3,009,077 )      (15.5 )%
Sales Tax                       (1,330,489 )                  (1,148,725 )                     181,764         15.8 %
Revenue, net of sales tax     $ 15,043,394                  $ 18,234,235                  $ (3,190,841 )      (17.5 )%

Our revenues are derived from the sale of residential buildings, commercial store-fronts and parking spaces in projects that we have developed. Our sales of completed real estate projects were lower during our second quarter ended March 31, 2014, because most of our completed real estate projects are in a later sales phase and only limited units are left for customer selection. Revenues before sales tax decreased by 15.5% to approximately $16.4 million for the three months ended March 31, 2014 from approximately $19.4 million for the same period last year. The total GFA sold during the three months ended March 31, 2014 was 17,998 square meters, representing a significant decrease from the 41,474 square meters completed and sold during the three months ended March 31, 2013. During this quarter, the Company sold approximately $7.0 million of commercial units in the Yang County Pearl Garden project with ASP of $$817.2 per square meter.
During the three months ended March 31, 2013, the Company completed and delivered two high-rise buildings in the Yangzhou Pearl Garden project and recognized approximately $8.2 million in revenue.

Sales tax for the three months ended March 31, 2014 and 2013 consisted of a business tax, 5% of the revenue, an urban construction tax, 7% of business tax, an education surcharge tax, 3% of business tax, and land appreciation tax. Land appreciation tax for the three months ended March 31, 2014 and 2013 was assessed at the rate of 0.5% of the customer deposits in Yang County and 1% of the customer deposits in Hanzhong. The sales tax for the three months ended March 31, 2014 increased by 15.8% from the same period last year, primarily as a result of changes in revenue mix and the increase of a surtax.

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