Unassociated Document


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

 (Mark One)
x
QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2009

¨
TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT

For the transition period from to

000-31539
(Commission file number)

CHINA NATURAL GAS, INC.
(Exact name of registrant as specified in its charter)

Delaware
98-0231607
(State or other jurisdiction of incorporation or organization)
(IRS Employer of Identification No.)

19th Floor, Building B, Van Metropolis
Tang Yan Road, Hi-Tech Zone
Xi’an, 710065, Shaanxi Province, China
(Address of principal executive offices)

 

(zip code)

86-29-8832-7391
(registrant 's telephone number, including area code)

N/A
(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 Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes x  No ¨

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. (Check one):
Large accelerated filer ¨
Accelerated filer x
Non-accelerated filer ¨
Smaller reporting company ¨
(Do not check if a smaller reporting company)

Number of shares of Common Stock outstanding as of November 4, 2009: 21,183,904
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes ¨  No x
 
 


 
China Natural Gas, Inc.
Index

PART I.
FINANCIAL INFORMATION
   
       
Item 1.
Financial Statements
 
1
       
 
Notes to Consolidated Financial Statements (unaudited)
 
4
       
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
 
20
       
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
 
34
       
Item 4.
Controls and Procedures
 
34
       
PART II.
OTHER INFORMATION
   
       
Item 1.
Legal Proceedings
 
35
 
     
Item 1A.
Risk Factors
 
35
     
 
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
 
35
       
Item 3.
Defaults Upon Senior Securities
 
35
       
Item 4.
Submission of Matters to a Vote of Security Holders
 
35
       
Item 5.
Other Information
 
35
       
Item 6.
Exhibits
 
35
       
SIGNATURES
 
36
 
 
 
 

 

PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
CHINA NATURAL GAS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
AS OF SEPTEMBER 30, 2009 AND DECEMBER 31, 2008
  
  
September 30,
  
  
December, 31
  
  
  
2009
  
  
2008
  
  
  
(Unaudited)
  
  
 
  
ASSETS
           
CURRENT ASSETS:
           
Cash & cash equivalents
 
$
55,931,579
   
$
5,854,383
 
Accounts receivable
   
1,141,615
     
906,042
 
Other receivable - employee advances
   
238,962
     
332,263
 
Inventories
   
1,464,958
     
519,739
 
Advances to suppliers
   
1,809,560
     
837,592
 
Prepaid expense and other current assets
   
455,586
     
838,294
 
Loan receivable
   
293,400
     
293,400
 
Total current assets
   
61,335,660
     
9,581,713
 
 
               
PROPERTY AND EQUIPMENT, NET
   
71,840,861
     
76,028,272
 
CONSTRUCTION IN PROGRESS
   
42,124,222
     
22,061,414
 
DEFERRED FINANCING COSTS
   
  1,439,456
     
1,746,830
 
OTHER ASSETS
   
13,350,012
     
8,844,062
 
                 
TOTAL ASSETS
 
$
190,090,211
   
$
118,262,291
 
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
CURRENT LIABILITIES:
               
Accounts payable and accrued liabilities
 
$
 1,412,215
   
$
800,013
 
Other payables
   
     245,397
     
124,151
 
Unearned revenue
   
 1,741,827
     
944,402
 
Accrued interest
   
       274,941
     
861,114
 
Taxes payable
   
   1,942,670
     
1,862,585
 
Total current liabilities
   
     5,617,050
     
4,592,265
 
                 
LONG TERM LIABILITIES:
               
Notes payable, net of discount of $13,457,880 and $15,478,395 as of
               
September 30, 2009 and December 31, 2008, respectively
   
  26,542,120
     
24,521,605
 
Redeemable liabilities - warrants
   
 17,500,000
     
17,500,000
 
Derivative liabilities - warrants
   
  2,488,070
     
-
 
Total long term liabilities
   
46,530,190
     
42,021,605
 
                 
COMMITMENTS AND CONTINGENCIES
               
                 
STOCKHOLDERS' EQUITY:
               
Preferred stock, $0.0001 per share; 5,000,000 shares authorized; none issued
           
-
 
Common stock, $0.0001 per share; 45,000,000 shares authorized, 21,183,904
               
and 14,600,154 shares issued and outstanding at September 30, 2009 and December 31, 2008, respectively
   
2,118
     
1,460
 
Additional paid-in capital
   
79,812,871
     
32,115,043
 
Cumulative translation adjustment
   
8,700,988
     
8,661,060
 
Statutory reserves
   
5,417,413
     
3,730,083
 
Retained earnings
   
44,009,581
     
27,140,775
 
Total stockholders' equity
   
137,942,971
     
71,648,421
 
                 
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
 
$
 190,090,211
   
$
118,262,291
 

The accompanying notes are an integral part of these statements

 
1

 

CHINA NATURAL GAS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME AND OTHER COMPREHENSIVE INCOME
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2009 AND 2008
(Unaudited)

  
 
Three months ended
   
Nine months ended
 
  
 
September 30
   
September 30
 
  
 
2009
   
2008
   
2009
   
2008
 
Revenue
                       
Natural gas revenue
 
$
15,454,386
   
$
15,354,461
   
$
46,140,884
   
$
40,494,646
 
Gasoline revenue
   
1,633,478
     
1,187,754
     
 4,440,892
     
3,466,601
 
Installation and other
   
3,037,320
     
1,858,985
     
 8,813,594
     
5,356,113
 
Total revenue
   
20,125,184
     
18,401,200
     
59,395,370
     
49,317,360
 
                                 
Cost of revenue
                               
Natural gas cost
   
 7,536,188
     
6,973,035
     
21,773,635
     
20,369,778
 
Gasoline cost
   
 1,534,806
     
1,085,311
     
4,194,615
     
3,208,326
 
Installation and other
   
  1,336,498
     
850,487
     
3,797,586
     
2,492,650
 
Total cost of revenue
   
10,407,492
     
8,908,833
     
 29,765,836
     
26,070,754
 
                                 
Gross profit
   
9,717,692
     
9,492,367
     
 29,629,534
     
23,246,606
 
                                 
Operating expenses
                               
Selling expenses
   
2,406,462
     
2,098,343
     
   7,062,429
     
5,008,631
 
General and administrative expenses
   
  1,422,300
     
968,169
     
 4,286,620
     
2,947,494
 
Total operating expenses
   
3,828,762
     
3,066,512
     
 11,349,049
     
7,956,125
 
                                 
Income from operations
   
5,888,930
     
6,425,855
     
 18,280,485
     
15,290,481
 
                                 
Non-operating income (expense)
                               
Interest income
   
7,248
     
13,536
     
23,940
     
120,297
 
Interest expense
   
      (68,407)
     
(212,774)
     
   (745,064)
     
(1,249,003)
 
Other income (expense), net
   
178,728
     
(6,786)
     
    (137,954)
     
(17,512)
 
Change in fair value of warrants
   
(357,979)
             
(1,473,762)
         
Foreign currency exchange income (loss)
   
       280
     
(48,605)
     
     (50,527)
     
(101,436)
 
Total non-operating expense
   
  (240,130)
     
(254,629)
     
(2,383,367)
     
(1,247,654)
 
                                 
Income before income tax
   
5,648,800
     
6,171,226
     
 15,897,118
     
14,042,827
 
                                 
Provision for income tax
   
1,001,281
     
1,034,636
     
3,185,220
     
2,584,774
 
                                 
Net income
   
4,647,519
     
5,136,590
     
12,711,898
     
11,458,053
 
                                 
Other comprehensive income
                               
Foreign currency translation gain
   
   195,040
     
756,316
     
        39,928
     
4,554,040
 
Comprehensive income
 
$
 4,842,559
   
$
5,892,906
   
$
 12,751,826
   
$
16,012,093
 
                                 
Weighted average shares outstanding
                               
Basic
   
15,754,696
     
14,600,154
     
 14,985,001
     
14,600,154
 
Diluted
   
 16,139,820
     
14,639,795
     
 15,035,172
     
14,658,419
 
                                 
Earnings per share
                               
Basic
 
$
     0.29
   
$
         0.35
   
$
            0.85
   
$
            0.78
 
Diluted
 
$
            0.29
   
$
          0.35
   
$
          0.85
   
$
         0.78
 

The accompanying notes are an integral part of these statements

 
2

 

CHINA NATURAL GAS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2009 AND 2008
(Unaudited)
 
  
  
Nine Months Ended September 30,
  
  
  
2009
  
  
2008
  
             
CASH FLOWS FROM OPERATING ACTIVITIES:
           
Net income
 
$
   12,711,898
   
$
11,458,053
 
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation and amortization
   
    4,175,175
     
        2,295,534
 
Loss on disposal of equipment
   
          21,372
     
        12,265
 
Amortization of discount on senior notes
   
     280,250
     
  555,001
 
Amortization of financing costs
   
       63,940
     
  147,002
 
Stock based compensation
   
       186,672
     
      51,861
 
Change in fair value of warrants
   
 1,473,762
     
                      -
 
Change in assets and liabilities:
               
Accounts receivable
   
      (235,396)
     
(1,269,832)
 
Other receivable
   
(31,011)
         
Other receivable - employee advances
   
           93,231
     
(273,759)
 
Inventories
   
     (754,309)
     
     (194,580)
 
Advances to suppliers
   
(971,240)
     
(508,417)
 
Prepaid expense and other current assets
   
223,206
     
 (783,706)
 
Accounts payable and accrued liabilities
   
          611,924
     
   193,212
 
Other payables
   
   121,234
     
    37,587
 
Unearned revenue
   
   796,827
     
       34,855
 
Accrued interest
   
       (586,173)
     
   350,002
 
Taxes payable
   
            80,025
     
606,233
 
Net cash provided by operating activities
   
     18,261,387
     
   12,711,311
 
                 
CASH FLOWS FROM INVESTING ACTIVITIES:
               
Purchase of property and equipment
   
         (47,797)
     
(21,693,376)
 
Proceeds from sales of equipment
   
            41,308
     
                -
 
Proceeds from short term investments
   
                  -
     
     249,464
 
Additions to construction in progress
   
(18,064,065)
     
   (16,679,747)
 
Prepayment on long term assets
   
    (4,434,118)
     
(6,774,616)
 
Proceeds from loan receivable
   
                    -
     
286,740
 
Return of acquisition deposit
   
          449,970
     
-
 
Payment for intangible assets
   
         (68,347)
     
-
 
Payment for land use rights
   
(455,830)
     
                      -
 
Net cash used in investing activities
   
(22,578,879)
     
(44,611,535)
 
                 
CASH FLOWS FROM FINANCING ACTIVITIES:
               
Stock issued for cash
   
      57,607,813
         
Proceeds from senior notes
   
                -
     
40,000,000
 
Payment for offering costs
   
(3,237,452)
     
(2,122,509)
 
Net cash provided by financing activities
   
54,370,361
     
37,877,491
 
                 
Effect of exchange rate changes on cash and cash equivalents
   
24,327
     
 1,115,706
 
                 
NET INCREASE IN CASH AND CASH EQUIVALENTS
   
50,077,196
     
 7,092,973
 
                 
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
   
 5,854,383
     
    13,291,729
 
                 
CASH AND CASH EQUIVALENTS, END OF PERIOD
 
$
     55,931,579
   
$
   20,384,702
 
                 
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
               
Interest paid, net of capitalized interest
 
$
1,014,956
   
$
   
Income taxes paid
 
$
       3,176,730
   
$
   1,203,048
 

The accompanying notes are an integral part of these statements 

 
3

 

 Notes to Consolidated Financial Statements
September 30, 2009
(Unaudited)

Note 1 - Organization

Organization and Line of Business

China Natural Gas, Inc. (the “Company” or “CHNG”) was incorporated in the state of Delaware on March 31, 1999. The Company through its wholly-owned subsidiaries and variable interest entities, located in Shaanxi and Henan Province in the People’s Republic of China (“PRC”), engages in sales and distribution of natural gas and gasoline to commercial, industrial and residential customers, construction of pipeline networks, installation of natural gas fittings and parts for end-users, and modification of automobiles services for vehicles to be able to use natural gas.

Recent Developments

On March 18, 2008, Shaanxi Xilan Natural Gas Equipment Co., Ltd (“SXNGE”) increased its registered capital from $30,000,000 to $53,929,260.  The additional $14,429,260 of registered capital was contributed by China Natural Gas, Inc. on April 17, 2008 and $9,500,000 of registered capital was contributed by China Natural Gas, Inc. as a payment to Chemtex International Inc. on January 31, 2008, for the purchase of license, know-how, and design of constructing the Liquefied Natural Gas (“LNG”) processing plant.

On April 22, 2008, Jingbian Liquefied Natural Gas Co., Ltd. (“JBLNG”) increased its registered capital by $2,862,000.  JBLNG is 100% owned by Xi’an Xilan Natural Gas Co., Ltd.

On April 30, 2008, the Industrial and Commercial Administration Bureau approved Xi’an Xilan Natural Gas Co., (“XXNGC”) to increase registered capital from $8,336,856 to $43,443,640 as an additional contribution by the shareholders of XXNGC under PRC Law. $15,513,526 was approved by the Industrial and Commercial Administration Bureau to be transferred out from the surplus reserve and retained earnings as an increase of registered capital.  Another $19,593,258 was contributed by SXNGE cumulatively prior to April 30, 2008, which was previously classified as an intercompany payable in XXNGC and was eliminated in the consolidated financial statements.  The increase in registered capital in XXNGC was in compliance with the Addendum to Option Agreement entered by the Company through SXNGE and XXNGC, Mr. Qinan Ji, chairman and shareholder of XXNGC, and each of the shareholders of XXNGC (hereafter collectively referred to as the “Transferor”) on August 8, 2008, and made retroactive to June 30, 2008.  See “Consolidation of Variable Interest Entity” section for further detail on the Addendum to Option Agreement.

On July 3, 2008, XXNGC formed Henan Xilan Natural Gas Co., Ltd. (“HXNGC”) as a wholly owned limited liability company, with registered capital of $4,383,000 in Henan province, PRC.  HXNGC was established for the purpose of natural gas city gasification engineering design, construction and technical advisory work services in Henan, PRC.

On October 2, 2008, China Natural Gas, Inc. (the “Company”) through its wholly-owned subsidiary, XXNGC, entered into an Equity Ownership Transfer Agreement (the “Acquisition Agreement”) with Lingbao Yuxi Natural Gas Co., Ltd. (“LBNGC”) and the shareholders of LBNGC (the “Sellers”).  Pursuant to the term of the Acquisition Agreement, XXNGC acquired for cash consideration of approximately $19,604,200 (RMB 134 million), 100% of all outstanding registered equity interest in LBNGC and all assets held by LBNGC, including the land use right to 0.44 acres and all of LBNGC’s local business’ exclusive operating rights. LBNGC owns the exclusive rights to operate CNG fueling stations and pipelines in Lingbao City. In conjunction with this acquisition, XXNGC has also secured an abundant supply of natural gas to support its future expansion in the Henan province. The Acquisition Agreement was fully executed in November, 2008.

Note 2 – Summary of Significant Accounting Policies

Basis of Presentation

The accompanying consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America.  The Company’s functional currency is the Chinese Renminbi (“RMB”); however, the Company’s reporting currency is the United States Dollar (“USD”); therefore, the accompanying consolidated financial statements have been translated and presented in USD.

In the opinion of management, the unaudited consolidated financial statements furnished herein include all adjustments, all of which are of a normal recurring nature, necessary for a fair statements of the results for the interim period presented.  Operating results for the period ended September 30, 2009 are not necessary indicative of the results that may be expected for the year ended December 31, 2009. The information included in this Form 10-Q should be read in conjunction with information included in the 2008 annual report filed on Form 10-K/A.
 
4


Use of Estimates

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of China Natural Gas, Inc. and its wholly owned subsidiary, Shaanxi Xilan Natural Gas Equipment Co., Ltd and its 100% variable interest entities (“VIE”), Xi’an Xilan Natural Gas Co. Ltd., Jingbian Liquefied Natural Gas Co., Ltd., Shaanxi Xilan Auto Bodyshop Co., Ltd. (“SXABC”), Henan Xilan Natural Gas Co., Ltd., and Lingbao Yuxi Natural Gas Co., Ltd.  All inter-company accounts and transactions have been eliminated in the consolidation.

Consolidation of Variable Interest Entity

In accordance with Financial Accounting Standards Board’s (“FASB”) accounting standard regarding consolidation,  VIEs are generally entities that lack sufficient equity to finance their activities without additional financial support from other parties or whose equity holders lack adequate decision making ability. All VIEs with which the Company is involved must be evaluated to determine the primary beneficiary of the risks and rewards of the VIE. The primary beneficiary is required to consolidate the VIE for financial reporting purposes.

On February 21, 2006, the Company formed Shaanxi Xilan Natural Gas Equipment Co., Ltd as a wholly-owned foreign enterprise (WOFE). Then through SXNGE, the Company entered into exclusive arrangements with Xi’an Xilan Natural Gas and its shareholders that give the Company the ability to substantially influence Xi’an Xilan Natural Gas’ daily operations and financial affairs, appoint its senior executives and approve all matters requiring shareholder approval. The Company memorialized these arrangements on August 17, 2007 and made retroactive to March 8, 2006.  As a result, the Company consolidates the financial results of Xi’an Xilan Natural Gas as variable interest entity .The arrangements consist of the following agreements:

a.
Xi’an Xilan Natural Gas holds the licenses and approvals necessary to operate its natural gas business in China.

b.
SXNGE provides exclusive technology consulting and other general business operation services to Xi’an Xilan Natural Gas in return for a consulting services fee which is equal to Xi’an Xilan Natural Gas’s revenue.

c.
Xi’an Xilan Natural Gas’ shareholders have pledged their equity interests in Xi’an Xilan Natural Gas to the Company.

d.
Irrevocably granted the Company an exclusive option to purchase, to the extent permitted under PRC law, all or part of the equity interests in Xi’an Xilan Natural Gas and agreed to entrust all the rights to exercise their voting power to the person appointed by the Company.

On August 8, 2008, the Company through SXNGE entered into an Addendum to Option Agreement with Mr. Qinan Ji, chairman and shareholder of XXNGC, and each of the shareholders of XXNGC (hereafter collectively referred to as the “Transferor”), and made retroactive to June 30, 2008.  According to the Agreement, the Chairman and the Shareholders of XXNGC irrevocably grants to SXNGE an option to purchase each Transferor’s Purchased Equity Interest at $1.00 or the lowest price permissible under the applicable laws at the time that SXNGE exercises the Option.  The Agreement limits XXNGC and the transferors’ right to make all equity interest related decisions.

Foreign Currency Translation

As of September 30, 2009 and December 31, 2008, the accounts of the Company were maintained, and their consolidated financial statements were expressed in RMB.  Such consolidated financial statements were translated into USD in accordance with an accounting standard issued by the FASB, with the RMB as the functional currency. All assets and liabilities were translated at the exchange rate as of the balance sheet date, stockholders’ equity were translated at the historical rates and statement of income and cash flow items were translated at the weighted average exchange rate for the year. The resulting translation adjustments are reported under other comprehensive income. Cash flows from the Company's operations are calculated based upon the local currencies and translated to USD at average translation rates for the period. As a result, translation adjustments amount related to assets and liabilities reported on the consolidated statement of cash flows will not necessarily agree with changes in the corresponding consolidated balances on the balance sheet.
 
5

 
The balance sheet amounts with the exception of equity at September 30, 2009, were translated 6.82 RMB to $1.00 as compared to 6.82 RMB at December 31, 2008. The equity accounts were stated at their historical rate. The average translation rates applied to income and cash flow statement amounts for the nine months ended September 30, 2009 and 2008, were 6.82 RMB and 6.98 RMB to $1.00, respectively.

Cash and Cash Equivalents

Cash and cash equivalents include cash on hand and demand deposits in accounts maintained with state-owned banks within the PRC and the United States. The Company considers all highly liquid investments with original maturities of three months or less at the time of purchase to be cash equivalents.

Certain financial instruments, which subject the Company to concentration of credit risk, consist of cash. The Company maintains balances at financial institutions which, from time to time, may exceed Federal Deposit Insurance Corporation insured limits for the banks located in the United States. Balances at financial institutions or state-owned banks within the PRC are not covered by insurance. As of September 30, 2009 and December 31, 2008, the Company had total deposits of $16,483,752 and $5,604,383 without insurance coverage.  And as of September 30, 2009 and December 31, 2008, the Company had deposits in the United States of $38,692,760 and $1,273,639 in excess of federally insured limits, respectively. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant risks on its cash in bank accounts.

Accounts Receivable

Accounts and other receivable are netted against an allowance for uncollectible accounts, as needed.  The Company maintains reserves for potential credit losses on accounts receivable.  Management reviews the composition of accounts receivable and analyzes historical bad debts, customer concentrations, customer credit worthiness, current economic trends and changes in customer payment patterns to evaluate the adequacy of these reserves. Reserves are recorded primarily on a specific identification basis in the period of the related sales. Delinquent account balances are written-off after management has determined that the likelihood of collection is not probable, and known bad debts are written off against allowance for doubtful accounts when identified. The Company’s management has determined that all receivables are collectible and there is no need for an allowance for uncollectible accounts as of September 30, 2009, and December 31, 2008.

Other Receivable – Employee Advances

From time to time, the Company advances predetermined amounts based upon internal Company policy to certain employees and internal units to ensure certain transactions are performed in a timely manner. The Company has full oversight and control over the advanced accounts. As of September 30, 2009 and December 31, 2008, no allowance for the uncollectible accounts was deemed necessary.

Inventory

Inventory is stated at the lower of cost, as determined on a first-in, first-out basis, or market.  Management compares the cost of inventories with the market value, and an allowance is made for writing down the inventories to their market value, if lower. Inventory consists of material used in the construction of pipelines and material used in repairing and modifying vehicles.  Inventory also consists of gasoline.

The following are the details of the inventories:

  
 
September 30, 2009
(Unaudited)
   
December 31, 2008
 
Materials and supplies
 
$
838,023
   
$
318,069
 
Gasoline
   
626,935
     
201,670
 
   
$
1,464,958
   
$
519,739
 

Advances to Suppliers

The Company advances to certain vendors for purchase of its materials. The advances are interest-free and unsecured.

Loan Receivable

Loan receivable consists of the following:
   
September 30, 2009
(Unaudited)
   
December 31, 2008
 
Shanxi Yuojin Mining Company, due on November 26, 2008, extended to November 30, 2009, annual interest at 6.57%
 
$
293,400
   
$
293,400
 
 
6


Property and Equipment

Property and equipment are stated at cost. Expenditures for maintenance and repairs are charged to earnings as incurred while additions, renewals and betterments are capitalized. When property and equipment are retired or otherwise disposed of, the related cost and accumulated depreciation are removed from the respective accounts, and any gain or loss is included in operations.  Depreciation of property and equipment is provided using the straight-line method for substantially all assets with estimated lives as follows:

Office equipment
5 years
Operating equipment
5-20 years
Vehicles
5 years
Buildings and improvements
5-30 years

The following are the details of the property and equipment:

  
 
September 30, 2009
(Unaudited)
   
December 31, 2008
 
Office equipment
 
$
415,859
   
$
412,490
 
Operating equipment
   
59,499,262
     
59,473,283
 
Vehicles
   
2,298,712
     
2,414,756
 
Buildings and improvements
   
21,209,086
     
21,190,599
 
     Total property and equipment
   
83,422,919
     
83,491,128
 
Less accumulated depreciation
   
(11,582,058
)
   
(7,462,856
)
     Property and equipment, net
 
$
71,840,861
   
$
76,028,272
 

Depreciation expense for the three months ended September 30, 2009 and 2008 was $1,390,659 and $937,156, respectively. Depreciation expense for the nine months ended September 30, 2009 and 2008 was $4,170,241 and $2,295,534, respectively.

Construction in Progress

Construction in progress (“CIP”) consists of the cost of constructing property and equipment for the Company’s gas stations and a new project of processing, distribution and sale of LNG. The major cost of construction in progress relates to technology licensing fees, equipment purchase, land use rights requisition cost, capitalized interest and other construction fees.  No depreciation is provided for construction in progress until such time as the assets are completed and placed into service.  Interest incurred during construction is capitalized into construction in progress. All other interest is expensed as incurred.

As of September 30, 2009 and December 31, 2008, the Company had construction in progress in the amount of $42,124,222 and $22,061,414, respectively. Interest cost capitalized into construction in progress for the three months ended September 30, 2009 and 2008, amounted to $1,388,870 and $990,061, respectively. Interest cost capitalized into construction in progress for the nine months ended September 30, 2009 and 2008, amounted to $3,419,796 and $1,672,565, respectively.

Construction in progress at September 30, 2009 consisted of the following:

No.
 
Project Description
 
Location
 
September 30, 2009
(Unaudited)
 
Commencement
date
 
Expected
completion
date
 
Estimated
additional
cost to
complete
 
1
 
Jingbian LNG – Phase I
 
JBLNG
 
$
34,735,672
 
Dec-06
 
May-10
 
$
14,218,000
 
2
 
Sa Pu mother station
 
HXNGC
   
769,413
 
Jul-08
 
Jun-11
   
6,300,000
 
3
 
Zijing Energy mother station
 
XXNGC
   
4,132,925
 
Sep-08
 
May-11
   
3,440,000
 
4
 
Xi'an Cangsheng mother station
 
XXNGC
   
1,855,599
 
Sep-08
 
May-11
   
3,220,000
 
5
 
Other CIP projects
 
XXNGC
   
630,613
 
Various
 
Dec-09
   
2,050,000
 
                               
           
$
42,124,222
         
$
29,228,000
 

Long-Lived Assets

The Company evaluates at least annually, more often when circumstances require, the carrying value of long-lived assets to be held and used.  Impairment losses to be recorded on long-lived assets used in operations when indicators of impairment are present and the undiscounted cash flows estimated to be generated by those assets are less than the assets' carrying amounts.  In that event, a loss is recognized based on the amount by which the carrying amount exceeds the fair market value of the long-lived assets.  Loss on long-lived assets to be disposed of is determined in a similar manner, except that fair market values are reduced for the cost of disposal.  Based on its review, the Company believes that, as of September 30, 2009, there were no significant impairments of its long-lived assets.
 
7


Unearned Revenue

Unearned revenue represents prepayments by customers for gas purchases and advance payments on installation of pipeline contracts. The Company records such prepayment as unearned revenue when the payments are received.

Fair Value of Financial Instruments

The accounting standards regarding fair value of financial instruments and related fair value measurements define fair value, establish a three-level valuation hierarchy for disclosures of fair value measurement, and enhance disclosure requirements for fair value measures. The carrying amounts reported in the consolidated balance sheets for current receivables and payables qualify as financial instruments.  Management concluded the carrying values are a reasonable estimate of fair value because of the short period of time between the origination of such instruments and their expected realization and if applicable, their stated interest rate approximates current rates available.  The three levels are defined as follows:

Level 1 inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.

Level 2 inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

Level 3 inputs to the valuation methodology are unobservable and significant to the fair value measurement.

FASB accounting standard regarding derivatives and hedging specifies that a contract that would otherwise meet the definition of a derivative but is both (a) indexed to the Company’s own stock and (b) classified in stockholders’ equity in the statement of financial position would not be considered a derivative financial instrument.  This FASB accounting standard also provides a new two-step model to be applied in determining whether a financial instrument or an embedded feature is indexed to an issuer’s own stock and thus able to qualify for the exception.

As a result of adopting this FASB accounting standard, 383,654 warrants previously treated as equity pursuant to the derivative treatment exemption are no longer afforded equity treatment because the strike price of the warrants is denominated in US dollar, a currency other than the Company’s functional currency, the Chinese Renminbi.  As a result, the warrants are not considered indexed to the Company’s own stock, and as such, all future changes in the fair value of these warrants will be recognized currently in earnings until such time as the warrants are exercised or expire.

As such, effective January 1, 2009, the Company reclassified the fair value of these warrants from equity to liability, as if these warrants were treated as a derivative liability since their issuance in October 2007. On January 1, 2009, the Company reclassified from additional paid-in capital, as a cumulative effect adjustment, $5,844,239 to beginning retained earnings and $1,014,308 to warrant liabilities to recognize the fair value of such warrants. The fair value of the warrants was $2,488,070 on September 30, 2009. The Company recognized a $357,979 loss from the change in fair value of the three months ended September 30, 2009. The Company recognized a $1,473,762 loss from the change in fair value of warrants for the nine months ended September 30, 2009.

These common stock purchase warrants do not trade in an active securities market, and as such, we estimate the fair value of these warrants using the Black-Scholes Option Pricing Model using the following assumptions:

  
 
September 30, 2009
   
January 1, 2009
 
   
(Unaudited)
 
Annual dividend yield
   
  -
     
   -
 
                 
Expected life (years)
   
3.07
     
3.82
 
Risk-free interest rate
   
 1.45
%
   
    1.13
%
Expected volatility
   
 90
%
   
   90
%

Expected volatility is based on historical volatility.  Historical volatility was computed using daily pricing observations for recent periods that correspond to the term of the warrants. The Company believes this method produces an estimate that is representative of our expectations of future volatility over the expected term of these warrants. The Company has no reason to believe future volatility over the expected remaining life of these warrants is likely to differ materially from historical volatility. The expected life is based on the remaining term of the warrants. The risk-free interest rate is based on U.S. Treasury securities according to the remaining term of the warrants.
 
8

 
Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. Depending on the product and the terms of the transaction, the fair value of the notes payable and derivative liabilities were modeled using a series of techniques, including closed-form analytic formula, such as the Black-Scholes Option Pricing Model, which does not entail material subjectivity because the methodology employed does not necessitate significant judgment, and the pricing inputs are observed from actively quoted markets.

The following table sets forth by level within the fair value hierarchy of the Company’s financial assets and liabilities that were accounted for at fair value on a recurring basis as of September 30, 2009.

  
 
Carrying Value at
September 30, 2009
(Unaudited)
   
Fair Value Measurement at
September 30, 2009
(Unaudited)
 
  
       
Level 1
   
Level 2
   
Level 3
 
Senior notes
 
$
26,542,120
   
$
-
   
$
-
   
$
35,366,413
 
Redeemable liability - warrants
   
17,500,000
     
-
     
-
     
13,475,197
 
Derivative liability - warrants
   
2,488,070
     
-
     
2,488,070
     
-
 
Total liability measured at fair value
 
$
46,530,190
   
$
-
   
$
2,488,070
   
$
48,841,610
 

Other than the derivative liabilities - warrants carried at fair value, the Company did not identify any other assets and liabilities that are required to be presented on the balance sheet.

Revenue Recognition

Revenue is recognized when services are rendered to customers when a formal arrangement exists, the price is fixed or determinable, the delivery is completed, no other significant obligations of the Company exist and collectability is reasonably assured. Payments received before all of the relevant criteria for revenue recognition are satisfied are recorded as unearned revenue.  Revenue from gas and gasoline sales is recognized when gas and gasoline is pumped through pipelines to the end users. Revenue from installation of pipelines is recorded when the contract is completed and accepted by the customers. The construction contracts are usually completed within one to two months.  Revenue from repairing and modifying vehicles is recorded when services are rendered to and accepted by the customers.

Enterprise Wide Disclosure

The Company’s chief operating decision-makers (i.e. chief executive officer and his direct reports) review financial information presented on a consolidated basis, accompanied by disaggregated information about revenues by business lines for purposes of allocating resources and evaluating financial performance. There are no segment managers who are held accountable for operations, operating results and plans for levels or components below the consolidated unit level. Based on qualitative and quantitative criteria established by the FASB’s accounting standard for segment reporting, the Company considers itself to be operating within one reportable segment.

Advertising Costs

The Company expenses the cost of advertising as incurred or, as appropriate, the first time the advertising takes place. Advertising costs for the three and nine months ended September 30, 2009 and 2008, were insignificant.

Stock-Based Compensation

The Company records and reports stock-based compensation pursuant to FASB’s accounting standard regarding stock compensation which defines a fair-value-based method of accounting for stock-based employee compensation and transactions in which an entity issues its equity instruments to acquire goods and services from non-employees. Stock compensation for stock granted to non-employees has been determined in accordance with this accounting standard, as the fair value of the consideration received or the fair value of equity instruments issued, whichever is more reliably measured.
 
9


Income Taxes

FASB’s accounting standard regarding income taxes, requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred income taxes are recognized for the tax consequences in future years of temporary differences between the tax bases of assets and liabilities and their financial reporting amounts at each period end based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized. At September 30, 2009 and December 31, 2008, there was no significant book to tax differences. There is no difference between book depreciation and tax depreciation as the Company uses the same method for both book and tax. A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded. The adoption had no affect on the Company’s consolidated financial statements.

Local PRC Income Tax

The Company’s subsidiary and VIEs operate in China. Starting January 1, 2008, pursuant to the tax laws of China, general enterprises are subject to income tax at an effective rate of 25% compared to 33% prior to 2008. The Company’s VIE, XXNGC, is in the natural gas industry whose development is encouraged by the government. According to the income tax regulation, any company engaged in the natural gas industry enjoys a favorable tax rate. Accordingly, except for income from SXNGE, JBLNG, SXABC, HXNGC and LBNGC which subjects to 25% PRC income tax rate, XXNGC’s income is subject to a reduced tax rate of 15%.  A reconciliation of tax at the United States federal statutory rate to the provision for income tax recorded in the financial statements is as follows:

  
 
For the three months ended
   
For the nine months ended
 
  
 
September 30,
   
September 30,
 
  
 
2009
   
2008
   
2009
   
2008
 
  
 
(Unaudited)
   
(Unaudited)
   
(Unaudited)
   
(Unaudited)
 
Tax provision (credit) at statutory rate
   
34
%
   
34
%
   
34
%
   
34
%
Foreign tax rate difference
   
(9
)%
   
(9
)%
   
(9
)%
   
(9
)%
Effect of favorable tax rate
   
(9
)%
   
(12
)%
   
(8
)%
   
(10
)%
Other item (1)
   
2
%
   
5
%
   
3
%
   
5
%
Total provision for income taxes
   
18
%
   
18
%
   
20
%
   
20
%

(1)  The 2% represents $649,484 in expenses incurred by CHNG are not deductible in PRC for the three months ended September 30, 2009. The 5% represents $1,434,740 expenses incurred by CHNG that are not deductible in PRC for the three months ended September 30, 2008. The 3% represents $3,774,073 in expenses incurred by CHNG that are not deductible in PRC for the nine months ended September 30, 2009. The 5% represents $4,013,188 expenses incurred by CHNG that are not deductible in PRC for the nine months ended September 30, 2008.

The estimated tax savings for the three months ended September 30, 2009 and 2008, amounted to approximately $570,006 and $645,717, respectively. The net effect on earnings per share, had the income tax been applied, would decrease basic and diluted earnings per share for the three months ended September 30, 2009 and 2008, from $0.29 to $0.25 and $0.35 to $0.31, respectively.

The estimated tax savings for the nine months ended September 30, 2009 and 2008, amounted to approximately $1,801,782 and $1,579,140, respectively. The net effect on earnings per share, had the income tax been applied, would decrease basic and diluted earnings per share for the nine months ended September 30, 2009 and 2008, from $0.85 to $0.73 and $0.78 to $0.67, respectively.

China Natural Gas, Inc. was incorporated in the United States and has incurred net operating loss for income tax purpose for the period ended September 30, 2009. The estimated net operating loss carry forwards for United States income tax purposes amounted to $2,278,525 and $1,657,473 as of September 30, 2009 and December 31, 2008, respectively, which may be available to reduce future years' taxable income. These carry forwards will expire, if not utilized, beginning in 2027 through 2029. Management believes that the realization of the benefits arising from this loss appear to be uncertain due to Company's limited operating history and continuing losses for United States income tax purposes. Accordingly, the Company has provided a 100% valuation allowance at September 30, 2009. Management reviews this valuation allowance periodically and makes adjustments as warranted. The valuation allowances were as follow:

  
 
Nine months ended
   
Year ended
 
  
 
September 30, 2009
   
December 31, 2008
 
Valuation allowance
 
(Unaudited)
       
Balance, beginning of period
 
$
563,541
   
$
322,614
 
Increase
   
211,158
     
240,927
 
Balance, end of period
 
$
774,699
   
$
563,541
 
 
10

 
The Company has cumulative undistributed earnings of foreign subsidiaries of approximately $27,431,955 as of September 30, 2009, which is included in consolidated retained earnings and will continue to be indefinitely reinvested in international operations.  Accordingly, no provision has been made for U.S. deferred taxes related to future repatriation of these earnings, nor is it practicable to estimate the amount of income taxes that would have to be provided if we concluded that such earnings will be remitted in the future.

Value added tax

Sales revenue represents the invoiced value of goods, net of a value-added tax (“VAT”). All of the Company’s variable interest entity XXNGC’s products that are sold in the PRC are subject to a Chinese value-added tax at a rate of 13% of the gross sales price. This VAT may be offset by VAT paid by the XXNGC on raw materials and other materials included in the cost of producing their finished product. XXNGC recorded VAT payable and VAT receivable net of payments in the financial statements. The VAT tax return is filed offsetting the payables against the receivables.

All revenues from SXABC are subject to a Chinese VAT at a rate of 6%. This VAT cannot offset with VAT paid for materials included in the cost of revenues.

Basic and Diluted Earnings Per Share
 
Earnings per share is calculated in accordance with the FASB’s accounting standard regarding earnings per share. Basic net earnings per share is based upon the weighted average number of common shares outstanding. Diluted net earnings per share is based on the assumption that all dilutive convertible shares and stock options were converted or exercised.  Dilution is computed by applying the treasury stock method. Under this method, options and warrants are assumed to be exercised at the beginning of the period (or at the time of issuance, if later), and as if funds obtained thereby were used to purchase common stock at the average market price during the period.

All share and per share amounts used in the Company's consolidated financial statements and notes thereto have been retroactively restated to reflect the 1-for-2 reverse stock split, which were effective on April 28, 2009.

Recently issued accounting pronouncements

In January 2009, the FASB’s accounting standard regarding other investments providing additional guidance which amended the impairment model to remove the exclusive reliance on “market participant” estimates of future cash flows used in determining fair value. Changing the cash flows used to analyze other-than-temporary impairment from the “market participant” view to a holder’s estimate of whether there has been a “probable” adverse change in estimated cash flows allows companies to apply reasonable judgment in assessing whether an other-than-temporary impairment has occurred. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.

In April 2009, the FASB’s accounting standard regarding fair value measurements and disclosures providing additional guidance for estimating fair value when the volume and level of activity for the asset or liability have significantly decreased and also includes guidance on identifying circumstances that indicate a transaction is not orderly for fair value measurements. This guidance shall be applied prospectively with retrospective application not permitted. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.

In April 2009, the FASBs accounting standard regarding debt and equity securities requires to make the other-than-temporary impairments guidance more operational and to improve the presentation of other-than-temporary impairments in the financial statements. This guidance will replace the existing requirement that the entity’s management assert it has both the intent and ability to hold an impaired debt security until recovery with a requirement that management assert it does not have the intent to sell the security, and it is more likely than not it will not have to sell the security before recovery of its cost basis. This guidance provides increased disclosure about the credit and noncredit components of impaired debt securities that are not expected to be sold and also requires increased and more frequent disclosures regarding expected cash flows, credit losses, and an aging of securities with unrealized losses. Although this guidance does not result in a change in the carrying amount of debt securities, it does require that the portion of an other-than-temporary impairment not related to a credit loss for a held-to-maturity security be recognized in a new category of other comprehensive income and be amortized over the remaining life of the debt security as an increase in the carrying value of the security. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.

In April 2009 In April 2009, the FASB issued an accounting standard that requires disclosures about fair value of financial instruments not measured on the balance sheet at fair value in interim financial statements as well as in annual financial statements. Prior to this guidance, fair values for these assets and liabilities were only disclosed annually. This guidance applies to all financial instruments and requires all entities to disclose the method(s) and significant assumptions used to estimate the fair value of financial instruments. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.
 
11

 
In May 2009, the FASB updated an accounting standard regarding subsequent events providing guidance to establish general standards of accounting for and disclosures of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. This accounting standard requires entities to disclose the date through which subsequent events were evaluated as well as the rationale for why that date was selected.  The Company adopted this Standard during the second quarter of 2009. This guidance requires that public entities evaluate subsequent events through the date that the financial statements are issued. The Company has evaluated subsequent events through the time of filing these consolidated financial statements with the SEC on November 9, 2009.

In June 2009, the FASB issued an accounting standard amending the accounting and disclosure requirements for transfers of financial assets.  This guidance is effective for the Company beginning in 2010. Should the Company’s accounts receivable securitization programs not qualify for sale treatment under the revised rules, future securitization transactions entered into on or after January 1, 2010 would be classified as debt and the related cash flows would be reflected as a financing activity. The Company is currently assessing the impact of the standard on its securitization programs.

In June 2009, the FASB updated an accounting standard regarding consolidation guidance which modifies how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. This guidance clarifies that the determination of whether a company is required to consolidate an entity is based on, among other things, an entity’s purpose and design and a company’s ability to direct the activities of the entity that most significantly impact the entity’s economic performance. This guidance requires an ongoing reassessment of whether a company is the primary beneficiary of a variable interest entity. This guidance also requires additional disclosures about a company’s involvement in variable interest entities and any significant changes in risk exposure due to that involvement. This guidance is effective for fiscal years beginning after November 15, 2009. The Company is currently assessing the impact of the standard on its securitization programs.

In August 2009, the FASB issued an Accounting Standards Update (“ASU”) regarding measuring liabilities at fair value. This ASU provides additional guidance clarifying the measurement of liabilities at fair value in circumstances in which a quoted price in an active market for the identical liability is not available; under those circumstances, a reporting entity is required to measure fair value using one or more of valuation techniques, as defined. This ASU is effective for the first reporting period, including interim periods, beginning after the issuance of this ASU. The Company is currently evaluating the impact of this ASU on its consolidated financial statements.

In October 2009, the FASB issued an ASU regarding accounting for own-share lending arrangements in contemplation of convertible debt issuance or other financing.  This ASU requires that at the date of issuance of the shares in a share-lending arrangement entered into in contemplation of a convertible debt offering or other financing, the shares issued shall be measured at fair value and be recognized as an issuance cost, with an offset to additional paid-in capital. Further, loaned shares are excluded from basic and diluted earnings per share unless default of the share-lending arrangement occurs, at which time the loaned shares would be included in the basic and diluted earnings-per-share calculation.  This ASU is effective for fiscal years beginning on or after December 15, 2009, and interim periods within those fiscal years for arrangements outstanding as of the beginning of those fiscal years. The Company is currently evaluating the impact of this ASU on its consolidated financial statements.

Note 3 – Other Assets

Other assets consisted of the following:

  
 
September 30,
   
December 31,
 
  
 
2009
   
2008
 
  
 
Unaudited
       
Prepaid rent – natural gas stations
 
$
369,392
   
$
272,635
 
Prepayment for acquiring land use right
   
1,422,990
     
1,060,675
 
Advances on purchasing equipment and construction in progress
   
10,862,520
     
6,427,974
 
Refundable security deposits
   
530,783
     
981,083
 
Others
   
164,327
     
101,695
 
      Total
 
$
13,350,012
   
$
8,844,062
 

All land in the PRC is government owned.  However, the government grants users land use rights.  As of September 30, 2009 and December 31, 2008, the Company prepaid $1,422,990  and $1,060,675, respectively, to the PRC local government to purchase land use rights. The Company is in the process of negotiating the final purchase price with the local government and the land use rights have not yet been granted to the Company.  Therefore, the Company did not amortize the prepaid land use rights.
 
12

 
Advances on the purchase of equipment and construction in progress are monies deposited or advanced to outside vendors/subcontractors for the purchase of operating equipment or for services to be provided for constructions in progress.

Refundable security deposits are monies deposited with one of the Company’s major vendors and gas station landlord.  These amounts will be returned to the Company if they terminate the business relationship or at the end of the lease.

Note 4 – Senior Notes Payable

On December 30, 2007, the Company entered into a Securities Purchase Agreement with Abax Lotus Ltd. (the “Investor”). The Purchase Agreement was subsequently amended on January 29, 2008, pursuant to which the Company (i) agreed to issue 5.00% Guaranteed Senior Notes due 2014 (the “Senior Notes”) of approximately $20,000,000, (ii) agreed to issue to the Investor Senior Notes in aggregate principal amount of approximately $20,000,000 on or before March 3, 2008 subject to the Company meeting certain closing conditions, (iii) granted the Investor an option to purchase up to approximately $10,000,000 in principal amount of its Senior Notes and (iv) agreed to issue to the Investor seven-year warrants exercisable for up to 1,450,000 shares of the Company’s common stock (the “Warrants”) at an initial exercise price equal to $14.7304 per share, subject to certain adjustments, which adjusted to $7.3652 on January 29, 2009.  On January 29, 2008, the Company issued $20,000,000 Senior Notes and 1,450,000 warrants pursuant to the Purchase Agreement. On March 3, 2008, the Investor exercised its first option for an additional $20,000,000 of Senior Notes. On March 10, 2008, the Company issued $20,000,000 in additional Senior Notes resulting in total Senior Notes of $40,000,000.

At the closing, the Company entered into:

·
An indenture for the 5.00% Guaranteed Senior Notes due 2014;
·
An investor rights agreement;
·
A registration rights agreement covering the shares of common stock issuable upon exercise of the warrants;
·
An information rights agreement that grants to the Investor, subject to applicable law, the right to receive certain information regarding the Company;
·
A share-pledge agreement whereby the Company granted to the Collateral Agent (on behalf of the holders of the Senior Notes) a pledge on 65% of the Company’s equity interest in Shaanxi Xilan Natural Gas Equipment Co., Ltd., a PRC corporation and wholly-owned subsidiary of the Company; and
·
An account pledge and security agreement whereby the Company granted to the Collateral Agent a security interest in the account where the proceeds from the Senior Notes are deposited.

In addition, Qinan Ji, Chief Executive Officer and Chairman of the Board of the Company, executed a non-compete agreement for the benefit of the Investor.

The Senior Notes were issued pursuant to an indenture between the Company and DB Trustees (Hong Kong) Limited, as trustee, at the closing. The Senior Notes will mature on January 30, 2014 and will initially bear interest at the stated interest rate of 5.00% per annum, subject to an increase in the event of certain circumstances. The Company is required to make mandatory prepayments on the Senior Notes on the following dates and in the following amounts, expressed as a percentage of the aggregate principal amount of Notes that will be outstanding on the first such payment date:
 
Date
 
Prepayment Percentage
 
July 30, 2011
   
8.3333
%
January 30, 2012
   
8.3333
%
July 30, 2012
   
16.6667
%
January 30, 2013
   
16.6667
%
July 30, 2013
   
25.0000
%

During the twelve month period commencing January 30 of the years set forth below, the Company may redeem the Senior Notes at the following principal amount:
 
Year
 
Principal
 
2009
   
43,200,000
 
2010
   
42,400,000
 
2011
   
41,600,000
 
2012
   
40,800,000
 
2013 and thereafter
   
40,000,000
 
 
13

 
Upon the occurrence of certain events defined in the indenture, the Company must offer the holders of the Senior Notes the right to require the Company to purchase the Senior Notes in an amount equal to 105% of the aggregate principal amount purchased plus accrued and unpaid interest on the Senior Notes purchased.

The indenture requires the Company to pay additional interest at the rate of 3.0% per annum of the Senior Notes if the Company has not obtained a listing of its common stock on the Nasdaq Global Market, the Nasdaq Capital Market or the New York Stock Exchange by January 29, 2009 and maintained such listing continuously thereafter as long as the Senior Notes are outstanding. As of January 29, 2009, the Company has not obtained a listing of its common stock on the market stated in the agreement. However, the Company obtained a three-month waiver from ABAX for the additional interest payment. The waiver gives the Company three more months until April 28, 2009 to achieve the uplisting status. By the end of the extended period, if the Company was not able to complete the uplisting, the Company would have to pay additional interest retroactively starting January 30, 2009 in accordance with the terms of the waiver. The Company was approved to be listed on Nasdaq on June 1, 2009 but was in negotiation with ABAX regarding the amount of additional interest to be paid as of June 30, 2009, thus the Company recognized additional interest payment amounted to $203,334 and $406,667 for the three months and six months ended June 30, 2009, respectively.

In August 2009, the Company reached an agreement with ABAX that the Company was to pay additional interest accrued for the period from April 29, 2009, the expiration date of previous waiver to June 1, 2009, the date of listing. As such, the Company paid $113,214 additional interest to ABAX in August 2009 and recorded other income of $293,453 accordingly.

The indenture limits the Company's ability to incur debt and liens, make dividend payments and stock repurchases, make investments, reinvest proceeds from asset sales and enter into transactions with affiliates, among other things. The indenture also requires the Company to maintain certain financial ratios.

The Company also entered into an investor rights agreement, pursuant to which, as long as an investor holds at least 10% of the aggregate principal amount of the Senior Notes issued and outstanding or at least 3% of the Company’s issued and outstanding common stock pursuant to the warrants on an as-exercised basis (“Minimum Holding”), the Company has agreed not to undertake certain corporate actions without prior Investor approval. In addition, so long as an Investor owns the Minimum Holding, such Investor shall have a right of first refusal for future debt securities offerings by the Company and the Company is subject to certain transfer restrictions on its securities and certain other properties.
 
From the Closing Date and as long as the Investor continues to hold more than 10% of the outstanding shares of common stock on an as-converted, fully-diluted basis, the Investor shall be entitled to appoint one of the Company’s board of directors (the “Investor Director”). The Investor Director shall be entitled to serve on each committee of the board, except that, the Investor Director shall not serve on the audit committee unless it is an independent director. Mr. Ji has agreed to vote his shares for the election of the Investor Director.
 
The Company was required to prepare and file a registration statement covering the sales of all of the shares of common stock issuable upon exercise of the warrants or incur additional interest of 1% on the Notes.  The Company’s registration statement was declared effective on May 6, 2008; therefore, no penalties were incurred.

In connection with the issuance of the Securities Purchase Agreement, the Company paid $2,122,509 in debt issuance costs which is being amortized over the life of the Senior Notes.  For the three months ended September 30, 2009 and 2008, the Company amortized $11,505 and $24,410 of the aforesaid issuance costs, net of capitalized interest.  For the nine months ended September 30, 2009 and 2008, the Company amortized $63,940 and $147,002 of the aforesaid issuance costs, net of capitalized interest.

In connection with the Securities Purchase Agreement, the Company agreed to issue to the Investor seven-year warrants exercisable for up to 1,450,000 shares of the Company’s common stock at an initial exercise price equal to $14.7304 per share, subject to certain adjustments. The exercise price of the Warrants is adjusted on the first anniversary of issuance and thereafter, at every six month anniversary beginning in the fiscal year 2009 if the volume weighted average price, or VWAP, (as defined therein) for the 15 trading days prior to the applicable reset date is less than the then applicable exercise price, in which case the exercise price shall be adjusted downward to the then current VWAP; provided, however, that in no event shall the exercise price be adjusted below $7.3652 per share. The exercise price was adjusted to $7.3652 on January 29, 2009. No further adjustments of the exercise price will be required (as that is the floor price).

The warrants granted to the Investor on January 29, 2008 are considered derivative instruments that need to be bifurcated from the original security.  If the Warrants have not been exercised within the seven year period, then the Investor can have the Company purchase the Warrants for $17,500,000.  This amount is shown as a debt discount and is being amortized over the term of the Senior Notes.  For the three months ended September 30, 2009 and 2008, the Company amortized $63,054 and $95,528 of the aforesaid discounts, net of capitalized interest. For the nine months ended September 30, 2009 and 2008, the Company amortized $280,250 and $555,001 of the aforesaid discounts, net of capitalized interest.
 
14

 
The warrants have been determined to be derivative liabilities instruments because there is a required redemption requirement if the holder does not exercise the Warrants.  However, the warrants are not required to be valued at fair value, rather, to be at its undiscounted redemption amount of $17.5 million.

Note 5 – Warrants

Following is a summary of the warrant activity:

  
 
Warrants
Outstanding
   
Weighted Average
Exercise Price
   
Aggregate
Intrinsic Value
 
Outstanding, December 31, 2007
   
544,242
   
$
13.10
     
376,977
 
Granted
   
1,450,000
   
 
14.74
     
-
 
Forfeited
   
-
     
-
     
-
 
Exercised
   
-
     
-
     
-
 
Outstanding, December 31, 2008
   
1,994,242
   
$
14.28
     
-
 
Granted
   
-
     
-
     
-
 
Forfeited
   
(160,588
)
 
$
7.20
     
-
 
Exercised
   
-
     
-
     
-
 
Outstanding, September 30, 2009 (Unaudited)
   
1,833,654
   
$
8.93
     
5,842,088
 

Following is a summary of the status of warrants outstanding at September 30, 2009 (Unaudited):

Outstanding Warrants
 
Exercise Price
 
Number
   
Average
Remaining
Contractual
Life
 
$
7.37
   
1,450,000
     
5.33
 
$
14.86
   
383,654
     
2.84
 
$
8.93
   
1,833,654
     
4.81
 

Note 6 – Defined Contribution Plan

The Company is required to participate in a defined contribution plan operated by the local municipal government in accordance with Chinese law and regulations.  The Company contributes 100RMB per employee per month to the plan. Starting from 2008, no minimum contribution is required but the maximum contribution cannot be more than 14% of the current salary expense. The total contribution for the above plan was $53,128 and $0 for the three months ended September 30, 2009 and 2008, respectively.  The total contribution for the above plan was $134,207and $0 for the nine months ended September 30, 2009 and 2008, respectively.

Note 7 – Secondary Public Offering

On September 9, 2009, the Company completed an underwritten public offering for 5,725,000 shares of its common stock at a price of $8.75 per share. China Natural Gas also granted the underwriters a 30-day option to purchase up to an additional 858,750 shares to cover over-allotments at the public offering price.

On September 21, 2009, the Company closed the sale of an additional 858,750 shares of common stock at the public offering price of $8.75 per share, pursuant to the over-allotment option exercised in full by the underwriter in connection with its public offering that closed on September 9, 2009.

The net proceeds, after deducting underwriting discounts and commissions and the relevant expenses, is approximately $54.4 million.

The net proceeds from the offering was intended to be used for the construction of the Company's liquefied natural gas facility, the acquisition of CNG fueling stations, the purchase of CNG trucks and the establishment of a joint venture company with China National Petroleum Corporation Kunlun Natural Gas Co., Ltd., as well as for general working capital purposes.

Note 8 – Statutory Reserve

As stipulated by the Company Law of the People’s Republic of China (PRC) as applicable to Chinese companies with foreign ownership, net income after taxation can only be distributed as dividends after appropriation has been made for the following:
 
15

 
 
  i.
Making up cumulative prior years’ losses, if any;

 
 ii.
Allocations to the “Statutory surplus reserve” of at least 10% of income after tax, as determined under PRC accounting rules and regulations, until the fund amounts to 50% of the Company's registered capital;

 
iii.
Allocations to the discretionary surplus reserve, if approved in the shareholders’ general meeting.

As of September 30, 2009, the remaining reserve needed to fulfill the 50% registered capital requirement totaled $53,257,563.

Note 9 – Accounting for stock-based compensation

1) Options from CEO to pay for certain Company’s legal expenses

On September 22, 2007, Mr. Qinan Ji, chairman and shareholder of the Company, transferred 50,000 of his personally-owned options to the Company’s attorney to cover certain Company legal expenses. 30% of the options vested on September 22, 2008, 30% vest on September 22, 2009, and the remaining 40% vest on September 22, 2010.  Upon termination of service to the Company, the attorney is required to return all unvested options.  These options expire June 1, 2012.

The Company used the Black-Sholes Option Pricing Model to value the options at the time they were issued, based on the stock price on its grant date, the stated exercise prices and expiration dates of the instruments and using a risk-free rate of 4.10%. The estimated life is based on one half of the sum of the vesting period and the contractual life of the option. This is the same as assuming that the options are exercised at the mid-point between the vesting date and expiration date. $14,842 and $12,965 of compensation expense was recorded during the three months ended September 30, 2009 and 2008, respectively. $44,527 and $38,896 of compensation expense were recorded during the nine months ended September 30, 2009 and 2008, respectively.

As of September 30, 2009, approximately $88,032 of estimated expense with respect to non-vested stock-based compensation has yet to be recognized and will be recognized in expense over the optionee’s remaining weighted average service period of approximately one year.

2) 2009 stock option plan

On March 11, 2009, the board of directors approved by written consent the Company’s stock option plan for its employees, directors and consultants. Pursuant to the plan, the total stock option pool will equal to 10% of the Company’s total shares outstanding as of March 11, 2009. Among the option pool approved, 4% shall be awarded in 2009 and another 4% shall be awarded in 2010, and 2% reserved for future awards. For the 2009 stock option award, the CEO and CFO were granted total options of 1% and 0.6% of the common shares outstanding respectively, 50% as Non-qualified Stock Options (NSO) and 50% as Incentive Stock Awards (ISA), for a vesting period of four years.  As Richard Wu has resigned as CFO, the Company granted to his successor, Veronica Chen, options to purchase 75,000 shares (post-split) of the Company’s common stock, representing approximately 0.5% of the Company’s outstanding shares as of March 11, 2009, with the same terms and conditions as specified in the stock options plan.  5,000 option shares per year will be granted to each non-executive board member and 6,000 option shares per year granted to the Audit Committee Chairman. Other senior management and employees will be granted total options of 2.11% of the Company’s common shares. On April 1, 2009 and May 1, 2009, the Company issued 243,850 and 75,000 stock options, respectively, pursuant to the Company's 2009 employee stock option and stock award plan.  The strike price for the options was $4.90 per share. The stock option has a term of six years and vests evenly over four years starting one year from the issuance date on an annually basis.

The Company used the Black-Sholes Option Pricing Model to value the options at the time they were issued, based on the stock price on its grant date, the stated exercise prices and expiration dates of the instruments and using risk-free rates. The estimated life is based on one half of the sum of the vesting period and the contractual life of the option. This is the same as assuming that the options are exercised at the mid-point between the vesting date and expiration date. $71,073 and $142,146 of compensation expense was recorded during three months and nine months ended September 30, 2009, respectively.

As of September 30, 2009, approximately $995,021 of estimated expense with respect to non-vested stock-based compensation has yet to be recognized and will be recognized in expense over the optionee’s remaining weighted average service period of approximately 3.50 years.
 
16


Following is a summary of the Stock option activity:

   
Options
Outstanding
   
Weighted Average
Exercise Price
   
Aggregate
Intrinsic Value
 
                   
Outstanding, December 31, 2007
 
-
   
-
   
-
 
Granted
    -       -       -  
Forfeited
    -       -       -  
Exercised
    -       -       -  
Outstanding, December 31, 2008
    -       -       -  
Granted
    318,850     $ 4.9       95,655  
Forfeited
    -       -       -  
Exercised
    -       -       -  
Outstanding, September 30, 2009 (Unaudited)
    318,850     $ 4.9       2,302,097  

Following is a summary of the status of stock options outstanding at September 30, 2009 (unaudited):

Outstanding Options
   
Exercisable Options
 
Exercise
Price
 
Number
   
Average
Remaining
Contractual
Life
   
Exercise
Price
   
Number
   
Average
Remaining
Contractual
Life
 
$
4.90
   
243,850
     
5.50
     
-
     
-
     
-
 
$
4.90
   
75,000
     
5.59
     
-
     
-
     
-
 

Note 10 – Earnings per Share

Earnings per share for the periods ended September 30, 2009 and 2008 is determined by dividing net income for the periods by the weighted average number of both basic and diluted shares of common stock and common stock equivalents outstanding. The following is an analysis of the differences between basic and diluted earnings per common share in accordance with FASB’s accounting standard.

The following demonstrates the calculation for earnings per
share for the periods ended September 30, 2009 and 2008:   
 
For the three months ended
   
For the nine months ended
 
  
 
September 30,
   
September 30,
 
Basic earning per share
 
2009
   
2008
   
2009
   
2008
 
   
(Unaudited)
   
(Unaudited)
   
(Unaudited)
   
(Unaudited)
 
                         
Net income
    4,647,519       5,136,590       12,711,898       11,458,053  
   
 
   
 
   
 
   
 
 
Weighted shares outstanding-Basic
    15,754,696       14,600,152       14,985,001       14,600,152  
   
 
   
 
   
 
   
 
 
Earnings per share-Basic
  $ 0.29     $ 0.35     $ 0.85     $ 0.78  
   
 
   
 
   
 
   
 
 
Diluted earning per share
 
 
   
 
   
 
   
 
 
   
 
   
 
   
 
   
 
 
Net income
    4,647,519       5,136,590       12,711,898       11,458,053  
   
 
   
 
   
 
   
 
 
Weighted shares outstanding-Basic
    15,754,696       14,600,154       14,985,001       14,600,154  
   Effect of diluted securities-Warrants
    385,124       39,641       50,171       58,265  
Weighted shares outstanding-Diluted
    16,139,820       14,639,795       15,035,172       14,658,419  
   
 
   
 
   
 
   
 
 
Earnings per share –Diluted
  $ 0.29     $ 0.35     $ 0.85     $ 0.78  

17


At September 30, 2009 and 2008, the Company had outstanding warrants of 1,833,654 and 1,994,242, respectively.  For the three months ended September 30, 2009, the average stock price was greater than the exercise prices of the 1,450,000 warrants which resulted in additional weighted average common stock equivalents of 385,124; 383,654 outstanding warrants were excluded from the diluted earnings per share calculation as they are anti-dilutive. For the three months ended September 30, 2008, the average stock price was greater than the exercise prices of the 160,588 warrants which resulted in additional weighted average common stock equivalents of 39,641; 1,833,654 outstanding warrants were excluded from the diluted earnings per share calculation as they are anti-dilutive. For the nine months ended September 30, 2009, the average stock price was greater than the exercise prices of the 1,450,000 warrants which resulted in additional weighted average common stock equivalents of 50,171; 383,654 outstanding warrants were excluded from the diluted earnings per share calculation as they are anti-dilutive.  For the nine months ended September 30, 2008, the average stock price was greater than the exercise prices of the 160,588 warrants which resulted in additional weighted average common stock equivalents of 58,265; 1,833,654 outstanding warrants were excluded from the diluted earnings per share calculation as they are anti-dilutive.
 
Note 11 – Current Vulnerability Due to Certain Concentrations

Concentration of natural gas vendors:
   
For the three months ended
   
For the nine months ended
 
  
 
September 30,
   
September 30,
 
  
 
2009
   
2008
   
2009
   
2008
 
   
(Unaudited)
   
(Unaudited)
   
(Unaudited)
   
(Unaudited)
 
                                 
Numbers of natural gas vendors
   
4
     
4
     
4
     
4
 
                                 
Percentage of total natural gas purchases
   
99
%
   
97
%
   
99
%
   
98
%

As of September 30, 2009 and December 31, 2008, the Company has $106,078 and $206,811, respectively, payable due to its major suppliers.

The Company maintains long-term natural gas minimum purchase agreements with one of its vendors as of September 30, 2009. There are no minimum purchase requirements by the Company.  Contracts are renewed on an annual basis. The Company’s management reports that it does not expect any issues or difficulty in continuing to renew the supply contracts with these vendors going forward. Price points for natural gas are strictly controlled by the government and have remained stable over the past three years.

The Company's operations are carried out in the People’s Republic of China. Accordingly, the Company's business, financial condition and results of operations may be influenced by the political, economic and legal environments in the People’s Republic of China, by the general state of the People’s Republic of China‘s economy. The Company's business may be influenced by changes in governmental policies with   respect to laws and regulations, anti-inflationary measures, currency conversion and remittance abroad, and rates and methods of taxation, among other things.

Note 12 – Commitments and Contingencies

(a)  Lease Commitments

The Company recognizes lease expense on a straight-line basis over the term of the lease in accordance to FASB’s accounting standard regarding leases. The Company entered into a series of long-term lease agreements with outside parties to lease land use rights to the self-built Natural Gas filing stations located in the PRC. The agreements have terms ranging from 10 to 30 years. The Company makes annual prepayments for most lease agreements.  The Company also entered into two office leases in Xi’an, PRC and New York, NY.  The minimum future payment for leasing land use rights and offices is as follows:

Year ending December 31, 2009
 
$
86,758
 
Year ending December 31, 2010
   
1,458,518
 
Year ending December 31, 2011
   
1,577,171
 
Year ending December 31, 2012
   
1,391,916
 
Year ending December 31, 2013
   
1,280,490
 
Thereafter
   
21,923,923
 
Total
 
$
27,718,776
 
 
18

 
For the three months ended September 30, 2009 and 2008, the land use right and office lease expenses were $411,452 and $256,876, respectively. For the nine months ended September 30, 2009 and 2008, the land use right and office lease expenses were $1,209,549 and $630,821 respectively.

 (b) Property and Equipment

In January 2008, the Company entered into a contract with Chemtex International Inc. to purchase equipment supply for the LNG plant and storage tank located in Jingbian County, Shannxi Province China, in the total amount of $13,700,000. On May 16, 2008, JBLNG entered into an agreement with Hebei Tongchan Import and Export Co. Ltd. (Hebei) and agreed that Hebei will act as the trade agency for JBLNG. On June 16, 2008, the Company entered into an equipment supply contract with Chemtex International Inc. to supply imported equipment for a LNG plant and a storage tank to be built by Jingbian Xilan LNG Co. Ltd. On September 8, 2008, the total contract value was reduced from $13,700,000 to $13,l00,000. As of September 30, 2009, the Company advanced $6,140,000 to the trade agency and the future commitment for equipment is $6,960,000.

(c) Natural Gas Purchase Commitments

The Company has existing long-term natural gas purchase agreements with its major suppliers. However, none of those agreements stipulate any specific purchase amount or quota each year, thus giving the Company enough flexibility to constantly look for lower-cost sources of supply. Therefore, the Company is not legally bound in purchase commitments by those agreements.

(d) Capital Commitments

In July 2009, the Company, through its variable interest entity, Xi’an Xilan Natural Gas Co., Ltd. (“Xi’an Xilan”), has entered into a joint venture agreement with China National Petroleum Corporation Kunlun Natural Gas Co., Ltd. and a Joint Venture Company will be established.  The Joint Venture Company will have an initial registered capital of RMB50,000,000 (approximately $7,350,000) and Xi’an Xilan has a capital commitment of RMB24,500,000, representing 49% of the Joint Venture Company’s total registered capital.  As of September 30, 2009, Xi’an Xilan has not yet made any capital contribution.

(e) Legal Proceedings

A former member of the board of directors filed a lawsuit against the Company in the New York State Supreme Court, Nassau County, in which he has sought, among other things to recover a portion of his monthly compensation plus 20,000 options that he alleges are due to him pursuant to a written agreement.  After the plaintiff rejected an offer by the Company that included the options that the plaintiff alleged were due to him, the Company moved to dismiss the complaint.  The judge ordered the Company to issue the 20,000 options to the plaintiff subject to any restrictions required by applicable securities laws, which was essentially what the Company had previously offered, and dismissed all of the plaintiff's remaining claims against the Company.  The current board of directors has complied with the court's decision by tendering an options agreement to the plaintiff consistent with the court's decision, but the plaintiff has refused to execute the agreement, and instead has filed an appeal.  Regardless of the outcome of the appeal, the Company believes that any liability it would incur will not have a materially adverse effect on its financial condition or its results of operations, and, accordingly, this matter has not been reflected on the Company's consolidated financial statements.

Note 13 – Subsequent event

The Company has performed an evaluation of subsequent events through November 9, 2009, which is the date the financial statements were issued.

 
19

 

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

CAUTIONARY STATEMENT

FORWARD-LOOKING STATEMENT

The information in this report contains forward-looking statements. All statements other than statements of historical fact made in this report are forward looking. In particular, the statements herein regarding industry prospects and future results of operations or financial position are forward-looking statements. These forward-looking statements can be identified by the use of words such as "believes," "estimates," "could," "possibly," "probably," anticipates," "projects," "expects," "may," "will," or "should" or other variations or similar words. No assurances can be given that the future results anticipated by the forward-looking statements will be achieved. Forward-looking statements reflect management's current expectations and are inherently uncertain. Our actual results may differ significantly from management's expectations.

The following discussion and analysis should be read in conjunction with our financial statements, included herewith. This discussion should not be construed to imply that the results discussed herein will necessarily continue into the future, or that any conclusion reached herein will necessarily be indicative of actual operating results in the future. Such discussion represents only the best present assessment of our management.

Overview

We are a distributor of compressed natural gas ("CNG") in China.. As of September 30, 2009, we operated 24 CNG fueling stations in Shaanxi province and 12 CNG fueling stations in Henan province. We own our CNG fueling stations while we lease the land upon which our CNG fueling stations operate. For the three and nine months ended September 30, 2009, we sold CNG of 40,420,123 and 120,866,756 cubic meters respectively through our fueling stations, compared to 40,547,584 and 107,226,877 cubic meters for the three and nine months ended September 30, 2008. We also transport, distribute and sell piped natural gas to residential and commercial customers in the Xi’an area, including Lantian County, and the districts of Lintong and Baqiao, in Shaanxi province through a high pressure pipeline network of approximately 120 kilometers.

We operate four main business lines:

 
·
Distribution and sale of compressed natural gas through our variable interest entity (VIE) owned CNG fueling stations for hybrid (natural gas/gasoline) powered vehicles (36 stations as of September 30, 2009);

 
·
Installation, distribution and sale of piped natural gas to residential and commercial customers. We distributed and sold piped natural gas to 118,973 residential customers as of September 30, 2009;

 
·
Distribution and sale of gasoline through our VIE owned CNG fueling stations for gasoline and hybrid (natural gas/gasoline) powered vehicles (7 of our VIE owned CNG fueling stations sold gasoline as of September 30, 2009); and

 
·
Conversion of gasoline-fueled vehicles to hybrid (natural gas/gasoline) powered vehicles at our auto conversion sites.

We buy all of the natural gas that we sell and distribute to our customers. We do not mine or produce any of our own natural gas and have no plans to do so during the next 12 months. We currently sell our natural gas in two forms: (i) CNG and (ii) piped natural gas.

On October 24, 2006, our variable interest entity, Xi'an Xilan Natural Gas Co., Ltd. ("XXNGC"), formed a wholly-owned subsidiary, Shaanxi Jingbian Liquefied Natural Gas Co., Ltd. ("SJLNG"), for the purpose of constructing a liquefied natural gas ("LNG") facility to be located in Jingbian, Shaanxi province. We planned to invest approximately $45 million to construct this facility but are anticipating now that the total investment increase to approximately $49.0 million primarily attributed to significant increase in material and labor costs incurred due to additional engineering reinforcement needs to ensure project safety, excluding $2.7 million additional payment of land use right for phase I, phase II and phase III because soaring local land price due to recent energy resource explorations as well as the cost of $4.5 million to purchase an additional 8.3 acres of land for the Yulin government’s construction of an electricity substation, phase II and phase III of the LNG plant.

The LNG plant was funded through the sale of senior notes to Abax Lotus Ltd. in January 2008 as well as the underwritten public offering in September 2009. When completed, the plant is expected to have LNG processing capacity of 500,000 cubic meters per day, or approximately 150 million cubic meters on an annual basis. Phase I of the LNG plant is under construction and is expected to be completed by May 2010, later than originally planned because of delays mainly due to macro tariff exemption policy changes and additional document requirements at Shaanxi Province customs; engineering reinforcement of plant basis; ocean shipment route change to avoid pirates in Somali area.
 
20

 

We had total revenues of 20,125,184 and 18,401,200 for the three months ended September 30, 2009 and 2008 respectively and revenues of 59,395,370 and 49,317,360 for the nine months ended September 30, 2009 and 2008, respectively. We had net income of 4,647,519 and 5,136,590 for the three months ended September 30, 2009 and 2008 respectively and net income of 12,711,898 and 11,458,053 for the nine months ended September 30, 2009 and 2008 respectively.

Factors Affecting Our Results of Operations

Significant factors affecting our results of operations are:

Successful expansion of our CNG fueling station business in our target markets. Our revenue increased by 9.37% during the three months ended September 30, 2009 from the three months ended September 30, 2008 and by 20.44% during the nine months ended September 30, 2009 from the nine months ended September 30, 2008 largely because of the addition of 3 new fueling stations added since the third quarter of 2008, as well as the increase of pipeline natural gas customers. As of September 30, 2009, we operated 36 CNG fueling stations in total and, in Shaanxi alone, we operated 24 CNG fueling stations. We believe we are the largest provider of CNG fueling stations in Xi’an, one of our core target markets for CNG.  As of September 30, 2009, we operated 12 CNG fueling stations in Henan province, another of our core target markets. The successful expansion of our CNG fueling station business in Xi’an and Henan province has been a significant factor driving our revenue growth and results of operations for the period reviewed. While we intend to expand into different provinces, we anticipate the growth of our CNG fueling business in Xi’an and Henan province will continue to significantly affect our results of operations as we intend to continue to increase the number of CNG fueling stations we operate in these areas.

Regulation of natural gas prices in the PRC. The prices at which we purchase our natural gas supplies and sell CNG and pipeline natural gas products are strictly regulated by the PRC central government, including the National Development and Reform Commission (“NDRC”), and the local state price bureaus who have the discretion to set natural gas prices within the boundaries set by the PRC central government.  In addition, natural gas procurement and sale prices are not uniform across China and can vary across provinces. For example, the prices at which we procure and sell CNG and piped natural gas are lower in Shaanxi than in Henan. Accordingly, our results of operations and, in particular, our revenue, cost of revenue and gross profit and gross margin are affected significantly by factors which are outside of our control. As we expand our natural gas business into other provinces, we expect our results of operations to continue to be affected significantly by the regulation of natural gas prices in the PRC.

Government policies encouraging the adoption of cleaner burning fuels. Our results of operations for the periods reviewed have benefited from environmental regulations and programs in the PRC that promote the use of cleaner burning fuels, including natural gas for vehicles. As an enterprise engaged in the natural gas industry, our VIE benefits from a reduced income tax rate of 15% compared to the standard 25% enterprise income tax rate in the PRC. In addition, the PRC government has encouraged companies to invest in and build the necessary transportation, distribution and sale infrastructure for natural gas in various policy pronouncements such as by officially including CNG/gasoline hybrid vehicles in the country's "encouraged development" category. These policies have benefited our results of operations by encouraging the demand for our natural gas products and also by lowering our expenses. As we expand into the LNG business, we anticipate that our results of operations will continue to be affected by government policies encouraging the adoption of cleaner burning fuels and the increased adoption of CNG and LNG technology.

Taxation

United States

We are incorporated in the State of Delaware and are subject to the tax laws of the United States. Since we do not have any revenue generating act ivies in the United States, we incurred a net operating loss for income tax purposes for the period ended September 30, 2009. The estimated net operating loss carry forwards for United States income tax purposes amounted to $2,278,525 and $1,657,473 as of September, 2009 and December 31, 2008, respectively, which may be available to reduce future years' taxable income. These carry forwards will expire, if not utilized, beginning in 2027 through 2029. Our management believes that the realization of the benefits arising from this loss appear to be uncertain due to our Company's limited operating history and continuing losses for United States income tax purposes. Accordingly, we have provided a 100% valuation allowance at September 30, 2009.

The PRC

Our subsidiary, VIE and its subsidiaries operate in China.  Starting January 1, 2008, pursuant to the tax laws of China, general enterprises are subject to income tax at an effective rate of 25% compared to 33% prior to 2008. Based on certain income tax regulations adopted in 2001 to encourage the development of certain industries, including the natural gas industry, in the western portions of China such as Shaanxi Province, XXNGC is subject to a reduced tax rate of 15%. Accordingly, except for income from XXNGC, which is subject to the reduced tax rate of 15%, income from Xilan Equipment, SJLNG, XXABC, HXNGC and LBNGC are subject to the 25% PRC income tax rate. Our effective income tax rate for the three months ended September 30, 2009 and 2008 were approximately 17.7% and 16.8%, respectively.

 
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Value Added Tax

Sales revenue represents the invoiced value of goods, net of a value-added tax ("VAT").  All of our variable interest entity XXNGC's products that are sold in the PRC are subject to a Chinese VAT at a rate of 13% of the gross sales price. This VAT may be offset by VAT paid by XXNGC on raw materials and other materials included in the cost of producing their finished products. XXNGC records VAT payable and VAT receivable net of payments in its financial statements. VAT tax returns are filed offsetting the payables against the receivables.

All revenues from XXABC are subject to a Chinese VAT at a rate of 6%. This VAT cannot be offset with VAT paid for materials included in the cost of revenues.

Internal Control Over Financial Reporting

We are subject to reporting obligations under the U.S. securities laws. The SEC, as required by Section 404 of the Sarbanes-Oxley Act, adopted rules requiring every public company to include a management report on such company’s internal control over financial reporting in its annual report, which contains management’s assessment of the effectiveness of the company’s internal control over financial reporting. In addition, an independent registered public accounting firm must report on our internal control over financial reporting. Based the Company’s evaluation, management concluded that, due to the identification of a material weakness in relation to inadequate US GAAP expertise, as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2008, as amended, and the fact that the company is still in the process of remediating such material weakness, as of September 30, 2009, the Company’s disclosure controls and procedures remained ineffective.

CONSOLIDATED RESULTS OF OPERATIONS

Three Months Ended September 30, 2009 Compared to Three Months Ended September 30, 2008

The following table represents the consolidated operating results for the three month period ended September 30, 2009 and 2008:

Sales Revenues

The following table sets forth a breakdown of our revenues for the period indicated:

 
  
September 30,
2009
  
  
September 30,
2008
  
  
Increase in
dollar
amount
  
  
Increase in
percentage
  
Natural gas from fueling stations
 
$
14,789,924
   
$
14,756,929
   
$
32,995
     
0.2%
 
                                 
Natural gas from pipelines
   
664,462
     
597,532
     
66,930
     
11.2%
 
                                 
Gasoline
   
1,633,478
     
1,187,754
     
445,724
     
37.5%
 
                                 
Installation
   
2,415,550
     
1,197,051
     
1,218,499
     
101.8%
 
                                 
Auto conversion
   
621,770
     
661,934
     
(40,164)
     
-6.1%
 
                                 
Total
 
$
20,125,184
   
$
18,401,200
   
$
1,723,984
     
9.4%
 

Overall. Total revenue for the three months ended September 30, 2009 increased to 20,125,184 from 18,401,200 for the three months ended September 30, 2008, an increase of 1,723,984 or 9.4 %. This increase was mainly due to the addition of 3 new fueling stations added since the third quarter of 2008, and an increase in the number of residential and commercial pipeline customers to 118,973 as of September 30, 2009 from 92,984 as of September 30, 2008. We sold natural gas of 43,209,817 cubic meters during the three months ended September 30, 2009, compared to 43,213,532 cubic meters during the three months ended September 30, 2008. For the three months ended September 30, 2009, 84.9% of our revenue was generated from the sale of natural gas and gasoline, and the other 15.1% was generated from our installation and auto conversion services.
 
 
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Natural Gas from Fueling Stations. Natural gas revenue from our fueling stations increased by 0.2% or $32,995, to $14,789,924 during the three months ended September 30, 2009, from $14,756,929 during the three months ended September 30, 2008, and contributed to 73.5% of our total revenue, which was the largest among our four major business lines. During the three months ended September 30, 2009, we sold compressed natural gas of 40,420,123 cubic meters, compared to 40,547,584 cubic meters during the three months ended September 30, 2008 through our fueling stations. In terms of average station sales value and volume, in the three months ended September 30, 2009, we sold approximately $418,622 and 1,144,074 cubic meters of compressed natural gas per station, compared to approximately $423,000 and 1,180,000 cubic meters in the three months ended September 30, 2008. The reason for the decline in per station sales by 3% in quantity was due to the construction of main subway lines in Xi'an, which caused certain bus routes to deviate from our stations as well as enhanced competition in Henan Province.  Unit selling price was relatively stable at $0.37 (RMB 2.5).

Natural Gas from Pipelines.  Natural gas revenue from our pipelines increased by 11.2%, or $66,930, to $664,462 during the three months ended September 30, 2009, from $597,532 during the three months ended September 30, 2008, and contributed to 3.3% of our total revenue. As of September 30, 2009, the Company had 118,973 pipeline customers, an increase of 25,989 customers comparing to as of September 30, 2008.  We also sold 2,789,694 cubic meters of natural gas through our pipelines during the three months ended September 30, 2009, compared to 2,665,948 cubic meters during the three months ended September 30, 2008.

Gasoline. Revenue from gasoline sales increased by 37.5%, or $445,724, to $1,633,478 during the three months ended September 30, 2009, from $1,187,754 during the three months ended September 30, 2008, and contributed 8.1% to our total revenue. The gasoline revenue increase was due to the sales volume increased 41.7% from 1,667,783 liters to 2,357,490 liters, offset by 2.67% decrease of unit sales price from $ 0.6500 (RMB4.86) per liter in the three months ended September 30, 2008 to $0.6934 (RMB 4.73) per liter in the three months ended September 30, 2009, affected by the decrease of international oil price. The increased sales volumes were due to our two stations, Xianning and Kaiyuan, began operation in the third quarter of 2008.

Installation Services. Revenue from installation services increased by 101.8%, or $1,218,499, to $ 2,415,550 during the three months ended September 30, 2009, from $1,197,051 during the three months ended September 30, 2008, and contributed 12.0% to our total revenue. The increase of installation sales was mainly due to the increase of pipeline customers in the newly acquired subsidiary, Lingbao Natural Gas, Co., since October 2008. Installation services to our top four customers contributed to 19.2%, 12.6%, 11.6% and 11.3% of our installation revenue for the three months ended September 30, 2009.

Auto Conversion Services. Revenue from our auto conversion division decreased by 6.1%, or $40,164, to $621,770 during the three months ended September 30, 2009, from $661,934 during the three months ended September 30, 2008, and contributed 3.1% to our total revenue.

Cost of Revenue

The following table sets forth a breakdown of our cost of revenue for the periods indicated:

 
  
September 30,
2009
  
  
September 30,
2008
  
  
Increase / 
(Decrease) in
dollar
amount
  
  
Increase / 
(Decrease) in
percentage
  
Natural gas from fueling stations
 
$
7,075,387
   
$
6,538,493
   
$
536,894
     
8.2%
 
                                 
Natural gas from pipelines
   
460,801
     
434,542
     
26,259
     
6.0%
 
                                 
Gasoline
   
1,534,806
     
1,085,311
     
449,495
     
41.4%
 
                                 
Installation
   
972,146
     
448,900
     
523,246
     
116.6%
 
                                 
Auto conversion
   
364,352
     
401,587
     
(37,235)
     
(9.3%)