UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-K
 
x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended December 31, 2012
 
or
 
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from _______________ to _____________
 
Commission File No. 001-34546
 
CHINA XD PLASTICS COMPANY LIMITED
(Exact name of registrant as specified in its charter)

Nevada
 
04-3836208
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
     
No. 9 Dalian North Road, Haping Road Centralized Industrial Park,
 Harbin Development Zone,
Heilongjiang Province, P. R. China
 
150060
(Address of principal executive offices)
 
(Zip Code)
 
Registrant’s telephone number, including area code: (86) 451-8434-6600
 
Securities registered pursuant to Section 12(b) of the Act:
 

Title of each class
 
Name of each exchange on which registered
Common Stock, $0.0001
 
NASDAQ Global Market
 
Securities registered pursuant to Section 12(g) of the Act:  None
 
Indicate by checkmark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes   o   No   x
 
Indicate by checkmark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.    Yes   o    No x
 
Indicate by checkmark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 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   o
 
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   x     No o
 
 
 
 

 
Indicate by checkmark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    o
 
Indicate by checkmark 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.
 
Large accelerated filer   o
Accelerated filer   o
   
Non-accelerated filer    o
(Do not check if a smaller reporting company)
Smaller reporting company   x
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes o   No x
 
The aggregate market value of the voting and non-voting common equity held by non-affiliates as of June 30, 2012 was approximately $72,853,606.
 
As of March 20, 2013, there were 47,563,772 shares of common stock, par value US$0.0001 per share, outstanding.
 
Documents incorporated by reference: None.
 

 
 

 
CHINA XD PLASTICS COMPANY LIMITED
FORM 10-K ANNUAL REPORT
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2012
 
 
Table of Contents
 
   
PART I 
 
  1
 
Item 1
Business
  1
 
Item 1A
Risk Factors
  22
 
Item 1B
Unresolved Staff Comments
  37
 
Item 2
Properties
  37
 
Item 3
Legal Proceedings
  38
 
Item 4
Mine Safety Disclosures
  38
   
PART II
 
  39
 
Item 5
Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
  39
 
Item 6
Selected Financial Data
  40
 
Item 7
Management’s Discussion and Analysis of Financial Condition and Results of Operations
  41
 
Item 7A
Quantitative and Qualitative Disclosures About Market Risk
  52
 
Item 8
Financial Statements and Supplementary Data
  53
 
Item 9
Changes In and Disagreements with Accountants on Accounting and Financial Disclosure
  53
 
Item 9A
Controls and Procedures
  53
 
Item 9B
Other Information
  54
   
PART III
 
  55
 
Item 10
Directors, Executive Officers and Corporate Governance
  55
 
Item 11
Executive Compensation
  64
 
Item 12
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
  73
 
Item 13
Certain Relationships and Related Transactions and Director Independence
  74
 
Item 14
Principal Accountant Fees and Services
  76
   
PART IV
 
  77
 
Item 15
Exhibits, Financial Statement Schedules
  77
 
Financial Statements
 
Index to Consolidated Financial Statements
  F-1
Report of Independent Registered Public Accounting Firm
  F-2
Consolidated Balance Sheets
  F-3
Consolidated Statements of Comprehensive Income
  F-4
Consolidated Statements of Changes in Equity
  F-5
Consolidated Statements of Cash Flows
  F-6
Notes to the Consolidated Financial Statements
  F-8

 
i
 
 
 

 
PART I
 
ITEM 1.   BUSINESS.
 
Our Business
 
China XD Plastics Company Limited (“China XD”, “we”, and the “Company”, and “us” or “our” shall be interpreted accordingly) is one of leading specialty chemical companies engaged in the research, development, manufacture and sale of modified plastics primarily for automotive applications in China. Through our wholly-owned subsidiary Heilongjiang Xinda Enterprise Group Company Limited (“Xinda Group”), we manufacture and sell modified plastics, primarily for use in the fabrication of automobile parts and components. We develop our products using our proprietary technology through our wholly-owned research laboratory, Heilongjiang Xinda Enterprise Group Macromolecule Material Research Center Company Limited. (“Xinda Group Material Research”). Xinda Group Material Research is a professional macromolecular material research and development institution and has 246 certifications from manufacturers in the automobile industry as of December 31, 2012. We are the only company certified as a National Enterprise Technology Center in modified plastics industry in Heilongjiang Province.  Our research and development (the “R&D”) team consists of 118  professionals and 18 consultants, including three consultants who are members of Chinese Academy of Engineering, and one consultant who is the former chief scientist of Specialty Plastics Engineering Institute of Jilin University. As a result of the combination of our academic and technological expertise, we have a portfolio of  69 patents, one of which we have obtained the patent rights and the remaining 68 of which we have applications pending in China as of December 31, 2012.  
 
Modified plastic is produced by changing the physical and/or chemical characteristics of ordinary resin materials. In order for plastics to be used to produce automobile parts and components, they must satisfy certain physical criteria in terms of mechanical functionality, stability under light and heat, durability, flame resistance, and environmental friendliness. Our unique proprietary formulas and processing techniques enable us to produce low-cost high-quality modified plastic materials, which have been certified by many of the major domestic and international automobile manufacturers in China. In addition, we also provide specially engineered plastics and environment-friendly plastics for use in oilfield equipment, mining equipment, vessel propulsion systems and power station equipments.
 
China XD’s primary end-market is the Chinese automotive industry that has been rapidly growing for the past few years where our modified plastics are used by our customers to fabricate the following auto components: exteriors (automobile bumpers, rearview and sideview mirrors, license plate parts), interiors (door panels, dashboard, steering wheel, glove compartment and safety belt components), and functional components (air conditioner casing, heating and ventilation casing, engine covers, and air ducts). Our specialized plastics are utilized in more than 23 automobile brands manufactured in China, including leading brands such as AUDI, BMW, Toyota, Buick, Mazda, Volkswagen, Cherry, Geely, and Hafei new energy vehicles. As of December 31, 2012, 246 of Xinda Group’s automotive-specific modified plastic products have been certified by one or more of the automobile manufacturers in China and are in commercial production. As of December 31, 2012, 38 of our products were in the process of product certification by automobile manufacturers.
 
We operate three manufacturing bases in Harbin, Heilongjiang in the People’s Republic of China (the “PRC”). Prior to December 2012, we had approximately 255,000 metric tons of annual production capacity across 58 automatic production lines utilizing German twin-screw extruding systems, automatic weighing systems and Taiwan conveyer systems. In December 2012, we further expanded our third production base in Harbin with additional 135,000 metric tons of annual production capacity, bringing total installed production capacity in our three production bases to 390,000 metric tons across an additional 30 new production lines.
 
 
 
1

 
 
Our History
 
China XD, formerly known as NB Payphones Ltd. and NB Telecom, Inc., was originally incorporated under the laws of the state of Pennsylvania on November 16, 1999. On December 27, 2005, we migrated to the state of Nevada.
 
On December 24, 2008, we acquired Favor Sea Limited (“Favor Sea (BVI)”), a British Virgin Islands corporation, which is the holding company for Harbin Xinda Macromolecule Material Co., Ltd. ( “Harbin Xinda ”) and Harbin Xinda’s wholly-owned subsidiary, Harbin Xinda Macromolecule Material Research Institute (“Research Institute”). Harbin Xinda is a high-tech manufacturer and developer of modified plastics, which was established in September 2004 under the laws of the PRC. In December 2010, our management determined that the Research Institute could not meet the Company’s development needs, including meeting the criteria to be a National Enterprise Technology Center. As a result, the Research Institute was deregistered.
 
On June 11, 2010, Harbin Xinda established Harbin Xinda Macromolecule Material Engineering Center Co., Ltd. (“Xinda Engineering Center”) to focus on research and development of high-end products such as engineering plastics, modified PA, alloy plastics and modified ABS. Xinda Engineering Center was deregistered in 2012 as part of our group restructuring.
 
On October 14, 2010, Harbin Xinda established Heilongjiang Xinda Software Development Company Limited (“Xinda Software”) to develop software applications that provide certain standard and programmable technical services remotely.
 
On December 10, 2010, Harbin Xinda established Harbin Xinda Macromolecule Material Research Center Co., Ltd. ("Xinda Macromolecule Research Center") to focus on research and development of products such as modified PP and environment-friendly modified plastics.  Xinda Macromolecule Research Center was deregistered in 2012 as part of our group restructuring.
 
On March 31, 2011, Harbin Xinda established a wholly-owned subsidiary, Harbin Xinda Macromolecule Material Testing Technical Co., Ltd. (“Xinda Testing”), to develop a nationally recognized testing laboratory and provide testing services of macromolecule materials, engineering plastics and other products.
 
In response to our rapid business expansion and in order to be eligible for beneficial tax policies for certain regions in China, we developed a group restructuring plan.

From August 2011 to December of 2012, Harbin Xinda established (i) Harbin Meiyuan Enterprise Management Service Company Limited. (“Meiyuan Training”) in Harbin to provide all year round training to both our existing and new employees, accommodate our customers and business partners as well as host industry conferences; and (ii) Heilongjiang Xinda Enterprise Group Technology Center Company Limited (“Xinda Group Technology Center”) in Harbin to focus on long-term research and development projects.

Xinda Group, a wholly-owned subsidiary of HK Engineering Plastics Company Limited and the proposed direct parent company of all of our PRC-based operating subsidiaries after the group restructuring was established in December 2011. Harbin Xinda Plastics Material Research Center Company Limited (“Xinda Material Research Center”) was established in December 2011 to focus on research and development of products close to commercialization phase.

Three companies, Haikou Xinda Plastics New Materials Company Limited. (“Haikou New Materials”), Haikou Xinda Plastics New Materials Enterprise Technical Center Company Limited (“Haikou Technical Center”), and Haikou Xinda Software Development Company Limited (“Haikou Software”) were established in December 2011 and are based in Haikou, the capital of Hainan province in the PRC. Harbin Xinda Plastics Composite Material Company Limited (“Xinda Composite”) and Harbin Xinda Plastics New Material Company Limited (“Xinda Plastics New”) were established in December 2011.

Xinda Group Material Research was established in December 2012.
 
Part of the restructuring plan is for Harbin Xinda to transfer its ownership of subsidiaries to Xinda Group.  As of December 31, 2012, we have completed internal transfer of three subsidiaries to Xinda Group: Xinda Software, Xinda Group Technology Center and Xinda Testing as shown in the organization chart below. Harbin Xinda is being merged into Xinda Group and will be deregistered. Meiyuan Service changed its name to Heilongjiang Xinda Enterprise Group Meiyuan Training Center Co. Ltd. (“Meiyuan Training”) to better reflect its nature of operation upon completion of the restructuring. Haikou New Materials, Haikou Technical Center and Haikou Software are planned to be deregistered in 2013. Xinda Group Technology Center, Xinda Testing and Xinda Material Research Center will be deregistered and merged into Xinda Group Material Research in 2013, whose major functions include technical support for our production bases, research and development of modified plastic products for applications in areas such as automotive, high-speed rail, aircraft and others, customer post-sales support, and collaboration with industry leading universities and institutions. Our restructuring is expected to be completed approximately by June 30, 2013.
 

 
2

 
 
Corporate Structure  The corporate structure of the Company as of December 31, 2012 was as follows:
 
 
 
 
 
 
3

 
 
 
 The planned corporate structure of the Company after the restructuring is as follows:
 
 


Starting in 2013, we plan to establish a production base, research and development and training center in Sichuan Province to develop market for our products in Southwest China and its adjacent regions.
 
 
 
4

 
 
Our Industry
 
According to a research report prepared exclusively for the Company and issued by Frost & Sullivan in February 2012, China is estimated to have consumed approximately 14.3 million Metric Ton (“MT”) of modified plastic products in 2012, representing an increase of 9.2% compared to 2011. With China being the world’s leading manufacturing center and with rising domestic individual consumption, we believe that demand for modified plastics from China will continue to increase in the foreseeable future. As shown in Figure 1, the market demand for modified plastics will reach 15.6 million MT in 2013 and 18.5 million MT in 2015, representing compound annual growth rates (“CAGR”) of 7.8% and 11.9% by sales volume and revenue from 2010 to 2015.  Currently, demand for our products is primarily driven by the Chinese automotive industry. In order for plastics to be used in automobile parts and components, they must satisfy specific physical criteria in terms of mechanical functionality, stability under light and heat, durability, flame resistance, and environmental friendliness. Modified plastics are usually found in interior materials, door panels, dashboards, mud flaps, chassis, bumpers, oil tanks, gas valves, grilles, unit heater shells, air conditioner shells, heat dissipating grids, wheel covers, and other components.
 
Figure 1: Analysis of Chinese Modified Plastics Market: Sales Volume and Revenue (China), 2005-2015E
 
 
Source: Frost & Sullivan
 
According to Frost & Sullivan’s report, the Chinese automotive modified plastics market has experienced rapid development from 2005 to 2010, with more than a six-fold growth in terms of revenue and more than a four-fold increase in terms of sales volume during this period. The market demand is projected to reach 2.8 million MT in 2013. As illustrated in Figure 2, the Chinese automotive modified plastics market is expected to sustain rapid increase in terms of revenue and sales volume, with CAGR of 18.8% and 14.2% from 2010 to 2015, respectively. Approximately 51% of the automotive modified plastic consumed in 2010 was imported from outside of the PRC or manufactured by multinational and joint venture companies. We believe that the demand for automotive modified plastic in China will grow continuously due to the fast growing Chinese automotive market, increasing use per unit of plastic content in automobiles and favorable government incentives and regulations. Moreover, domestic producers will likely gain larger market share from imports as they are able to manufacture products with comparable quality at highly competitive prices and close proximity to their customers. We believe that the following are the key drivers for the automotive modified plastic industry in China.
 
 
5

 
Figure 2: Analysis of Chinese Automotive Modified Plastics Market: Sales Volume and Revenue (China), 2005-2015E
 
Source: Frost & Sullivan
 
Continual Growth in Chinese Auto Demand
 
According to the statistics by the China Association of Automobile Manufacturers (“CAAM”) in 2012, China’s production volume of automobiles increased from 5.7 million units in 2005 to 19.27 million units in 2012. The market is expected to sustain the growth with a CAGR of 5.9% from 2010 to 2015, reaching 24.3 million units in 2015. China has exceeded the United States to become the world’s largest auto market as measured by the number of automobiles sold. We believe the growth momentum in China’s auto sales will remain strong over the next five years. The automotive industry in China is still in its infancy with passenger car ownership of 69 vehicles per 1,000 inhabitants in 2011, which is significantly below the developed countries’ average of 824 and global average of 473 according to the Economist Intelligence Unit as shown in Figure 3 below.
 
Figure 3: Overview of Chinese Macro Economy:
Vehicle Per 1,000 People Comparison (Units per 1,000 People), 2005-2015E
 
 

 
 
Source: National Bureau of Statistics, US Department of Energy, Eurosta, Frost and Sullivan
 
According to the National Bureau of Statistics, the total number of Chinese automobile parts has experienced a rapid growth because of the economic development and the incentive policies issued by the government. The number maintained a booming trend from 31.8 million units in 2005 to 112 million units in 2012, and is forecasted to hit a record of 134 million units in 2013 and 192 million units by 2015, with a CAGR of 19.8% between 2010 and 2015 as shown in Figure 4.
 
 
6

 
Figure 4: Overview of Chinese Macro Economy: Growth of Automotive Parts, 2005-2015E
 
 
Source: National Bureau of Statistics
 
Rising personal income in China is one of the key drivers for the rapid growth of the Chinese automobile industry. As shown in Figure 5, China has shown strong economic growth with its GDP increased from approximately RMB 18,493.7 billion in 2005 to RMB 51,517.8  billion in 2012, and is expected to sustain the steady growth from 2012 to 2015. Per Capita Consumption Expenditure of Urban Household also shows an optimistic picture with a total nominal increase of 116.6% between 2005 and 2010, and is forecasted to reach RMB 22,551.6 by the end of 2015. Moreover, cars have become more affordable in China as local or joint venture automobile manufacturers continuously expand their production to achieve economies of scale to lower production cost and source cheaper auto parts locally. Growing income and decreasing vehicle prices will continue to make car ownership more affordable for China’s rising middle class.
 
 
Figure 5: Overview of Chinese Macro Economy: Growth of Nominal GDP and Per Capita Consumption Expenditure of Urban Household (China), 2005-2015E
 
Source: National Bureau of Statistics, International Monetary Fund, and Frost & Sullivan
 
 
 
7

 
 
Benefit and Increasing Use of Plastics in Automobiles
 
(1) Cost Reduction: The primary demand driver for modified automotive plastics arises out of the cost-reduction characteristics evidenced by the plastics material inclusion in the automobile manufacturing process. Modified plastics can deliver the same performance as metallic materials at approximately a tenth of the cost. In addition, modified plastics can substitute some kinds of more expensive engineering plastics. This benefit of modified plastics will become more significant with the increasing competition in automobile manufacturing industry to improve efficiency and reduce costs.
 
(2) Vehicle Emissions Reduction: Plastic components impact fuel efficiency by saving approximately 2.5 liters of fuel per kilograms (“kg”) used (equivalent to 6kg of CO2 emissions) over the lifetime of the vehicle. Automobile manufacturers have been reducing vehicle weights in an attempt to reduce emissions and increase efficiencies. Modified plastics reduce the weight of components by 40% compared with traditional metallic materials.
 
(3) Performance and Safety Improvement: The development of advanced plastics applications lead to the improvement in performance through reducing the number and weight of the vehicle parts, causing the fuel consumption per vehicle to drop significantly. In addition, the lower net weight of the vehicles improves handling performance and thereby eliminates the likelihood of losing control in case of emergency stops. The involvement of modified plastics in automotive applications results in significant improvement of the safety features of the vehicle parts, like seat belts, air bags, and air bag containers in the recent years.
 
(4) New Applications: Plastics reduce the number of the required parts used in automobile manufacturing and introduce new design possibilities. Conventional materials struggle to compete against this open innovation platform associated with the plastics industry. In addition, the performance benefits associated with plastic materials continue to create a competitive advantage for the plastics industry.
 
(5) Increasing Use of Plastics per Vehicle: Weight of modified plastics per vehicle in China continually increased from 2005 to 2010, and is forecasted to reach 152.0 kg by the end of 2015, with a growth rate of 45.5% as shown in Figure 6. Although the weight of modified plastics per vehicle in China will still be less than that in North America and Europe, the highest growth rate indicates the huge potential for market growth. In 2010, plastic use in China is estimated to be about 104.5 kg per vehicle, representing 8% of the vehicle weight, whereas models imported from Europe contain on average as much as 190 kg per vehicle, or 15% of the vehicle weight. In addition, the Chinese government’s goals regarding electric and hybrid vehicles may also push the market further as weight concerns are more important for these vehicles than for traditional passenger cars. 
 
 
8

 
 
 
Figure 6: Comparison of Weight of Modified Plastics per Vehicle in China, North America, and Europe, 2005, 2010, 2015E
 
Source: Frost & Sullivan, American Chemistry Council’s Plastics Industry Producers' Statistics Group
 
Increasing Substitution of Imports
 
Though China’s automotive plastic market has been dominated by foreign or joint venture (“JV”) companies, Chinese suppliers are continually gaining market share. It is estimated that automotive plastics imported and manufactured by multinational and JV companies accounted for 45% of the total China automotive plastic supply in 2011, decreasing from 65.0% in 2005 according to a report by Frost & Sullivan . Compared to foreign competitors including JV companies, local manufacturers can largely benefit from the lower cost and geographical convenience in China and their product sales can be customized with time-efficient after sales services and technical supports. As the local production capacity of both domestic and foreign companies has been expanding, share of imports is expected to decrease to 10.0% and that of multiple national companies (the “MNC”) and JV companies is expected to decrease to 25% by the end of 2015, while the share of domestic manufacturers is forecast to rise to 65.0% in 2015 as they expand at a greater rate than MNC and JV in China.
 
The financial crisis beginning in 2008 and the European debt crisis beginning in 2011 forced global automakers and suppliers to concentrate on their cost structure and pricing mechanisms. Many automakers accelerated cost reduction initiatives. Moving manufacturing operations to and sourcing raw materials from low cost regions have emerged as key measures to save costs. With its huge consumer market, low labor costs and high-quality manufacturing and logistics infrastructure, China is a location favored by global auto and component makers who source parts and components not only for their local operations in China but also for their global operations. As a result, we believe that China’s local plastic suppliers will benefit from such global outsourcing trends and increasingly become a good substitute for expensive imported plastic products. JV manufacturers based in China in automotive plastics sector have been slow to invest and expand in China.
 
Favorable National Government Policies
 
In the past decade, the Chinese government has adopted a number of policies and initiatives intended to encourage the development of the Chinese modified plastics industry and stimulate the growth of the Chinese automobile industry. 
 
 
 
9

 
Since 2000, modified plastics, including engineering plastics, have been categorized as a prioritized industrialization area by a series of government guidelines or development plans. Some of these policies include: 
 
●        
It was stated in the “Outline of China’s Twelfth Five-year Plan (2011)” that new functional materials, advanced structural materials, common base materials, fiber of high performance and its compounded material are key development directions of new material industry.
 
●        
It was stated in the “Catalogue for Guidance on Adjustment of Industrial Structure (2011)” promulgated by the National Development and Reform Commission on March 27, 2011, that the country is currently promoting the development of production equipment of polycarbonate by the use of non-phosgene method, with annual output of 60000t/year and above, production of engineering plastic including liquid crystalline polymer (LCP) and development and application of bleeding modification and alloying; development and production of water – absorbed resin, conductible resin and biodegradable polymers; development and production of new polyamide including nylon 11, nylon 1414 and nylon 46, nylon with long carbon chain and heat resistant nylon.
 
  ●
It was stated in the “Guidance on Key Areas of Industrialization of High Technology with Current Priority in Development (2011)” jointly promulgated by the National Development and Reform Commission, the Ministry of Science and Technology, the Ministry of Commerce and the State Intellectual Property Office on June 23, 2011 that modified technologies applied to general plastics, including new engineering plastics and plastic alloy, new special engineering plastics, fire resistant modified plastics, and modified technology of general plastics, are currently prioritized areas to develop and industrialize in China’s macromolecule materials sector.
 
●        
 
       
A series of modified plastics technologies have been listed in the “National Support for Key High-tech Fields” as stated in the Circular on the Issuance of the Administrative Measure for the Recognition of High-tech Enterprise jointly promulgated by the Ministry of Science and Technology, Ministry of Finance, the State Administration of Taxation in April 2008. These technologies include special engineering plastics, macromolecular compound or new synthetic modified, etc.
 
In addition, with the Chinese government strongly encouraging the production of more fuel-efficient and environmentally friendly vehicles, as one means to help resolve the nation’s worsening air pollution problem, especially in big cities, opportunities abound for suppliers of plastics materials and auto components.
 
We believe that the above government measures and programs will continue to accelerate the demand for automotive modified plastics in China.
 
Tightening Trend and Local Government Policies
 
Despite the favorable national government policies as set forth above, in the past couple of years, the Chinese government has implemented certain measures to control the pace of economic growth and discontinued certain stimulus measures implemented to deal with the recent global financial crisis, including incentives for consumers to purchase automobiles.
 
 
 
 
10

 
Since 2011, in order to resolve the extreme traffic congestion, Beijing government has been implementing a vehicle purchase quota policy, which limits the maximum vehicles sold in Beijing per month to 20,000. Other cities which have begun to show signs of traffic congestion have also begun to implement similar measures to control traffic congestion, including the limited automobile licenses policy implemented in Shanghai and the imposition of congestion charges in Shenzhen.  The termination of nation-wide preferential policies can negatively affect consumer demand for new vehicles, and local restrictive measures over automobile purchases in major cities may result in the reduction in the sale of vehicles nationwide.
 
Our Products
 
Modified plastic is processed by adding chemical agents to basic plastics to generate or improve certain physical and/or chemical characteristics of plastic, such as heat resistance, hardness, tensile strength, wear resistance, and flame resistance. Based on the type of materials, modified plastics include modified common plastics, such as polypropylene (PP), acrylonitrile butadiene styrene (ABS), modified engineering plastics, such as polyamides (PA or nylon), environment-friendly plastics and specialty engineering plastics.
 
Our products are organized into seven product groups, based on their physical characteristics, as set forth below:
 
 
Product Group
 
 
Brand Name
 
Number of Products Certified
 
 
Characteristics
 
Automotive or Other Application
Modified PP
 
COMPNIPER
   
41
 
High fluidity and impact resistance
 
Interior parts, such as inner panels, instrument panels and box lids
                   
   
COMPWIPER
   
55
 
Resistance to low temperature and impact
 
External parts, such as front and back bumpers and mudguards
                   
   
COMPGOPER
   
39
 
Resistance to high temperature and static
 
Functional components, such as unit heater shells and air conditioner shells
                   
Modified ABS
 
MOALLOLY
   
13
 
High gloss, high rigidity and size stability
 
Functional components such as heat dissipating grids and wheel covers
                   
Modified PA
 
POLGPAMR
   
20
 
High wear and heat resistance
 
Parts requiring high flame and heat resistance
                   
Engineering Plastics
 
MOAMIOLY
   
20
 
Heat resistance and wear resistance
 
Engine hoods, intake manifold and bearings
                   
Alloy Plastic
 
BRBSPCL
   
31
 
Combines two different plastics, such as PP and ABS
 
Rearview mirrors, grilles, automotive electronics and other components. Products can also be used in computers, plasma TVs and mobile phones
                   
Environmentally friendly plastics
 
POLGBSMR
   
27
 
Environmentally-friendly features such as low odor and low carbon emission
 
Used in automobiles meeting environmental standard requirements
                   
Modified Plastic for Special Engineering
 
PEEK
   
N/A *
 
Excellent mechanical and chemical resistance and temperature tolerance
 
Used in communications and transport, electronics and electrical appliances, machinery, medicaland analytical equipment.
                   
Total
       
246
       

* PEEK is primarily used in applications that are unrelated to automotive applications, which does not require certifications and is in the product development stage.
 
 
 
11

 
 
Raw Materials
 
The principal raw materials used for the production of our modified plastic products are plastic resins such as polypropylene, ABS and nylon. Polypropylene is a chemical compound manufactured from petroleum.  ABS is a common thermoplastic used to make light, rigid, molded products such as automotive body parts and wheel covers.  Nylon is a thermoplastic silky material.  Approximately 54.5% of our total raw materials purchased by volume are sourced from overseas petrochemical enterprises and 45.5% from domestic petrochemical enterprises during the year ended December 31, 2012.
 
The Company has one-year renewable contracts with its major suppliers, which are distributors of petrochemical enterprises. Because the raw materials used in our products are primarily petroleum products, the rise in oil prices directly affects the cost of the raw materials. We attempt to mitigate the increase in our raw materials prices by appropriately raising the price for our products to pass the cost to our customers as part of our pricing policy.
 
Because raw materials constitute a substantial part of the cost of our products, we seek to reduce costs by dealing with three major suppliers. During the year ended December 31, 2012, the Company purchased approximately 98% of the Company’s raw material purchases from three major suppliers. By dealing in large quantities with these major suppliers, we obtain reduced prices for raw materials, therefore reducing the cost of our products. If we were unable to purchase from these suppliers, we believe we would still have adequate sources of raw materials from other petrochemical distributors without material impact on the cost of our products.
 
Research and Development

Xinda Material Research Center and Xinda Group Technology Center were organized to provide us with ongoing additions to our technology through advanced development methods, which represent the key to our competitive strength and success. Our goal is to utilize our state-of-the-art methods, equipment and our technical expertise to produce plastics of the highest quality that are cost-efficient for our customers. Toward this end, we have staffed Xinda Material Research Center and Xinda Group Technology Center with 38  employees who have Ph.D. and Master’s degrees and 80 employees who have Bachelor’s degrees. On average, our employees have been working in our industry for more than three years, and our key R&D employees have on average more than 10 years of experience in our industry.
 
As aforementioned, Xinda Group Material Research assumed the functions of Xinda Material Research Center and Xinda Group Technology Center as part of our group restructuring.  To supplement the efforts of our Xinda Group Material Research, we have cooperated with a number of the leading technology institutions in China. Besides providing specialized research and development skills, these relationships help us to formulate cutting edge research programs aimed at developing new technologies and applications in plastics engineering.
 
All our significant research and development activities are overseen by the members of our Scientific Advisory Board, which we have assembled from the leaders in China’s chemical engineering industry.  Currently, the members of the Scientific Advisory Board are:

Yong Jin: Member of Chinese Academy of Engineering, Dean of Chemical Science Department of Tsinghua University.
Shanyi Du:  Member of Chinese Academy of Engineering,  Professor of Harbin Institute of Technology.
Qingquan Lei: Member of Chinese Academy of Engineering, Post-PhD Advisor of Harbin Institute of Technology.
Zhongwen Wu: Chief Scientist and Director of the Research Institute of Special Plastics Engineering of Jilin University.
Kai Zheng: Secretary General of China’s Plastics Engineering Industry Association.
Huixuan Zhang: Vice Principal of Changchun University of Technology.
Bin Li: Vice Principal, Dean of the Science Department at Eastern Forest Industry University.
 
 
12

 
 
Zhenhua Jiang: Director of the Engineering Research Center of the Special Plastics Engineering Education Department of Jilin University.
Xiabin Jing: Post-PhD Advisor and Researcher of Changchun Institute of Applied Chemistry of the Chinese Academy of Sciences.
Guibin Wang: Post-PhD Advisor of Jilin University.
Feng Li: Senior Engineer of Sinopec, Beijing Chemical Engineering Institute.
Ke Li: Senior Supervisor of Volkswagen China.
 
We host our annual seminar on the Development of the Macromolecule Materials Industry since 2008, during which we bring prominent industry-leading consultants to meet with our R&D staffs. The annual seminar gives industry experts an opportunity to review and evaluate the Company’s R&D initiatives in terms of technology advancement on the backdrop of government policies which support development of the modified plastics industry. During the seminar, industry experts assess the progress of the Company’s R&D projects for the current year, and then evaluate the Company’s R&D projects for the next year. Projects are reviewed in terms of overall strategy, alignment with government policies, market opportunities, efficient utilization of R&D and technical feasibility. 
 
Xinda Group and Xinda Group Material Research are located within the same facility of our Dalian North Road production base. Xinda Group Material Research provides technical support for our recently expanded modified plastics annual theoretical production capacity of 390,000 MT and ongoing service to our customers, and enhanced our research and development capabilities for modified plastics in new applications in areas such as aerospace, high-speed rail and new energy vehicles. We have been certified as a National Level Enterprise Technology Center, the only institution certified as such in the modified plastics industry in Heilongjiang. This certification makes us eligible for participation of issuing modified plastics industry standards, certain tax and tariff relief for scientific research and development, certain funding designated for National Enterprise Technology Center and municipal subsidies and Post-PhD and Academy Member WorkStation in Heilongjiang Province.
 
Our research and development expense was US$21,586,074 and US$11,640,243 during the years ended December 31, 2012 and 2011, respectively.
 
 
 
13

 
Intellectual Property
 
Patents
 
As a result of our collection of academic and technological expertise, we have one approved patents and 68 pending patent applications in China, as set forth in the following table.

 
  No.
Patent Name
Application No.
Application Date and Status
1
A sprayed directly material used in car  humer
200810051570.8
December 10, 2008
Approved
         
2
Supercritical fluid rapid diffusion synthesis of nano calcium carbonate enhanced  microcrystalline polypropylene composites
200910073402.3
December 11, 2009
pending
         
3
A molding method for PEEK
201010173663.5
May 17, 2010
pending
         
4
A PA /ASA alloy material with high notched impact strength and its preparation method
201010230061.9
July 19, 2010
pending
         
5
A method for automotive interior matte, anti-scratch modified polypropylene composites
201010230064.2
July 19, 2010
pending
         
6
A lower mold shrinkage ratio method of calcium carbonate / polypropylene nanocomposites
201010230088.8
July 19, 2010
pending
         
7
A method for automotive interior low odor, low VOC, high performance polypropylene composites
201010258937.0
August 20, 2010
pending
         
8
A high impact and high flow PC / ASA alloy material and its preparation method
201010258950.6
August 20, 2010
pending
         
9
Nano-ZnO filled with modified PEEK film and its preparation method
201010258955.9
August 20, 2010
pending
         
10
A supercritical preparation method to prepare pre-foamed polypropylene
201010258970.3
August 20, 2010
pending
         
11
A microporous zeolite materials modified PEEK and its preparation method
201010282022.3
September 15, 2010
pending
         
12
A preparation method of SiO2/CaCO3 nano-composite particles modified polypropylene
201010282042.0
September 15, 2010
pending
         
13
A high heat-resistant PC / ASA alloy material and its preparation method
201010508149.2
October 15, 2010
pending
         
14
An anti-aging, anti-yellowing, low odor polypropylene composite material and its preparation method
201010508177.4
October 15, 2010
pending
         
15
An ASA alloy material of high-impact strength, high-brightness
201010543439.0
November 15, 2010
pending
         
16
A preparation method of polylactic acid used in auto dashboard
201110035716.1
February 11, 2011
pending
         
17
A preparation method of the thermoplastic elastomers PP with high mobility and high resistance of deformation
201110035725.0
February 11, 2011
pending
 
 
14

 
         
18
A preparation method of polymer composites with high toughness
201110035736.9
February 11, 2011
pending
         
19
A rapid detection method of the tensile propertie of modified PP used in auto specially by non-standard situation
201110094454.6
April 15, 2011
pending
         
20
A special material of cooling grille with high heat resistance and high weather resistance
201110094466.9
April 15, 2011
pending
         
21
A preparation process of centralized control method used in plastic production line
201110122566.8
May 12, 2011
pending
         
22
Apreparation process of ABS alloy with high impact performance and high heat resistance
201110122586.5
May 12, 2011
pending
         
23
A preparation process of the premixed screening system
201110158488.7
June 14, 2011
pending
         
24
A preparation method of easily dispersed and easily processimg polyprolene composite material
201110158511.2
June 14, 2011
pending
         
25
A preparation method of high heat-resistant and high rigid PLA composite material reinforced by fully biodegrdable natural fiber
201110158512.7
June 14, 2011
pending
         
26
A rapid detection method of the impact propertie of midfide plastics used in automobile specially
201110158528.8
June 14, 2011
pending
         
27
A high-powered aircraft tail composite material and its preparation process
201110196209.6
July 13, 2011
pending
         
28
A high impact PA6 composite material with core-shell toughening and its preparation method
201110196226.X
July 13, 2011 pending
         
29
A preparation method of polypropylene resin foam particles with supercritical CO2 act
201110230302.4
August 12, 2011
pending
         
30
A preparation methed of the plastic production line with high performance and high honogeneity
201110233488.9
August 16, 2011
pending
         
31
A high toughness,low warpage and high-mobility PET/PBT/PC alloy renforced by glass fiber and its preparation method
201110235189.9
August 17, 2011
pending
         
32
A high impact and high heat-resistant flame retardant ABS composite material reinforce by glass fiber and its preparation process
201110268625.2
September 13, 2011
pending
         
33
A preparation method of polylactic acid used composite material modified by hydroxyapatite with supercritical water act
201110268687.3
September 13, 2011
pending
         
34
A polycarbonate blend material with high toughness and its preparation method
201110319832.6
December 20, 2011
pending
         
35
A polypropylene composite material used in battery tank of new source of energy automobile and its preperation  method
201110347320.0
November 1, 2011
pending
 
 
15

 
         
36
A preperation process of high weathering  colour ASA resin
201110347336.1
February 11, 2011
pending
         
37
A high heat-resistant and high wear-resistant PEEX composite material and its preperation  process
201110347338.0
January 10, 2011
pending
         
38
A high toughnees,low warpage and low mold temperature PET/PA6 alloy reinfoced by glass fiber and preperation method
201110347339.5
November 1, 2011
pending
         
39
A preparation method of glass fiber reinforced polyether ether ketone with high strength and high heat resestance
201110399890.4
December 5, 2011
pending
         
40
A high-strength carbon fiber reinforced polyetheretherketone composite material and its preparation method
201210114931.5
April 20, 2012
pending
         
41
A high-impact, green flame retardant PC / ABS alloy material and its preparation process
201210122281.9
April 1, 2012
pending
         
42
A preparation method of the natural fiber reinforced polylactic acid composites with  heat-resistant and easy processing
201210147444.9
May 14, 2012
pending
         
43
High performance halogen-free flame-retardant PC / ABS composite material and its preparation method
201210201826.5
June 19, 2012
pending
         
44
A high temperature conductive PPO/PA6 alloy material and its preparation method
201210241856.9
July 13, 2012
pending
         
45
High-performance, green flame retardant reinforced PA66 composites technology
201210260160.0
July 26, 2012
pending
         
46
A preparation method of high encapsulation efficiency and stable release polylactic lysozyme drug microsphere
201210295154.9
August 20, 2012
pending
         
47
An antistatic LSOH flame retardant PC / ABS alloy material and its preparation method
201210296750.9
August 20, 2012
pending
         
48
A Supercritical carbon dioxide reactor pressure method for preparating polypropylene foamed material
201210298694.2
August 22, 2012
pending
         
49
An antimicrobial, dust suppression, halogen-free flame retardant ABS and its preparation process
201210305824.0
August 27, 2012
pending
         
50
A free primer and  sprayed directly on the bumper composites
201210306240.5
August 27, 2012
pending
         
51
An extrusion grade sisal fiber reinforced polypropylene composite material and its preparation process
201210357867.3
September 25, 2012
pending
         
52
A preparation methods of ultra-hydrophobic microporous polymer film
201210358122.9
September 25, 2012
pending
 
 
16

 
         
53
A long glass fiber reinforced polypropylene material and its preparation method
201210362626.8
September 26, 2012
pending
         
54
A modified Kevlar fiber reinforced PA66 material and its preparation method
201210369747.5
September 29, 2012  
         
55
A flame-retardant glass fiber reinforced PA66 and its preparation method
201210370558.X
September 29, 2012
pending
         
56
A non-asbestos and non-metal materials brake pads composite material and its preparation method
201210395921.3
October 18, 2012
pending
         
57
A high toughness wear-resistant fiberglass /PA6 composites for rail transit fasteners
201210396122.8
October 18, 2012
pending
         
58
A wear-resistant, anti-static, flame retardant ultra-high molecular weight polyethylene composite material
201210402814.9
October 22, 2012
pending
         
59
A high impact, high heat-resistant PC / PBT alloy material and its preparation process
201210403095.2
October 22, 2012
pending
         
60
A glass fiber reinforced poly (ethylene terephthalate) / polycarbonate alloy
201210403197.4
October 22, 2012
pending
         
61
Graphene / polymer conductive composites
201210411231.2
October 25, 2012
pending
         
62
A production method of antimicrobial, hydrophilic polypropylene particle
201210411680.7
October 25, 2012
pending
         
63
A glass fiber, SiO2 enhanced strength and toughening polyphenylene sulfide material and its preparation method
201210439116.6
November 7, 2012
pending
         
64
An alcohol solution PA66 material special for intake manifold and its preparation method
201210442251.6
November 8, 2012
pending
         
65
A mechanical enhanced polypropylene power lithium battery separator and its preparation method
201210472283.0
November 21, 2012
pending
         
66
The chest protection belts
201220526299.0
October 15, 2012
pending
         
67
A continuous aramid fiber reinforced POM materials and preparation methods
201210411967.X
October 25, 2012
pending
         
68
An environmentally friendly self-aromatic polypropylene material and its preparation process
201210457403.X
November 15, 2012
pending
         
69
A multilayer hot pressing method for preparating hydroxyapatite / polylactide composite
201210474211.X
November 21, 2012
pending
 
 
17

 
Trademark
 
We own the trademarks for our graphic logo and Chinese characters of “Xinda”, which we use in packaging our products and marketing.
 
Certification Process
 
To meet the requirements of an automobile manufacturer, products used as component parts must pass a rigorous certification process by the manufacturer’s technological quality assurance department before they can be approved for and used in production. The certification process consists of three stages.
 
First, the automobile manufacturer reviews the manufacturer of modified plastics.  The examination involves assessment of the operation history of the modified plastics manufacturer, their experience in providing component services, the specialization of their factory equipment, their research and development capacity and quality assurance systems. The manufacturer’s operations need to meet the requirements of the automobile manufacturer. Once the initial review is passed, the modified plastics manufacturer will obtain a qualification as an automobile component manufacturer. This initial stage takes approximately sixteen to twenty two months to complete.
 
Second, the automobile manufacturer and the manufacturer of modified plastics reach an understanding about a product specification. The modified plastics manufacturer provides product research and development materials to the automobile manufacturer for inspection. The automobile manufacturer tests the product specification according to its standards and, if results are satisfactory, the modified plastics manufacturer obtains a product specification certification and enters the product certification stage. The second stage takes approximately eight months to complete.
 
Third, the parties complete technology R&D tests and perform automobile component finished parts tests.  The product undergoes additional testing by the automobile manufacturer and is used in road tests. This stage takes approximately five to fifteen months depending on whether the car model is an existing model or a new model. At the conclusion of the third stage, the modified plastics manufacturer receives a product certification from the automobile manufacturer.
 
We believe that the necessity, rigorousness, complexity and duration of the certification process make it difficult for outside competitors to enter the field in a short period of time. We have 246 certifications from automobile manufacturers as of December 31, 2012 which we believe is currently one of the largest portfolios of product certifications in the Chinese automobile modified plastics industry.
 
 
18

 
Sales and Marketing
 
Currently, our sales network focuses on the northeastern, northern and eastern regions of China. We primarily sell to end customers through our approved distributors.  To a less extent, we also sell directly to end customers.  A typical customer development cycle starts when our R&D staff develop customized products for new customers and obtain product certifications. These customers are usually major automobile parts manufacturers who can only source from suppliers like China XD with product certifications granted by major automobile manufacturers. After we established relationships with these customers and began to have large volume of transactions with them, we assign the customers to our approved distributors according to our internal policies. In 2012, approximately 98% of our sales were generated from approved distributors.
 
We enter into distribution agreements with local distributors in areas where large automobile manufacturers are located. The distribution agreements usually have a term of three years, during which period we can enter into distribution agreements with other distributors for our products. The distributors are responsible for marketing and distributing our products. Through the established sales channels, we can quickly respond to local market demand, address customer needs, enhance our ability to provide technical support and after-sales services, and lower our marketing expenses. Our general credit term with our distributors is three months and our collection of payment from distributors is not contingent upon their cash collection from end customers. We manufacture products according to orders received from our distributors and maintain a certain quantity of raw materials based on our experience and the distributors order patterns. By doing this we hope to ensure the smooth implementation of the production plan of major automobile manufacturers and avoid risks of inventory shortage.  We do not provide the distributors nor end customers with the right of return, price protection or any other concessions.  We allow for an exchange of products or return only if the products are defective.
 
We have been actively extending our distribution network to 8 distributors in 2012 and we believe we have good relationships with our distributors.  We believe that we have been able to secure and maintain strong relationships with our customers due to our existing certifications, advanced technologies and high product quality, which establish a higher barrier to entry for others. Most of the new customer relationships will be developed through our own R&D and sales force and maintained by our R&D and sales professionals and our distributors.  According to our distribution contracts, our distributors are prohibited from selling our competitors’ products and required to use the product certificate, brand name and package standards set by  us during the distribution period. After the expiration of the distribution contracts in absence of renewal, we retain the customer relationships with end customers.
 
While the pricing volatility of our raw materials is a primary cause of cost variations in our products, we are generally able to pass the cost of price changes in our raw materials to our customers, although there are timing delays of varying lengths depending upon volatility of raw material prices, the type of products, competitive conditions and individual customer arrangements.
 
The Company sells its products substantially through approved distributors in the PRC.  The Company’s sales to its distributors are highly concentrated. Sales to six major distributors, which individually exceeded 10% of the Company’s revenues, accounted for approximately 95% and 89% of the Company’s revenues for the years ended December 31, 2012 and 2011, respectively. The Company expects revenues from these distributors to continue to represent a substantial portion of its revenue in the future.
 
 
19

 
Competition
 
The PRC automotive modified plastics industry is growing rapidly and highly fragmented with the top three domestic producers occupying less than approximately 21.4% of the market shares in 2012 according to the Frost & Sullivan’s report. According to Frost & Sullivan’s report, in terms of sales volume and production capacity, we are one of the leading domestic specialized manufacturers of modified plastic for automobile parts in China, with a market share of approximately 8.0% in 2011 and 7.2% in 2012. In 2012, our sales volume of automotive plastics was approximately 223,982 MT. As of December 31, 2012, our annual production capacity of automotive plastics was 255,000 MT.
 
We installed 30 new product lines in December of 2012. The 30 new production lines will be utilized primarily for the manufacture of higher value-added modified plastics products. Once fully ramped up, the lines will increase the Company’s total production capacity by 135,000 MT to 390,000 MT per annum. The additional capacity will start to contribute to the Company’s production capacity during the first quarter of 2013.
 
Currently, Xinda Group’s primary Chinese competitor in the automobile industry is Guangzhou Kingfa Science & Technology Co., Ltd. (“Guangzhou Kingfa”). Guangzhou Kingfa entered the automotive modified plastics market in 2006 and its facilities had an annual manufacturing capacity of 800,000 MT for its modified plastics products used in the automobile industry at the end of 2012, according to the research report by Huatai Securities- "Jinfa Science & Technology- Short-Term Development Slowed Down While Automotive Plastics Sector Performing Up Against The Trend". Kingfa has the largest capacity expansion plans and was expected to expand to 1,200,000 MT by 2013 accoriding to a report by www.cfinet.cn - " The Debt Grading Report on Jinfa Science & Technology", but its utilization rate of production capacity is expected to be lower than that of China XD based on Frost & Sullivan’s report. Guangzhou Kingfa has much larger financial resources than Xinda Group. However, we believe that it currently holds fewer number of product certifications for automotive modified plastic to the automobile industry compared to Xinda Group. Another top domestic manufacturer of modified plastic is Shanghai Pret Composites Co., Ltd. (“Shanghai Pret”), which focuses on the production of automotive plastics.  It had an annual capacity of 100,000MT according to the 3Q report of Shanghai Pret filed with Shanghai Securities Exchange, and sales volume of 67,000 MT in 2012, according to a report by www.plas.hc360.com-"Shanghai Pret Achieving Well Performance from Automotive Modified Plastics".
 
The Chinese auto market predominantly uses modified plastics manufactured overseas or in factories controlled by foreign companies, such as manufacturers from Germany, the Netherlands and Japan. Although China’s automotive plastic market has been dominated by foreign or JV players, Chinese suppliers are continuing to gain market share. It is estimated that automotive plastics imported or manufactured by multinational and JV companies accounted for approximately 45% of the total China automotive plastic supply in 2012, decreased from 65% in 2005. JV manufacturers based in China in automotive plastics sector have been slow to invest and expand in China. Compared to non-domestic competitors including JV manufacturers, domestic manufacturers can benefit from the lower costs and geographical proximity in China. As local players continue to invest in research and development, enhance product quality and improve management skills, we believe that domestic production of automotive plastics will compete very favorably with the foreign competitors in terms of price, quality, services and delivery times and continue to replace imported plastics.
 
 
20

 
Our Competitive Strengths
 
We believe that the following competitive strengths continue to enable us to compete effectively in the automotive modified plastics market in the PRC:
 
 ●
Leading Market Position with High Barrier to Entry . We believe that we are one of the China’s leading specialized manufacturers of modified plastic for automobile parts in terms of sales volume and production capacity, with a market share of approximately 8% in 2012. The PRC automotive modified plastics industry is growing rapidly and is highly fragmented with the top three domestic producers occupying less than approximately 21.4% of the market shares in 2012. In 2012, our sales volume of automotive plastics was approximately 223,982 MT, representing a growth of 48.1% compared to that in 2011. As of December 31, 2012, our annual production capacity of automotive plastics was 390,000 MT. We believe our leading market position allows us to successfully compete with other foreign and domestic modified plastic manufacturers in the market. Being one of the leading specialized manufacturer of automotive modified plastics in China, we believe we are well-positioned to not only grow with the increasing market demand but increase market share by replacing smaller and less efficient modified plastic manufacturer.
 
In addition, as a result of our consistent research and development efforts, we have 246 product certifications from major automotive manufacturers in the PRC as of December 31, 2012, which we believe is among the largest numbers of product certifications by any domestic player in China’s automotive plastics industry. Strict certification requirements and long certification periods result in high barriers to entry. Our current or potential competitors are required to obtain relevant product certifications from automotive manufacturers in order to compete with us. Each certification normally takes over two years to complete, and as a result, automotive manufacturers are reluctant to replace suppliers like us who have already received necessary certifications and proven consistent product quality. We believe that having one of the largest portfolios of product certifications in China allows us to strengthen our competitive position.
 
Long-Term Relationships with Reputable End Users . Our senior management has been involved in the business of modified plastics since 1985. We benefit from the industry connections and experience of our senior management, which have enabled us to establish long-term customer relationships and strong industry recognition. We are a qualified provider of high-quality automotive plastics, and have sold our products through plastic auto part manufacturers to many leading automotive manufacturers in China. Currently, our modified plastics are utilized in more than 23 automobile brands and over 70 automobile models manufactured in China, including Audi, Volkswagen, BMW, GM Mazda, Toyota, Cherry, Geely and Hafei new energy vehicles. We believe that our brand and our products are well recognized and respected in China’s automotive modified plastics market.
 
High Quality Products with Lower Costs .  We purchase our raw materials from a small number of large suppliers who procure resins locally or internationally. By concentrating our purchases from a small group of suppliers, we are able to keep the costs of purchasing raw materials relatively low. Also, since our manufacturing facilities are located in China where labor, raw materials and operation costs are relatively lower, we are able to charge lower prices than our international competitors while maintaining comparable quality. Compared to our domestic competitors, we believe our long-standing manufacturing experience, in-depth market knowledge, significant scale of economy and strong R&D capabilities enable us to provide higher quality products at competitive prices.
 
Manufacturing facilities are critical to the quality of products. We have in the past invested substantial time and resources in building state-of-the-art production lines to enhance our product quality. Our facilities have maintained ISO/TS16949, a certification of quality management systems specific to the automotive industry. 
 
 
21

 
Strong Customer-Oriented R&D Capabilities . The modified plastics industry is characterized by rapid development and increasing demand for high quality products. We have strong R&D capabilities that allow us to have successfully passed OEM automakers’ certification processes in the past and continually introduce new and high quality products to the market. Compared to international plastic supply models, which target larger scale applications of common plastics and involve less customization and specialization, we provide customer-oriented product development through our certification process.  By working closely with our customers, we are able to adjust our product features to better satisfy the specific needs of each customer. To achieve this, we have staffed our R&D team with 118 professionals, of whom 38  have Ph.D. and Master’s degrees. On average, our R&D employees have worked with us for more than three years, and some key experts have more than 10 years of experience in our industry. We have also cooperated with a number of the leading technology centers in China. Besides providing specialized research and development skills, these relationships help us formulate cutting edge research programs aimed at developing new technologies and applications in plastics engineering.  We currently have 1 approved patent and 68 patent applications pending with the State Intellectual Property Office of the PRC, or SIPO.
 
Established Distribution Model .  Through eight distributors across China, we have established distribution networks that cover northeast, north and east China, with a current focus on northeast China. We enter into distribution agreements with local distributors in areas where large automobile manufacturers are located.  By leveraging the proximity of our distributors to the automobile manufacturers, we can enhance our relationships with our customers. Through the established sales channels, we can quickly respond to local market demand, address customer needs, enhance our ability to provide superior technological support and after-sales services, and lower our marketing expenses.  At the same time, our distributors are responsible for the payments to us which is not contingent upon their cash collection from end customers. By actively managing our distribution network, we are also able to accelerate local market penetration and increase sales opportunities. For example, we entered the north China market in 2009 through a local distributor, one year earlier than we planned, and in 2012, northeast, north and east China account for approximately 57%, 21% and 22% of our revenues, respectively.
 
 ●
Seasoned Management Team . Our senior management team and key personnel have extensive operating and industry experience. Mr. Han, our chief executive officer and president, founded our former affiliate Harbin Xinda Nylon Factory in 1985. With 28 years of industry experience, Mr. Han has in-depth knowledge and expertise in China’s modified plastics industry. He currently serves as executive director of the China Plastics Processing Industry Association and as a member of the Standing Committee of the Heilongjiang Association of Industry and Commerce. Our chief executive officer, chief technology officer and chief operating officer have over 50 years combined experience in the modified plastics industry and we believe their extensive expertise and knowledge can well serve our customers.
 
 
 
 
22

 
Our Strategies
 
Our goal is to capitalize on China’s modified plastics growth trend, with a specific focus on applications in the auto sector, and to eventually be the leading modified plastics manufacturer in China. We are committed to enhancing our sales and profitability and achieving our goals through the following strategies:
 
 ●
Continue to Increase Production Capacity .  Over the past five years, we have consistently increased production capacity to meet the rising demands of the automotive industry in the PRC. As of December 31, 2012, we have an installed annual production capacity of 390,000 MT, and we have been operating at near full capacity since 2007. With the expected strong growth in the automotive modified plastics market of China, we expect that we will continue to experience strong demand from our customers. Therefore, we intend to continue to strategically increase our production capacity to meet customer demands from both expanded geographical locations and future downstream sector growth. We plan to continue to increase our annual capacity to reach approximately 690,000 MT by 2015.
 
Focus on R&D and Develop New Product Offerings .  We are currently utilizing our research and development capabilities to obtain further product certifications, develop new products, applications and technologies. Approximately 90% of our automotive plastics product certification applications are currently undergoing trial manufacturing periods to obtain the necessary certifications. In addition, we are developing new products for automotive applications to expand our product portfolio, including initiating R&D on modified plastic for use in electric vehicles. We are also developing specialty engineering plastics and bio-plastics for use in other applications, such as high-speed trains, vessel-propulsion systems, mining and oil-field equipment and aerospace equipments. We are the first non State-Owned-Enterprise awarded National Level Enterprise Technology Center, in Heilongjiang Province. In addition, we have Post-PhD and Academy Member WorkStation in Heilongjiang Province enhancing our research and development capabilities.
 
Expand Customer Base Domestically and Internationally .  The automotive plastics market in the PRC is highly fragmented with significant barriers to entry. Although we have approximately 8% of the market share in 2012, our customer coverage is concentrated in the northeast regions of the PRC. We seek to steadily enhance our market share in northeast China, and also expand our reach to northern and eastern China. In addition, we intend to have sales in overseas markets and export our products by 2013. We plan to implement such strategies through further expanding our distribution network by working with local distributors who have contacts and networks overseas and directly establishing strategic alliances with certain of our non-PRC customers.
 
Pursue Selective Strategic Acquisitions .  While we have experienced substantial organic growth, we plan to pursue a disciplined and targeted acquisition strategy to accelerate our growth. Our strategy will focus on strengthening presence in certain geographies, improving our penetration in attractive markets, enhancing research and development capabilities and acquiring new markets or customers.
 
Increase Efficiency by Corporate Restructuring . We are currently implementing a corporate restructuring plan with the aim of establishing a more efficient company group structure, as a result of which every subsidiary will be more easily accessible to the customers and our operation will respond to the market changes in a more efficient manner. We aim to complete the corporate restructuring plan by June 30, 2013.
 
 
23

 
Environmental Laws
 
The cost of compliance with Chinese environmental regulations currently is minimal. Most of the waste produced from our production process is water, which we circulate in our enclosed water treatment system.  
 
Employees
 
China XD’s operations are organized into several operational departments including manufacturing, R&D, management, finance, sales, purchasing and marketing and others. As of December 31, 2012, there were 606  employees, including 231 in manufacturing, 97 in R&D, 90 in management, 27 in finance, 56  in sales, purchasing and marketing and 105 in other departments.
 
 
24

 
 
ITEM 1A.   RISK FACTORS
 
In addition to the other information in this Form 10-K, readers should carefully consider the following important factors. These factors, among others, in some cases have affected, and in the future could affect, our financial condition and results of operations and could cause our future results to differ materially from those expressed or implied in any forward-looking statements that appear in this on Form 10-K or that we have made or will make elsewhere.
 
The global economic crisis could further impair the automotive industry thereby limiting demand for our products.
 
The continuation or intensification of the recent global economic crisis arising from the European debt crisis may adversely impact our business and the businesses of our customers. Our specialized plastics are sold to automobile parts manufacturers and distributors. The recent global economic crisis harmed most industries and has been detrimental to the automotive industry. Since virtually all of our sales are made to auto industry participants, our sales and business operations are dependent on the financial health of the automotive industry and could suffer if our customers experience, or continue to experience, a downturn in their business. Presently, it is unclear whether and to what extent the economic stimulus measures facilitated by the European Union and other governments throughout the world will mitigate the effects of the crisis on the automotive industry and other industries that affect our business.
 
We concentrate our operations primarily in the automotive industry, therefore, a contraction in automotive sales and production could have a material adverse effect on our results of operations and liquidity.
 
We develop, manufacture, and distribute modified plastic, primarily for use in automobiles. Automotive sales and production are highly cyclical and depend, among other things, on general economic conditions and consumer spending and preferences (which can be affected by a number of issues including fuel costs and the availability of consumer financing). As the volume of automotive production fluctuates, the demand for our products also fluctuates. While the China automotive sales and production maintained growth momentum in 2011 and continued to grow in 2012, however the growth rate was significantly down from previous years. A contraction in automotive sales and production could harm our results of operations and financial condition. Consequently, we are exposed to the risks of adverse developments affecting the auto industry to a greater extent than if our operations were dispersed over a variety of industries.
 
The withdrawal of preferential government policies and the tightening control over the Chinese automotive industry and automobile purchase restrictions imposed in certain major cities may limit market demand for our products.
 
In 2011, Chinese government terminated two preferential policies for its automotive industry: (1) vehicles with 1.6L or lower air displacement were given a 50% discount in purchase tax and (2) the vehicles sold in rural area were given a government subsidy. Since 2011, in order to resolve the extreme traffic congestion, the Beijing government has been implementing the vehicle purchase quota policy, which limits the maximum vehicles sold in Beijing per month to 20,000. Other cities which have begun to show signs of traffic congestion have also begun to implement similar measures to control traffic congestion, including the limited automobile licenses policy implemented in Shanghai and the imposition of congestion charges in Shenzhen. The termination of two nation-wide preferential policies negatively affected consumer demand for new vehicles, and local restrictive measures over automobile purchases in major cities may result in slower growth or the reduction in the sale of vehicles nationwide. According China Passenger Vehicle Association as reported in January 2013, China’s total new automobile sales to end-users in 2012 were up 4.3 percent compared to those in 2011. The national and local policies over the Chinese automotive industry may continue to impact market demand for automobiles in 2013 and eventually result in a reduction in our product sales.
 
 
 
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The Chinese automotive industry’s growth is slowing after the rapid growth since 2000 and such slowdown may adversely affect the market demand for our products.
 
There is a direct correlation between our business and automobile production volume and sales, which are dependent on economic policies and market sentiment. The Chinese automotive industry had been rapidly growing for a decade prior to 2011. However, inflation, higher interest rates, tighter bank lending, lifting of consumer subsidies and buying restrictions in congested cities all contributed to a more modest environment since 2011, resulting in the sharp slow-down in automobile sales volume growth rate to 4.3% in 2012 and 3% in 2011, compared to 34% in 2010, representing the lowest growth rate in the past 13 years, according to the latest data issued by China Association of Automobile Manufacturers. Any significant reduction in automobile production and sales would have a material and adverse effect on our business. There can be no assurance that the market conditions, government policies and other factors leading to the existing slowdown in demand for automobiles will not continue. The decline in demand for automobiles would directly and adversely affect demand for our products and hence our business, financial condition and results of operations.
 
A large percentage of our sales revenue is derived from sales to a limited number of distributors and a limited number of customers, and our business will suffer if sales to these customers decline.
 
A significant portion of our sales revenue historically has been derived from a limited number of distributors. Sales to six major distributors, which individually exceeded 10% of the Company’s revenues is approximately 95% and 89% in 2012 and in 2011, respectively. Any significant reduction in demand for modified plastics by any of these major distributors and any decrease in demand of products by its customers could harm our sales and business operations, financial condition and results of operations.
 
We are dependent on a limited number of suppliers. While we have identified alternative sources for the materials and equipment we use, a temporary disruption in our ability to procure necessary materials and equipment could adversely impact our sales in future periods.
 
Materials constitute a substantial part of the cost of our products.  We seek to reduce the cost of raw materials by dealing with major suppliers. During the year ended December 31, 2012, we purchased approximately 98% of our raw materials from three major suppliers. The Company purchased equipment from one major supplier, which accounted for 99% of the Company’s equipment purchases for the year ended December 31, 2012. We believe the relationship with our suppliers is satisfactory and that alternative suppliers are available if relationships falter or existing suppliers should become unable to keep up with our requirements. However, there can be no assurance that our current or future suppliers will be able to meet our requirements on commercially reasonable terms or within scheduled delivery times. An interruption of our arrangements with suppliers could cause a delay in the production of our products for timely delivery to distributors and customers which could result in a loss of sales in future periods.
 
 
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If we are subject to product quality or liability claims relating to our products, we may incur significant litigation expenses and management may have to devote significant time defending such claims, which if determined adversely to us, could require us to pay significant damage awards.
 
Although we have adopted certain internal measures to supervise and examine the quality of our products, we may be subject to legal proceedings and claims from time to time relating to our product quality. The defense of these proceedings and claims could be both costly and time-consuming and significantly divert the efforts and resources of our management. An adverse determination in any such proceedings could subject us to significant liability. In addition, any such proceeding, even if ultimately determined in our favor, could damage our market reputation and prevent us from maintaining or increasing sales and market share. Protracted litigation could also result in our customers or potential customers deferring or limiting their purchase of our products.
 
We have limited insurance coverage on our assets in China and any uninsured loss or damage to our property, business disruption or litigation may result in our incurring substantial costs.
 
The insurance industry in China is still at an early stage of development. Insurance companies in China offer limited insurance products. Other than automobile insurance on certain vehicles and property and casualty insurance for some of our assets such as factories and equipments we do not have insurance coverage on our other assets or inventories, nor do we have any business interruption, product liability or litigation insurance for our operations in China. We have determined that the costs of insuring for these risks and the difficulties associated with acquiring such insurance on commercially reasonable terms make it impractical for us to have such insurance. Any uninsured loss or damage to property, business disruption or litigation may result in our incurring substantial costs and the diversion of our resources, which may have a material adverse effect on our results of operations, financial condition and/or liquidity.
 
SAFE regulations relating to offshore investment activities by PRC individuals may increase our administrative burden and restrict our overseas and cross-border investment activity. If our shareholders and beneficial owners who are PRC individuals fail to make any required applications, registrations and filings under such regulations, we may be unable to distribute profits and may become subject to liability under PRC laws.
 
The State Administration of Foreign Exchange, or “SAFE”, has promulgated several regulations, including Notice on Relevant Issues Concerning Foreign Exchange Administration for Domestic Residents’ Financing and Roundtrip Investment Through Offshore Special Purpose Vehicles, or “Circular No. 75,” issued in November 2005 and its implementation rules issued in recent years, requiring PRC residents and PRC corporate entities to register with local branches of the SAFE in connection with their direct or indirect offshore investment activities.
 
In May 2011, SAFE enacted “Circular of the State Administration of Foreign Exchange on Printing and Distributing on the Operating Rules for the Administration of Foreign Exchange with Respect to the Financing and Round-tripping Investment of Domestic Residents Through Offshore Special Purpose Companies” (“Circular No. 19”). Circular No. 19 does not change the registration requirements imposed by Circular No. 75, but clarifies and simplifies the registration procedures. These regulations apply to our shareholders and beneficial owners who are PRC residents.
 
 
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Circular No. 75 requires PRC individuals to register with relevant local branches of SAFE for their establishment or control of any overseas special purpose vehicles, or the “SPVs,” and the contribution of assets of or their equity interests in any domestic company to any SPV, or any material changes of the SPVs.  Failure to make the required SAFE registration may result in penalties including that our PRC subsidiaries may be prohibited from making distributions of profit to the SPV and from paying the SPV proceeds from any reduction in capital, share transfer or liquidation in respect of the PRC subsidiaries, and the SPVs may be prohibited from making additional capital contribution into its PRC subsidiaries.
 
We have requested our shareholders and beneficial owners who are PRC residents to make the necessary applications and filings as required under these regulations and under any implementation rules or approval practices that may be established under these regulations. As of the date of this Annual Report on Form 10-K, Mr. Han, our Chief Executive Officer, has registered his beneficial ownerships in China XD and XD Engineering Plastics Company Limited ("XD Engineering Plastics") respectively with local SAFE in accordance with Circular No. 75 and Circular No. 19. However, we cannot assure you that the rest of our shareholders and beneficial owners who are PRC individuals have timely updated their registrations with SAFE in accordance with SAFE regulations. The failure or inability of our PRC shareholders and beneficial owners make any required registrations may subject us to fines and legal sanctions, restrict our overseas or cross-border investment activities, limit our PRC subsidiaries’ ability to make distributions or pay dividends or affect our ownership structure, as a result of which our acquisition strategy and business operations and our ability to distribute profits to you could be materially and adversely affected.
 
On December 25, 2006, the People’s Bank of China issued the Administration Measures of Foreign Exchange Matters for Individuals, which set forth the respective requirements for foreign exchange transactions by individuals (both PRC and non-PRC citizens) under the current account or the capital account, and the corresponding Implementing Rules were issued by SAFE on January 5, 2007, both of these regulations became effective on February 1, 2007. According to these regulations, all foreign exchange matters relating to employee stock holding plans, share option plans or similar plans of an overseas publicly-listed company in which PRC citizens will participate require approval from SAFE or its authorized branch. 

In February 2012, SAFE promulgated the Notice on Issues Concerning the Foreign Exchange Administration for Domestic Individuals Participating in Stock Incentive Plan of Overseas Publicly-Listed Company, or the New Stock Option Rules, which replaced and substituted the Application Procedure of Foreign Exchange Administration for Domestic Individuals Participating in Employee Stock Holding Plan or Stock Option Plan of Overseas-Listed Company, or the Stock Option Rule. According to the New Stock Option Rules, if a PRC resident participates in any stock incentive plan of an overseas publicly-listed company, a qualified PRC domestic agent, which could be a PRC subsidiary of such overseas publicly-listed company or another qualified institution selected by such PRC subsidiary, among other things, must file on behalf of such participant an application with SAFE to conduct the SAFE registration with respect to such stock incentive plan and obtain approval for an annual allowance with respect to the purchase of foreign exchange in connection with the exercise or sale of stock options or stock such participant holds. Such participants must also retain an overseas entrusted institution to handle matters in connection with their exercise of stock options, the purchase and sale of corresponding stocks or interests and fund transfers. In addition, the qualified PRC domestic agent is required to amend the SAFE registration with respect to the stock incentive plan if there is any material change to the stock incentive plan, the qualified PRC domestic agent or the overseas entrusted institution or other material changes. Such participant’s foreign exchange income received from the sale of stock and dividends distributed by the overseas publicly-listed company must be fully remitted into a specific domestic foreign currency account opened and managed by such qualified PRC domestic agent first, before distribution to such participants.
 
 
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We are an offshore listed company and, as a result, any Chinese employee or foreign employee of our PRC subsidiaries, who resides in PRC more than one year consecutively, including without limitation, directors, supervisors and other senior management staffs of our PRC subsidiaries, who have been granted share options or shares under our existing share incentive plan, are subject to the New Stock Option Rules.  We aim to complete the application with local SAFE in Heilongjiang to obtain a registration in respect of our incentive share plan in accordance with the New Stock Option Rules. If our PRC subsidiaries or their qualified employees fail to comply with these regulations, including the New Stock Option Rules, they may be subject to fines or other legal sanctions imposed by SAFE or other Chinese government authorities. In that case, our ability to compensate our employees, directors, supervisors and other senior management staffs through equity compensations may be hindered and our business operations may be adversely affected.
 
Under the PRC EIT Law, we and/or Favor Sea BVI may be classified as a “resident enterprise” of the PRC. Such classification could result in tax consequences to us, our non-PRC resident shareholders and Favor Sea BVI.
 
On March 16, 2007, the National People’s Congress approved and promulgated the PRC Enterprise Income Tax Law, or “EIT Law,” which took effect on January 1, 2008. Under the EIT Law, enterprises are classified as resident enterprises and non-resident enterprises. An enterprise established outside of China with “de facto management bodies” within China is considered a “resident enterprise,” and subject to the uniform 25% enterprise income tax rate on global income. The implementing rules of the EIT Law define “de facto management bodies” as a managing body that in practice exercises “substantial and overall management and control over the production and operations, personnel, accounting, and properties” of the enterprise; however, due to the short history of the EIT Law and lack of applicable legal precedents, it remains unclear whether the PRC tax authorities would deem our managing body as being located within China, or whether we or our non-PRC subsidiaries would be deemed as resident enterprises of the PRC.
 
If the PRC tax authorities determine that we, Favor Sea Limited, a British Virgin Islands corporation (“Favor Sea BVI”) and/or Hong Kong Engineering Plastics Company Limited, a Hong Kong corporation (“HK Engineering Plastics”), are “resident enterprises” for PRC enterprise income tax purposes, a number of PRC tax consequences could follow.  We, Favor Sea BVI and/or HK Engineering Plastics may be subject to enterprise income tax at a rate of 25% on our, Favor Sea BVI and/or HK Engineering Plastics’s worldwide taxable income, as well as PRC enterprise income tax reporting obligations. However, under the EIT Law and its implementing rules, dividends paid between “qualified resident enterprises” are exempt from enterprise income tax. As a result, if we, Favor Sea BVI and HK Engineering Plastics are treated as PRC “qualified resident enterprises,” all dividends paid from Xinda Group to HK Engineering Plastics, from HK Engineering Plastics to Favor Sea BVI and from Favor Sea BVI to us may be exempt from PRC tax. Otherwise, all dividends paid from Xinda Group to HK Engineering Plastics, from HK Engineering Plastics to Favor Sea BVI and from Favor Sea BVI to us may be subject to withholding tax under the EIT Law and its implementing rules. 

On April 22, 2009, State Administration of Taxation (“SAT”) enacted “Circular of the State Administration of Taxation on Issues Concerning the Identification of Chinese-Controlled Overseas Registered Enterprises as Resident Enterprises in Accordance With the Actual Standards of Organizational Management”. On July 27, 2011, SAT enacted “Announcement of the State Administration of Taxation on Printing and Distributing the Administrative Measures for Income Tax on Chinese-controlled Resident Enterprises Incorporated Overseas (Trial Implementation)”. Under those two rules, either the enterprises may request the PRC tax authorities to determine their “resident enterprises” identity or the tax authority may investigate and determine an enterprise’s identity. The target enterprises under those two rules are foreign registered companies controlled by the PRC companies, however, the PRC tax authority may determine if a foreign registered company controlled by the PRC individual(s) is a “resident enterprise” or not by reference to those two rules.
 
 
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Under the EIT Law and its implementation rules, dividends payable by a foreign-invested enterprise in China to its shareholders that are "non-resident enterprises" are subject to a 10% withholding tax, unless such shareholders' jurisdiction of incorporation has a tax treaty with China that provides for a preferential arrangement. Pursuant to the Notice of the SAT on Issuing the Table of Tax Rates on Dividends in Treatises, or Notice 112, which was issued on January 29, 2008, the Arrangement between the PRC and the Hong Kong Special Administrative Region on the Avoidance of Double Taxation and Prevention of Fiscal Evasion, or the Double Taxation Arrangement (Hong Kong), which became effective on December 8, 2006, such withholding tax may be lowered to 5% if the PRC enterprise is at least 25% directly held by a Hong Kong enterprise. In October 2009, the SAT further issued the Notice on How to Understand and Determine the "Beneficial Owners" in Tax Treaties, or Circular 601. According to Circular 601, non-resident enterprises that cannot provide valid supporting documents as "beneficial owners" may not be approved to enjoy tax treaty benefits, and "beneficial owners" refers to individuals, companies or other organizations which are normally engaged in substantive operations. These rules also set forth certain adverse factors on the recognition of a "beneficial owner." Specifically, they expressly exclude a "conduit company" that is usually established for the purposes of avoiding or reducing tax obligations or transferring or accumulating profits and not engaged in substantive operations such as manufacturing, sales or management, from being a "beneficial owner." As a result, if we was treated as PRC “non-resident enterprises” under the EIT Law, then dividends from Xinda Group (assuming such dividends were considered sourced within the PRC) paid to us through HK Engineering Plastics may be subject to a reduced withholding tax at a rate of 5% if HK Engineering Plastics is determined to be Hong Kong tax residents and are considered to be "beneficial owners" that are generally engaged in substantive business activities and entitled to treaty benefits under the Double Taxation Arrangement (Hong Kong). Otherwise, we may not be able to enjoy the preferential withholding tax rate of 5% under the tax arrangement and therefore be subject to withholding tax at a rate of 10% with respect to dividends to be paid by Xinda Group (assuming such dividends were considered sourced within the PRC) to us through HK Engineering Plastics. Any such taxes on dividends could materially reduce the amount of dividends, if any, we could pay to our shareholders.
 
However, if we were deemed as a “resident enterprise,” the new “resident enterprise” classification could result in a situation in which an up to 10% PRC tax is imposed on dividends we pay to our non-PRC shareholders that are not PRC tax “resident enterprises”. In such event, we may be required to withhold an up to 10% PRC tax on any dividends paid to non-PRC resident enterprise shareholders. Our non-PRC resident enterprise shareholders also may be responsible for paying PRC tax at a rate of 10% on any gain realized from the sale or transfer of our ordinary shares in certain circumstances if such income is considered PRC-sourced income by relevant tax authorities. We would not, however, have an obligation to withhold PRC tax with respect to such gain.
 
On December 15, 2009, the State Administration of Taxation (“SAT”) released the Notice on Strengthening Administration of Enterprise Income Tax for Share Transfers by Non-PRC Resident Enterprises (“Circular 698”) that reinforces the taxation of non-listed equity transfers by non-resident enterprises through overseas holding vehicles. Circular 698 is retroactively effective from January 1, 2008.  Circular 698 addresses indirect share transfer as well as other issues.  According to Circular 698, where a foreign (non-PRC resident) investor who indirectly holds shares in a PRC resident enterprise through a non-PRC offshore holding company indirectly transfers equity interests in a PRC resident enterprise by selling the shares of the offshore holding company, and the latter is located in a country or jurisdiction where the effective tax burden is less than 12.5% or where the offshore income of its residents is not taxable, the foreign investor is required to provide the PRC tax authority in charge of that PRC resident enterprise with certain relevant information within 30 days of the transfer. The tax authorities in charge will evaluate the offshore transaction for tax purposes. In the event that the tax authorities determine that such transfer is abusing forms of business organization lack of reasonable commercial purpose or for purpose of avoidance of PRC income tax liability, the PRC tax authorities will have the power to re-assess the nature of the equity transfer under the doctrine of substance over form. If the relevant tax authority’s challenge of a transfer is successful, it may disregard the existence of the offshore holding company that is used for tax planning purposes and require seller to pay PRC tax on the capital gain from such transfer.  Circular 698 also points out that when a non-resident enterprise transfers its equity interests in a PRC resident enterprise to its related parties at a price lower than the fair market value, the relevant tax authorities have the power to make a reasonable adjustment on the taxable income of the transaction. Since Circular 698 has a short history, there is uncertainty as to its application. We (or a foreign investor) may become at risk of being taxed under Circular 698 and may be required to expend valuable resources to comply with Circular 698 or to establish that we (or such foreign investor) should not be taxed under Circular 698, which could have a material adverse effect on our financial condition and results of operations (or such foreign investor’s investment in us).
 
If any such PRC taxes apply, a non-PRC resident shareholder may be entitled to a reduced rate of PRC taxes under an applicable income tax treaty and/or a foreign tax credit against such shareholder’s domestic income tax liability (subject to applicable conditions and limitations). Prospective investors should consult with their own tax advisors regarding the applicability of any such taxes, the effects of any applicable income tax treaties, and any available foreign tax credits. 
 
 
 
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PRC regulations relating to mergers and acquisitions of domestic enterprises by foreign investors may increase the administrative burden we face and create regulatory uncertainties.

On August 8, 2006, six PRC regulatory agencies, namely, the PRC Ministry of Commerce, or MOFCOM, the State Assets Supervision and Administration Commission, or SASAC, the State Administration for Taxation, the State Administration for Industry and Commerce, the China Securities Regulatory Commission, or CSRC, and SAFE, jointly adopted the Regulations on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors, or the M&A Rule, which became effective on September 8, 2006. The M&A Rule purports, among other things, (i) to require any PRC company, enterprise or individual that intends to merge or acquire its domestic affiliated company in the name of an overseas company which it lawfully established or controls, to apply for MOFCOM’s  examination on and approval for the  proposed merger or acquisition; and (ii) to require SPVs, formed for overseas listing purposes through acquisitions of PRC domestic companies and controlled directly or indirectly by PRC companies or individuals, to obtain the approval of CSRC prior to publicly listing their securities on an overseas stock exchange. However, there are substantial uncertainties regarding the interpretation, application and enforcement of these rules, and CSRC has yet to promulgate any written provisions or formally to declare or state whether the overseas listing of a PRC-related company structured similar to ours is subject to the approval of CSRC.   As a result, we are not sure whether the M&A Rule would require us or our entities in China to obtain the approval from either MOFCOM or CSRC or any other regulatory agencies in connection with the transaction contemplated by the share transfer contracts which were entered into between Mr. Jie Han, Mr. Qingwei Ma and Hong Kong Engineering Plastics Company Limited on June 26, 2008 , the transaction contemplated in the Agreement and Plan of Merger entered into by and among NB Telecom, Favor Sea (BVI) and the shareholders of Favor Sea (BVI) on December 24, 2008 (detailed description of both of the two aforesaid transactions and relevant contracts can be found in our Annual Report on Form 10-K for the fiscal year ended December 31, 2009, filed on April 14, 2010) the adoption and performance of the option agreement dated May 16, 2008 between Ms. Piao and Mr. Han.
 
Further, in the event MOFCOM or CSRC deems it necessary for us to obtain its approval prior to our entry into the aforesaid agreements, we could be subject to severe penalties. The M&A Rule does not stipulate the specific penalty terms, therefore, we are unable to determine what penalties we may face, and how such penalties may affect our business operations or future strategy.
 
Our business will suffer if we cannot obtain or maintain necessary permits or approvals.
 
Under PRC laws, we are required to obtain from various PRC governmental authorities certain permits and licenses in relation to the operation of our business. These permits and licenses are subject to periodic renewal and/or reassessment by the relevant PRC government authorities and the standards of compliance required in relation thereto may from time to time be subject to change. We cannot assure you that we can always obtain, maintain or renew all the permits and licenses in a timely manner. Additionally, any changes in compliance standards, or any new laws or regulations that may prohibit or render it more restrictive for us to conduct our business or increase our compliance costs may adversely affect our operations or profitability. Any failure by us to obtain, maintain or renew necessary licenses, permits and approvals, could subject us to fines and other penalties and limit the business we could conduct, which could have a material adverse effect on the operation of our business. In addition, we may not be able to carry on business without such permits and licenses being renewed and/or reassessed.
 
Pursuant to PRC laws and regulations, construction or expansion of a building or a production facility is subject to various permits and approvals from different government authorities. In connection with the construction of Xinda Group’s factory and production facilities, which has already been completed and put into operation, we obtained a project approval from Administration Committee of Harbin Economic and Technological & High-tech Development Zone and an approval for the environmental impact assessment report on the construction project of Xinda Group in 2003. However, certain other necessary permits relating to the construction and operation of Xinda Group’s factory and production facilities are outstanding. Failure to obtain all necessary approvals/permits may subject us to various penalties, such as fines or being required to vacate from the facilities where we currently operate our business.
 
 
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Increased environmental regulation in China could increase our costs of operation.
 
Certain processes utilized in the production of modified plastics result in toxic by-products. To date, the Chinese government has imposed only limited regulation on the production of these by-products, and enforcement of the regulations has been sparse. Recently, however, there is a substantial increase in focus on the Chinese environment, which has inspired considerable new regulation. Because we plans to export plastics to the U.S. and Europe in coming years, we have developed certain safeguards in our manufacturing processes to assure compliance with the environmental protection standard ISO/TS16949 Quality Assurance Standard, the European Union’s RoHS Standards and Germany’s PAHs Standards.  Furthermore, we are in the process of applying for the U.S.’s UL Safety Certification, ISO14001 Environmental Management System Certification and OHSAS18001 Occupational Health Management System Certification. This compliance regimen brings us into compliance with all Chinese environmental regulations. Additional regulation, however, could increase our cost of doing business, which would impair our profitability.

Our independent registered public accounting firm’s audit documentation related to their audit reports included in our annual report may include audit documentation located in the Peoples’ Republic of China. The Public Company Accounting Oversight Board currently cannot inspect audit documentation located in China and, as such, you may be deprived of the benefits of such inspection.
 
Our independent registered public accounting firm that issues the audit reports included in our annual reports filed with the U.S. Securities and Exchange Commission, as auditors of companies that are traded publicly in the United States and a firm registered with the PCAOB, is required by the laws of the United States to undergo regular inspections by the PCAOB to assess its compliance with the laws of the United States and professional standards. Our operations are conducted in China, a jurisdiction where the PCAOB is currently unable to conduct inspections without the approval of the Chinese authorities. Accordingly, no audit documentation located in China related to our independent registered public accounting firm’s reports included in our filings with the U.S. Securities and Exchange Commission is currently inspected by the PCAOB.

Inspections conducted by the PCAOB outside of China have identified deficiencies in those firms’ audit procedures and quality control procedures, which may be addressed as part of the inspection process to improve future audit quality. This lack of PCAOB inspections in China prevents the PCAOB from regularly evaluating audit documentation located in China and its related quality control procedures. As a result, investors may be deprived of the benefits of PCAOB inspections.

The inability of the PCAOB to conduct inspections in China makes it more difficult to evaluate the effectiveness of our auditor’s audit procedures or quality control procedures as compared to auditors outside of China that are subject to PCAOB inspections.  Investors may lose confidence in our reported financial information and procedures and the quality of our financial statements.
 
We may fail to develop and maintain an effective system of internal controls over financial reporting.  As a result, we may not be able to accurately report our financial results or prevent fraud and current and potential shareholders could lose confidence in the integrity of our financial reports, which could harm our business and the trading price of our common stock.
 
Prior to our listing on the US stock exchange, we were a private company with all business operations within China. Our accounting and reporting system was designed to satisfy local statutory requirements and internal management needs. We had limited accounting personnel and resources to address internal control over financial reporting for the purpose of compliance with U.S. GAAP and SEC reporting requirements. Management concluded that our internal controls over financial reporting were ineffective as of December 31, 2012, due to two material weaknesses. The material weaknesses relate to (i) inadequate controls over the preparation of U.S. GAAP financial statements and disclosures due to lack of personnel with sufficient understanding, experience and training in U.S. GAAP and compliance with the SEC reporting requirements, and (ii) insufficient controls over  cash disbursements and monitoring the construction in progress.
 
Our management is committed to strengthening our internal controls and complying with Section 404 of the Sarbanes-Oxley Act of 2002 (“SOX 404”).  In 2012, we continued to implement a plan, pursuant to which (1) our accounting staff obtained external training of US GAAP and SEC reporting by qualified entity in 2012, (2) we continue to seek senior qualified people with requisite expertise and knowledge to help improve our internal control procedures.  
 
However, we cannot be certain that these measures we have undertaken will ensure that we will maintain adequate controls over our financial processes and reporting in the future. Furthermore, if we are able to rapidly grow our business, the internal controls that we will need may become more complex, and significantly more resources may be required to ensure our internal controls remain effective. Failure to implement required controls, or difficulties encountered in their implementation, could harm our operating results or cause us to fail to meet our reporting obligations. If we fail to maintain an effective internal control system, our stockholders and other potential investors may lose confidence in our business operations and the integrity of our financial statements, and may be discouraged from future investments in our company, which may delay or hinder any future business development or expansion plans if we are unable to raise funds in future financings, and our current stockholders may choose to dispose of the shares of common stock they own in our company, which could have a negative impact on our stock price. In addition, non-compliance with SOX 404 could subject us to a variety of administrative sanctions, including the suspension of trading of our stock on the NASDAQ Global Market, ineligibility for listing on other national securities exchanges, and the inability of registered broker-dealers to make a market in our common stock, which could further reduce our stock price.
 
 
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We may be subject to or be liable for US taxes, interest and penalties.
 
Because we incur cumulative losses in the U.S., we do not believe that we owe U.S. federal income taxes for the taxable years ended December 31, 2012 and 2011. However, there can be no assurance that the IRS will agree with this position, and therefore we ultimately could be held liable for U.S. federal income taxes, interest and penalties.
 
Our inability or failure to protect our intellectual property rights may significantly and materially impact our business, financial condition and results of operations.
 
Protection of our proprietary processes, methods and other technology is important to our business. We generally rely on a combination of the patent, trademark and copyright laws of the PRC and laws protecting trade secret in the PRC, as well as licenses and non-disclosure and confidentiality agreements, to protect our intellectual property rights. The patent, trademark and copyright laws of the PRC, as well as laws protecting trade secret in the PRC, may not protect our intellectual property rights to the same extent as the laws of the U.S.
 
Failure to protect our intellectual property rights may result in the loss of valuable proprietary technologies. Additionally, some of our technologies are not covered by any patent or patent application and, even if a patent application has been filed, it may not result in an issued patent. If patents are issued to us, those patents may not provide meaningful protection against competitors or against competitive technologies. In addition, upon the expiration of patents issued to us, we will be unable to prevent our competitors from using or introducing products using the formerly-patented technology. As a result, we may be faced with increased competition and our results of operations may be adversely affected. We cannot assure you that our intellectual property rights will not be challenged, invalidated, circumvented or rendered unenforceable.
 
We also rely upon unpatented proprietary manufacturing expertise, continuing technological innovation and other trade secrets to develop and maintain our competitive position. While we generally enter into confidentiality/non-disclosure agreements with our employees and third parties to protect our intellectual property, we cannot assure you that our confidentiality/non-disclosure agreements will not be breached, that they will provide meaningful protection for our trade secrets and proprietary manufacturing expertise or that adequate remedies will be available in the event of an unauthorized use or disclosure of our trade secrets or manufacturing expertise.
 
Our intellectual property rights may be challenged or infringed upon by third parties or we may be unable to maintain, renew or enter into new license agreements that are important to our business with third-party owners of intellectual property on reasonable terms. We could also face patent infringement claims from our competitors or others alleging that our processes or products infringe on their proprietary technologies. If we are found to be infringing on the proprietary technology of others, we may be liable for damages, and we may be required to change our processes, to redesign our products partially or completely, to pay to use the technology of others or to stop using certain technologies or producing the infringing product(s) entirely. Even if we ultimately prevail in an infringement suit, the existence of the suit could prompt customers to switch to products that are not the subject of infringement suits. We may not prevail in any intellectual property litigation and such litigation may result in significant legal costs or otherwise impede our ability to produce and distribute key products.
 
 
 
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We may be unable to renew the leases for our factories on acceptable terms or these leases may be terminated.
 
As of December 31, 2012, Xinda Group operated three separate factories located at 9 Qinling Road (the “Qinling Road Factory”), 9 North Dalian Road (the “Dalian Road Factory”) and 9 Jiangnan First Road (the “Jiangnan Road Factory”), respectively. Xinda Group owns the titles to the land and premises of the Qinling Road Factory.  Xinda Group leases land and premises of the Dalian Road Factory from Xinda High-Tech. Xinda Group is in the process of acquiring the titles to the land and premises at Jiangnan Road Factory. Xinda Group’s leases will expire on April 30, 2015. If we are unable to renew our lease on acceptable terms in due course or if our lease is terminated by the lessor unilaterally for the Dalian Road Factory or acquire the titles to the land and premises at Jiannan Road Factory:
 
we may be unable to find a new property with the amenities and in the location we require for our factories, which may result in a factory closure;

we may have to relocate to a less desirable location;
  
we may have to relocate to a location with facilities that do not meet our requirements;
 
we may incur significant costs in connection with identifying, securing and relocating  to a replacement location; or
 
our factories may experience significant disruption in operations and, as a result,  we may be unable to produce products during the period of disruption.
 
Any of these events may materially and adversely affect our business, prospects, results of operations and financial condition.
 
A sharp increase in the demand or the price for raw materials may have a negative impact on our results of operations if we are unable to pass on increases in the cost of raw materials to our customers on a timely basis.
 
The total cost of raw materials made up approximately 98% of our cost of revenues in both 2012 and 2011.
 
Currently, plastic resins are mainly used as a raw material in China’s plastic parts molding industry. The market prices of plastic resins may fluctuate due to changes in supply and demand conditions in that industry. Any sudden shortage of supply or significant increase in demand of plastic resins and additives may result in higher market prices and thereby increase our cost of sales. The prices of plastic resins and additives are, to a certain extent, affected by the price movement of crude oil which caused the price of raw materials to fluctuate. In addition, under the terms of our customer agreements, we can only increase the sales price for our products if the cost of our raw materials increases by more than 5%. As a result, our inability to increase the selling price of our products to cover increases of less than 5%, may limit our profitability.
 
 
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Our assets are primarily located in China. So any dividends or proceeds from liquidation are subject to the approval of the relevant Chinese government agencies.
 
Our assets are primarily located inside China. Under the laws governing FIEs in China, dividend distribution and liquidation are allowed but subject to respective administrative procedures under the relevant laws and rules. Any dividend payment will be subject to the decision of the Board of Directors and be subject to foreign exchange rules governing such repatriation. Any liquidation is subject to the decision of the highest authority of the company, the relevant government agency’s approval and supervision (including but not limited to the local branch of MOFCOM), as well as the whole process of liquidation under PRC laws and regulations, including without limitation personnel resettlement, assets disposition, settlement of debts and creditor’s rights as well as deregistration, which process could be very time-consuming and complex. Since the dividend distribution procedure is subject to foreign exchange rules governing such repatriation, risks may arise for our investors when Xinda Group pays dividend to us through HK Engineering Plastics. Furthermore, the liquidation procedure is a complex and time consuming procedures subject to government approvals, additional risks and costs may arise for our investors in the process.
 
Governmental control of currency conversions may affect the value of your investment.
 
All of our revenue is earned in Renminbi, and any future restrictions on currency conversions may limit our ability to use revenue generated in Renminbi to make dividend or other payments in U.S. dollars. Although the PRC government introduced regulations in 1996 to allow greater convertibility of the Renminbi for current account transactions, significant restrictions still remain, including primarily the restriction that foreign-invested enterprises like us may buy, sell or remit foreign currencies only after providing valid commercial documents at a PRC banks specifically authorized to conduct foreign-exchange business.
 
In addition, conversion of Renminbi for capital account items, including direct investment and loans, is subject to governmental approval in the PRC, and companies are required to open and maintain separate foreign-exchange accounts for capital account items. There is no guarantee that PRC regulatory authorities will not impose additional restrictions on the convertibility of the Renminbi. Such restrictions could prevent us from distributing dividends and thereby reduce the value of our stock.
 
The fluctuation of the exchange rate of the Renminbi against the dollar could reduce the value of your investment.
 
The value of our common stock will be affected by the foreign exchange rate between U.S. dollars and Renminbi. For example, to the extent that we need to convert U.S. dollars we receive from an offering of our securities into Renminbi for our operations, appreciation of the Renminbi against the U.S. Dollar could reduce the value in Renminbi of our funds. Conversely, if we decide to convert our Renminbi into U.S. dollars for the purpose of declaring dividends on our common stock or for other business purposes and the U.S. dollar appreciates against the Renminbi, the U.S. dollar equivalent of our earnings from our subsidiaries in China would be reduced.
 
On July 21, 2005, the PRC government changed its decade-old policy of pegging the value of the Renminbi to the U.S. Dollar. Under the 2005 policy, the Renminbi is permitted to fluctuate within a narrow and managed band against a basket of certain foreign currencies. This change in policy has resulted in an appreciation of the Renminbi against the U.S. dollar of approximately 28.8% from July 21, 2005 to December 31, 2012. While the international reaction to the Renminbi revaluation has generally been positive, there remains significant international pressure on the PRC government to adopt an even more flexible currency policy, which could result in a further and more significant appreciation of the Renminbi against the U.S. Dollar.
 
We receive all of our revenues in Renminbi. The PRC government imposes controls on the convertibility of Renminbi into foreign currencies and, in certain cases, the remittance of currency out of the China. Shortages in the availability of foreign currency may restrict our ability to remit sufficient foreign currency to pay dividends, or otherwise satisfy foreign currency denominated obligations. Under existing PRC foreign exchange regulations, payments of current account items, including profit distributions, interest payments and expenditures from the transaction, can be made in foreign currencies without prior approval from SAFE by complying with certain procedural requirements. However, approval from appropriate governmental authorities is required where Renminbi are to be converted into foreign currency and remitted out of the PRC to pay capital expenses, such as the repayment of bank loans denominated in foreign currencies.
 
 
 
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The PRC government could also restrict access in the future to foreign currencies for current account transactions. If the foreign exchange control system prevents us from obtaining sufficient foreign currency to satisfy our currency demands, we may not be able to pay certain expenses as they become due.
 
MSPEA Modified Plastics Holding Limited (“MSPEA”) has significant influence over our affairs .
 
MSPEA currently owns 100% of our outstanding Series D Preferred Stock, representing approximately 23.8% of our issued and outstanding shares of common stock on an as converted basis. Pursuant to the Certificate of Designation of Series D Preferred Stock, holders of Series D Preferred Stock have the right to elect, voting as a separate class, two directors to serve on the Board so long as at least 12,800,000 (adjusted for any dilutive corporate actions) shares of Series D Preferred Stock are outstanding, and one director to serve on the Board if the number of shares of Series D Preferred Stock outstanding at such time is less than 12,800,000 but more than 1,600,000 (in each case adjusted for any dilutive corporate actions). For so long as at least 1,600,000 (adjusted for any dilutive corporate actions) shares of Series D Preferred Stock remain outstanding, holders of Series D Preferred Stock have veto rights over certain material corporate actions of the Company and its subsidiaries as described in the Certificate of Designation of Series D Preferred Stock. As such, MSPEA currently has significant influence over our affairs.
 
Upon the occurrence of certain events, we may be required to redeem all or a portion of the Series D Preferred Stock .
 
The holders of the Series D Preferred Stock have the right to require us to redeem all or a portion of the outstanding shares of the Series D Preferred Stock, subject to certain restriction on the redemption date, at a price per share equal to an amount that would yield a total internal rate of return of 15% to such holder on the original issue price of $6.25 per share, upon the occurrence of any of the following events: (i) our failure to achieve an adjusted consolidated net income of RMB608 million for fiscal year 2013, (ii) a breach by us, XD Engineering Plastics or Mr. Han of certain provisions of the financing documents in connection with the issuance and sale of the Series D Preferred Stock, which breach gives rise to a material adverse effect on us or which materially diminishes the value of the Series D Preferred Stock, (iii) the commencement by the Company or any of its subsidiaries of any bankruptcy, insolvency, reorganization or the like, or (iv) the appointment of a custodian, receiver, liquidator, assignee, trustee or other similar officials of the Company or any of its subsidiaries for the winding up or liquidation of its affairs. In the event we are required to redeem the Series D Preferred Stock, if we have insufficient cash available and do not have access to bank borrowings, we may have to liquidate assets to fund such redemption. Any such liquidation may yield proceeds lesser than might otherwise be the case.
 
 
 
 
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ITEM 1B.    UNRESOLVED STAFF COMMENTS
 
None.
 
ITEM 2.  PROPERTIES
 
Physical Plant and Production
 
Our executive offices and production facilities are located in the Harbin Development Zone in the City of Harbin, which is the provincial capital of Heilongjiang Province in northeast China. Our owned facility has a total usable area of 7,359 square meters (79,212 square feet). The facility includes six buildings with one office building attached by one workshop, one storage room, one transformer station, and two guard rooms. All the company’s properties are insured by China Pacific Property Insurances Co., Ltd.
 
The land on which our owned facility is located measures 14,715 square meters (158,391 square feet). The land use right was issued to Xinda Group by the City of Harbin and will expire in 2053. We also have a long-term lease of the production facilities with Harbin Xinda High-Tech Co., Ltd ( Xinda High-Tech ). The land on which our leased facility is located measures 16,537 square meters (178,009 square feet). The facility we rent includes three buildings with two office buildings attached by one workshop respectively and one guard room.
 
On May 9, 2011, Harbin Xinda, a subsidiary of China XD, entered into a purchase agreement with Harbin Shengtong Engineering Plastics Co. Ltd. (“Harbin Shengtong”) as amended on June 1, 2011. The legal representative of Harbin Shengtong is a former employee of Harbin Xinda. Pursuant to the purchase agreement, Harbin Xinda will purchase from Harbin Shengtong land use rights and a plant consisting of five workshops and a building (the “Project”), in exchange for a total consideration of RMB435 million (approximately US$67.3 million) in cash. Harbin Shengtong is responsible to complete the construction of the plant and workshops according to Harbin Xinda’s specifications. Once the Project is fully completed and accepted by Harbin Xinda, Harbin Shengtong shall transfer titles of the Project to Harbin Xinda. During the year ended December 31, 2011, the Company paid Harbin Shengtong a cash deposit of RMB118.9 million (equivalent to US$18.9 million). In December 2011, two workshops were completed and subsequently placed into service by the Company. Accordingly, the cost of these two workshops of approximately RMB59.5 million (equivalent to US$9.5 million) was recorded in workshops and buildings as of December 31, 2011. The allocable cost of the land use right related to the two workshops of approximately RMB24.1 million (equivalent to US$3.8 million) was recorded in land use rights in the Company’s balance sheet as of December 31, 2011. In December 2012, the remaining three workshops were completed and placed into service by the Company. Accordingly, the cost of these three workshops of approximately RMB139.6 million (equivalent to US$22.2 million) was recorded in workshops and buildings as of December 31, 2012. The allocable cost of the land use right related to the two workshops of approximately RMB40.5 million (equivalent to US$6.5 million) was recorded in land use rights in the Company’s balance sheet as of December 31, 2012. The titles of the five workshops and the related land use rights are expected to be transferred to the Company once the Project is completed in the second half of 2013.
 
As of December 31, 2012, we had approximately 390,000 metric tons of production capacity across 88 automatic production lines utilizing German twin-screw extruding systems, automatic weighing systems and Taiwan conveyer systems, including the newly launched three additional workshops with 30 production lines completed the trial-run in December of 2012 and further expanded our annual capacity potential by approximately 135,000 metric tons and support our future growth in 2013.

 
 
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The process of manufacturing modified plastic consists of modifying a standard plastic (polypropylene, ABS, PA6, PA66, etc.) by adding various agents and additives that will alter the physical and/or functional characteristics of the plastic. Catalysts are added that facilitate the desired chemical reactions, all of which occurs in a specially designed equipment. The resulting plastics are then extracted from the equipment by an extraction technique that is proprietary to Xinda Group. Further processing may involve additional blending, extrusion, cooling and cutting, homogenizing and packing, as needed to meet the customer’s requirements.
 
In addition to its unique extraction technology, Xinda Group has developed its own techniques and equipment for many of the steps in the production process. Among the aspects of production for which Xinda Group has proprietary technology are product formulae, a technique for combining extruder screws, and certain stuffing techniques . With these unique formulas and techniques, our products can satisfy clients’ standard requirements at a lower cost than competitive products.
 
Our facilities have been certified under the following international qualifications criteria: ISO9001: 2000 quality management system certification and ISO/TS16949: 2002 international auto parts industry quality systems certification. The government of China has designated Xinda Group as a National Torch Project and a National Spark Plan Project, and has given Xinda Group the “Most Valuable High Tech in China” award. Xinda Group is an executive member of the Council of the Chinese Automobile Parts Association, a member of the Chinese Modified Plastics Professional Committee, a member of the Chinese Plastics Engineering Committee and Heilongjiang Province Post Doctoral Working Station.
 
ITEM 3.   LEGAL PROCEEDINGS
 
None.
 
ITEM 4.   MINE SAFETY DISCLOSURES
 
Not applicable.
 
 
 
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PART II
 
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
 
Prior to November 27, 2009, our common stock was quoted on the OTC Bulletin Board (“OTCBB”) under the symbol “CXDC”. On November 27, 2009, we terminated our listing on OTCBB and listed our common stock on NASDAQ Global Market, also under the symbol “CXDC.” The following table sets forth, for the indicated periods, the high and low sales prices for our common stock, as reported on NASDAQ.
 
  
 
Common Stock
 
   
High
   
Low
 
Fiscal Year Ended December 31, 2011
           
First Quarter
   
7.35
     
5.12
 
Second Quarter
   
5.67
     
3.18
 
Third Quarter
   
5.55
     
3.10
 
Fourth Quarter
   
5.41
     
3.78
 
                 
Fiscal Year Ending December 31, 2012
               
First Quarter
   
5.82
     
4.71
 
Second Quarter
   
5.62
     
4.40
 
Third Quarter
   
4.78
     
3.52
 
Fourth Quarter
   
4.36
     
3.70
 
 
Number of Holders
 
As of March 20, 2013, there were 427 record holders of our common stock.
 
Interwest Transfer Company Inc. is the registrar and transfer agent for our common stock. Its address is 1981 Murray Holladay Road, Suite 100, Salt Lake City, UT  84117 USA, telephone: (801) 272-9294.
 
Dividend Policy
 
We have not paid any cash dividends since our inception and do not anticipate paying any cash dividends on our common stock in the foreseeable future. We expect to retain our earnings, if any, to provide funds for the expansion of our business. Future dividend policy will be determined periodically by the Board of Directors based upon conditions then existing, including our earnings and financial condition, capital requirements and other relevant factors.
 
Under current PRC regulations, wholly foreign-owned enterprises and Sino-foreign equity joint ventures in the PRC may pay dividends only out of their accumulated profits, if any, determined in accordance with PRC accounting standards and regulations. Additionally, these foreign-invested enterprises are required to set aside certain amounts of their accumulated profits each year, if any, to fund certain reserve funds. These reserves are not distributable as cash dividends. Payment of future dividends, if any, will be at the discretion of our Board of Directors after taking into account various factors, including current financial condition, operating results and current and anticipated cash needs.
 
 
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Securities Authorized for Issuance under Equity Compensation Plans
 
The Company adopted the 2009 Stock Option / Stock Issuance Plan (the “Plan”) on May 26, 2009, which reserved 7,800,000 shares of common stock for issuance under the Plan. The Plan allows the Company to issue awards of stock options and stock issuances to directors, officers, employees and consultants of the Company, which may be subject to restrictions.
 
The following table provides certain information with respect to the Company’s Plan in effect as of December 31, 2012.
 
Plan category
 
Number of securities to be issued upon exercise of outstanding options and nonvested shares
(a)
   
Weighted-average exercise price of outstanding options, warrants and rights
(b)
 
                 
Stock options
   
148,500
     
8.01
 
Nonvested shares
   
513,000
     
-
 
Total
   
661,500
         
 
As of December 31, 2012, the number of securities remaining available for future issuance under equity compensation plans was 4,948,715 shares.
 
  Purchases of Equity Securities by the Issuer and Affiliated Purchasers
 
On April 7, 2011, the Board of Directors approved a stock repurchase program that allows the Company to repurchase up to US$10 million of its stock until May 31, 2012. On September 28, 2011, the Company purchased 21,000 shares of its common stock in the public stock market for a total consideration of US$92,694. The stock repurchase program expired on May 31, 2012.
 
ITEM 6.   SELECTED FINANCIAL DATA

Not applicable.
 
 
 
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ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
We make forward-looking statements in this report, in other materials we file with the Securities and Exchange Commission (the “SEC”) or otherwise release to the public, and on our website. In addition, our senior management might make forward-looking statements orally to analysts, investors, the media and others. Statements concerning our future operations, prospects, strategies, financial condition, future economic performance (including growth and earnings) and demand for our products and services, and other statements of our plans, beliefs, or expectations, including the statements contained in this Item 7, “Management’s Discussion and Analysis or Plan of Operation,” regarding our future plans, strategies and expectations are forward-looking statements. In some cases these statements are identifiable through the use of words such as “anticipate,” “believe,” “estimate,” “expect,” “intend,” “plan,” “project,” “target,” “can,” “could,” “may,” “should,” “will,” “would” and similar expressions. We intend such forward-looking statements to be covered by the safe harbor provisions contained in Section 27A of the Securities Act of 1933, as amended (the “Securities Act”) and in Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). You are cautioned not to place undue reliance on these forward-looking statements because these forward-looking statements we make are not guarantees of future performance and are subject to various assumptions, risks, and other factors that could cause actual results to differ materially from those suggested by these forward-looking statements. Thus, our ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on our operations and future prospects include, but are not limited to, changes in: global and domestic economic conditions generally and the automotive modified plastics market specifically, legislative or regulatory changes that affect our business, including changes in environmental regulations and control policies over the domestic automotive industry, the availability of working capital, the introduction of competing products, and other risk factors described herein. These risks and uncertainties, together with the other risks described from time-to-time in reports and documents that we filed with the SEC should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Indeed, it is likely that some of our assumptions will prove to be incorrect. Our actual results and financial position will vary from those projected or implied in the forward-looking statements and the variances may be material. We expressly disclaim any obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law.

 
 
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General
 
China XD Plastics Company Limited (“China XD”, “we”, and the “Company”, and “us” or “our” shall be interpreted accordingly) is one of the leading specialty chemical companies engaged in the research, development, manufacture and sale of modified plastics primarily for automotive applications in China. Through our wholly-owned operating subsidiaries in China, we develop modified plastics using our proprietary technology, manufacture and sell our products primarily for use in the fabrication of automobile parts and components. We have 246 certifications from manufacturers in the automobile industry as of December 31, 2012. We are the only company certified as a National Enterprise Technology Center in modified plastics industry in Heilongjiang province. Our Research and Development (the “R&D”) team consists of 118 professionals and  18 consultants, including three consultants who are members of Chinese Academy of Engineering, and one consultant who is the former chief scientist of Specialty Plastics Engineering Institute of Jilin University. As a result of the integration of our academic and technological expertise, we have a portfolio of 69 patents, one of which we have obtained the patent rights and the remaining 68 of which we have applications pending in China as of December 31, 2012.

Our products include seven categories: polypropylene (PP), acrylonitrile butadiene styrene (ABS), modified engineering plastics, polyamides (PA or nylon), environment-friendly plastics, specialty engineering plastics and polyether ether ketone (PEEK). The Company's products are primarily used in the production of exterior and interior trim and functional components of more than 23 automobile brands and 70 automobile models manufactured in China, including Audi, Volkswagen, BMW, GM, Mazda, Toyota, Cherry, Geely and Hafei new energy vehicles. Our research center is dedicated to the research and development of modified plastics, and benefits from its cooperation with well-known scientists from prestigious universities in China. We operate three manufacturing bases in Harbin, Heilongjiang in the PRC. As of December 31, 2012, we had approximately 390,000 metric tons of production capacity across 83 automatic production lines utilizing German twin-screw extruding systems, automatic weighing systems and Taiwan conveyer systems, including the newly launched three additional workshops with 30 production lines completed the trial-run in December of 2012 and further expanded our annual capacity potential by approximately 135,000 metric tons and support our future growth in 2013.

Critical Accounting Policies
 
We prepare our consolidated financial statements in accordance with U.S. GAAP, which requires us to make judgments, estimates and assumptions that affect (1) the reported amounts of our assets and liabilities; (2) the disclosure of our contingent assets and liabilities at the end of each reporting period; and (3) the reported amounts of revenues and expenses during each reporting period. We continually evaluate these judgments, estimates and assumptions based on our own historical experience, knowledge and assessment of current business and other conditions and our expectations regarding the future based on available information which together form our basis for making judgments about matters that are not readily apparent from other sources. Since the use of estimates is an integral component of the financial reporting process, our actual results could differ from those estimates. Some of our accounting policies require a higher degree of judgment than others in their application.

When reading our consolidated financial statements, you should consider our selection of critical accounting policies, the judgment and other uncertainties affecting the application of such policies, and the sensitivity of reported results to changes in conditions and assumptions. We believe the following accounting policies involve the most significant judgments and estimates used in the preparation of our consolidated financial statements.

Long-Lived Assets

Our long-lived assets include property, plant and equipment and land use rights.

 
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We depreciate and amortize our property, plant and equipment and land use rights, using the straight-line method of accounting over the estimated useful lives of the assets. We make estimates of the useful lives of property, plant and equipment, including the salvage values, and land use rights in order to determine the amount of depreciation and amortization expense to be recorded during each reporting period. The estimated useful life is the period over which the long-lived assets are expected to contribute directly or indirectly to the future cash flows of the Company.
 
We evaluate long-lived assets, including property, plant and equipment, and land use rights for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. We assess recoverability by comparing carrying amount of a long-lived asset or asset group to estimated undiscounted future cash flows expected to be generated by the asset or asset group. If the carrying amount of an asset or asset group exceeds its estimated undiscounted future cash flows, we recognize an impairment charge based on the amount by which the carrying amount exceeds the estimated fair value of the asset or asset group. We estimate the fair value of the asset or asset group through various valuation techniques, including discounted cash flow models, quoted market values and third-party independent appraisals, as considered necessary. Assets to be disposed are reported at the lower of carrying amount or fair value less costs to sell, and are no longer depreciated.
 
Allowance for Doubtful Accounts

We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. In establishing the required allowance, we consider historical losses adjusted to take into account current market conditions, the amount of receivables in dispute, and the current receivables aging and current payment patterns. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. We do not have any off-balance-sheet credit exposure related to our customers.

We extend unsecured credit to customers with good credit history. We review our accounts receivable on a regular basis to determine if the bad debt allowance is adequate at each year-end. We have not experienced any material write-offs in history.

Valuation of Inventories

Our inventories are stated at the lower of cost or market. We routinely evaluate quantities and value of our inventories in light of current market conditions and market trends, and record a write-down against the cost of inventories for a decline in market. Expected demand and anticipated sales price are the key factors affecting our inventory valuation analysis. For purposes of our inventory valuation analysis, we develop expected demand and anticipated sales prices primarily based on sales orders as well as industry trends and individual customer analysis. We also consider sales and sales orders after each reporting period-end but before the issuance of our financial statements to assess the accuracy of our inventory valuation estimates. Historically, actual demand and sales price have generally been consistent with or greater than expected demand and anticipated sales price used for purposes of the our inventory valuation analysis. The evaluation also takes into consideration new product development schedules, the effect that new products might have on the sale of existing products, product obsolescence, customer concentrations, product merchantability and other factors. Market conditions are subject to change and actual consumption of inventories could differ from forecasted demand. Furthermore, the price of plastic resins, our primary raw material, is subject to fluctuations based on global supply and demand. Our management continually monitors the changes in the purchase price paid for plastic resins, including advances to suppliers, and the impact of such change on our ability to recover the cost of inventory and our prepayments to suppliers. Our products have a long life cycle and obsolescence has not historically been a significant factor in the valuation of inventories. We have not experienced any material inventory write-downs before.
 
 
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Income Tax Uncertainties and Realization of Deferred Income Tax Assets

Our income tax provision, deferred income tax assets and deferred income tax liabilities are recognized and measured primarily based on actual and expected future income, PRC statutory income tax rates, PRC tax regulations and tax planning strategies. Significant judgment is required in interpreting tax regulations in the PRC, evaluating uncertain tax positions, and assessing the realizability of deferred income tax assets. Actual results could differ materially from those judgments, and changes in judgments could materially affect our consolidated financial statements. As of December 31, 2012 and 2011, we had total gross deferred income tax assets of US$556,677 and US$1,005,361, respectively. We record a valuation allowance to reduce our deferred income tax assets if, based on the weight of available evidence, we believe expected future taxable income is not likely to support the use of a deduction or credit in that jurisdiction. We evaluate the level of our valuation allowances quarterly, and more frequently if actual operating results differ significantly from forecasted results. As of December 31, 2012 and 2011, our valuation allowance against deferred income tax assets was US$556,677 and US$1,005,361, respectively. The change in valuation allowance was attributable primarily to deferred income tax assets, consisting primarily of tax losses carryforward of China XD and Favor Sea (US) Inc. which in our judgment, are not more likely than not to be realized as tax benefits in view of the cumulative loss positions of these entities.

We recognize the impact of a tax position if we determine the position is more likely than not to be sustained upon examination, including resolution of any related appeals or litigation processes, based solely on the technical merits of the position. In evaluating whether a tax position has met the more-likely-than-not recognition threshold, it is presumed that the position will be examined by the appropriate tax authority that has full knowledge of all relevant information. In addition, a tax position that meets the more-likely-than-not recognition threshold is measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon settlement. The tax positions are regularly re-evaluated based on the results of the examination of income tax filings, statute of limitations expirations and changes in tax law that would either increase or decrease the technical merits of a position relative to the more-likely-than-not recognition threshold. In the normal course of business, we are regularly audited by the PRC tax authorities. The settlement of any particular issue with the applicable tax authority could have a material impact on our consolidated financial statements.
 
Probability of the redemption of Series D convertible preferred stocks

At the date of issuance, we recognized our redeemable Series D convertible preferred stocks at their fair value. Under the terms of the Series D preferred stock agreement,  the redeemable Series D convertible preferred stock becomes redeemable upon the occurrence of certain events, the most significant being if for the years ended December 31, 2011, 2012 and 2013, the Company does not meet the Actual Profit Targets, as defined and prescribed in the Series D preferred stock agreement. Based on the terms of the redeemable Series D preferred stock agreement, the redemption amount would be US$119 million as of December 31, 2012 and US$137 million as of December 31, 2013.

For the years ended December 31, 2011 and 2012, our Actual Profit, as defined in the Series D preferred stock agreement, was RMB379 million and RMB524 million, respectively, which exceeded the 2011 Actual Profit Targets of RMB360 million and the 2012 Actual Profit Targets of RMB468 million.  Accordingly, the redeemable Series D convertible preferred stocks are not currently redeemable.

In addition, since we believe the Company will meet the Actual Profit Targets of RMB608 million for the year ending December 31, 2013, we have concluded it is not probable that the redeemable Series D convertible preferred stocks will become redeemable.  As a result, we have not adjusted the initial carrying value of the redeemable Series D convertible preferred stocks.

The determination of the probability that the redeemable Series D convertible preferred stocks will become redeemable required us to project a Actual Profit Targets for the year ending December 31, 2013. The calculation of a Actual Profit Targets for the year ending December 31, 2013 required us to consider various estimates and assumptions, including among other things, future market demand and unit selling prices of products and product mix, revenue growth rates of different products, unit costs of raw materials, production capacity and utilization ratio, gross margin percentages, operating expenses to revenues ratio, projected working capital needs, capital expenditures forecasts, interest rate and income tax rate.
 
 
 
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Stock Based Compensation
 
We measure the cost of employee services received in exchange for an award of equity instruments based on the grant date fair value of the award and recognize the cost over the period the employee is required to provide service in exchange for the award, which generally is the vesting period. We have elected to recognize the compensation cost for an award with only service conditions and a graded vesting schedule on a straight-line basis over the requisite service period for the entire award. However, the cumulative amount of compensation cost recognized at any date equals at least the portion of the grant date value of such award that is vested at that date.

We estimated the fair value of our share options using the Black-Scholes Option Pricing model. The model incorporates subjective assumptions. The expected volatility was based on implied volatilities from traded options and historical volatility of the Company’s common stock. The risk free interest rate assumption is determined using the Federal Reserve nominal rates for U.S. Treasury zero-coupon bonds with maturities similar to those of the expected term of the award being valued. There is no expected dividend yield, as the Company has not paid dividend and does not anticipate paying dividend over the term of the grants.

Changes in our estimates and assumptions regarding the expected volatility could significantly impact the estimated fair values of our share options determined under the Black-Scholes valuation model and, as a result, our net income.
 
Fair Value Measurements

We apply the provisions of ASC Subtopic 820-10, Fair Value Measurements , for fair value measurements of financial assets and financial liabilities and for fair value measurements of nonfinancial items that are recognized or disclosed at fair value in the financial statements.  The fair values are measured pursuant to the three levels defined as follow:

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 assets or liability, either directly or indirectly, for substantially the full term of the financial instruments.

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

The fair values of the warrants outstanding as of December 31, 2012 and 2011 were determined based on the Black-Scholes option pricing model, using the following key assumptions:
 
     
Series A Investor Warrants
     
Series A Placement Agent Warrants
     
Series C Placement Agent Warrants
 
     
December 31,
     
December 31,
     
December 31,
 
     
2012
     
2011
     
2012
     
2011
     
2012
     
2011
 
Exercise price (per share)
   
4.9
     
4.9
     
5.5
     
5.5
     
7.5
     
7.5
 
Risk-free interest rate per annum
   
0.3
%
   
0.4
%
   
0.3
%
   
0.4
%
   
0.1
%
   
0.2
%
Expected volatility
   
48.8
%
   
72.0
%
   
48.8
%
   
72.0
%
   
77.4
%
   
55.4
%
Expected dividends yield
   
0
%
   
0
%
   
0
%
   
0
%
   
0
%
   
0
%
Expected term (years)
 
1.9
   
2.9
   
1.9
   
2.9
   
0.5
   
1.5
 
 
Results of Operations

The following table sets forth, for the periods indicated, statements of income data in thousands of USD:

   
For the Years Ended December 31,
(in thousands, except
 
2012
   
2011
 
percentages)
 
Amount
   
%
   
Amount
   
%
 
Revenues
 
$
599,819
     
100
%
 
$
381,625
     
100
%
Cost of revenues
 
$
456,012
     
76
%
 
$
285,802
     
75
%
Gross profit
 
$
143,807
     
24
%
 
$
95,823
     
25
%
Total operating expenses
 
$
31,929
     
5
%
 
$
18,961
     
5
%
O Operating income
 
$
111,878
     
19
%
 
$
76,862
     
20
%
InIncome before income taxes
 
$
115,384
     
19
%
 
$
78,629
     
21
%
Income tax expenses
 
$
29,516
     
5
%
 
$
18,110
     
5
%
Net income
 
$
85,868
     
14
%
 
$
60,519
     
16
%
 
 
45

 
Revenues
 
Revenues were US$599.8 million, an increase of US$218.2 million, or 57.2%, as compared to US$381.6 million in 2011, due to approximately 48.1% increase in sales volume and 7.5% increase in the average RMB selling price of our products. The increase of sales volume was driven by the strong demand of modified plastics in the PRC market and higher penetration of our business in our existing markets supported by our newly installed twenty production lines in December 2011, as well as the marketing efforts to develop new customers. Such increase in demand was driven by increasing demand for middle and high-end automobiles by Chinese consumers, continuing substitution of imported modified plastics by domestic suppliers, as well as the increase of plastic content on the per-vehicle-basis in China. The increase of average selling price was due to the shift of product mix towards higher-end products as well as higher raw material prices that we have been able to effectively pass through to our customers. 
 
The following table summarizes the breakdown of revenues by categories in millions of US$:
 
 
Revenues
           
(in millions, except  percentage)
For the Years Ended December 31,
           
 
2012
     
2011
           
 
Amount
   
%
     
Amount
   
%
   
Change in Amount
 
Change in %
Modified Polypropylene (PP)
284.3
   
47.4
%
   
185.0
   
48.5
%
 
99.3
 
53.7
%
                                   
Engineering Plastics
124.5
   
20.8
%
   
70.9
   
18.6
%
 
53.6
 
75.6
%
                                   
Modified Polyamide (PA)
48.9
   
8.1
%
   
26.3
   
6.9
%
 
22.6
 
85.9
%
                                   
Alloy Plastics
37.8
   
6.3
%
   
28.3
   
7.4
%
 
9.5
 
33.6
%
                                   
Environment Friendly Plastics
72.1
   
12.0
%
   
32.6
   
8.5
%
 
39.5
 
121.2
%
                                   
Modified Acrylonitrile Butadiene Styrene (ABS)
24.7
   
4.1
%
   
20.3
   
5.3
%
 
4.4
 
21.7
%
                                   
     Sub-total
592.3
   
98.7
%
   
363.4
   
95.2
%
 
228.9
 
63.0
%
                                   
After-sales service
7.5
   
1.3
%
   
18.2
   
4.8
%
 
(10.7)
 
(58.8)
%
Total Revenues
599.8
   
100
%
   
381.6
   
100
%
 
218.2
 
57.2
%

 
46

 
The following table summarizes the breakdown of metric tons (MT) by product mix:
 
   
Sales Volume
             
(in MTs, except percentage)
 
For the Years Ended December 31,
             
   
2012
     
2011
             
   
MT
     
%
     
MT
     
%
   
Change in MT
   
Change in %
Modified Polypropylene (PP)
 
136,698
     
61.0
%
   
99,051
     
65.5
%
 
37,647
   
38.0
%
                                           
Engineering Plastics
 
25,284
     
11.3
%
   
14,885
     
9.8
%
 
10,399
   
69.9
%
                                           
Modified Polyamide (PA)
 
10,228
     
4.6
%
   
6,167
     
4.1
%
 
4,061
   
65.9
%
                                           
Alloy Plastics
 
10,753
     
4.8
%
   
9,427
     
6.2
%
 
1,326
   
14.1
%
                                           
Environment Friendly Plastics
 
31,784
     
14.2
%
   
14,368
     
9.5
%
 
17,416
   
121.2
%
                                           
Modified Acrylonitrile Butadiene Styrene (ABS)
 
9,235
     
4.1
%
   
7,373
     
4.9
%
 
1,862
   
25.3
%
                                           
Total sales volume
 
223,982
     
100
%
   
151,271
     
100
%
 
72,711
   
48.1
%
 
 
The Company has continued its shift of product mix to higher-end product categories such as Environmental Friendly Plastics and Polyamide (PA) as well as enhance gross margin of other product categories, including Modified Polypropylene (PP), Engineering Plastics, Alloy Plastics, and Modified Acrylonitrile Butadiene Styrene (ABS) by focusing on applications used in higher-end car models, primarily due to (i) the increasing demand of advanced modified plastics in luxury automobile models in China, (ii) the stronger demand promoted by Chinese government for clean energy vehicles and (iii) stronger sales of higher-end cars made by automotive manufacturers from China and Germany, US and Japan joint ventures, which tend to use more and higher-end modified plastics in quantity per vehicle in China.
 
Gross Profit and Gross Margin

   
For the Years Ended December 31,
   
Change
 
(in millions, except percentage)
 
2012
   
2011
   
Amount
   
%
 
Gross Profit
 
$
143.8
   
$
95.8
   
$
48.0
     
50.1
%
Gross Margin
   
24.0
   
25.1
           
(1.1)
%
 
Gross profit was US$143.8 million in 2012 compared to US$95.8 million in 2011, representing an increase of 50.1%. Our gross margin decreased to 24.0% in 2012 from 25.1% in 2011 mainly due to the decrease of post-sales service revenue.
 

 
47

 
General and Administrative Expenses

   
For the Years Ended
December 31,
   
Change
 
(in millions, except percentage)
 
2012
   
2011
   
Amount
   
%
 
General and Administrative Expenses
 
$
10.0
   
$
7.1
   
$
2.9
     
40.8
%
as a percentage of revenues
   
1.7
%
   
1.8
%
           
(0.1)
%

General and administrative (“G&A”) expenses were US$10.0 million in 2012 compared to US$7.1 million in 2011, representing an increase of 40.8%, or US$2.9 million. This increase is primarily due to   increase of US$1.9 million payroll resulting from raised average salary and increased headcount, and of US$0.7 million share based compensation.

On a percentage basis, G&A expenses in 2012 decreased to 1.7% of revenues from 1.8% in 2011.

Research and Development Expenses

   
For the Years Ended
December 31,
   
Change
 
(in millions, except percentage)
 
2012
   
2011
   
Amount
   
%
 
Research and Development Expenses
 
$
21.6
   
$
11.6
   
$
10.0
     
86.2
%
as a percentage of revenues
   
3.6
%
   
3.1
%
           
0.5
%

Research and development (“R&D”) expenses were US$21.6 million  in  2012 compared with US$11.6 million in 2011, an increase of US$10.0 million, or 86.2%, reflecting  increased research and development activities on new products primarily in consumption of raw materials for various experiments for automotive applications from automobile manufacturers as well as other non-automotive applications.  As of December 31, 2012, the number of ongoing research and development projects was 194, an increase of 85 from 109 as of December 31, 2011, including 47 newly added during the fourth quarter ended December 31, 2012.  The consumption of raw materials for these projects increased by 97% for the year ended December 31, 2012.
 
We expect to complete and realize economic benefits on approximately 30% of the projects in the near term. The remaining projects are expected to be carried out for a longer period. The majority of the projects are in the field of modified plastics in automotive applications and the rest are in advanced fields such as ships, airplanes, high-speed rail, medical devices, etc.
 
 
 
48

 

Operating Income
 
Total operating income was US$111.9 million in 2012 compared to US$76.8 million in 2011, representing an increase of 45.6% or US$35.1 million. This increase is primarily due to higher gross profit, partially offset by higher G&A and R&D expenses.
 
  Interest Income (Expenses)
 
   
For the Years Ended
December 31,
   
Change
 
(in millions, except percentage)
 
2012
   
2011
   
Amount
   
%
 
Interest Income
 
$
4.6
   
$
0.7
   
$
3.9
     
557.1
 %
Interest Expenses
   
(4.6
)
   
(1.8
)
   
(2.8
   
155.6
%
Net Interest Expenses
 
$
0.0
   
$
(1.1)
   
$
1.1
     
100
%

Net interest expenses was US$25,678  in 2012 compared to that of net interest expenses of  US$1.1 million in 2011, primarily due to US$3.9 million increase in interest income generated from term deposits and restricted cash for the year ended December 31, 2012.

Foreign Currency Exchange Gains

   
For the Years Ended
December 31,
   
Change
 
(in millions, except percentage)
 
2012
   
2011
   
Amount
   
%
 
Foreign currency exchange gains
 
$
0.6
   
$
0.8
   
$
(0.2)
     
(25.0)
%
as a percentage of revenues
   
0.1
%
   
0.3
%
           
(0.2)
%

Foreign currency exchange gain was US$ 0.6 million in 2012, compared to US$0.8 million in 2011.
 
Change in Fair Value of Warrants Liabilities

   
For the Years Ended
December 31,
   
Change
 
(in millions, except percentage)
 
2012
   
2011
   
Amount
   
%
 
Change in fair value of warrants liabilities
 
$
2.9
   
$
1.9
   
$
1.0
     
52.6
%
as a percentage of revenues
   
0.5
%
   
0.5
%
           
0.0
%

Change in fair value of warrants liabilities was a gain of US$2.9 million in 2012, compared to a gain of US$1.9 million in 2011, primarily due to the change of fair value of warrants driven by the fluctuation of stock prices in the respective periods. On a percentage basis, change in fair value of warrants liabilities in 2012 remained stable to 0.5% of revenues as compared to that in 2011.
 
 
 
49

 
Income Taxes

   
For the Years Ended
December 31,
   
Change
 
(in millions, except percentage)
 
2012
   
2011
   
Amount
   
%
 
Income before Income Taxes
 
$
115.4
   
$
78.6
   
$
36.8
     
46.8
%
Income Tax Expense
   
(29.5)
     
(18.1)
     
(11.4)
     
63.0
%
Effective income tax rate
   
25.6%
     
23.0%
             
2.6
%
 
The increase of the effective income tax rate for the year ended December 31, 2012 when compared to the same period in 2011 is primarily due to an internal reorganization, in which all assets and liabilities, business and employees of Harbin Xinda were transferred to Xinda Group.  Harbin Xinda is being liquidated after the transfer.  Harbin Xinda was an Advanced and New Technology Enterprise and was entitled to a preferential income tax rate of 15% in 2011.  Xinda Group remains subject to income tax at 25% after the transfer.
 
The effective income tax rate of 25.6% for the year ended December 31, 2012 differs from the PRC statutory income tax rate of 25% primarily due to (i) the net operating loss of one of the Company's PRC subsidiaries, which is to be merged into another subsidiary in 2013.  Pursuant to the PRC tax laws and regulations, its losses cannot be carried forward to the surviving entity, after the merger, (ii) subpart F income for controlled foreign operations and (iii) non-deductible entertainment expenses.

The effective income tax rate of 23.0% for the year ended December 31, 2011 differs from the PRC statutory income tax rate of 25% primarily due to (i) the preferential income tax rate of 15% entitled by Harbin Xinda, as an Advanced and New Technology Enterprise and (ii) the additional 50% bonus deduction against taxable income for the research and development expenses incurred by the Xinda Group Material Research.
 
Our PRC subsidiaries have US$148.7 million of cash and cash equivalents, restricted cash and time deposits as of December 31, 2012, which is planned to be indefinitely reinvested in the PRC. The distributions from our PRC subsidiaries are subject to the U.S. federal income tax at 34%, less any applicable foreign tax credits. Due to our policy of indefinitely reinvesting our earnings in our PRC business, we have not provided for deferred income tax liabilities on undistributed earnings of our PRC subsidiaries.
 
Net Income

As a result of the above factors, we had a net income of US$85.9 million in 2012 compared to net income of US$60.5 million in 2011.


 
50

 
Selected Balance Sheet Data as of December 31, 2012 and 2011:
 
     
Selected Balance Sheet Data
 
     
2012
     
2011
 
Change
 
( in millions, except percentage)
               
Amount
   
%
 
Cash and cash equivalents
   
83.8
     
135.5
 
(51.7)
   
(38.2)
%
Restricted cash
   
16.9
     
11.1
 
5.8
   
52.3
%
Time deposits
   
48.0
     
-
 
48.0
   
-
 
Accounts receivable, net of allowance for doubtful accounts
   
143.8
     
45.2
 
98.6
   
218.1
%
Inventories
   
78.3
     
45.0
 
33.3
   
74.0
%
Property, plant and equipment, net
   
223.8
     
100.9
 
122.9
   
121.8
%
Land use rights, net
   
10.5
     
4.1
 
6.4
   
156.1
%
Total assets
   
611.6
     
360.6
 
251.0
   
69.6
%
Short-term bank loans
   
162.1
     
31.5
 
130.6
   
414.6
%
Bills payable
   
15.8
     
22.2
 
(6.4)
   
(28.8)
 %
Income tax payable
   
8.5
     
5.8
 
2.7
   
46.6
%
Accrued expenses and other current liabilities
   
34.4
     
3.2
 
31.2
   
975.0
 %
Redeemable Series D convertible preferred stock
   
97.6
     
97.6
 
-
   
-
 
Stockholders' equity
   
264.4
     
173.9
 
90.5
   
52.0
%

Our financial condition continues to improve as measured by an increase of 52.0% in shareholders’ equity as of December 31, 2012 compared to December 31, 2011.   Accounts receivable increased by 218.1% as a result of increase in revenues and increase in turnover days from 34 days in 2011 to 56 days in 2012.  Short term loans increased by 414.6% to meet our needs to finance working capital and capital expenditures for future growth, and accrued expenses and other current liabilities increased by 975.0% primarily due to payables for purchase of property, plant and equipment.
 
 
51

 
 
LIQUIDITY AND CAPITAL RESOURCES

Historically, our primary uses of cash have been to finance working capital needs and capital expenditures for new production lines. We have financed these requirements primarily from cash generated from operations, short-term bank borrowings, and the issuance of our convertible preferred stocks and other equity financings. As of December 31, 2012 and 2011, we had US$83.8 million and US$135.5 million, respectively, in cash and cash equivalents, which were primarily deposited with banks in China (including Hong Kong). As of December 31, 2012, we had US$162.1 million outstanding short-term bank loans, including US$66.0 million unsecured loans, US$72.2 million loans secured by accounts receivable, and US$23.9 million loans secured by time deposits.  These loans bear a weighted average interest rate of 6.1% per annum and have terms of no longer than one year and do not contain any renewal terms. We have historically been able to make repayments when due.  In addition, we obtained a line of credit from below banks during 2012.
 
A summary of lines of credit for the year ended December 31, 2012 and the remaining line of credit as of December 31, 2012 is as below:
 
(in millions)
Year 2012
 
 
Lines of Credit, Obtained
     
Remaining Available
 
Name of Financial Institution
Date of Approval
   
RMB
     
USD
     
USD
 
Bank of Communication
January 17, 2012
   
100.0
     
16.1
     
0.0
 
Bank of Longjiang, Heilongjiang
March 30, 2012
   
150.0
     
24.1
     
0.0
 
Bank of China
June 26, 2012
   
150.0
     
24.1
     
0.2
 
HSBC
June 28, 2012
   
93.5
     
15.0
     
2.0
 
Guangdong Development Bank
August 28, 2012
   
30.0
     
4.8
     
0.0
 
Industrial and Commercial Bank of China
October 11,2012
   
300.0
     
48.2
     
0.0
 
Agriculture Bank of China
December 7,2012
   
200.0
     
32.1
     
16.1
 
China Construction Bank
December 19, 2012
   
175.0
     
28.1
     
20.1
 
Total
     
1,198.5
     
192.5
     
38.4
 

We have historically been able to make repayments when due.  In addition, as of December 31, 2012, we have contractual obligations to pay (i) lease commitments in the amount of US$1.6 million, including US$0.7 million due in 2013; (ii) plant construction in the amount of US$27.8 million; (iii) warehouse construction in the amount of US$0.8 million; and (iv) equipment acquisition in the amount of US$1.5 million, all of capital commitments are due in 2013.
 
We expect that we will be able to meet our needs to fund operations, capital expenditures and other commitments in the next 12 months primarily with our cash and cash equivalents, operating cash flows and bank borrowings. 
 
We may, however, require additional cash resources due to changes in business conditions or other future developments. If these sources are insufficient to satisfy our cash requirements, we may seek to sell additional equity or debt securities or obtain a credit facility. The sale of additional equity or equity-linked securities could result in additional dilution to stockholders. The incurrence of indebtedness would result in increased debt service obligations and could result in operating and financial covenants that would restrict operations. Financing may not be available in amounts or on terms acceptable to us, or at all.
 
 
 
52

 

The following table sets forth a summary of our cash flows for the periods indicated.

   
For the Years Ended December 31,
 
(in millions US$)
 
2012
   
2011
 
       
Net cash provided by (used in) operating activities
   
(31.5
)    
67.3
 
Net cash used in investing activities
   
(144.9
)    
(62.4
)
Net cash provided by financing activities
   
123.9
     
105.6
 
Effect of foreign currency exchange rate changes on cash and cash equivalents
   
0.7
     
2.3
 
Net increase (decrease) in cash and cash equivalents
   
(51.7
)    
112.8
 
Cash and cash equivalents at the beginning of year
   
135.5
     
22.7
 
Cash and cash equivalents at the end of year
   
83.8
     
135.5
 

Operating Activities
 
Net cash used in operating activities was US$31.5 million in 2012, as compared to US$67.3 million provided by operating activities in 2011. This decrease of US$98.8 million net cash in operating activities was primarily due to (i) increase of approximately US$214.9 million in cash operating expenditures, including raw material purchases, rental and personnel costs, (ii) the increase of approximately US$15.5 million income tax payment in 2012 resulting from increase in income before taxes and increase of income tax rate as a result of internal reorganization and (iii) the increase of interest expenses approximately US$1.8 million as a result of increase of average loan balance. The increase of cash operating expenditures and income tax payment were partially offset by (i) the increase of approximately US$130.7 million in cash collected from our customers in the twelve months ended December 31, 2012 resulting from increasing sales during the year and (ii) the increase of approximately US$2.7 million in interest income.
 
Investing Activities

Net cash used in the investing activities was US$144.9 million for the year ended December 31, 2012 as compared to US$62.4 million for the same period of last year, mainly due to the increase of US$35.0 million purchase and deposits for property, plant and equipment and land use rights in order to expand the production capacity, and of US$47.5 million net time deposits purchase to earn interest income.
 
Financing Activities
 
Net cash provided by the financing activities was US$123.9 million for in 2012, primarily as a result of $243 million borrowings of short-term bank loans from local banks, which was offset by US$114.3 million repayments of bank borrowings, as well as US$4.8 million placement of restricted cash as collateral for bank borrowings for the year ended December 31, 2012.
 
Net cash provided by the financing activities was $105.6 million in 2011, primarily as a result of $100 million and $30.6 million proceeds from issuance of Series D convertible preferred stock and bank loans, which were partially offset by our repayment of $21.7 million bank loans and $1.8 million interest free loan to a related party.

 
53

 
As of December 31, 2012, our cash and cash equivalents balance was US$83.8 million, compared to US$135.5 million at December 31, 2011.

Days Sales Outstanding (DSO) has increased from 34 days for the year ended December 31, 2011 to 56 days for the year ended December 31, 2012 as a result of overall China economic slowdown and its impact to our industry. It takes longer to collect from our customers. Our DSO is still below industry average. The average DSO for the automotive modified plastic industry is generally 90 days based on our industry experience. We anticipate our DSO to remain this level for the early next year.

Industry Standard Customer and Supplier Payment Terms (days) as below:
 
 
Year ended December 31, 2012 and 2011
 
Customer Payment Term 
Payment in advance/up to 90 days
 
Supplier Payment Term
Payment in advance/up to 30 days
 
 
Inventory turnover days increased from 44 days for the year ended December 31, 2011 to 49 days for the year ended December 31, 2012, due to inventory buildup in anticipation of increasing demand from our customers in the following quarters.

The Company is required to pay deposits to the suppliers in the range of 20% of total purchase contract amounts. The Company makes advanced orders of raw materials based upon (1) the demand and supply situation in the raw materials market, and (2) the forecasted demand of products. All of the raw materials relating to advances to suppliers as of December 31, 2012 have been subsequently received by the Company in January 2013.

Based on past performance and current expectations, we believe our cash and cash equivalents and cash generated from operations and short-term bank borrowings will satisfy our working capital needs, capital expenditures and other liquidity requirements associated with our operations for at least the next 12 months.
 
All of the Company’s revenues and majority of its expenses were denominated in Renminbi (“RMB”), the currency of the PRC. There is no assurance that exchange rates between the RMB and the U.S. Dollar will remain stable. The Company does not engage in currency hedging. Inflation has not had a material impact on the Company’s business.

COMMITMENTS AND CONTINGENCIES

Contractual Obligations

Our contractual obligations as of December 31, 2012 are as follows:

Contractual obligations
 
Total
   
Payment due 
less than 1 year
   
2 – 3 years
   
4-5 years
   
More than 5
years
 
Lease commitments
   
1,577,821
     
691,608
     
886,213
     
-
     
-
 
Plant construction
   
27,759,958
     
27,759,958
     
-
     
-
     
-
 
Warehouse construction
   
791,753
     
791,753
     
-
     
-
         
Equipment acquisition
   
1,462,189
     
1,462,189
     
-
     
-
     
-
 
Total
   
31,591,721
     
30,705,508
     
886,213
     
-
     
-
 

On March 8, 2013, Xinda Holding (HK) Company Limited (" Xinda Holding (HK)" )  entered into an investment agreement for the establishment of a 300,000 Metric Tons Plastics New Material Production, R&D and Training Center (the "Investment Agreement") with the People's Government of Shunqing District, Nanchong City, Sichuan Province, pursuant to which, Xinda Holding (HK) will invest through its PRC affiliate or otherwise approximately RMB1.7 billion (equivalent to US$270 million) in property, plant and equipment  and approximately RMB0.6 billion (equivalent to US$100 million) in working capital from 2013 to 2015.
 
 
 
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Off-Balance Sheet Arrangements
 
Neither us, nor any of our subsidiaries has any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on their financial condition or results of operations.
 
ITEM 7A.  
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
Interest Rate Risk
 
We are exposed to interest rate risk primarily with respect to our short-term bank loans. Although the interest rates of our short-term bank loans, which are based on the prime rates set by People’s Bank of China, are fixed during the terms of the loans, increase in interest rates will increase the cost of new borrowings and our interest expense.
 
A hypothetical 1.0% increase in the annual interest rate for all of our credit facilities under which we had outstanding borrowings as of December 31, 2012 would decrease income before income taxes by approximately $1.62 million for the year ended December 31, 2012. Management monitors the banks’ prime rates in conjunction with our cash requirements to determine the appropriate level of debt balances relative to other sources of funds. We have not entered into any hedging transactions in an effort to reduce our exposure to interest rate risk.
 
Foreign Currency Exchange Rates
 
All of our revenues are collected in and substantially all of our expenses are paid in RMB. We face foreign currency rate translation risks when our results are translated to U.S. dollars.
 
The RMB was relatively stable against the U.S. dollar at approximately 8.28 RMB to the $1.00 U.S. dollar until July 21, 2005 when the Chinese currency regime was altered resulting in a 2.1% revaluation versus the U.S. dollar. From July 21, 2005 to June 30, 2010, the RMB exchange rate was no longer linked to the U.S. dollar but rather to a basket of currencies with a 0.3% margin of fluctuation resulting in further appreciation of the RMB against the U.S. dollar. Since June 30, 2009, the exchange rate had remained stable at 6.8307 RMB to 1.00 U.S. dollar until June 30, 2010 when the People's Bank of China allowed a further appreciation of the RMB by 0.43% to 6.798 RMB to 1.00 U.S. dollar. On December 31, 2012, the RMB traded at 6.2301 RMB to 1.00 U.S. dollar.
 
There remains international pressure on the Chinese government to adopt an even more flexible currency policy and the exchange rate of RMB is subject to changes in China’s government policies which are, to a large extent, dependent on the economic and political development both internationally and locally and the demand and supply of RMB in the domestic market. There can be no assurance that such exchange rate will continue to remain stable in the future amongst the volatility of currencies, globalization and the unstable economies in recent years. Since (i) our revenues and net income of our PRC operating entities are denominated in RMB, and (ii) the payment of dividends, if any, will be in U.S. dollars, any decrease in the value of RMB against U.S. dollars would adversely affect the value of the shares and dividends payable to shareholders, in U.S. dollars.
 
 
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ITEM 8
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
The consolidated financial statements of the Company and its subsidiaries as of and for the years ended December 31, 2012 and 2011, including the notes thereto, together with the report of our independent registered public accounting firm, are presented beginning on page F-1 of this report and are incorporated into this Item 8.
 
  ITEM 9.