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 June 30, 2010

¨
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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).     Yes ¨ No x

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 August 6: 21,215,337
 
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

     
Page
PART I.
FINANCIAL INFORMATION
 
2
       
Item 1.
Financial Statements
 
2
       
 
Notes to Consolidated Financial Statements (unaudited)
 
5
       
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
 
34
       
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
 
51
       
Item 4.
Controls and Procedures
 
52
       
PART II.
OTHER INFORMATION
 
54
       
Item 1.
Legal Proceedings
 
54
       
Item 1A.
Risk Factors
 
54
       
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
 
54
       
Item 3.
Defaults Upon Senior Securities
 
54
       
Item 4.
Other Information
 
54
       
Item 5.
Exhibits
 
55
       
SIGNATURES
 
56
 
1

 
PART I. FINANCIAL INFORMATION
 
Item 1. Financial Statements
 
CHINA NATURAL GAS, INC. AND SUBSIDIARIES
 
CONSOLIDATED BALANCE SHEETS
 AS OF JUNE 30, 2010 AND DECEMBER 31, 2009
 
   
June 30,
   
December, 31
 
   
2010
   
2009
 
   
(Unaudited)
       
ASSETS
           
CURRENT ASSETS:
           
Cash & cash equivalents
  $ 42,606,410     $ 48,177,794  
Accounts receivable, net of allowance for doubtful accounts of $206,514 and $163,280 as of June 30, 2010 and December 31, 2009, respectively
    1,174,673       1,289,116  
Other receivables
    36,942       709,741  
Other receivable - employee advances
    303,887       338,689  
Inventories
    842,259       841,837  
Advances to suppliers
    1,385,058       596,868  
Prepaid expense and other current assets
    3,769,977       1,076,915  
Loans receivable
    -       293,400  
Total current assets
    50,119,206       53,324,360  
                 
INVESTMENT IN UNCONSOLIDATED JOINT VENTURES
    1,467,000       1,467,000  
PROPERTY AND EQUIPMENT, NET
    80,342,000       72,713,012  
CONSTRUCTION IN PROGRESS
    78,363,718       52,918,236  
DEFERRED FINANCING COSTS
    1,132,082       1,336,998  
OTHER ASSETS
    17,262,417       15,854,910  
TOTAL ASSETS
  $ 228,686,423     $ 197,614,516  
LIABILITIES AND STOCKHOLDERS' EQUITY
               
CURRENT LIABILITIES:
               
   Accounts payable and accrued liabilities
  $ 3,550,860     $ 2,081,261  
Other payables
    96,412       80,788  
Unearned revenue
    2,282,024       1,813,641  
Accrued interest
    706,065       786,052  
Taxes payable
    2,051,374       1,901,577  
Notes payable, net of discount $11,135,111 and $0 as of June 30, 2010 and December 31, 2009, respectively
    28,864,889       -  
Redeemable liabilities - warrants
    17,500,000       -  
Total current liabilities
    55,051,624       6,663,319  
                 
LONG TERM LIABILITIES:
               
Notes payable, net of discount $0 and $12,707,713 as of June 30, 2010 and December 31, 2009, respectively
    -       27,292,287  
Derivative liabilities - warrants
    987,455       19,545,638  
Long term debt
    17,676,000       -  
Total long term liabilities
    18,663,455       46,837,925  
                 
Total liabilities
    73,715,079       53,501,244  
                 
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,  21,321,904 shares issued and outstanding at June 30, 2010 and December 31, 2009
    2,132       2,118  
Additional paid-in capital
    81,394,533       79,851,251  
Cumulative other comprehensive gain
    9,473,023       8,714,019  
Statutory reserves
    6,925,689       5,962,695  
Retained earnings
    57,175,967       49,583,189  
Total stockholders' equity
    154,971,344       144,113,272  
                 
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
  $ 228,686,423     $ 197,614,516  
 
The accompanying notes are an integral part of these consolidated statements.
 
2

 
CHINA NATURAL GAS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME AND OTHER COMPREHENSIVE INCOME
FOR THE THREE MONTHS AND SIX MONTHS ENDED JUNE 30, 2010 AND 2009
(Unaudited)
 
   
Three Months Ended
June 30,
   
Six Months Ended
June 30,
 
   
2010
   
2009
   
2010
   
2009
 
Revenues
                       
Natural gas revenue
  $ 16,221,003     $ 15,720,679     $ 31,704,632     $ 30,686,498  
Gasoline revenue
    2,033,840       1,633,016       3,502,656       2,807,414  
Installation and others
    2,880,756       3,388,825       5,295,134       5,776,274  
      Total revenues
    21,135,599       20,742,520       40,502,422       39,270,186  
                                 
Cost of revenues
                               
Natural gas cost
    8,357,990       7,490,518       16,222,644       14,237,447  
Gasoline cost
    1,910,294       1,529,752       3,277,572       2,659,809  
Installation and others
    1,251,783       1,444,060       2,291,706       2,461,088  
      Total cost of revenues
    11,520,067       10,464,330       21,791,922       19,358,344  
                                 
Gross profit
    9,615,532       10,278,190       18,710,500       19,911,842  
                                 
Operating expenses
                               
Selling expenses
    3,054,992       2,596,784       5,946,782       5,177,609  
General and administrative expenses
    1,913,866       917,354       3,731,522       2,342,678  
      Total operating expenses
    4,968,858       3,514,138       9,678,304       7,520,287  
                                 
Income from operations
    4,646,674       6,764,052       9,032,196       12,391,555  
                                 
Non-operating income (expense):
                               
Interest income
    260,021       7,784       349,387       16,692  
Interest expense
    -       (388,618 )     -       (970,110 )
Other income (expense), net
    (3,031 )     (20,926 )     43,538       (23,229 )
Change in fair value of warrants
    665,115       (1,312,834 )     1,058,183       (1,115,783 )
Foreign currency exchange loss
    (34,665 )     (19 )     (42,775 )     (50,807 )
     Total non-operating income (expense)
    887,440       (1,714,613 )     1,408,333       (2,143,237 )
                                 
Income before income tax
    5,534,114       5,049,439       10,440,529       10,248,318  
                                 
Provision for income tax
    973,611       1,186,683       1,884,756       2,183,939  
                                 
Net income
    4,560,503       3,862,756       8,555,773       8,064,379  
                                 
Other comprehensive income
                               
      Foreign currency translation gain (loss)
    797,858       (2,997 )     759,004       (155,112 )
Comprehensive income
  $ 5,358,361     $ 3,859,759     $ 9,314,777     $ 7,909,267  
                                 
Weighted average shares outstanding
                               
Basic
    21,246,771       14,600,154       21,215,337       14,600,154  
Diluted
    21,582,662       14,726,647       21,619,989       14,600,154  
                                 
Earnings per share
                               
Basic
  $ 0.21     $ 0.26     $ 0.40     $ 0.55  
Diluted
  $ 0.21     $ 0.26     $ 0.40     $ 0.55  
 
The accompanying notes are an integral part of these consolidated statements.

 
3

 
CHINA NATURAL GAS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE SIX MONTHS ENDED JUNE 30, 2010 AND 2009
(Unaudited)
 
   
Six Months Ended
June 30,
 
   
2010
   
2009
 
CASH FLOWS FROM OPERATING ACTIVITIES:
           
Net income
  $ 8,555,773     $ 8,064,379  
Adjustments to reconcile net income to net cash
               
provided by operating activities:
               
Depreciation and amortization
    3,070,705       2,782,209  
Loss on disposal of equipment
    -       21,370  
Provision for bad debt
    42,390       -  
Amortization of discount on senior notes
    -       217,196  
Amortization of financing costs
    -       52,435  
Stock based compensation
    867,096       100,758  
Change in fair value of warrants
    (1,058,183 )     1,115,783  
Change in assets and liabilities:
               
Accounts receivable
    76,830       (74,409 )
Other receivable
    658,742       (69,120 )
Other receivable - employee advances
    50,142       179,083  
Inventories
    3,008       (487,908 )
Advances to suppliers
    (782,495 )     (268,922 )
Prepaid expense and other current assets
    (2,594,001 )     157,372  
Accounts payable and accrued liabilities
    1,455,262       822,997  
Other payables
    15,266       73,210  
Unearned revenue
    459,057       1,026,693  
Accrued interest
    (79,987 )     376,664  
Taxes payable
    141,433       306,975  
Net cash provided by operating activities
    10,881,038       14,396,765  
                 
CASH FLOWS FROM INVESTING ACTIVITIES:
               
Proceeds from sales of equipment
    -       41,305  
Loan to third parties
    (14,259,240 )     -  
Repayment from loan to third parties
    14,552,620       -  
Purchase of property and equipment
    (6,260,885 )     (21,033 )
Additions to construction in progress
    (14,317,621 )     (10,372,858 )
Return of acquisition deposit
    1,613,590       449,910  
Prepayment for long term assets
    (6,520,371 )     (110,836 )
Payment for acquisition deposits
    (3,637,912 )     -  
Payment for intangible assets
    (4,869,242 )     (66,971 )
Payment for land use rights
    (1,147,360 )     (463,870 )
Net cash used in investing activities
    (34,846,421 )     (10,544,353 )
                 
CASH FLOWS FROM FINANCING ACTIVITIES:
               
Proceeds from long term loan
    17,602,800       -  
Stock issued from exercise of stock options
    676,201       -  
Net cash provided by financing activities
    18,279,001       -  
                 
Effect of exchange rate changes on cash and cash equivalents
    114,998       (5,619 )
                 
NET (DECREASE) INCREASE IN CASH & CASH EQUIVALENTS
    (5,571,384 )     3,846,793  
                 
CASH & CASH EQUIVALENTS, BEGINNING OF PERIOD
    48,177,794       5,854,383  
                 
CASH & CASH EQUIVALENTS, END OF PERIOD
  $ 42,606,410     $ 9,701,176  
                 
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
               
Interest paid
  $ 1,288,328     $ 237,641  
Income taxes paid
  $ 2,030,575     $ 1,934,887  
                 
Non-cash transactions for investing and financing activities:
               
Construction in progress transferred to property and equipment
  $ 4,107,320     $ -  
Prepayment on long term assets transferred to construction in process
    1,678,940       -  
Capitalized interest - amortization of  discount of notes payable and issuance cost
  $ 1,777,516     $ 1,773,594  
 
The accompanying notes are an integral part of these consolidated statements.
 
 
4

 
 
China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
JUNE 30, 2010
(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 HongKong, Shaanxi, Henan and Hubei 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 September 8, 2009, Shaanxi Xilan Natural Gas Equipment Co., Ltd (“SXNGE”) increased its registered capital by $26,000,000 from $53,929,260 to $79,929,260. CHNG contributed $10,000,000 and $16,000,000 registered capital to SXNGE on September 29, 2009 and January 13, 2010, respectively.

On February 5, 2010 and April 23, 2010, Jingbian Liquefied Natural Gas Co., Ltd. (“JBLNG”) increased the registered capital by $6,026,343 and $11,668,376, respectively, which was invested by Xi’an Xilan Natural Gas Co., Ltd. (“XXNGC”) in the form of equipment and cash.

During the second quarter of 2010, XXNGC effectively acquired 100% assets and operating rights of four natural gas stations in Xi’an, PRC, for a total combined cash consideration of $10,502,490 (RMB 71,300,000), which consists of approximately $5.6 million plant and equipment and approximately $4.9 million operating rights.

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 June 30, 2010 are not necessary indicative of the results that may be expected for the year ended December 31, 2010. The information included in this Form 10-Q should be read in conjunction with information included in the 2009 annual report filed on Form 10-K.

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.
 
5


China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
JUNE 30, 2010
(Unaudited)
 
Principles of Consolidation

The accompanying consolidated financial statements include the accounts of China Natural Gas, Inc. and its wholly owned subsidiaries, and its 100% variable interest entities (“VIE”).  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 SXNGE as a wholly-owned foreign enterprise (WOFE). Then through SXNGE, the Company entered into exclusive arrangements with XXNGC and its shareholders that give the Company the ability to substantially influence XXNGC’s 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 XXNGC as VIE. The arrangements consist of the following agreements:

 
a.
XXNGC 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 XXNGC in return for a consulting services fee which is equal to XXNGC’s revenue.

 
c.
XXNGC’ shareholders have pledged their equity interests in XXNGC 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 XXNGC 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 (“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.
 
6

 
China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
JUNE 30, 2010
(Unaudited)
 
Foreign Currency Translation

The Company’s reporting currency is the US dollar. The functional currency of PRC subsidiaries is the Chinese Renminbi (“RMB”). Our results of operations and financial position of the PRC subsidiaries are translated to United States dollars using the period end exchange rates as to assets and liabilities and weighted average exchange rates as to revenues, expenses and cash flows. Capital accounts are translated at their historical exchange rates when the capital transaction occurred. The resulting currency translation adjustments are recorded as a component of accumulated other comprehensive income (loss) within stockholders’ equity. 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. Transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the functional currency are included in the results of operations as incurred.

The balance sheet amounts with the exception of equity at June 30, 2010 were translated RMB 6.79 to $1.00 as compared to RMB 6.82 at December 31, 2009. The equity accounts were stated at their historical rate. The average translation rates applied to income and cash flow statement amounts for the six months ended June 30, 2010 and 2009 were RMB 6.82 to $1.00.

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, Hong Kong 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 Hong Kong Deposit Protection Board (“HKDPB”) insured limits for the banks located in Hong Kong or may exceed Federal Deposit Insurance Corporation (“FDIC”) 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 June 30, 2010 and December 31, 2009, the Company had total deposits of $41,832,543 and $47,459,560, respectively, without insurance coverage or in excess of HKDPB or FDIC insured limits. 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 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.
 
7


China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
JUNE 30, 2010
(Unaudited)
 
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 recorded allowance for bad debts of $206,514 and $163,280 as of June 30, 2010 and December 31, 2009, respectively.

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 June 30, 2010 and December 31, 2009, no allowance for the uncollectible accounts was deemed necessary.

Inventories

Inventories are 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. Inventories consist of materials used in the construction of pipelines and in repairing and modifying vehicles. Inventories also consist of gasoline.

The following are the details of the inventories:

   
June 30,
2010
(Unaudited)
   
December 31,
2009
 
Materials and supplies
 
$
414,639
   
$
345,611
 
Gasoline
   
427,620
     
496,226
 
Total
 
$
842,259
   
$
841,837
 

Advances to Suppliers

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

Loans Receivable

Loans receivable consists of the following:
 
   
June 30,
2010 
(unaudited)
   
December 31,
2009
 
Shanxi Yuojin Mining Company, due on November 30, 2009, extended to November 30, 2010, annual interest at 5.84% (1)
  $ -     $ 293,400  
Shanxi JunTai Housing Purchase Ltd., due on January 10, 2011, annual interest at 5.84%  (2)
    -       -  
Ms. Taoxiang Wang, due on February 19, 2011, annual interest at 5.84% (3)
    -       -  
    $ -     $ 293,400  
 
(1) Shanxi Yuojin Mining Company paid off this loan on March 11, 2010.

(2) On January 11, 2010, the Company extended a loan of $4,401,000 to Shanxi JunTai Housing Purchase Ltd., a third party with an interest rate of 5.84% and an term of one year. On May 26, 2010, the Company received the loan repayment of $4,488,923 from JunTai Housing Purchase Ltd, with whole principle of $4,401,000 and interest income of $87,923. As of May 26, 2010, this loan was paid off.

(3) On February 20, 2010, the Company extended a loan of $ 9,858,240 to Ms. TaoXiang Wang, a third party individual. On April 22 and April 27, 2010, Ms. Wang repaid $5,868,000 and $4,130,962, respectively, of which $140,722 was the interest payments. As of April 27, 2010, this loan was paid off.

Investments in Unconsolidated Joint Ventures

Investee companies that are not consolidated, but over which the Company exercises significant influence, are accounted for under the equity method of accounting. Whether or not the Company exercises significant influence with respect to an Investee depends on an evaluation of several factors including, among others, representation on the Investee company’s board of directors and ownership level, which is generally a 20% to 50% interest in the voting securities of the Investee company. Under the equity method of accounting, an Investee company’s accounts are not reflected within the Company’s consolidated balance sheets and statements of income and other comprehensive income; however, the Company’s share of the earnings or losses of the Investee company is reflected in the caption “Earnings (loss) on equity investment” in the consolidated statements of income and other comprehensive income. The Company’s carrying value in an equity method Investee company is reflected in the caption “Investments in Unconsolidated Joint Ventures” in the Company’s consolidated balance sheets.

When the Company’s carrying value in an equity method, the investee company is reduced to zero and no further losses are recorded in the Company’s consolidated financial statements unless the Company guaranteed obligations of the Investee company or has committed additional funding. When the Investee company subsequently reports income, the Company will not record its share of such income until it equals the amount of its share of losses not previously recognized.
 
8


China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
JUNE 30, 2010
(Unaudited)
 
The Company’s investment in unconsolidated joint ventures that are accounted for on the equity method of accounting represents the 49% interest in Henan CNPC Kunlun Xilan Compressed Natural Gas Co., Ltd. (“JV”), which is engaged in building and operating CNG compressor stations and fueling stations, sell CNG, provide vehicle conversion services from gasoline-fueled vehicles to hybrid (natural gas/gasoline) powered vehicles and technical advisory work services in Henan, PRC. The investment in this company amounted to $1,467,000 at June 30, 2010 and December 31, 2009. The JV does not have any operations as of June 30, 2010.

The results of financial position of the JV as of June 30, 2010 are summarized below:

   
June 30,
2010
(unaudited)
   
December 31,
2009
 
Condensed balance sheet information:
           
Current assets
 
$
2,993,878
   
$
2,993,878
 
Noncurrent assets
   
-
     
-
 
Total assets
 
$
2,993,878
   
$
2,993,878
 
Current liabilities
   
-
     
-
 
Noncurrent liabilities
   
-
     
-
 
Equity
 
$
2,993,878
   
$
2,993,878
 
Total liabilities and equity
 
$
2,993,878
   
$
2,993,878
 

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

9


China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
JUNE 30, 2010
(Unaudited)

 
The following are the details of the property and equipment:

   
June 30,
2010
(unaudited)
   
December 31,
2009
 
Office equipment
 
$
496,376
   
$
439,055
 
Operating equipment
   
67,798,379
     
61,350,503
 
Vehicles
   
2,899,475
     
2,486,614
 
Buildings and improvements
   
25,258,288
     
21,414,553
 
Total property and equipment
   
96,452,518
     
85,690,725
 
Less accumulated depreciation
   
(16,110,518
)
   
(12,977,713
)
Property and equipment, net
 
$
80,342,000
   
$
72,713,012
 

Depreciation expense for the three months ended June 30, 2010 and 2009 was $1,596,146 and $1,390,017, respectively. Depreciation expense for the six months ended June 30, 2010 and 2009 was $3,066,972 and $2,779,582, 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 purchases, 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 June 30, 2010 and December 31, 2009, the Company had construction in progress in the amount of $78,363,718 and $52,918,236, respectively. Interest cost capitalized into construction in progress for the three months ended June 30, 2010 and 2009, amounted to $1,627,034 and $1,172,547, respectively. Interest cost capitalized into construction in progress for the six months ended June 30, 2010 and 2009, amounted to $2,990,697 and $2,030,926, respectively.
 
10


China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
JUNE 30, 2010
(Unaudited)
 
Construction in progress at June 30, 2010 consisted of the following:

No.
 
Project Description
 
Location
 
June 30,2010
(unaudited)
 
Commencement
Date
Expected
completion
date
 
Estimated
additional
cost to
complete
 
1  
Jingbian LNG (1)
 
JBLNG
  $ 68,708,384  
Dec-06
Oct-10
  $ 12,600,000  
2
Sa Pu mother station
 
Henan Xilan Natural
Gas Co., Ltd. (HXNGC)
      873,043  
Jul-08
Jun-11
      6,300,000  
3
 
International port
 
XXNGC
    5,040,189  
May-09
Dec-11
    9,730,000  
4
 
Other CIP projects
 
XXNGC
    3,742,102  
Various
Various
    500,000  
              $ 78,363,718         $ 29,130,000  

(1)
Including $60,063,478 construction cost and $7,801,659 capitalized interest for phase I of the LNG
project, and additional $13,443,247 in connection with phase II and phase III of the LNG plant.

Intangible Assets

The Intangible Assets mainly consist of operating rights for four newly acquired natural gas stations. The operating rights are deemed to have an indefinite useful life as cash flows are expected to continue indefinitely.

The operating right will not be amortized until its useful life is deemed to be no longer indefinite. The Company evaluates intangible assets for impairment, at least annually and whenever events or changes in circumstances indicate that the assets might be impaired.

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 June 30, 2010, there were no significant impairments of its long-lived assets.
 
11


China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
JUNE 30, 2010
(Unaudited)
 
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 upon 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 $987,455 and $2,045,638 on June 30, 2010 and December 31, 2009, respectively. The Company recognized a gain of $665,115 and a loss of $1,312,834 for the three months ended June 30, 2010 and 2009, respectively. The Company recognized a gain of $1,058,183 and a loss of $1,115,783 for the six months ended June 30, 2010 and 2009, respectively.
 
12


China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
JUNE 30, 2010
(Unaudited)
 
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:

   
June 30,
2010
(unaudited)
   
December 31,
2009
 
Annual dividend yield
   
-
     
-
 
Expected life (years)
   
2.32
     
2.82
 
Risk-free interest rate
   
0.74
%
   
1.49
%
Expected volatility
   
80
%
   
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.

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 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.
 
13


China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
JUNE 30, 2010
(Unaudited)
 
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 June 30, 2010.

   
Carrying Value at
June 30,2010
   
Fair Value Measurement at
June 30, 2010
 
   
(unaudited)
   
Level 1
   
Level 2
   
Level 3
 
Long-term debt
 
$
17,676,000
     
-
   
$
    -
   
$
16,720,097
 
Derivative liability - warrants
   
987,455
     
-
     
987,455
     
-
 
Total liability measured at fair value
 
$
18,663,455
   
$
-
   
$
987,455
   
$
16,720,097
 

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 its fair value 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 six months ended June 30, 2010 and 2009, 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.
 
14


China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
JUNE 30, 2010
(Unaudited)
 
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 June 30, 2010 and 2009, 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.  Penalties and interest incurred related to underpayment of income tax are classified as income tax expense in the year incurred.  No significant penalties or interest relating to income taxes have been incurred during the three and six months ended June 30, 2010 and 2009.

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, Shaanxi Xilan Auto Bodyshop(SXABC), HXNGC, LBNGC and Hubei Xilan Natural Gas Co.,ltd (HBXNGC) 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
June 30,
   
For the six months ended
June 30,
 
   
2010
   
2009
   
2010
   
2009
 
   
(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
)%
   
(9
)%
   
(8
)%
   
(9
)%
Other item (1)
   
     2
%
   
8
%
   
1
%
   
5
%
Total provision for income taxes
   
      18
%
   
24
%
   
18
%
   
21
%
 

(1)
The 2% represents $366,824 in expenses incurred by CHNG are not deductible in PRC for the three months ended June 30, 2010. The 8% represents $2,198,394 expenses incurred by CHNG that are not deductible in PRC for the three months ended June 30, 2009. The 1% represents $655,016 in expenses incurred by CHNG that are not deductible in PRC for the six months ended June 30, 2010. The 5% represents $3,124,589 expenses incurred by CHNG that are not deductible in PRC for the six months ended June 30, 2009.
 
15


China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
JUNE 30, 2010
(Unaudited)
 
The estimated tax savings for the three months ended June 30, 2010 and 2009, amounted to approximately $527,818 and $721,445, 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 June 30, 2010 and 2009, from $0.21 to $0.19 and $0.26 to $0.21, respectively.

The estimated tax savings for the six months ended June 30, 2010 and 2009, amounted to approximately $1,026,442 and $1,231,776 respectively. The net effect on earnings per share, had the income tax been applied, would decrease basic and diluted earnings per share for the six months ended June 30, 2010 and 2009, from $0.40 to $0.35 and $0.55 to $0.47, 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 June 30, 2010. The estimated net operating loss carry forwards for United States income tax purposes amounted to $3,033,370 and $2,699,276 as of June 30, 2010 and December 31, 2009, respectively, which may be available to reduce future years' taxable income. These carry forwards will expire, if not utilized, beginning in 2027 through 2030. 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 June 30, 2010. Management reviews this valuation allowance periodically and makes adjustments as warranted. The valuation allowances were as follow:

Valuation allowance
 
For the six months end
June 30, 2010
(unaudited)
   
Year ended
December 31,
2009
 
Balance, beginning of period
 
$
917,754
   
$
563,541
 
Increase
   
113,592
     
354,213
 
Balance, end of period
 
$
1,031,346
   
$
917,754
 
 
The Company has cumulative undistributed earnings of foreign subsidiaries of approximately $38,037,669 as of June 30, 2010, 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.
 
16


China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
JUNE 30, 2010
(Unaudited)
 
Taxes Payable

Taxes payable at June 30, 2010 and December 31, 2009 consisted of the following:

   
June 30,
2010
(unaudited)
   
December 31,
2009
 
Value added tax payable
 
$
1,028,769
   
$
740,772
 
Business tax payable
   
-
     
1,540
 
Income tax payable
   
977,411
     
1,127,961
 
Urban maintenance tax payable
   
41,384
     
27,442
 
Income tax for individual payable
   
3,810
     
3,862
 
Total tax payable
 
$
2,051,374
   
$
1,901,577
 

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 2010, FASB issued ASU No. 2010-01- Accounting for Distributions to Shareholders with Components of Stock and Cash. The amendments in this Update clarify that the stock portion of a distribution to shareholders that allows them to elect to receive cash or stock with a potential limitation on the total amount of cash that all shareholders can elect to receive in the aggregate is considered a share issuance that is reflected in EPS prospectively and is not a stock dividend for purposes of applying Topics 505 and 260 (Equity and Earnings Per Share). The amendments in this update are effective for interim and annual periods ending on or after December 15, 2009, and should be applied on a retrospective basis. The adoption of this ASU did not have a material impact on its consolidated financial statements.
 
17


China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
JUNE 30, 2010
(Unaudited)
 
In January 2010, FASB issued ASU No. 2010-02 – Accounting and Reporting for Decreases in Ownership of a Subsidiary – a Scope Clarification. The amendments in this Update affect accounting and reporting by an entity that experiences a decrease in ownership in a subsidiary that is a business or nonprofit activity. The amendments also affect accounting and reporting by an entity that exchanges a group of assets that constitutes a business or nonprofit activity for an equity interest in another entity. The amendments in this update are effective beginning in the period that an entity adopts SFAS No. 160, “Non-controlling Interests in Consolidated Financial Statements – An Amendment of ARB No. 51.” If an entity has previously adopted SFAS No. 160 as of the date the amendments in this update are included in the Accounting Standards Codification, the amendments in this update are effective beginning in the first interim or annual reporting period ending on or after December 15, 2009. The amendments in this update should be applied retrospectively to the first period that an entity adopted SFAS No. 160. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.

In January 2010, FASB issued ASU No. 2010-06 – Improving Disclosures about Fair Value Measurements. This update provides amendments to Subtopic 820-10 that requires new disclosure as follows: 1) Transfers in and out of Levels 1 and 2. A reporting entity should disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers. 2) Activity in Level 3 fair value measurements. In the reconciliation for fair value measurements using significant unobservable inputs (Level 3), a reporting entity should present separately information about purchases, sales, issuances, and settlements (that is, on a gross basis rather than as one net number). This update provides amendments to Subtopic 820-10 that clarifies existing disclosures as follows: 1) Level of disaggregation. A reporting entity should provide fair value measurement disclosures for each class of assets and liabilities. A class is often a subset of assets or liabilities within a line item in the statement of financial position. A reporting entity needs to use judgment in determining the appropriate classes of assets and liabilities. 2) Disclosures about inputs and valuation techniques. A reporting entity should provide disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements. Those disclosures are required for fair value measurements that fall in either Level 2 or Level 3. The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. These disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. The Company is currently evaluating the impact of this ASU, however, the Company does not expect the adoption of this ASU to have a material impact on its consolidated financial statements.

In February 2010, FASB issued ASU No. 2010-9 –Amendments to Certain Recognition and Disclosure Requirements. This update addresses certain implementation issues related to an entity’s requirement to perform and disclose subsequent-events procedures, removes the requirement that public companies disclose the date of their financial statements in both issued and revised financial statements. According to the FASB, the revised statements include those that have been changed to correct an error or conform to a retrospective application of U.S. GAAP. The amendment is effective for interim and annual reporting periods in fiscal year ending after June 15, 2010. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.
 
18


China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
JUNE 30, 2010
(Unaudited)
 
In March 2010, FASB issued ASU No. 2010-10 –Amendments for Certain Investment Funds. This update defers the effective date of the amendments to the consolidation requirements made by FASB Statement 167 to a reporting entity’s interest in certain types of entities. The deferral will mainly impact the evaluation of reporting enterprises’ interests in mutual funds, private equity funds, hedge funds, real estate investment entities that measure their investment at fair value, real estate investment trusts, and venture capital funds. The ASU also clarifies guidance in Statement 167 that addresses whether fee arrangements represent a variable interest for all service providers and decision makers. The ASU is effective for interim and annual reporting periods in fiscal year beginning after November 15, 2009. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.

In March 2010, FASB issued ASU No. 2010-11 –Scope Exception Related to Embedded Credit Derivatives. Embedded credit-derivative features related only to the transfer of credit risk in the form of subordination of one financial instrument to another are not subject to potential bifurcation and separate accounting as clarified by recently issued FASB guidance. Other embedded credit-derivative features are required to be analyzed to determine whether they must be accounted for separately. This update provides guidance on whether embedded credit-derivative features in financial instruments issued by structures such as collateralized debt obligations (CDOs) and synthetic CDOs are subject to bifurcation and separate accounting. The guidance is effective at the beginning of a company’s first fiscal quarter beginning after June 15, 2010. The Company does not expect the adoption of this ASU to have a material impact on the Company’s consolidated financial statements.

In April 2010, the FASB issued Accounting Standards Update 2010-13, “Compensation—Stock Compensation (Topic 718): Effect of Denominating the Exercise Price of a Share-Based Payment Award in the Currency of the Market in Which the Underlying Equity Security Trades,” or ASU 2010-13. ASU 2010-13 provides amendments to Topic 718 to clarify that an employee share-based payment award with an exercise price denominated in currency of a market in which a substantial porting of the entity’s equity securities trades should not be considered to contain a condition that is not a market, performance, or service condition. Therefore, an entity would not classify such an award as a liability if it otherwise qualifies as equity. The amendments in this Update are effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2010. The Company does not expect the adoption of this ASU to have a material impact on the Company’s consolidated financial statements.

In April 2010, the FASB issued Accounting Standard Update 20-10-17, “Revenue Recognition—Milestone Method (Topic 605): Milestone Method of Revenue Recognition” or ASU 2010-17. This Update provides guidance on the recognition of revenue under the milestone method, which allows a vendor to adopt an accounting policy to recognize all of the arrangement consideration that is contingent on the achievement of a substantive milestone (milestone consideration) in the period the milestone is achieved. The pronouncement is effective on a prospective basis for milestones achieved in fiscal years and interim periods within those years, beginning on or after June 15, 2010. The adoption of this ASU does not have a material impact on the Company’s consolidated financial statements.
 
19


China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
JUNE 30, 2010
(Unaudited)
 
Reclassification

Certain prior period expense amounts have been reclassified to conform to the current period presentation. These reclassifications have no effect on net income or cash flows.

Note 3 – Other Assets

Other assets consisted of the following:

   
June 30,
2010
(unaudited)
   
December 31,
2009
 
Prepaid rent – natural gas stations
 
$
315,333
   
$
340,211
 
Prepayment for acquiring land use right
   
3,136,017
     
1,936,440
 
Prepayment for acquisition deposit
   
3,653,040
     
-
 
Advances on purchasing equipment and construction in progress
   
3,703,622
     
12,056,964
 
Refundable security deposits
   
1,394,648
     
1,264,283
 
Intangible assets
   
5,059,757
     
257,012
 
Total
 
$
17,262,417
   
$
15,854,910
 

All land in the PRC is government owned. However, the government grants users land use rights. As of June 30, 2010 and December 31, 2009, the Company prepaid $3,136,017 and 1,936,440 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.

Prepayment for acquisition deposit represents the payment of $3,653,040 (RMB 24,800,000) made for acquisition of Hanchuan Makou Yuntong Compress Natural Gas Co., Ltd. (“Makou”) by Hubei Xilan Natural Gas Co., Ltd.  As of June 30, 2010, the transfer of the assets was under progress and the company has not exercised full control over its operations. The Company takes full control of the operations in Makou in July, 2010.
 
20


China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
JUNE 30, 2010
(Unaudited)
 
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.

Intangible assets represent operating rights acquired during acquisition of four natural gas stations, consisting of following:

   
June 30,
2010
(unaudited)
   
December 31,
 2009
 
Operating rights
  $ 4,886,575     $ -  
Other intangible assets
    173,182       257,012  
Total
  $ 5,059,757     $ 257,012  
 
Note 4 – Senior Notes Payable

On March 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;
 
21


China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
JUNE 30, 2010
(Unaudited)
 
 
·
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 SXNGE, 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 repayments 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
 
Repayment
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
%
January 30, 2014
   
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
 
2010
 
$
42,400,000
 
2011
   
41,600,000
 
2012
   
40,800,000
 
2013 and thereafter
   
40,000,000
 
 
22


China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
JUNE 30, 2010
(Unaudited)
 
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 had 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 gave 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, which passed the wavier period. 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.

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. On February 26, 2010, JBLNG entered into a fixed assets loan contract (see Note 5) with Pudong Development Bank Xi’an Branch (“SPDB”), pursuant to which the SPDB agreed to lend $17,676,000 to JBLNG. SPDB transferred $13,257,000 and $4,419,000 to JBLNG on March 17, 2010 and May 31, 2010, respectively. This loan is secured by Xi’an Xilan Natural Gas Co., ltd (“XXNGC”)’s equipments and vehicles located within PRC. The lien incurred with this loan is in violation of the Indenture of the Senior Notes with Abax Lotus Ltd. Under the terms of the Indenture for the 5.00% Guaranteed Senior Notes issued to Abax Lotus Ltd. dated January 20, 2008, the Company and its subsidiaries including XXNGC, are prohibited from entering into such pledge of assets and guaranty agreements. As a result, Abax Lotus Ltd. has the right to declare a default under the Indenture after written notice and the Company’s 30 days right to cure. Upon an event of default, Abax may accelerate the outstanding indebtedness together with all accrued interest thereon and demand immediate repayment. As of the date of this report, the Company has not received a notice of default from Abax Lotus Ltd. nor does the Company receive a notice of wavier from Abax Lotus Ltd. As the payment date of the indenture become dues on demands, the Company reclassified the indenture to short term liability.
 
23


China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
JUNE 30, 2010
(Unaudited)
 
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.

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 June 30, 2010 and 2009, the Company amortized $0 and $13,857 of the aforesaid issuance costs, net of capitalized interest. For the six months ended June 30, 2010 and 2009, the Company amortized $0 and $52,435 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 June 30, 2010 and 2009, the Company amortized $811,397 and $676,981 of the aforesaid discounts, of which $811,397 and $630,497, respectively, were capitalized into construction in progress. For the six months ended June 30, 2010 and 2009, the Company amortized $1,572,602 and $1,311,061 of the aforesaid discounts, of which $1,572,602 and $1,093,865, respectively, were capitalized into construction in progress.

The warrants have been determined to be derivative liabilities instruments because there is a 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 in the aggregate. Under the terms of the Warrant Agreement, in the event of a default under the indenture for the Senior Notes, the warrants holders are entitled to redeem the warrants for a price equal to the pro rata portion of the aggregate redemption price of $17,500,000 applicable to the warrants tendered by such holder. As the redemption requirement of the warrants become due on demands in connection to the default under the indenture, the Company reclassified the redemption value to short term liability.
 
24


China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
JUNE 30, 2010
(Unaudited)
 
Note 5- Long term Loan

The Company’s long term bank loan as of June 30, 2010 and December 31, 2009 are as following:

   
June 30,
2010
(unaudited)
   
December 31,
2009
 
Loan from Pudong Development Bank Xi’an Branch, due various dates from 2012 to 2014. Interest at 5.76% for the first year and subject to adjustment after the second year, secured by equipment
 
$
17,676,000
   
$
-
 


The above loan is secured by Xi’an Xilan Natural Gas Co., ltd (“XXNGC”)’s equipments and vehicles located within PRC. The carrying net value of the asset pledged is $12,435,247 as of June 30, 2010. Interest expense for the three months and six months ended in June 30, 2010 were $212,625, of which all expenses were capitalized into construction in progress. XXNGC also entered into a guaranty with SPDB to guaranty the repayment of the loans. The Company is required to make mandatory prepayments on the long term loan in the following date and amounts:

Date
 
Repayment Percentage
 
Repayment Amount
March 5, 2012
   
25
%
 $ 4,419,000
March 5, 2013
   
25
%
4,419,000
March 5, 2014
   
25
%
4,419,000
December 5, 2014
   
25
%
 4,419,000
 
25


China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
JUNE 30, 2010
(Unaudited)
 
Note 6 – Warrants

Following is a summary of the warrant activity:
 
   
Warrants
Outstanding
   
Weighted Average
Exercise Price
   
Aggregate
Intrinsic Value
 
Outstanding, December 31, 2008
   
1,994,242
   
$
14.28
     
-
 
Granted
   
-
     
-
     
-
 
Forfeited
   
(160,588
)
   
7.20
     
-
 
Exercised
   
-
     
-
     
-
 
Outstanding, December 31, 2009
   
1,833,654
   
$
8.93
   
$
4,008,434
 
Granted
   
-
     
-
     
-
 
Forfeited
   
-
     
-
     
-
 
Exercised
   
-
     
-
     
-
 
Outstanding, June 30, 2010 (unaudited)
   
1,833,654
   
$
8.93
   
$
1,384,750
 

Following is a summary of the status of warrants outstanding at June 30, 2010:

Outstanding Warrants
 
Exercise Price
 
Number
 
Average
Remaining
Contractual
Life
 
$
7.37
 
1,450,000
   
4.58
 
$
14.86
 
383,654
   
2.09
 
$
8.93
 
 1,833,654
   
4.06
 

Note 7 – 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 $58,435 and $33,891 for the three months ended June 30, 2010 and 2009, respectively. The total contribution for the above plan was $248,783 and $81,079 for the six months ended June 30, 2010 and 2009, respectively.
 
26


China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
JUNE 30, 2010
(Unaudited)
 
Note 8 – 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 9 – 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:

 
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 June 30, 2010, the remaining reserve needed to fulfill the 50% registered capital requirement was approximately $75,053,000.

Note 10– 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.
 
27


China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
JUNE 30, 2010
(Unaudited)
 
The Company used the Black-Scholes 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. $22,008 and $14,842 of compensation expense was recorded during the three months ended June 30, 2010 and 2009, respectively. $44,016 and $29,685 of compensation expense were recorded during the six months ended June 30, 2010 and 2009, respectively.

As of June 30, 2010, $22,008 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 three months.

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 former CFO were granted total options of 1% and 0.6% of the common shares outstanding, 50% as Non-qualified Stock Options (NSO) and 50% as Incentive Stock Awards (ISA), for a vesting period of four years. The Company granted the former CFO, Veronica Chen, options to purchase 75,000 shares of the Company’s common stock, representing approximately 0.5% of the Company’s outstanding shares as of March 11, 2009, which forfeited as Veronica Chen resigned as CFO. 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, the Company issued 243,850 stock options pursuant to the Company's 2009 employee stock option and stock award plan. During the six months ended June 30, 2010, options exercisable 61,700 shares of the Company's common stock were forfeit. On May 5, 2010, the company issued 380,850 stock options, including 87,600 stock options to the CFO, David She. The strike price for the options was $4.90 per share.

The Company used the Black-Scholes 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 volatility of the Company’s common stock was estimated by management based on the historical volatility of the Company’s common stock, the risk free interest rate was based on Treasury Constant Maturity Rates published by the U.S. Federal Reserve for periods applicable to the estimated life of the options, and the expected dividend yield was based on the current and expected dividend policy. The Company currently uses the “simplified” method to estimate the expected term for share option grants as it does not have sufficient historical experience to provide a reasonable estimate. The Company will continue to use the “simplified” method until it feels that it has sufficient historical experience to provide a reasonable estimate of expected terms. 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. Compensation expense of $770,242 and $823,080 was recorded during the three and six months ended June 30, 2010, respectively.
 
28


China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
JUNE 30, 2010
(Unaudited)
 
As of June 30, 2010, $2,048,326 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 years.

Following is a summary of the stock option activity:

   
Options
Outstanding
   
Weighted Average
Exercise Price
   
Aggregate
Intrinsic Value
 
Outstanding, December 31, 2008
   
-
   
$
-
   
$
-
 
Granted
   
318,850
     
4.90
     
1,983,247
 
Forfeited
   
(75,000)
     
4.90
     
466,500
 
Exercised
   
-
     
-
     
-
 
Outstanding, December 31, 2009
   
243,850
   
$
4.90
   
$
1,516,747
 
Granted
   
 380,850
                 
Forfeited
   
 (61,700)
                 
Exercised
   
(138,000)
     
-
     
-
 
Outstanding, June 30, 2010 (unaudited)
   
425,000
   
$
4.90
   
$
1,453,500
 
 
Following is a summary of the status of stock options outstanding at June 30, 2010:

Outstanding Options
   
Exercisable Options
 
Exercise
Price
 
Number
   
Average
Remaining
Contractual
Life
   
Exercise
Price
   
Number
   
Average
Remaining
Contractual
Life
 
$
4.90
   
425,000
     
4.75
     
$
4.90
   
2,750
     
4.75
 
 
29


China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
JUNE 30, 2010
(Unaudited)
 
Note 11 – Earnings per Share

Earnings per share for three and six months ended June 30, 2010 and 2009 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 June 30, 2010 and 2009:
 
   
For the three months ended
June 30,
   
For the six months ended
June 30,
 
Basic earnings per share
 
2010
   
2009
   
2010
   
2009
 
   
(Unaudited)
   
(Unaudited)
   
(Unaudited)
   
(Unaudited)
 
Net income
  $ 4,560,503     $ 3,862,756     $ 8,555,773     $ 8,064,379  
                                 
Weighted shares outstanding-Basic
    21,246,771       14,600,154       21,215,337       14,600,154  
                                 
Earnings per share-Basic
  $ 0.21     $ 0.26     $ 0.40     $ 0.55  
                                 
Diluted earnings per share
                               
                                 
Net income
  $ 4,560,503     $ 3,862,756     $ 8,555,773     $ 8,064,379  
                                 
Weighted shares outstanding-Basic
    21,246,771       14,600,154       21,215,337       14,600,154  
   Effect of diluted securities-Warrants
    137,044       126,493       287,917          
   Effect of diluted securities-Options
    198,847    
 
      116,734    
 
 
Weighted shares outstanding-Diluted
    21,582,662       14,726,647       21,619,988       14,600,154  
                                 
Earnings per share –Diluted
  $ 0.21     $ 0.26     $ 0.40     $ 0.55  
 
30


China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
JUNE 30, 2010
(Unaudited)
 
The Company had outstanding warrants of 1,833,654 at June 30, 2010 and 2009.  For the three months ended June 30, 2010 and 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 137,044 and 126,493, respectively; 383,654 outstanding warrants were excluded from the diluted earnings per share calculation as they are anti-dilutive. For the six months ended June 30, 2010, 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 287,917; 383,654 outstanding warrants were excluded from the diluted earnings per share calculation as they are anti-dilutive. For the six months ended June 30, 2009, all 1,833,654 outstanding warrants were excluded from the diluted earnings per share calculation as they are anti dilutive.

The Company had outstanding employee’s stock options of 425,000 at June 30, 2010. For the three and six months ended June 30, 2010, the average stock price was greater than the exercise prices options which resulted in additional weighted average common stock equivalents of 198,847 and 116,734, respectively.

Note 12 – Current Vulnerability Due to Certain Concentrations

Concentration of natural gas vendors:
   
Three months ended
June 30,
   
Six months ended
June 30,
 
   
2010
   
2009
   
2010
   
2009
 
   
(unaudited)
   
(unaudited)
   
(unaudited)
   
(unaudited)
 
Numbers of natural gas vendors
    4       4       4       4  
Percentage of total natural gas purchases
    96 %     97 %     96 %     90 %

As of June 30, 2010 and December 31, 2009, the Company has $108,454 and $82,146 payable due to its major suppliers.

The Company maintains long-term natural gas minimum purchase agreements with one of its vendors as of June 30, 2010. 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.
 
31


China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
JUNE 30, 2010
(Unaudited)
 
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 13 – 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 fueling 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, one office lease in Jingbian, PRC, one office lease in Wuhan, PRC and one office lease in New York, NY. The minimum future payment for leasing land use rights and offices is as follows:

Year ending December 31, 2010
 
$
1,219,507
 
Year ending December 31, 2011
   
2,087,346
 
Year ending December 31, 2012
   
1,921,385
 
Year ending December 31, 2013
   
1,830,217
 
Year ending December 31, 2014
   
2,218,208
 
Thereafter
   
34,447,281
 
Total
 
$
43,723,944
 

For the three months ended June 30, 2010 and 2009, the land use right and office lease expenses were $405,785 and $406,016, respectively. For the six months ended June 30, 2010 and 2009, the land use right and office lease expenses were $836,413 and $798,097, respectively.
 
32


China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
JUNE 30, 2010
(Unaudited)
 
(b) Property and Equipment Purchase Commitments

The Company has purchase commitments for materials, supplies, services and property and equipment for constructing the LNG plant and other CIP projects. The Company has future commitments as followings:

Year ending December 31, 2010
 
$
12,215,777
 
Year ending December 31, 2011
   
382,887
 
Thereafter
   
-
 
Total
 
$
12,598,664
 

(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.

Note 14- Subsequent Event

On May 29, 2010, the Company agreed to purchase the 100% ownership in Hanchuan Makou Yuntong Compress Natural Gas Co., Ltd. (“Makou”) from eight individuals. The Company prepaid $3,653,040 (RMB 24,800,000) for the acquisition. As of June 30, 2010, the company has not exercised full control over its operating and financial policies and thus did not consolidate Makou into its consolidated financial statements dated June 30, 2010.

In July 2010, HBXNGC has obtained full control of the assets, operating and financial policies of Makou. The Company will consolidate the assets of Makou in its quarterly financial report for the third quarter of 2010.

The Company has performed an evaluation of subsequent events through the date these consolidated financial statements were issued to determine whether the circumstances warranted recognition and disclosure of those events or transactions in the consolidated financial statements as of June 30, 2010.
 
 
33

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 an integrated natural gas operator in The People’s Republic of China (“China” or the “PRC”), primarily involved in distribution of compressed natural gas (“CNG”) through our VIE-owned CNG fueling stations. As of June 30, 2010, our VIE operated 28 CNG fueling stations in Shaanxi province and 12 CNG fueling stations in Henan province. Our VIE own the CNG fueling stations while we lease the land upon which our VIE owned CNG fueling stations operate. For the three and six months ended June 30, 2010, we sold 42,955,867 and 83,548,324 cubic meters of CNG through our fueling stations, compared to 41,152,513 and 80,446,633 cubic meters for the three and six months ended June 30, 2009. Our VIE also transport, distribute and sell piped natural gas to residential and commercial customers in the city of Xi’an in Shaanxi Province, including Lantian County, and the districts of Lintong and Baqiao, and in the city of Lingbao in Henan Province.

We operate four main business lines:

 
·
Distribution and sale of compressed natural gas through our VIE owned CNG fueling stations for hybrid (natural gas/gasoline) powered vehicles (40 stations as of June 30, 2010,);

 
·
Installation, distribution and sale of piped natural gas to residential and commercial customers through our VIE owned pipelines. We distributed and sold piped natural gas to 112,343 residential customers as of June 30, 2010;

 
·
Distribution and sale of gasoline through our VIE owned CNG fueling stations for gasoline and hybrid (natural gas/gasoline) powered vehicles (eight of our VIE owned CNG fueling stations sold gasoline as of June 30, 2010);

 
·
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.
 
34

 
On October 24, 2006, our variable interest entity XXNGC, formed a wholly-owned subsidiary, SJLNG, for the purpose of constructing a LNG facility to be located in Jingbian, Shaanxi province. We planned to invest approximately $81 million to construct this facility, with approximately $60 million in phase I construction and installations, $8 million in capitalized interest and $13 million associated with phase II and III of the plant. The construction is funded through the sale of senior notes to Abax and our September 2009 equity financing, as well as cash flows from operations. The LNG plant is under test run currently. The test run is expected to be completed by third quarter 2010. Once test run is completed, the plant is expected to have a processing capacity of 500,000 cubic meters per day, or approximately 150 million cubic meters on an annual basis.
 
We had total revenues of $21,135,599 and $20,742,520 for the three months ended June 30, 2010 and 2009 respectively and revenues of $40,502,422 and $39,270,186 for the six months ended June 30, 2010 and 2009. We had net income of $4,560,503 and $3,862,756 for the three months ended June 30, 2010 and 2009 respectively and net income of $8,555,773 and $8,064,379 for the six months ended June 30, 2010 and 2009 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 1.9% during the three months ended June 30, 2010 from the three months ended June 30, 2009 and by 3.1% during the six months ended June 30, 2010 from the six months ended June 30, 2009 largely because of the addition of 5 new fueling stations added in third quarter of 2009 and first half of 2010, as well as the increase of pipeline natural gas customers. As of June 30, 2010, we operated 40 CNG fueling stations in total and, in Shaanxi alone, we operated 28 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 June 30, 2010, 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 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 plan to 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.
 
35

 
The overall economic growth of China’s economy. We do not export our products outside China and our results of operations are thus substantially affected by the growth of the industrial base, the increase in residential, commercial and vehicular consumption and the overall economic growth of China. While China's economy has experienced a slowdown in 2008 and a recovery period in 2009 and 2010, Although the government has initiated extensive domestic stimulus spending, expanded bank lending, increases in the speed of regulatory approvals of new construction projects and other economic policies, we are currently unable to predict the overall direction of PRC economy. Our results of operations rely on the overall success of China’s economy and may be affected by the macro economic trends.

Taxation

United States

We are incorporated in the State of Delaware and are subject to the tax laws of the United States. We incurred a net operating loss for income tax purposes for the period ended June 30, 2010, and the estimated net operating loss carry forwards for United States income tax purposes amounted to $3,033,370 and $2,699,276 as of June 30, 2010 and December 31, 2009, respectively, which may be available to reduce future years' taxable income. These carry forwards will expire, if not utilized, beginning in 2027 through 2030. 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 June 30, 2010.

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 SXNGE, SJLNG, XXABC, HXNGC, LBNGC, and HBXNGC are subject to the 25% PRC income tax rate. Our effective income tax rate for the three months ended June 30, 2010 and 2009 were approximately 17.6% and 23.5%, respectively. Our effective income tax rate for the six months ended June 30, 2010 and 2009 were approximately 18.1% and 21.3%, respectively.

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 17%. This VAT also can be offset with VAT paid for materials included in the cost of revenues.

36

 
CONSOLIDATED RESULTS OF OPERATIONS

Three Months Ended June 30, 2010 Compared to Three Months Ended June 30, 2009

The following table represents the consolidated operating results for the three months period ended June 30, 2010 and 2009:
 
Sales Revenues

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

   
June 30,
2010
   
June 30,
2009
   
Increase in
Dollar amount
   
Increase in
percentage
 
Natural gas from fueling stations
 
$
15,490,300
   
$
15,051,319
   
$
438,981
     
2.9%
 
                                 
Natural gas from pipelines
   
730,703
     
669,360
     
61,343
     
9.2%
 
                                 
Gasoline
   
2,033,840
     
1,633,016
     
400,824
     
24.5%
 
                                 
Installation
   
2,341,553
     
2,690,164
     
(348,611)
     
(13.0)%
 
                                 
Auto conversion
   
539,203
     
698,661
     
(159,458)
     
(22.8)%
 
                                 
Total
 
$
21,135,599
   
$
20,742,520
   
$
393,079
     
1.9%
 

Overall. Total revenue for the three months ended June 30, 2010 increased to $21,135,599 from $20,742,520 for the three months ended June 30, 2009, an increase of $393,079 or 1.9 %. This increase was mainly due to the addition of 5 new fueling stations added in third quarter of 2009 and first half of 2010, as well as an increase in the number of residential and commercial pipeline customers to 112,343 as of June 30, 2010 from 103,343 as of June 30, 2009, We sold natural gas of 46,033,415 cubic meters during the three months ended June 30, 2010, compared to 44,090,672 cubic meters during the three months ended June 30, 2009. We also sold gasoline of 2,584,827 liters during the three months ended June 30, 2010, compared to 2,707,531 liters during the three months ended June 30, 2009. For the three months ended June 30, 2010, 86.4% of our revenue was generated from the sale of natural gas and gasoline, and the other 13.6% was generated from our installation and auto conversion services.

Natural Gas from Fueling Stations. Natural gas revenue from our fueling stations increased by 2.9% or $438,981 to $15,490,300 during the three months ended June 30, 2010, from $15,051,319 during the three months ended June 30, 2009, and contributed to 73.3% of our total revenue, which was the largest among our four major business lines. During the three months ended June 30, 2010, we sold 42,955,867 cubic meters of compressed natural gas, compared to 41,152,513 cubic meters during the three months ended June 30, 2009 through our fueling stations. In terms of average station sales value and volume, in the three months ended June 30, 2010, we sold approximately $387,257 and 1,073,897 cubic meters of compressed natural gas per station, compared to approximately $430,038 and 1,175,786 cubic meters in the three months ended June 30, 2009. Unit selling price remained stable at $0.34 (RMB2.34) and $0.42 (RMB2.83) net of VAT in Shaanxi and Henan province, respectively, or $0.37 (RMB 2.49) on an average basis.
 
37

 
Natural Gas from Pipelines. Natural gas revenue from our pipelines increased by 9.2%, or $61,343 to $730,703 during the three months ended June 30, 2010, from $669,360 during the three months ended June 30, 2009, and contributed to 3.5% of our total revenue. As of June 30, 2010, the Company had 112,343 pipeline customers, an increase of 9,000 customers comparing to as of June 30, 2009. We also sold 3,077,548 cubic meters of natural gas through our pipelines during the three months ended June 30, 2010, compared to 2,938,159 cubic meters during the three months ended June 30, 2009.

Gasoline. Revenue from gasoline sales increased by 24.5 % or $400,824, to $2,033,840 during the three months ended June 30, 2010 from $1,633,016 during the three months ended June 30, 2009, and contributed 9.6% to our total revenue. The gasoline revenue increase was due to 31.7% increase of unit sales price from $ 0.60 (RMB4.11) per liter in the three months ended June 30, 2009 to $0.79 (RMB 5.36) per liter in the three months ended June 30, 2010, mainly attributable to the increase of international oil price, partially offset by the sales volume decrease of 4.5% from 2,707,531 liters to 2,567,364 liters.

Installation Services. Revenue from installation services decreased by 13.0%, or $348,611 to $ 2,341,553 during the three months ended June 30, 2010, from $2,690,164 during the three months ended June 30, 2009, and contributed 11.1% to our total revenue. Installation services to our top four customers contributed to 19.4%, 19.4%, 16.6% and 16.6% of our installation revenue for the three months ended June 30, 2010.

Auto Conversion Services. Revenue from our auto conversion division decreased by 22.8%, or $159,458 to $539,203 during the three months ended June 30, 2010, from $698,661 during the three months ended June 30, 2009, and contributed 2.6% to our total revenue.

Cost of Revenue

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

   
June 30, 2010
   
June 30, 2009
   
Increase in dollar
amount
   
Increase in
percentage
   
Natural gas from fueling stations
 
$
7,847,102
   
$
7,023,175
   
$
823,927
     
11.7
 
                                   
Natural gas from pipelines
   
510,888
     
467,343
     
43,545
     
9.3
%
 
                                   
Gasoline
   
1,910,294
     
1,529,752
     
380,542
     
24.9
%
 
                                   
Installation
   
925,145
     
1,039,116
     
(113,971)
     
(11.0)
%
 
                                   
Auto conversion
   
326,638
     
404,944
     
(78,306)
     
(19.3)
%
 
                                   
Total
 
$
11,520,067
   
$
10,464,330
   
$
1,055,737
     
10.1
%
 
 
38