SGTI Shengtai Pharmaceutical Inc (GM)

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

Note 1 - Organization principal activities

Shengtai Pharmaceutical, Inc, the "Company,” was incorporated in March 2004 in the State of Delaware. The Company, through its subsidiaries, manufactures and distributes glucose and starch as pharmaceutical raw materials, other starch products and other glucose products such as corn meals, food and beverage glucose and dextrin. The Company's business operations are conducted in the People's Republic of China, the "PRC.”

Note 2 – Accounting policies

Accounting principles

In the opinion of management, the accompanying balance sheets and related interim statements of income and comprehensive income, and cash flows include all adjustments, consisting only of normal recurring items, necessary for their fair presentation in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”). Interim results are not necessarily indicative of results for a full year. The information included in this Form 10-Q should be read in conjunction with information included in the Company’s 2012 Form 10-K filed on September 28, 2012 with the U.S. Securities and Exchange Commission.

Principles of consolidation

The consolidated financial statements of Shengtai Pharmaceutical, Inc. and its subsidiaries reflect the activities of the parent and its wholly-owned subsidiaries Shengtai Holding, Inc., “SHI,” and Weifang Shengtai Pharmaceutical Co., Ltd., “Weifang Shengtai.” All material inter-company transactions and balances have been eliminated in consolidation.

Use of estimates

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America 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.

Reclassification

Certain reclassification has been made to the previous year’s financial statements to conform to current year presentation.

Recently issued accounting pronouncements

In December 2011, the FASB issued guidance on offsetting (netting) assets and liabilities. Entities are required to disclose both gross information and net information about both instruments and transactions eligible for offset in the statement of financial position and instruments and transactions subject to an agreement similar to a master netting arrangement. The new guidance is effective for annual periods beginning after January 1, 2013.

Note 3 – Earnings per share

Basic earnings per share is computed based on the weighted average number of shares of common stock outstanding during the period.  Diluted 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.

The components of basic and diluted earnings per share consisted of the following:

The Company’s warrants and stock options were not included in the calculation of diluted earnings per share for the three months ended September 30, 2012 and 2011 as the effect would be anti-dilutive.

Note 4 - Concentrations of risk

The Company's operations are conducted solely within the PRC. Accordingly, the Company's business, financial condition and results of operations may be influenced by the political, economic and legal environments in the PRC, and by the general state of the Chinese economy. The Company's operations in the PRC are subject to specific considerations and significant risks not typically associated with companies in North America and Western Europe. These include risks associated with, among others, the political, economic and legal environments and foreign currency exchange. The Company's results may be adversely affected 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 others.

The cash deposits in U.S. financial institutions exceed the amounts insured by the U.S. government. Balances at financial institutions or state owned banks within the PRC are not covered by insurance. Non-performance by these institutions could expose the Company to losses for amounts in excess of insured balances. At September 30, 2012 and June 30, 2012, the Company’s bank balances with the banks and cash in hand in PRC amounted to $16,486,679 and $17,987,762, respectively, which are uninsured and subject to credit risk. The Company has not experienced nonperformance by these institutions.

For the three months ended September 30, 2012 and 2011, there were no customers that individually comprised 10% or more of the Company’s total revenues.

The Company has one vendor, Changle Shengshi Redian Co.,Ltd. that individually comprised 10.96% or $5,336,545 of the Company’s total purchase for the three months ended September 30, 2012. The Company has one vendor, Dezhou No.5 Grain and Cooking Oil Warehouse that individually comprised 33.06% or $11,516,774 of the Company’s total purchase for the three months ended September 30, 2011.

For export sales, the Company frequently requires significant down payments or letter of credit from its customers prior to shipment. During the year, the Company maintained export credit insurance to protect the Company against the risk that the overseas customers may default on settlement.

The following table summarizes financial information for Company’s revenues based on geographic area:

Note 5 - Restricted cash

The Company through its bank agreements is required to keep certain amounts on deposit that are subject to withdrawal restrictions. These amounts were $7,010,195 and $13,084,586 as of September 30, 2012 and June 30, 2012, respectively.

Note 6 - Other receivables

Other receivables include receivables from unrelated parties for transactions other than sales. Other receivables amounted to $5,918,337 and $8,862,789 as of September 30, 2012 and June 30, 2012, respectively.

The other receivables include Company's advances to employees of $4,220,343 and $8,029,394 to purchase corn as of September 30, 2012 and June 30, 2012, respectively. These are advances to its purchasing department employees as purchase advances for corn purchases. This amount is 100% secured by the personal assets of the Company’s CEO as the guarantee extended by him.

The Company reviews its inventory periodically for possible obsolete goods or to determine if any reserves are necessary. As of September 30, 2012, the Company has determined that no reserves are necessary.

Note 8 - Prepayments and other assets

Prepayments and other assets mainly represent partial payments or deposits for inventory and equipment and other purchases and services. Prepayments and other assets mainly represent partial payments or deposits for repairing parts, decorating fee, monitoring system, consulting services, gardening fee, and other fees. Prepayments and other assets amounted to $1,986,828 and $1,023,154 as of September 30, 2012 and June 30, 2012, respectively.

Construction-in-progress represents the costs incurred in connection with the construction of buildings or new additions to the Company’s plant facilities. No depreciation is provided for construction-in-progress until such time as the assets are completed and placed into service. Depreciation expense for the three months ended September 30, 2012 and 2011 amounted to $2,272,344 and $1,896,910, respectively. Interest costs totaling $63,569 and $81,049 were capitalized into construction-in-progress for the three months ended September 30, 2012 and 2011, respectively.

Note 10 - Equity investment

On September 16, 2003, Weifang Shengtai entered into a joint venture partnership with Weifang City Investment Company and Changle Century Sun Paper Industry Co., Ltd, “Changle Paper,” and formed Changle Shengshi Redian Co., Ltd, "Changle Shengshi.”  Changle Shengshi was incorporated in Weifang City, Shandong Province, the PRC. Changle Shengshi's principal activity is to produce and sell electricity and steam to Weifang Shengtai and Changle for the use of their own production. Weifang Shengtai owns 20% of Changle Shengtai and the Company accounts for this 20% investment under the equity method of accounting.

Summarized financial information of Changle Shengshi is as follows:

Equity Investment Reconciliation is as follows as of September 30, 2012 and June 30, 2012:

Summarized financial information of Changle Shengshi is as follows for the three months ended September 30, 2012 and 2011:

In order to meet increasing demands for electricity and steam by Weifang Shengtai and Changle Paper, during the year ended June 30, 2012, the Company increased investment in Changle Shengshi by 8,000,000 RMB (approximately $1.26 million) and Changle Paper invested a corresponding amount such that Weifang Shengtai and Changle Sunshine Paper Ltd. continue to be 20% and 80% owners, respectively, of Changle Shengshi. After the investment, the Company still owns 20% of Changle Shengshi.

Note 11 - Advance for construction

Advances amounted to $1,483,711 and $2,188,892 as of September 30, 2012 and June 30 2012, respectively. Advances for construction are paid to unrelated parties, interest free, and with no collateral and no guarantee.

Intangible assets are reviewed at least annually and more often if circumstances dictate, to determine whether their carrying value has become impaired. The Company considers assets to be impaired if the carrying value exceeds the future projected cash flows from related operations. The Company also re-evaluates the periods of amortization to determine whether subsequent events and circumstances warrant revised estimates of useful lives. As of September 30, 2012 and June 30, 2012, the Company determined that there had been no impairment. For the three months ended September 30, 2012 and June 30, 2012, amortization expense relating to these intangible assets amounted to $15,260 and $59,368, respectively. The Company increased $10,322 and $2,511 for software upgrade during the quarter ended September 30, 2012 and during the year ended June 30, 2012, respectively.

The following table consists of the expected amortization expenses for the next five years:

Note 13 - Value added tax

Enterprises or individuals who sell products, engage in repair and maintenance or import and export goods in the PRC are subject to a value added tax in accordance with Chinese laws. The standard value added tax rate is 17% of the gross sales price; however, for the Company’s corn, the VAT rate is 13%. A credit is available whereby VAT paid on the purchases of semi-finished products, raw materials used in the production of the Company's finished products, and payment of freight expenses can be used to offset the VAT due on sales of the finished products.

VAT on sales and VAT on purchases amounted to $6,627,171 and $6,870,394, respectively, for the three month ended September 30, 2012. VAT on sales and VAT on purchases amounted to $ 5,384,598 and $5,878,878 , respectively, for the three months ended September 30, 2011. Sales and purchases are recorded net of VAT collected and paid as the Company acts as an agent for the Chinese government. VAT taxes are not impacted by the income tax holiday in the PRC.

Note 14 - Notes payable

Notes payable represents arrangements with various banks for payments to suppliers, which are normally due within one year. However, these notes can typically be renewed with the banks on an annual basis. As of September 30, 2012 and June 30, 2012, the Company’s notes payables consisted of the following:

Note 15 - Short term bank loans

Short term bank loans represent amounts due to various banks that are normally due within one year. However, these loans can typically be renewed with the banks on an annual basis. As of September 30, 2012 and June 30, 2012, the Company’s short term bank loans consisted of the following:

Short term bank loan interest expenses, net of capitalized interest amounted to $1,433,176 and $783,614 for the three months ended September 30, 2012 and 2011, respectively.

Note 16 - Employee loans

From time to time, the Company borrows money from certain employees for cash flow purposes. These loans accrue interest at 9.6%, do not require collateral, and the principal is due upon demand. Employee loans amounted to $292,926 and 295,076 as of September 30, 2012 and June 30, 2012, respectively. Interest expense related to these loans were approximately $7,031 and $6,597 for the three months ended September 30, 2012 and 2011, respectively. 

Note 17 - Income taxes

Our effective tax rates were approximately 33% and 29% for the three months ended September 30, 2012 and 2011, respectively. Our effective tax rate was lower than the U.S. federal statutory rate primarily due to the fact that our operations are carried out in foreign jurisdictions, which are subject to lower income tax rates.

Note 18 - Commitments and contingent liabilities

Guarantees

As of September 30, 2012, the Company had guaranteed loans on behalf of the unrelated party. The Company is obligated to perform under the guarantee if the guarantee company fails to pay principal and interest payments when due. The maximum potential amount of future undiscounted payments under the guarantee is $1.66 million for the guarantee company, including accrued interest. However, the guarantee given by the Company have been fully secured by their CEO’s personal assets. The Company has not recorded a liability for the guarantee because management estimates that the company is current in the payment obligations, and the likelihood of the Company having to make payments under the guarantee is remote.

Details of guarantee amounts to unrelated parties as of September 30, 2012 are as follows:

As of September 30, 2012, Weifang Century-Light Industry Co., Ltd and Yuanli Chemical Engineering Inc. guaranteed $6,638,742 and $4,741,958 for the Company, respectively.

Litigation

In April 2012, several law firms announced investigation of the Company in connection with the receipt of a going private proposal from Chairman and Chief Executive Officer Mr. Liu to acquire common stock at $1.65 per share in cash. To the best of our knowledge, no actions have been filed against the Company or its current officers and directors as of the date of this quarterly report. 

Note 19 - Stockholders’ equity

On November 9, 2010, the Company effected a 1-for-2 reverse stock split of its issued and outstanding shares of Common Stock; reducing the number of its authorized shares of Common Stock and Preferred Stock by the same reverse stock split ratio.  The reverse stock split and the reduction of the number of authorized shares of Common Stock and Preferred Stock were authorized by the stockholders of the Company at its annual general meeting of stockholders held on October 26, 2010. As of November 12, 2010, the outstanding and issued shares were approximately 9,584,912 shares (prior to the reverse stock split, the number outstanding was 19,169,805), before rounding up fractional shares.  The authorized number of shares of Common Stock was reduced from 100,000,000 to 50,000,000, and the authorized number of shares of Preferred Stock was reduced from 5,000,000 to 2,500,000.  These financial statements have been adjusted retroactively to reflect the reverse stock split.

In connection with the 1-for-2 reverse stock split, all outstanding warrants and options will have 1-for-2 reverse split with the exercise price doubled.

Warrants

On May 15, 2007, in connection with the Share Purchase Agreement, the Company issued 2,187,500 warrants, "Investor Warrants,” which carry an exercise price of $5.20 and a 5-year term. The Investor Warrants are callable if the Company's shares trade at or above $16.00 per share for 20 consecutive trading days and underlying shares are registered for resale. The Investor Warrants contain standard adjustment provisions upon stock dividend, stock split, stock combination, recapitalization, and a change of control transaction. During the year ended June 30, 2008, a total of 97,403 warrants were exercised by three stockholders.

Also in connection with the Share Purchase Agreement, the Company issued 109,375 warrants, "Placement Agent Warrants,” to Brill Securities, the Placement Agent. These Placement Agent Warrants have the same terms as the Investor Warrants. These warrants were issued on August 8, 2007.

Concurrent with the offering related to the Share Purchase Agreement, the Company issued 37,500 warrants to Chinamerica Fund, LLP and 12,500 warrants to Jeff Jenson, collectively, the "Lead Investor Warrants,” to compensate Chinamerica Fund LLP as the lead investor and Jeff Jenson in assisting in providing the shell company, West Coast Car Company. These Lead Investor Warrants have the same terms as the Investor Warrants except that they have an exercise price of $0.02 per share. In June 2008, Jeff Jenson exercised the 12,500 warrants issued to him. In November 2008, Chinamerica Fund, LLP exercised the 37,500 warrants issued to the fund.

All Investor Warrants, Placement Agent Warrants and Lead Investor Warrants meet the conditions for equity classification pursuant to ASC 815 (formerly SFAS 133, "Accounting for Derivatives") and ASC 815 (formerly EITF 00-19, "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock").  Therefore, these warrants were classified as equity and accounted for as common stock issuance cost.

All warrants were expired as of June 30, 2012. No warrants were issued for three months ending September 30, 2012.

Stock options

On January 4, 2008, the Company adopted the "Shengtai Pharmaceutical, Inc. 2007 Stock Incentive Plan,” the "Stock Incentive Plan.” The Company believes that awards under the Stock Incentive Plan better align the interests of its employees with those of its shareholders. Option awards are generally granted with an exercise price equal to the fair value of the Company's stock at the date of grant.

On May 14, 2008, the Company granted 250,000 stock options and 80,000 non-qualified stock options pursuant to the Stock Incentive Plan. All options have an exercise price of $6.68, which was the closing price on the date of grant, and expire five years after the date of grant. All options vest over a period of three years on a quarterly basis from the date of grant.

The Company uses the Black-Scholes option pricing model which was developed for use in estimating the fair value of options. Option pricing models require the input of highly complex and subjective variables, including the expected life of options granted and the Company's expected stock price volatility over a period equal to or greater than the expected life of the options. Because changes in the subjective assumptions can materially affect the estimated value of the Company's employee stock options, it is management's opinion that the Black-Scholes option valuation model may not provide an accurate measure of the fair value of the Company's employee stock options and that value may not be indicative of the fair value observed in a willing buyer/willing seller market transaction.

The assumptions used in calculating the fair value of options granted in 2008 using the Black-Scholes option pricing model are as follows:

The volatility of the Company's common stock was estimated by management based on the historical volatility; 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 fair value of the options was based on the Company's common stock price on the date the options were granted. Because the Company does not have sufficient applicable history of employee stock options activity, the Company uses the simplified method to estimate the life of the options by taking the sum of the vesting period and the contractual life and then calculating the midpoint, which is the estimated term of the options.

In the Chief Financial Officer Employment Agreement, the “Employment Agreement,” entered into on March 1, 2010 between the Company and Mr. Hu Ye, the former Chief Financial Officer, the Company granted Mr. Hu Ye an option to purchase 150,000 shares of common stock of the Company. The shares vest over 3 years starting March 1, 2010 and terminate on the third anniversary of the date of issuance of this option. The Company valued the shares at $5.20 per share, which represents 130 % of the fair market value being calculated in the private placement price on May 15, 2007. The fair values of stock options granted to the CFO were estimated at the date of grant using the Black-Scholes option-pricing model with the following assumptions:

The Chief Financial Officer Employment Agreement between the Company and Mr. Hu Ye was terminated in December 2010, and the 150,000 options granted were forfeited.

On June 1, 2010, the Company hired two directors, Mr. Yaojun Liu and Mr. Fei He. In the Employment Agreements entered into on June 1, 2010 between the Company and each director, the Company granted each director an option to purchase 40,000 shares of common stock of the Company. The shares vest over 3 years starting June 1, 2010 and terminate on the third anniversary of the date of issuance of this option. The Company valued the shares at $5.20 per share. The fair values of stock options granted to the two directors were estimated at the date of grant amounting $165,611 using the Black-Scholes option-pricing model with the following assumptions:

The stock option activity was as follows for the year ended September 30, 2012:

The Company’s forfeiture rate for the year ended September 30, 2012 is 0%.

Following is a summary of the status of options outstanding at September 30, 2012:

Compensation expense from stock options recognized for the three months ended September 30, 2012 and 2011 were $0 and $6,900, respectively. As of September 30, 2012, there is $27,602 estimated expense with respect to unvested stock-based awards yet to be recognized as an expense over the employee's remaining weighted average service period.

Note 20 - Statutory reserves

The laws and regulations of the PRC require that before a Sino-foreign cooperative joint venture enterprise distributes profits to its partners, it must first satisfy all tax liabilities, provide for losses in previous years, and make allocations in proportions determined at the discretion of the board of directors, after the statutory reserves. The statutory reserves include the surplus reserve fund, and the enterprise fund. These statutory reserves represent restricted retained earnings.

Surplus reserve fund

The Company is required to transfer 10% of its net income, as determined in accordance with the PRC’s accounting rules and regulations, to a statutory surplus reserve fund until such reserve balance reaches 50% of the Company’s registered capital. The transfer to this reserve must be made before distribution of any dividends to stockholders. For the three months ended September 30, 2012 and 2011, the Company transferred $31,324 and $110,517 to this reserve. The surplus reserve fund is non-distributable other than during liquidation and can be used to fund previous years’ losses, if any, and may be utilized for business expansion or converted into share capital by issuing new shares to existing stockholders in proportion to their shareholding or by increasing the par value of the shares currently held by them, provided that the remaining reserve balance after such issue is not less than 25% of the registered capital.

Pursuant to the Company’s articles of incorporation, the Company is to appropriate 10% of its net profits as statutory surplus reserve up to $7,500,000. As of September 30, 2012 the Company had appropriated to the statutory reserve $4,257,449.

Enterprise fund

The enterprise fund may be used to acquire fixed assets or to increase the working capital to expand production and operations of the Company. No minimum contribution is required and the Company has not made any contribution to this fund as of September 30, 2012.

Note 21 - Retirement benefit plans

Regulations in the PRC require the Company to contribute to a defined contribution retirement plan for the benefit of all permanent employees. The Company is required to make contributions to the state retirement plan at 15% to 20% of the monthly base salaries of all current permanent employees. The PRC government is responsible for the administration and benefit liability to retired employees. For the three months ended September 30, 2012 and 2011, the Company made contributions in the amounts of $155,251 and $141,372, respectively, to the Company’s retirement plan.

Note 22 - Related party transactions

The Company’s utilities (electricity and steam) are mostly provided by Changle Shengshi. As of September 30, 2012 and June 30, 2012, the Company’s accounts payable due to Changle Shengshi was $980,243 and $405,926, respectively, which related to a portion of the Company’s utilities being provided by Changle Shengshi. The Company’s transaction amounts with Changle Shengshi amounted to approximately $4,614,102 and $3,434,972 for the three months ended September 30, 2012 and 2011, respectively.

From time to time, the Company borrows money from Qingtai Liu, the Company’s CEO and President, for cash flow purposes of the Company. The loans do not require collateral and the principal is due upon demand. Before January 1, 2009, the interest rate was at 7.2% for the first nine months, and then 10.8% thereafter until the full principal amounts are paid by the Company. After January 1, 2009, the interest rate was changed to 7.2% for the loan period. Employee loan from officer amounted to $36,965 and $37,027 as of September 30, 2012 and June 30, 2012, respectively. Interest expense related to this loan was approximately $767 and $3,056 for the three months ended September 30, 2012 and June 30, 2012, respectively.

As of September 30, 2012, the other receivable includes Company's advances of $4,220,343, to its purchasing department employees as purchase advances for corn purchases. This amount is secured by the personal assets of CEO as per guarantee extended by him.