UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-KSB
|X| ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934
For the fiscal year ended December 31, 2006
|_| TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
Commission File Number: 000-31539
CHINA NATURAL GAS, INC.
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(Name of small business issuer in its charter)
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Delaware 98-0231607
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State or other jurisdiction of I.R.S. Employer
incorporation or organization Identification Number
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19th Floor, Building B, Van Metropolis
Tang Yan Road, Hi-Tech Zone
Xian,710065, Shaanxi Province
China
(Address of principal executive office)
Issuer's telephone number: 86-29-88323325
Securities registered under Section 12(b) of the Exchange Act: None
Securities registered under Section 12(g) of the Exchange Act:
Common Stock, $.0001 par value per share
Check whether the Issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter
period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. YES [X] NO [_]
Check if there is no disclosure of delinquent filers in response to Item 405 of
Regulation S-B contained in this form, and no disclosure will 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-KSB or any
amendment to this Form 10-KSB. [X]
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act.) YES [_] NO [X]
The issuer's revenues for the fiscal year ended December 31, 2006 were
$18,828,790.
The number of shares of the Registrant's common stock, par value $0.0001 per
share, outstanding as of April 13, 2007 held by non-affiliates was 18,278,587
shares. All executive officers and directors of the registrant have been deemed,
solely for the purpose of the foregoing calculation, to be "affiliates" of the
registrant. The aggregate market value of the common equity held by
non-affiliates as of April 13, 2007 was $38,750,604.
As of April 13, 2007, there were 24,210,183 shares of the issuer's common stock,
$0.0001 par value, outstanding.
Transitional Small Business Disclosure format (Check one): YES [_] NO [X]
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FORM 10-KSB
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2006
INDEX
Page
PART I........................................................................ 4
ITEM 1. DESCRIPTION OF BUSINESS........................................ 4
ITEM 2. DESCRIPTION OF PROPERTY........................................19
ITEM 3. LEGAL PROCEEDINGS..............................................19
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS.............20
PART II.......................................................................20
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER
MATTERS AND SMALL BUSINESS ISSUER PURCHASES OF EQUITY
SECURITIES.....................................................20
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION......21
ITEM 7. FINANCIAL STATEMENTS...........................................29
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE.......................................30
ITEM 8A. CONTROLS AND PROCEDURES........................................30
ITEM 8B. OTHER INFORMATION..............................................30
PART III......................................................................30
ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT.............30
ITEM 10. EXECUTIVE COMPENSATION.........................................34
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT AND RELATED STOCKHOLDER MATTERS.....................35
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.................36
ITEM 13. EXHIBITS.......................................................36
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.........................37
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STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
In this annual report, references to "China Natural Gas," "CHNG," "the Company,"
"we," "us," and "our" refer to China Natural Gas, Inc.
Except for the historical information contained herein, some of the statements
in this Report contain forward-looking statements that involve risks and
uncertainties. These statements are found in the sections entitled "Business,"
"Management's Discussion and Analysis or Plan of Operation," and "Risk Factors."
They include statements concerning: our business strategy; expectations of
market and customer response; liquidity and capital expenditures; future sources
of revenues; expansion of our proposed product line; and trends in industry
activity generally. In some cases, you can identify forward-looking statements
by words such as "may," "will," "should," "expect," "plan," "could,"
"anticipate," "intend," "believe," "estimate," "predict," "potential," "goal,"
or "continue" or similar terminology. These statements are only predictions and
involve known and unknown risks, uncertainties and other factors, including, but
not limited to, the risks outlined under "Risk Factors," that may cause our or
our industry's actual results, levels of activity, performance or achievements
to be materially different from any future results, levels of activity,
performance or achievements expressed or implied by such forward-looking
statements. For example, assumptions that could cause actual results to vary
materially from future results include, but are not limited to: our ability to
successfully develop and market our products to customers; our ability to
generate customer demand for our products in our target markets; the development
of our target markets and market opportunities; our ability to manufacture
suitable products at competitive cost; market pricing for our products and for
competing products; the extent of increasing competition; technological
developments in our target markets and the development of alternate, competing
technologies in them; and sales of shares by existing shareholders. Although we
believe that the expectations reflected in the forward-looking statements are
reasonable, we cannot guarantee future results, levels of activity, performance
or achievements. Unless we are required to do so under US federal securities
laws or other applicable laws, we do not intend to update or revise any
forward-looking statements.
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PART I
ITEM 1. DESCRIPTION OF BUSINESS
Organizational History
We were incorporated in the state of Delaware on March 31, 1999, as Bullet
Environmental Systems, Inc. On May 25, 2000 we changed our name to Liquidpure
Corp. and on February 14, 2002 we changed our name to Coventure International
Inc. On December 6, 2005, we closed a Share Purchase Agreement with Xian Xilan
Natural Gas Co., Ltd., a corporation formed under the laws of the People's
Republic of China on January 8, 2000, and the shareholders of Xian Xilan Natural
Gas Co., Ltd. Pursuant to the Share Purchase Agreement, we acquired all of the
issued and outstanding capital stock of Xian Xilan Natural Gas Co., Ltd. from
the shareholders of Xian Xilan Natural Gas Co., Ltd. On December 19, 2005, we
changed our name to China Natural Gas, Inc.
Overview of our Business
We distribute and sell natural gas to commercial, industrial and
residential customers in the Xian area, including Lantian County and the Lintong
and Baqiao Districts, of Shaanxi province of The Peoples' Republic of China
("China" or the "PRC"). The Shaanxi province is located in central China and has
a population of approximately 36 million in an area of over 200,000 square
kilometers (about 77,225 square miles). Xian, the capital of Shaanxi Province,
is located in the southern part of Shaanxi Province and has a population of
approximately 8 million people, with about 5 million people living within the
urban area.
We operate three primary business lines:
o Distribution and sale of compressed natural gas (CNG) through
Company-owned CNG filling stations for hybrid (natural gas/gasoline)
powered vehicles (17 stations as of March 21, 2007);
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o Distribution and sale of CNG to third party-owned CNG filling
stations for hybrid (natural gas/gasoline) powered vehicles; and
o Distribution and sale of natural gas to residential, commercial and
industrial customers through Company-owned pipelines. As of March
31, 2007, the Company distributed and sold natural gas to
approximately 75,000 homes and businesses.
We buy all of the natural gas that we sell and distribute to our customers
from government owned enterprises. We do not mine or produce any of our own
natural gas and have no plans to do so during the next 12 months. The natural
gas that we buy is available in two forms: (1) piped natural gas; and (ii) CNG.
We believe that the Company is the first China based natural gas company
publicly traded in the US capital markets (stock symbol: CHNG.OB).
Our Products, Services and Customers
Our Pipeline Distribution System
We own and operate a network of approximately 120 km of high pressure
pipeline in the Xian area. Our pipeline network connects with a high pressure
pipeline network from the government operated Shaanxi Natural Gas Company. This
pipeline supplies natural gas directly from a gas field in the northern region
of the province to the high pressure pipes that then feed into citygate
"let-down" stations at HongQing and Lantian County. At HongQing and LanTian the
pressure is reduced and transported through a network of low-pressure
distribution pipes to supply our residential, commercial and industrial
customers in Lantian County, and the Lintong and Baqiao Districts. The spur also
feeds a compressor station at HongQing where CNG is collected by tankers to
supply CNG filling stations.
Each of our pipeline customers is physically connected to our pipeline
network through Company installed and maintained connection equipment and
natural gas usage monitoring systems. We generate additional fees from the
construction and installation of connections to our natural gas distribution
system.
We believe that we are currently the sole authorized provider of natural
gas to residential customers in our service area and the only privately owned
company in the Shaanxi province to own and operate this type of high pressure
pipeline.
CNG Filling Stations
We also distribute CNG as a vehicular fuel through our own and through
third party-owned CNG filling stations. We currently own and operate thirteen
natural gas filling stations in the Xian metropolitan area and four natural gas
filling stations in Henan province. CNG is sold to taxis and buses that operate
on CNG technology.
Currently, we purchase natural gas for 1.26 RMB/cubic meter and sell each
cubic meter for 2.65RMB net of value added taxes. We can construct a CNG filling
station in approximately 60 days for a cost of approximately US$800,000. As of
March 17, 2007, we were in the process of constructing seven additional CNG
filling stations. We continue to evaluate additional sites for CNG filling
stations in the Xian metropolitan area. In July 2005, we purchased a Compressor
Station located near our pipeline that will allow us to compress and transport
CNG via truck to CNG filling stations.
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Our CNG Market
We estimate that currently there are approximately 50,000 vehicles using
CNG in the Xian area. PRC government statistics indicate that there are
currently 5,000 buses and 20,000 taxis using CNG in Xian. Each bus uses an
average of 70 cubic meters of CNG per day and taxis use an average of 30 cubic
meters of CNG per day (source: Xian Clean Fuel Vehicles Commission 2005).
The PRC government estimates in its Eleventh Five Year Plan (2006-2010)
that current total demand for CNG as a vehicular fuel in the Xian area is
approximately one million seventy thousand (1,070,000) cubic meters per day. The
PRC government's clean energy policy as expressed in the proposal for the
Eleventh Five Year Plan (2006-2010) encourages the use of CNG as a vehicular
fuel. In addition, currently CNG is cheaper than gasoline. We estimate that the
average CNG station in Xian pumps approximately 15,000 cubic meters of CNG per
day and in November 2006, based on a survey we conducted, there were 53 CNG
filling stations in Xian. Therefore, we estimate that approximately 800,000
cubic meters of CNG is pumped per day, a figure well below estimated total
demand. As a result, we believe that there is significant unmet demand for CNG
in the Xian area and that the market for CNG vehicular fuel provides us with the
greatest opportunities for profit and growth.
We believe that our vertically integrated operations and our proprietary
pipeline and supply contracts gives us greater access to CNG supplies and
customers and uniquely position us to become a major supplier of CNG vehicular
fuel in the Xian area.
Our Pipeline Network Customers
As of December 31, 2006, we had approximately 75,000 customers, including
residential, industrial and commercial customers. We are continuing to expand
our customer base in Xian's newly developed business and residential areas
including the districts of Xihan and Chanliu. Our industrial customers,
including the Xiwei Aluminum Company and the Hungtian Company, use natural gas
as a raw material for their production process. We are not dependent upon any
single customer or group of customers for a material portion of our natural gas
sales or revenues.
Our pipeline customers purchase natural gas by means of prepaid cards that
can be inserted into the connection equipment to initiate gas flow.
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We are currently seeking to expand pipeline distribution to the Shangluo
and Ankang areas of Shaanxi province. In September 2005, we submitted
applications to local government authorities for approval to supply the Shanglou
and Ankang areas on an exclusive basis. Approval is still pending and can take
up to three years. As a result, we cannot be certain if we will receive such
government approval at all or, if approved, when we will receive such government
approval. However, we believe that if we receive government approval, the
approval would give us the exclusive right to provide natural gas to
residential, commercial and industrial customers in those areas.
Our Proposed Liquefied Natural Gas Project
During 2007, we plan to move into the processing, distribution and sale of
liquefied natural gas (LNG). We believe that adding LNG to our product offerings
will expand our geographic sales footprint and increase revenues and
profitability.
Both CNG and LNG are natural gas that has been compressed into canisters
to enable transportation, usually by truck, to the point of distribution or
consumption. Typically CNG is compressed at 200 times atmospheric pressure and
can be transported at normal temperatures to distances of up to 300 km. LNG is
typically compressed at up to 625 times atmospheric pressure and must be
transported at sub-zero degree temperatures. LNG can be transported over greater
distances by gas tanker truck. LNG is compressed at much higher pressure and
transported at much lower temperature than CNG. Therefore, the cost of
compression and processing of LNG is higher than that of CNG, although the LNG
transportation costs are lower.
We plan to construct an LNG processing and distribution plant in Jinbiang,
Shananxi province (the "LNG Project"). We estimate that the construction of the
LNG Project will cost approximately US$40 million (RMB 309 million). If we can
obtain financing for the project by the end of 2007, we believe that the plant
can be completed by June 2008. We have obtained the required permits and
approvals to build the LNG plant from local government authorities; however, we
will require approval from the Shaanxi Development and Reform Commission to
begun LNG production at the plant.
Our Subsidiaries
On October 24, 2006, we formed a wholly-owned subsidiary, Xilan Liquefied
Natural Gas Ltd., a limited liability company organized under the laws of PRC to
administer the production and sales of LNG.
In 2006, the Company, through its wholly-owned subsidiary, Xilan
Liquefied Natural Gas Co., Ltd, received a letter from PetroChina Company
Limited pursuant to which PetroChina agreed in principle, subject to the
negotiation and execution of a final contract, to supply up to 150,000,000 cubic
meters of natural gas annually upon the completion of our LNG project.
In 2006, we formed a wholly-owned subsidiary, Xian Xilan Natural Gas
Equipment Ltd., a limited liability company organized under the laws of PRC
("Xilan Equipment"), to provide equipment to our own CNG filling stations.
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Suppliers
During 2006, we had only one natural gas supplier, the Shaanxi Natural Gas
Co., Ltd., a government owned enterprise. In the past, contracts were renewed on
an annual basis. However, as the volume of usage has increased, Shaanxi Natural
Gas has revised its policies, and contract terms are now six months and subject
to review prior to renewal. The price of natural gas is strictly controlled by
the government and has remained stable over the past 3 years.
In 2006, we signed a three-year contract with Zhengzhou Zhongyou
Hengran Petroleum Gas Co., Ltd., a branch company of China Petrochemical, to
supply 350,000 cubic meters of CNG daily and to supply CNG for a filling station
built by the Company in Henan province.
On October 19, 2006, we received a letter from PetroChina Company
Limited pursuant to which PetroChina agreed in principle to supply up to 150
million cubic meters of LNG annually to our subsidiary subject to the
negotiation of a final agreement once our LNG plant is built.
We do not expect any difficulty in continuing to renew our supply
contracts during the next 12 months.
PRC Natural Gas Industry Overview
China's rapidly expanding economy is stretching the limits of its energy
resources. Currently, only 3% of China's total energy usage is natural gas,
while the world's average consumption of natural gas is 24% of total energy
usage. (source: US Energy Information Administration ("EIA"), August 2005) Over
the next 5 years, China's use of natural gas is expected to significantly
increase. In 2005, China's domestic reserve of natural gas was estimated to be
53.3 trillion cubic feet. (source: EIA August 2005). The country's largest
reserves are located in western and north central China.
In order to meet the demand for natural gas, the PRC government has
encouraged private companies to invest in and build the necessary
transportation, distribution and sale infrastructure for natural gas. On
December 27, 2002, the Ministry of Construction issued a memorandum stating that
regulation of the public utility industry (including natural gas distribution)
should be liberalized. It also stated that foreign and private investment
participation should be encouraged and welcomed. The memorandum encouraged
private investment in the sector and provided a legal framework for private
urban natural gas distribution.
Sources of Energy
Although the PRC is the world's second largest energy consumer, its energy
consumption per capita is lower than most other countries. This is largely
because large portions of the Chinese population live in rural areas where
access to energy sources is limited and the necessary infrastructure is still
relatively underdeveloped. Energy consumption is concentrated in the urban areas
where there is greater access to energy sources.
Traditionally, the PRC has relied heavily on coal and crude oil as its
primary energy sources. According to the China Statistical Yearbook, in 2004,
coal, crude oil, hydro-electricity and natural gas accounted for 65.0%, 23.2%,
8.8% and 3%, respectively, of the PRC's total energy consumption. In 2003, the
ratios were 68.0%, 23.0%, 7.9% and 2.5% respectively. Traditionally, natural gas
has been primarily used as a raw material for chemical fertilizer and to operate
oil and gas fields. Accordingly, most natural gas is consumed for production of
fertilizer. Only a little over 10% of natural gas is consumed as fuel. (Source:
The Institute of Energy Economics of Japan).
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The PRC's heavy reliance on coal exceeds world consumption rates for the
same period, which was 22.2% (Source: Energy Information Administration, U.S.
Department of Energy). The use of coal, however, causes air pollution and other
negative consequences to the environment. In the PRC, the heavy use of unwashed
coal has led to large emissions of sulfur dioxide and particulate matter. An air
pollution study conducted by the World Health Organization in 1998 showed that
seven of the 10 most polluted cities in the world were located in the PRC. As
such, there have been serious environmental concerns in many countries around
the world, resulting in a global trend to reduce coal usage. In consideration of
such trends, in 1996, the PRC presented a plan to raise the share of natural gas
in the country's energy mix (Source: Ninth Five-Year Plan (1996-2000)). In many
locations where natural gas supply is available, local governments often require
all new residential buildings to install piped gas connections as a condition to
the issuance of the construction or occupancy permits. Before 2000, local
municipal governments controlled gas distribution. Since then, the industry has
been opened to private companies, whose investments have fostered an increase in
the use of natural gas in the PRC. The PRC government has deemed the natural gas
industry a suitable industry for public and private investments.
China's Natural Gas Reserves and Gas Pipeline Infrastructure
Recognizing the serious problems caused by the heavy reliance on coal
usage, the PRC government has aggressively moved to reduce coal usage by
substituting coal with other, more environmentally friendly forms of fuel, such
as natural gas. The PRC abounds in rich natural gas reserves, which are
distributed among Xinjiang, Sichuan, and Shaanxi Provinces, as well as Inner
Mongolia. According to the Second Oil and Gas Reserve Assessment published by
the Geological and Mineral Resources Department of China, natural gas reserves
in China are estimated to be 38,000 billion cubic meters with 30,000 billion
cubic meters onshore and 8,000 billion cubic meters offshore. These reserves are
sufficient for approximately 74 to 120 years of Chinese consumption based on
current consumption levels.
Because the PRC's largest reserves of natural gas are located in western
and north-central China, it requires a significant investment in gas
transportation infrastructure to carry natural gas to eastern cities and the
rest of the PRC. Until recently, the PRC's natural gas consumption was limited
to local natural gas producing provinces because of the lack of national
long-distance pipeline infrastructure. Because natural gas transportation was
limited to areas near production sites, an economical supply was possible.
The principal method for transportation of natural gas is by means of
pipelines. In order to develop the natural gas industry, it is essential that
the necessary pipeline infrastructure be in place so that natural gas is easily
accessible for distribution at affordable rates.
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In its Eleventh Five Year Plan (2006 - 2010), the PRC government
re-affirmed its commitment to making significant investments in the expansion of
the natural gas pipeline infrastructure over a period of 20 years.
Demand for Natural Gas
Currently, natural gas consumption in the PRC accounts for less than 3% of
its total energy consumption. However, driven by environmental pressures,
improvements in social infrastructure fueled by economic growth, and a stable
energy supply, it is anticipated that the use of natural gas will grow very
rapidly in the PRC over the next 20 years.
Intellectual Property
We have applied for a service mark on the "Xilan" name, which is used in
connection with all our products and services.
Research and Development
We have not had and do not anticipate having any material research and
development expenses. The funding for all research and development expenses is
expected to come from operating cash flows.
Governmental and Environmental Regulation
To date, we comply with all registrations and requirements for the
issuance and maintenance of all licenses required by the applicable governing
authorities in China. These licenses include:
o Qualified Urban Fuel Operator Business License authorized by the
Shaanxi Construction Bureau, the local office of the Ministry of
Construction, effective from January 2, 2004 to January 2,
2009.(License number SHAANRANZHI 166)
o License to Supply, Install Equipment and Maintain Gas Fuel Lines
issued by the local Gas Fuels for Heating Bureau, an agency of the
Ministry of Construction and the Xian Natural Gas Management Bureau.
License number: XIRAN 136)
o Safety and Inspection Regulation for Special Equipment Safety
Inspection Standards for High Pressure Pipeline and Technical Safety
Inspection Regulations from the Shaanxi Quality and Technology
Inspection Bureau for compressor stations and pressure storage tank
system. (Approval letter reference: 2004SHAANGUOCHUHAN033)
o Annual Safety Inspection of Lightning Conductor Equipment approved
by the Shaanxi Meteorology Bureau. (Certificate number 0005274) The
Citygate and Compressor Stations are approved by the local office of
the Ministry of Construction.
o Business license to operate Xilan Equipment effective from
02/22/2006 to 02/21/2021.
o Business license to operate Xilan Liquified Natural Gas effective
from 10/24/2006 to 10/23/2036.
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Fuel service station standards are subject to regulation by the Ministry
of Construction, the General Administration of Quality Supervision, and the
Bureau of Inspection and Quarantine of the People's Republic of China. Upon
satisfactory inspection of service stations, certificates will be issued.
Various standards must be met for filling stations, including the handling
and storage of CNG, tanker handling, and compressor operation. The Local
Ministry of Construction and the Gas Field Operation Department of the Municipal
Administration Committee regulates these standards. The Municipal Development
and Reform Commission, which issues certificates for the handling of dangerous
chemical agents, carries out inspections.
Standards for the design and construction of filling stations must conform
to GB50156-2202 and technology standard BJJ84-2000.
Competition
The three largest state owned energy companies, CNPC (China National
Petroleum Corporation) Group, SINOPEC (China Petroleum and Chemical Corporation
Group), and CNOOC (China National Offshore Oil Corporation Group) are
principally engaged in the upstream supply of energy and are material
competitors in the exploration and transportation of oil and gas. They build
much of the country's high-pressure pipeline infrastructure. Natural gas is
distributed to smaller regional firms that redistribute the gas to the end user,
either through lower pressure pipeline networks, or via tankers in the form of
liquid natural gas (LNG).
With respect to our pipeline services, we compete with privately owned
companies: Xinjiang Guanghui LNG Development Corporation Ltd. and Xin'Ao Gas
Field Ltd. Xinjiang Guanghui LNG Development Corporation Ltd. is primarily
involved in the transportation of LNG via tanker truck to storage facilities
from natural gas wells. Xin'Ao Gas Field Ltd. is a publicly owned company traded
on the Hong Kong Exchange that distributes natural gas via pipeline in 13
provinces and municipalities that have a combined population of 31 million.
Neither Xinjiang Guanghui nor Xin'Ao is approved to supply natural gas to any
area in which Xilan is currently operating.
With respect to our CNG filling station market, currently, there are
approximately 53 CNG filling stations in Xian City. Thirteen of these stations
are state owned enterprises. The other 40 stations are privately owned with the
majority of these being single station operators. We believe that we effectively
compete with the stations based upon our organization, experience and financial
resources.
Employees
As of March 17, 2007, we had 310 employees in the following capacities: 6
in management; 18 in administrative; 87 in operations; 25 in sales; 38 in
research and development; 16 in finance and 120 employees at the retail filling
stations. We have not experienced any industrial actions and we have excellent
relationships with our employees. We are not a party to any collective
bargaining agreements.
RISK FACTORS
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We are subject to various risks that could have a negative effect on the Company
and its financial condition. You should understand that these risks could cause
results to differ materially from those expressed in forward looking statements
contained in this report and in other Company communications. Because there is
no way to determine in advance whether, or to what extent, any present
uncertainty will ultimately influence our business, you should give equal weight
to each of the following:
Risks Related To Our Business
Prices of natural gas can be subject to significant fluctuations, which may
affect our ability to provide supplies to our customers.
We obtain most of our supplies of natural gas from a government owned entity and
our supply contracts are subject to review every six months. However, our costs
for natural gas are strictly controlled by the government and have remained
stable over the past 3 years. Management does not expect any difficulty in
continuing to renew the supply contracts during the next 12 months. The price of
natural gas can fluctuate in response to changing national or international
market forces. Accordingly, price levels of natural gas may rise or fall
significantly over the short to medium term due to political events, OPEC
actions and other factors, industry economics over the long term.
We are dependent on supplies of natural gas to deliver to our customers.
With the exception of certain compressed and liquid natural gas supplies, we
obtain our supplies of natural gas from one supplier, which is a government
owned entity. The ability to deliver our product is dependent on a sufficient
supply of natural gas and if we are unable to obtain a sufficient natural gas
supply, it could prevent us making deliveries to our customers. While we have
supply contracts, we do not control the government owned or other suppliers, nor
are we able to control the amount of time and effort they put forth on our
behalf. It is possible that our suppliers will not perform as expected, and that
they may breach or terminate their agreements with us. It is also possible that,
after a semi-annual review of our primary supply contract, they will choose to
provide services to a competitor. Any failure to obtain supplies of natural gas
could prevent us from delivering such to our customers and could have a material
adverse affect on our business and financial condition.
Our business operations are subject to a high degree of risk and insurance may
not be adequate to cover liabilities resulting from accidents or injuries that
may occur.
Our operations are subject to potential hazards incident to the gathering,
processing, separation and storage of natural gas, such as explosions, product
spills, leaks, emissions and fires. These hazards can cause personal injury and
loss of life, severe damage to and destruction of property and equipment, and
pollution or other environmental damage, and may result in curtailment or
suspension of our operations.
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The occurrence of a significant event for which we are not fully insured or
indemnified, and/or the failure of a party to meet its indemnification
obligations, could materially and adversely affect our operations and financial
condition. Moreover, no assurance can be given that we will be able to maintain
adequate insurance in the future at rates it considers reasonable. To date,
however, we have maintained adequate coverage at reasonable rates and have
experienced no material uninsured losses.
Changes in the regulatory atmosphere could adversely affect our business.
The distribution of natural gas and operations of filling stations are highly
regulated requiring registrations for the issuance of licenses required by
various governing authorities in China. In addition, various standards must be
met for filling stations including handling and storage of natural gas, tanker
handling, and compressor operation which are regulated. The costs of complying
with regulations in the future may harm our business. Furthermore, future
changes in environmental laws and regulations could result in stricter standards
and enforcement, larger fines and liability, and increased capital expenditures
and operating costs, any of which could have a material adverse effect on our
financial condition or results of operations.
We depend on our senior management's experience and knowledge of the industry
and would be adversely affected by the loss of any of our senior managers.
We are dependent on the continued efforts of our senior management
team. We do not currently have employment contracts with our senior executives.
If, for any reason, our senior executives do not continue to be active in
management, our business, or the financial condition of our Company, our results
of operations could be adversely affected. In addition, we do not maintain life
insurance on our senior executives and other key employees.
We may need to raise capital to fund our operations, and our failure to obtain
funding when needed may force us to delay, reduce or eliminate acquisitions and
business development plans.
If in the future, we are not capable of generating sufficient revenues from
operations and our capital resources are insufficient to meet future
requirements, we may have to raise funds to continue the development,
commercialization and marketing of our business. We must raise $40 million in
order complete the LNG Project.
We cannot be certain that funding will be available. To the extent that we raise
additional funds by issuing equity securities, our stockholders may experience
significant dilution. Any debt financing, if available, may involve restrictive
covenants that impact our ability to conduct our business. If we are unable to
raise additional capital if required or on acceptable terms, we may have to
delay, scale back, discontinue our planned acquisitions or business development
plans or obtain funds by entering into agreements on unattractive terms.
Risks Related To The People's Republic of China
China's economic policies could affect our business.
13
Substantially all of our assets are located in China and substantially all of
our revenue is derived from our operations in China. Accordingly, our
results of operations and prospects are subject, to a significant extent, to the
economic, political and legal developments in China.
While China's economy has experienced a significant growth in the past
twenty years, growth has been irregular, both geographically and among various
sectors of the economy. The Chinese government has implemented various measures
to encourage economic growth and guide the allocation of resources. Some of
these measures benefit the overall economy of China, but may also have a
negative effect on us. For example, our operating results and financial
condition may be adversely affected by the government control over capital
investments or changes in tax regulations.
The economy of China has been transitioning from a planned economy to a more
market-oriented economy. In recent years the Chinese government has
implemented measures emphasizing the utilization of market forces for economic
reform and the reduction of state ownership of productive assets and the
establishment of corporate governance in business enterprises; however, a
substantial portion of productive assets in China are still owned by the Chinese
government. In addition, the Chinese government continues to play a significant
role in regulating industry development by imposing industrial policies. It also
exercises significant control over China's economic growth through the
allocation of resources, controlling payment of foreign currency-denominated
obligations, setting monetary policy and providing preferential treatment to
particular industries or companies.
Capital outflow policies in The People's Republic of China may hamper our
ability to remit income to the United States.
The People's Republic of China has adopted currency and capital
transfer regulations. These regulations may require that we comply with complex
regulations for the movement of capital. Although we believe that we are
currently in compliance with these regulations, should these regulations or the
interpretation of them by courts or regulatory agencies change we may not be
able to remit all income earned and proceeds received in connection with our
operations or from the sale of our operating subsidiary to the U.S. or to our
stockholders.
Although we do not import goods into or export goods out of The People's
Republic of China, fluctuation of the Renminbi may indirectly affect our
financial condition by affecting the volume of cross-border money flow.
The value of the Renminbi fluctuates and is subject to changes in the
People's Republic of China political and economic conditions. Since July 2005,
the conversion of Renminbi into foreign currencies, including United States
dollars, has been based on rates set by the People's Bank of China which are set
based upon the interbank foreign exchange market rates and current exchange
rates of a basket of currencies on the world financial markets. As of March 19,
2007, the exchange rate between the Renminbi and the United States dollar was
7.73 Renminbi to every one United States dollar.
We may face obstacles from the communist system in The People's Republic of
China.
Foreign companies conducting operations in The People's Republic of China face
significant political, economic and legal risks. The Communist regime in The
People's Republic of China, including a stifling bureaucracy may hinder Western
investment.
14
We may have difficulty establishing adequate management, legal and financial
controls in The People's Republic of China.
The People's Republic of China historically has been deficient in Western style
management and financial reporting concepts and practices, as well as in modern
banking, computer and other control systems. We may have difficulty in hiring
and retaining a sufficient number of qualified employees to work in The People's
Republic of China. As a result of these factors, we may experience difficulty in
establishing management, legal and financial controls, collecting financial data
and preparing financial statements, books of account and corporate records and
instituting business practices that meet Western standards.
Because our assets and operations are located in China, you may have difficulty
enforcing any civil liabilities against us under the securities and other laws
of the United States or any state.
We are a holding company, and all of our assets are located in the Republic of
China. In addition, our directors and officers are non-residents of the United
States, and all or a substantial portion of the assets of these non-residents
are located outside the United States. As a result, it may be difficult for
investors to effect service of process within the United States upon these
non-residents, or to enforce against them judgments obtained in United States
courts, including judgments based upon the civil liability provisions of the
securities laws of the United States or any state.
There is uncertainty as to whether courts of the Republic of China would
enforce:
o Judgments of United States courts obtained against us or these
non-residents based on the civil liability provisions of the securities laws of
the United States or any state; or
o In original actions brought in the Republic of China, liabilities
against us or non-residents predicated upon the securities laws of the United
States or any state. Enforcement of a foreign judgment in the Republic of China
also may be limited or otherwise affected by applicable bankruptcy, insolvency,
liquidation, arrangement, moratorium or similar laws relating to or affecting
creditors' rights generally and will be subject to a statutory limitation of
time within which proceedings may be brought.
The PRC legal system embodies uncertainties, which could limit law enforcement
availability.
The PRC legal system is a civil law system based on written statutes. Unlike
common law systems, decided legal cases have little precedence. In 1979, the PRC
government began to promulgate a comprehensive system of laws and regulations
governing economic matters in general. The overall effect of legislation over
the past 27 years has significantly enhanced the protections afforded to various
forms of foreign investment in China. Each of our PRC operating subsidiaries and
affiliates is subject to PRC laws and regulations. However, these laws and
regulations change frequently and the interpretation and enforcement involve
uncertainties. For instance, we may have to resort to administrative and court
proceedings to enforce the legal protection that we are entitled to by law or
contract. However, since PRC administrative and court authorities have
significant discretion in interpreting statutory and contractual terms, it may
be difficult to evaluate the outcome of administrative court proceedings and the
level of law enforcement that we would receive in more developed legal systems.
Such uncertainties, including the inability to enforce our contracts, could
affect our business and operation. In addition, intellectual property rights and
confidentiality protections in China may not be as effective as in the United
States or other countries. Accordingly, we cannot predict the effect of future
developments in the PRC legal system, particularly with regard to the industries
in which we operate, including the promulgation of new laws. This may include
changes to existing laws or the interpretation or enforcement thereof, or the
preemption of local regulations by national laws. These uncertainties could
limit the availability of law enforcement, including our ability to enforce our
agreements with the government entities and other foreign investors.
15
The admission of China into the World Trade Organization could lead to increased
foreign competition.
Provincial and central government authorities regulate the natural gas industry
for safety and ensure that all areas receive natural gas service. However, as a
result of China becoming a member of the World Trade Organization (WTO),
restrictions on foreign investment in the industry may be reduced. With China's
need to meet growth in natural gas demand and the WTO's requirement for a
reduction of restrictions on foreign investment as a condition of membership,
such events could lead to increased competition in the natural gas industry.
RISKS RELATED TO CORPORATE AND STOCK MATTERS
The limited prior public market and trading market may cause volatility in the
market price of our common stock.
Our common stock is currently traded on a limited basis on the OTCBB
under the symbol, "CHNG.OB" The quotation of our common stock on the OTCBB does
not assure that a meaningful, consistent and liquid trading market currently
exists, and in recent years, such market has experienced extreme price and
volume fluctuations that have particularly affected the market prices of many
smaller companies like us. Our common stock is thus subject to volatility. In
the absence of an active trading market:
o investors may have difficulty buying and selling or obtaining market
quotations;
o market visibility for our common stock may be limited; and
o a lack of visibility for our common stock may have a depressive
effect on the market for our common stock.
Our stock is a penny stock. Trading of our stock may be restricted by the SEC's
penny stock regulations which may limit a stockholder's ability to buy and sell
our stock.
16
Our stock is a penny stock. The SEC has adopted Rule 15g-9 which generally
defines "penny stock" to be any equity security that has a market price (as
defined) less than $5.00 per share or an exercise price of less than $5.00 per
share, subject to certain exceptions. Our securities are covered by the penny
stock rules, which impose additional sales practice requirements on
broker-dealers who sell to persons other than established customers and
"accredited investors". The term "accredited investor" refers generally to
institutions with assets in excess of $5,000,000 or individuals with a net worth
in excess of $1,000,000 or annual income exceeding $200,000 or $300,000 jointly
with their spouse. The penny stock rules require a broker-dealer, prior to a
transaction in a penny stock not otherwise exempt from the rules, to deliver a
standardized risk disclosure document in a form prepared by the SEC which
provides information about penny stocks and the nature and level of risks in the
penny stock market. The broker-dealer also must provide the customer with
current bid and offer quotations for the penny stock, the compensation of the
broker-dealer and its salesperson in the transaction and monthly account
statements showing the market value of each penny stock held in the customer's
account. The bid and offer quotations, and the broker-dealer and salesperson
compensation information, must be given to the customer orally or in writing
prior to effecting the transaction and must be given to the customer in writing
before or with the customer's confirmation. In addition, the penny stock rules
require that prior to a transaction in a penny stock not otherwise exempt from
these rules, the broker-dealer must make a special written determination that
the penny stock is a suitable investment for the purchaser and receive the
purchaser's written agreement to the transaction. These disclosure requirements
may have the effect of reducing the level of trading activity in the secondary
market for the stock that is subject to these penny stock rules. Consequently,
these penny stock rules may affect the ability of broker-dealers to trade our
securities. We believe that the penny stock rules discourage investor interest
in and limit the marketability of our common stock.
NASD sales practice requirements may also limit a stockholder's ability to buy
and sell our stock.
Section 15(g) of the Securities Exchange Act of 1934, as amended, and
Rule 15g-2 promulgated thereunder by the SEC require broker-dealers dealing in
penny stocks to provide potential investors with a document disclosing the risks
of penny stocks and to obtain a manually signed and dated written receipt of the
document before effecting any transaction in a penny stock for the investor's
account.
Potential investors in our common stock are urged to obtain and read such
disclosure carefully before purchasing any shares that are deemed to be "penny
stock." Moreover, Rule 15g-9 requires broker-dealers in penny stocks to approve
the account of any investor for transactions in such stocks before selling any
penny stock to that investor. This procedure requires the broker-dealer to (i)
obtain from the investor information concerning his or her financial situation,
investment experience and investment objectives; (ii)reasonably determine, based
on that information, that transactions in penny stocks are suitable for the
investor and that the investor has sufficient knowledge and experience as to be
reasonably capable of evaluating the risks of penny stock transactions; (iii)
provide the investor with a written statement setting forth the basis on which
the broker-dealer made the determination in (ii) above; and (iv) receive a
signed and dated copy of such statement from the investor, confirming that it
accurately reflects the investor's financial situation, investment experience
and investment objectives. Compliance with these requirements may make it more
difficult for holders of our common stock to resell their shares to third
parties or to otherwise dispose of them in the market or otherwise.
17
Shares eligible for future sale may adversely affect the market price of our
Common stock, as the future sale of a substantial amount of our restricted stock
in the public marketplace could reduce the price of our common stock.
From time to time, certain of our stockholders may be eligible to sell all or
some of their shares of common stock by means of ordinary brokerage transactions
in the open market pursuant to Rule 144, promulgated under the Securities Act
("Rule 144"), subject to certain limitations. In general, pursuant to Rule 144,
a stockholder (or stockholders whose shares are aggregated) who has satisfied a
one-year holding period may, under certain circumstances, sell within any
three-month period a number of securities which does not exceed the greater of
1% of the then outstanding shares of common stock or the average weekly trading
-volume of the class during the four calendar weeks prior to such sale. Rule 144
also permits, under certain circumstances, the sale of securities, without any
limitations, by a non-affiliate of our company that has satisfied a two-year
holding period. Any substantial sale of common stock pursuant to Rule 144 or
pursuant to any resale prospectus may have an adverse effect on the market price
of our securities.
If we or our independent registered public accountants cannot attest our
adequacy in the internal control measures over our financial reporting, as
required by Section 404 of the U.S. Sarbanes-Oxley Act, for the fiscal year
ending December 31, 2007, we may be adversely affected.
As a public company, we are subject to report our internal control structure and
procedures for financial reporting in our annual reports on Form 10-KSB, as a
requirement of Section 404 of the U.S. Sarbanes-Oxley Act of 2002 by the U.S.
Securities and Exchange Commission (the "SEC"). The report must contain an
assessment by management about the effectiveness of our internal controls over
financial reporting. Moreover, the independent registered public accountants of
our Company must attest to and report on management's assessment of the same.
Even if our management attests to our internal control measures to be effective,
our independent registered public accountants may not be satisfied with our
internal control structure and procedures. We cannot guarantee the outcome of
the report and it could result in an adverse impact on us in the financial
marketplace due to the loss of investor confidence in the reliability of our
financial statements, which could negative influence to our stock market price.
Stockholders should have no expectation of any dividends.
The holders of our common stock are entitled to receive dividends when declared
by the Board of Directors out of funds available. To date, we have not declared
nor paid any cash dividends. The Board of Directors does not intend to declare
any dividends in the near future, but instead intends to retain all earnings, if
any, for use in our business operations.
18
ITEM 2. DESCRIPTION OF PROPERTY
Our principal executive offices are located at 19th Floor, Building B, Van
Metropolis Tang Yan Road, Hi-Tech Zone, Xian, 710065, Shaanxi Province, People's
Republic of China. Our property consists of approximately 818 square meters,
which is rented on an annual basis for $37,753.
We have additional properties located in Lantian county, the districts of
Baqiao, Tong and Gaoxin in the city of Xian, and the cities of Jiyuan, Kaifung
and Pindingshan, in Henan province. We own a 120km high-pressure underground
pipeline network and two Citygate stations (terminals) with accompanying
buildings and equipment. We lease the main office building where we are
headquartered and all of our CNG filling station sites.
In February, 2006 we formed our 100%-owned subsidiary, Xilan Equipment,
which maintains an office in the No. 3 Xianmen St., Lantian county, Xian,
Shaanxi Province, China. The office consists of approximately 1001 sq. feet,
with annual rental payment of $5,560.
On October 24, 2006, we formed our 100% owned subsidiary, Xilan
Liquified Natural Gas Co., Ltd., which maintains an office in the Tongwang Road,
Zhangjiapan Town, Jingbian County, China, China. The office consists of
approximately 3,921 sq. feet, with annual rental payment of $7,036.
As of December 31, 2006, the Company owned 11 trucks and 13 tankers that
the Company used to transport natural gas.
Insurance
The Company carries auto insurance on its vehicles and maintains workers
compensation insurance for its filling station workers. The Company believes
this insurance is adequate for its needs. The Company does not carry any product
liability insurance or property insurance on its office buildings or other
property.
We believe that current facilities are adequate for our current and
immediately foreseeable operating needs. We do not have any policies regarding
investments in real estate, securities or other forms of property.
ITEM 3. LEGAL PROCEEDINGS
From time to time, we may become involved in various lawsuits and legal
proceedings, which arise in the ordinary course of business. However, litigation
is subject to inherent uncertainties, and an adverse result in these or other
matters may arise from time to time that may harm our business. We are currently
not aware of any such legal proceedings or claims that we believe will have,
individually or in the aggregate, a material adverse affect on our business,
financial condition or operating results.
19
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS.
None
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
SMALL BUSINESS ISSUER PURCHASES OF EQUITY SECURITIES.
On March 17, 2004, our common stock was approved for listing on the
Over-the-Counter Bulletin Board under the symbol "CVNI" and on December 19, 2005
our symbol was changed to "CHNG" and our fiscal year end was changed to December
31. The following table sets forth, the range of high and low closing bid
quotations for our common stock in 2005 and 2006. The quotations represent
inter-dealer prices without retail markup, markdown or commission, and may not
necessarily represent actual transactions. The source of the following
information is Yahoo Finance.
OTC Bulletin Board
COMMON STOCK MARKET
PRICE
HIGH LOW
---- ---
FISCAL YEAR ENDED DECEMBER 31, 2006:
Fourth Quarter $ 3.15 $ 3.08
Third Quarter $ 3.05 $ 2.82
Second Quarter $ 2.55 $ 2.35
First Quarter $ 4.49 $ 4.40
FISCAL YEAR ENDED DECEMBER 31, 2005:
Fourth Quarter $ 3.40 $ 3.30
Third Quarter $ 3.00 $ 3.00
Second Quarter $ 5.50 $ 5.50
First Quarter $ 1.35 $ 1.35
----------------------
As of March 22, 2007, there were approximately 22 holders of record of our
common stock.
Dividends
There are no restrictions in our articles of incorporation or bylaws that
prevent us from declaring dividends. The Delaware General Corporation Law,
however, does prohibit us from declaring dividends where, after giving effect to
the distribution of the dividend:
1. We would not be able to pay our debts as they become due in the
usual course of business; or
20
2. Our total assets would be less than the sum of our total liabilities
plus the amount that would be needed to satisfy the rights of
shareholders who have preferential rights superior to those
receiving the distribution.
We have never declared or paid any cash dividends on our common stock. We
currently intend to retain future earnings, if any, to finance the expansion of
our business. As a result, we do not anticipate paying any cash dividends in the
foreseeable future.
Recent Issuances of Unregistered Securities.
Not Applicable
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
CAUTIONARY STATEMENT
The following discussion and analysis should be read in conjunction with
the Company's Consolidated Financial Statements and the Notes thereto included
in Part II, Item 7 of this Report. Unless otherwise noted, all amounts are
expressed in U.S. dollars. The following discussion regarding the Company and
its business and operations contains forward-looking statements that consist of
any statement other than a recitation of historical fact and can be identified
by the use of forward-looking terminology such as "may", "expect", "anticipate",
"estimate" or "continue" or the negative thereof or other variations thereon or
comparable terminology. In particular, these include statements relating to our
expectation that we will continue to have adequate liquidity from cash flow from
operations the other risks and uncertainties, which are described above under
"RISK FACTORS". The reader is cautioned that all forward-looking statements are
necessarily speculative and there are certain risks and uncertainties that could
cause actual events or results to differ materially from those referred to in
such forward-looking statements, including the risk factors discussed in this
Report. The Company does not have a policy of updating or revising
forward-looking statements and thus it should not be assumed that silence by
management of the Company over time means that actual events are bearing out as
estimated in such forward-looking statements.
OVERVIEW
We were incorporated in the state of Delaware on March 31, 1999, as Bullet
Environmental Systems, Inc. On May 25, 2000, we changed our name to Liquidpure
Corp. and on February 14, 2002, we changed our name to Coventure International
Inc. On December 6, 2005, we closed a Share Purchase Agreement with Xian Xilan
Natural Gas Co., Ltd., a corporation formed under the laws of the People's
Republic of China on January 8, 2000, and the shareholders of Xian Xilan Natural
Gas Co., Ltd. Pursuant to the Share Purchase Agreement, we acquired all of the
issued and outstanding capital stock of Xian Xilan Natural Gas Co., Ltd. from
the shareholders of Xian Xilan Natural Gas Co., Ltd. On December 19, 2005, we
changed our name to China Natural Gas, Inc.
We transmit and distribute natural gas to commercial, industrial and
residential customers in the Xian area, including Lantian County and the
districts of Lintong and Baqiao, in the Shaanxi Province of The Peoples'
Republic of China ("China" or the "PRC"). Shaanxi Province is located in central
China and has a population of approximately 36 million in an area of over
200,000 square kilometers (about 77,225 square miles). Xian, the capital of
Shaanxi Province, is located in the southern part of Shaanxi Province and has a
population of approximately 8 million people, with about 5 million people living
within the urban area.
21
We operate three primary business lines:
o Distribution and sale of compressed natural gas (CNG) through
Company-owned CNG filling stations for hybrid (natural gas/gasoline)
powered vehicles (17 stations as of March 21, 2007);
o Distribution and sale of CNG to third party-owned CNG filling
stations for hybrid (natural gas/gasoline) powered vehicles; and
o Distribution and sale of natural gas to residential, commercial and
industrial customers through Company-owned pipelines. As of March
31, 2007, the Company distributed and sold natural gas to
approximately 75,000 pipeline customers.
We buy all of the natural gas that we sell and distribute to our
customers. We do not mine or produce any of our own natural gas and have no
plans to do so during the next 12 months. The natural gas that we buy is
available in two forms: (1) piped natural gas; and (ii) CNG.
CONSOLIDATED RESULTS OF OPERATIONS
Comparing Fiscal Years Ended December 31, 2006 and 2005:
The following table presents certain consolidated statement of operations
information. Financial information is presented for the 12-month period ending
December 31, 2006 and December 31, 2005.
2006 2005
---- ----
Revenues $18,828,790 $ 4,850,699
Cost of Revenues $ 9,718,000 $ 2,404,037
Operating Expenses $ 2,596,199 $ 975,083
Income from Operations $ 6,514,591 $ 1,471,579
Net Income $ 5,451,095 $ 1,252,083
Revenue. We generated approximately 74% of our revenues in 2006 from the sale of
natural gas and approximately 26% of our revenues from construction and
installation fees charged to connect end-user customers to our natural gas
distribution system. Sales of natural gas at the Company-owned filling stations
accounted for approximately 49.58% of our total revenues in 2006, or
approximately $9,335,314, which was the largest contribution of our three
business lines. Sales of natural gas to end-user customers connected to our
pipeline distribution system accounted for approximately 22.2% of our total
revenues in 2006, or approximately $4,179,991, including both natural gas sales
and construction and installation fees. Sales of natural gas to third
party-owned filling stations accounted for approximately 3% of our total
revenues in 2006, or approximately $564,863.The Company expects installation
revenues to increase on both an actual basis and as a percentage of revenue. In
2007, the Company expects to add up to 30,000 pipeline customers and construct
an additional 15 filling stations, which the Company estimates will increase
sales of natural gas by 80 million cubic meters.
We had total revenues of $18,828,790 for the twelve months ended December 31,
2006, an increase of $13,978,091 or approximately 288%, compared to $4,850,699
for the twelve months ended December 31, 2005. The increase in revenues was due
primarily to the construction of 14 new company-owned filling stations during
2006 as well as an increase in the number of residential, commercial and
industrial pipeline customers from approximately 50,000 in 2005 to approximately
75,000 in 2006.
22
New pipeline customers pay approximately 60% of the construction costs to
connect to our pipeline system up front and the balance is payable as part of
their monthly natural gas bill. During 2006, our installation revenues increased
approximately 62% over the previous year and our sales of natural gas increased
approximately 700% over the previous year. Four customers accounted for
approximately 47%, 18%, 8% and 6% of the Company's installation revenue for the
year ended December 31, 2006.
Cost of Sales. Our cost of sales consists of both the cost of gas sales
and the cost of construction and installation. Cost of gas sales consists
primarily of the cost that we pay for natural gas purchased from our supplier,
together with transportation costs and depreciation of equipment. Cost of
connection includes certain construction costs related to connecting customers
to our pipeline system that are generally expensed when incurred.
Cost of sales in 2006 was $9,718,000, an increase of $7,313,963 or
approximately 404% from 2005. Cost of gas sales increased by approximately 492%
to $7,663,060 in 2006, as compared with $1,293,585 in 2005. The increase in our
cost of sales was primarily related to a material increase in the amount of gas
sold in 2006. In addition, our construction and installation costs increased in
2006 by approximately 85% to $2,054,940, as compared with $1,110,452 in 2005 as
a result of the addition of new pipeline customers. The price that we paid for
gas in 2006 remained relatively constant compared to 2005.
Gross profit. The Company earned a gross profit of $9,110,790 for the
twelve months ended December 31, 2006, an increase of $6,664,128 or
approximately 273%, compared to $2,446,662 for the twelve months ended December
31, 2005. The increase in gross profit is due to a material increase in gas
sales and installation revenues in 2006, partially offset by an increase in
cost of sales.
Gross margin. Gross margin, as a percentage of revenues, decreased to
approximately 48% for the twelve months ended December 31, 2006, from
approximately 50% for the twelve months ended December 31, 2005. The decrease in
gross margin is primarily attributable to the significant increase in revenues
generated from our Company-owned filling stations. Construction of our filling
stations requires a significant capital outlay, approximately $800,000 per
station, and involves significant costs of operations, including value added
taxation and employee expenses to operate the station. As a result, our margins
on natural gas sold at filling stations are lower than our margins on natural
gas sold to end users connected to our pipeline system. However, we believe that
sales of CNG and LNG provide the best opportunity for future revenue and profit
growth.
23
Operating expenses. The Company incurred operating expenses of $2,596,199 for
the twelve months ended December 31, 2006, an increase of $1,621,116 or
approximately 166%, compared to $975,083 for the twelve months ended December
31, 2005. Our operating expenses increased primarily as a result of expenses
related to the construction and operation of 14 new filling stations in 2006, as
well as continuing expenses related to the identification of possible locations
for additional filling stations and the governmental licensing and approval
process. In addition, sales and marketing costs increased in 2006 as we
increased our efforts to obtain new residential and commercial customers and
attract customers to our filling stations. General and administrative expenses
increased from $500,228 in 2005 to $1,287,735 in 2006 due to an increase in
personnel as a result of our growth.
We purchase all of our natural gas for resale from the Shaanxi Natural Gas
Co. Inc., a government-owned entity. As the government owns all land in China,
the government controls and owns all the natural resources coming from the
ground, thus the government controls the price and flow of the natural gas. As
China shifts from a centrally planned economy to a market economy, we believe
that it is in the government's best interest to keep prices stable, as they have
been for the last 3 years (See Note 8), and maintain a stable flow of supply.
The government has undertaken programs to promote the growth of the region in
which we are located. Therefore, we expect supply and price to continue to be
stable in the future.
For the year ended December 31, 2006, two suppliers accounted for 27.3%
and 17.6% of the total equipment we purchased for construction activities. We
believe that as a result of our relationships within the construction industry
and the construction equipment vendor community, and the availability of other
vendors to supply the construction equipment and materials, the loss of any one
of these two vendors would not have a material adverse effect on our operations.
Net Income. Net income increased to $5,451,095 for the twelve months ended
December 31, 2006, an increase of $4,199,012, from $1,252,083 for the twelve
months ended December 31, 2005. Increase in net income is attributed to our
material increase in revenues, partially offset by a higher increase in cost of
sales and operating expenses in 2006. The Company expects installation revenues
to increase on both an actual basis and as a percentage of revenue. In 2007, the
Company expects to add up to 30,000 pipeline customers and construct an
additional 15 filling stations, which the Company estimates will increase sales
of natural gas by 80 million cubic meters.
Income tax was $1,025,584 for the twelve months ended December 31, 2006,
as compared to $220,956 for the twelve months ended December 31, 2005. The
increase in income tax was attributed to the growth of construction and
installation fees and the sale of natural gas.
Liquidity and Capital Resources
As of December 31, 2006 the Company had $5,294,213 of cash and cash
equivalents on hand compared to $675,624 of cash and cash equivalents as of
December 31, 2005.
The primary sources of cash in 2006 were income from operations and
financing activities. The Company had net cash flows provided by operations of
$4,385,524 for the twelve months ended December 30, 2006 as compared to net cash
provided by operations of $1,935,871 in the corresponding period last year. The
increase in net cash flows from operations in 2006 as compared to 2005 was
mainly due to the increase in net income and an increase in other payables
during the twelve months ended December 31, 2006 offset by a decrease in
unearned revenue.
24
In January 2006, we completed several private placement offerings, which
generated net proceeds of $10,400,000, which were used for the construction of
natural gas filling stations, the purchase of raw materials and working capital.
Furthermore, in September 2006, the Company received $1,050,001 from the
exercise of 291,667 warrants.
Cash outflows for investing activities increased from $4,871,821 in 2005
to $9,738,469 in 2006 as a result of advance payments made to equipment
suppliers for investments necessary to construct and build 14 filling stations
and for construction materials used to build the pipelines to individual
households.
The Company expects to construct an additional 15 CNG filing stations in
2007. The Company expects the funds for these investing activities will come
from the Company's operating cash flow.
The Company is obligated to contribute $10 million of registered capital
to its wholly-owned subsidiary, Xilan Natural Gas Equipment Co. As of December
31, 2006, the Company had contributed $6,480,000 of this capital commitment and
is obligated to contribute the remaining $3,520,000 by February 2008.
We also will require financing of at least $40 million in order to
complete our proposed LNG Project.
Based on past performance and current expectations, we believe our cash
and cash equivalents, cash generated from operations, as well as future possible
cash investments, will satisfy our working capital needs, capital expenditures
(other than the LNG Project) and other liquidity requirements associated with
our operations for at least the next 12 months.
The majority of the Company's revenues and expenses were denominated
primarily in Renminbi ("RMB"), the currency of the People's Republic of China.
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.
OFF-BALANCE SHEET ARRANGEMENTS
We do not have any off-balance sheet arrangements that have or are
reasonably likely to have a current or future effect on our financial condition,
changes in financial condition, revenues or expenses, results of operations,
liquidity, capital expenditures or capital resources that are material to our
investors.
CRITICAL ACCOUNTING POLICIES
Use of Estimates
The preparation of financial statements in conformity with generally
accepted accounting principles requires us to make estimates and assumptions
that affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
25
Cash and Cash Equivalents
Cash and cash equivalents include cash on hand and cash in time deposits,
certificates of deposit and all highly liquid debt instruments with original
maturities of three months or less.
Accounts and Other Receivable
We maintain reserves for potential credit losses on accounts receivable.
We review the composition of accounts receivable and analyzes historical bad
debts, customer concentrations, customer credit worthiness, current economic
trends and changes in customer payment patterns to evaluate the adequacy of
these reserves. Reserves are recorded primarily on a specific identification
basis.
Inventory
Inventory is stated at the lower of cost, as determined on a first-in,
first-out basis, or market. We compare the cost of inventories with the market
value, and allowance is made for writing down the inventories to their market
value, if lower. Inventory consists of material used in the construction of
pipelines.
Property and Equipment
Property and equipment are stated at cost. Expenditures for maintenance
and repairs are charged to earnings as incurred; additions, renewals and
betterments are capitalized. When property and equipment are retired or
otherwise disposed of, the related cost and accumulated depreciation are removed
from the respective accounts, and any gain or loss is included in operations.
Depreciation of property and equipment is provided using the straight-line
method for substantially all assets with estimated lives as follows:
Office equipment 5 years
Operating equipment 5-20 years
Vehicles 5 years
Buildings 30 years
Construction In Progress
Construction in progress consists of the cost of constructing building and
plant for our company's use. The major cost of construction in progress relates
to material, labor and overhead.
Contracts in Progress
Contracts in progress consist of the cost of constructing pipelines for
customers. The major cost of construction relates to material, labor and
overhead. Revenue from construction and installation of pipelines is recorded
when the contract is completed and accepted by the customers. The construction
contracts are usually completed within one to two months time.
Revenue Recognition
Our revenue recognition policies are in compliance with Staff accounting
bulletin (SAB) 104. Revenue is recognized when services are rendered to our
customers when a formal arrangement exists, the price is fixed or determinable,
the delivery is completed, no other significant obligations by us exist and
collectibility is reasonably assured. Payments received before all of the
relevant criteria for revenue recognition are satisfied are recorded as unearned
revenue. Revenue from gas sales is recognized when gas is pumped through
pipelines to the end users. Revenue from construction and installation of
pipelines is recorded when the contract is completed and accepted by the
customers. The construction contracts are usually completed within one to two
months time.
26
Stock-Based Compensation
In October 1995, the FASB issued SFAS No. 123, "Accounting for Stock-Based
Compensation". SFAS No. 123 prescribes accounting and reporting standards for
all stock-based compensation plans, including employee stock options, restricted
stock, employee stock purchase plans and stock appreciation rights. SFAS No. 123
requires compensation expense to be recorded (i) using the new fair value method
or (ii) using the existing accounting rules prescribed by Accounting Principles
Board Opinion No. 25, "Accounting for stock issued to employees" (APB 25) and
related interpretations with pro forma disclosure of what net income and
earnings per share would have been had we adopted the new fair value method. We
use the intrinsic value method prescribed by APB 25 and has opted for the
disclosure provisions of SFAS No.123.
Income Taxes
We utilizes SFAS No. 109, "Accounting for Income Taxes," which requires
the recognition of deferred tax assets and liabilities for the expected future
tax consequences of events that have been included in the financial statements
or tax returns. Under this method, deferred income taxes are recognized for the
tax consequences in future years of differences between the tax bases of assets
and liabilities and their financial reporting amounts at each period end based
on enacted tax laws and statutory tax rates applicable to the periods in which
the differences are expected to affect taxable income. Valuation allowances are
established, when necessary, to reduce deferred tax assets to the amount
expected to be realized.
Local PRC Income Tax
Pursuant to the tax laws of China, general enterprises are subject to
income tax at an effective rate of 33%. The Company is in the natural gas
industry whose development is encouraged by the government. According to the
income tax regulation, any company engaged in the natural gas industry enjoys a
favorable tax rate. Accordingly, the Company's income is subject to a reduced
tax rate of 15%.
Foreign Currency Transactions and Comprehensive Income (Loss)
Accounting principles generally require that recognized revenue, expenses,
gains and losses be included in net income. Certain statements, however, require
entities to report specific changes in assets and liabilities, such as gain or
loss on foreign currency translation, as a separate component of the equity
section of the balance sheet. Such items, along with net income, are components
of comprehensive income. Our transactions occur in Chinese Renminbi. The unit of
Renminbi is in Yuan.
27
RECENT ACCOUNTING PRONOUNCEMENTS
In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error
Corrections." This statement applies to all voluntary changes in accounting
principle and requires retrospective application to prior periods' financial
statements of changes in accounting principle, unless this would be
impracticable. This statement also makes a distinction between "retrospective
application" of an accounting principle and the "restatement" of financial
statements to reflect the correction of an error. This statement is effective
for accounting changes and corrections of errors made in fiscal years beginning
after December 15, 2005.
In February 2006, FASB issued SFAS No. 155, "Accounting for Certain Hybrid
Financial Instruments". SFAS No. 155 amends SFAS No 133, "Accounting for
Derivative Instruments and Hedging Activities", and SFAF No. 140, "Accounting
for Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities". SFAS No. 155, permits fair value remeasurement for any hybrid
financial instrument that contains an embedded derivative that otherwise would
require bifurcation, clarifies which interest-only strips and principal-only
strips are not subject to the requirements of SFAS No. 133, establishes a
requirement to evaluate interest in securitized financial assets to identify
interests that are freestanding derivatives or that are hybrid financial
instruments that contain an embedded derivative requiring bifurcation, clarifies
that concentrations of credit risk in the form of subordination are not embedded
derivatives, and amends SFAS No. 140 to eliminate the prohibition on the
qualifying special-purpose entity from holding a derivative financial instrument
that pertains to a beneficial interest other than another derivative financial
instrument. This statement is effective for all financial instruments acquired
or issued after the beginning of the Company's first fiscal year that begins
after September 15, 2006.
In December 2004, the FASB issued FASB Statement No. 123R, "Share-Based
Payment, an Amendment of FASB Statement No. 123" ("FAS No. 123R"). FAS No. 123R
requires companies to recognize in the statement of operations the grant- date
fair value of stock options and other equity-based compensation issued to
employees. FAS No. 123R is effective beginning in the Company's first quarter of
fiscal 2006.
In June 2005, the EITF reached consensus on Issue No. 05-6, Determining
the Amortization Period for Leasehold Improvements ("EITF 05-6.") EITF 05-6
provides guidance on determining the amortization period for leasehold
improvements acquired in a business combination or acquired subsequent to lease
inception. The guidance in EITF 05-6 will be applied prospectively and is
effective for periods beginning after June 29, 2005. EITF 05-6 is not expected
to have a material effect on its consolidated financial position or results of
operations.
We believe that the adoption of these standards will have no material
impact on our financial statements.
28
ITEM 7. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
FINANCIAL STATEMENT INDEX
China Natural Gas, Inc. and Subsidiaries
Consolidated Financial Statements
Years Ended December 31, 2006and 2005
Contents
Page
Report of Independent Registered Public Accounting Firm F-1
Financial Statements:
Consolidated Balance Sheet as of December 31, 2006 F-2
Consolidated Statements of Operations and Other Comprehensive
Income for the years ended December 31, 2006 and 2005 F-3
Consolidated Statement of Stockholders' Equity for the years
ended December 31, 2006 and 2005 F-4
Consolidated Statements of Cash Flows for the years ended
December 31, 2006 and 2005 F-5
Notes to Consolidated Financial Statements F-6
29
Report of Independent Registered Public Accounting Firm
Board of Directors and Stockholders of
China Natural Gas, Inc.
We have audited the accompanying consolidated balance sheet of China Natural
Gas, Inc. and subsidiaries as of December 31, 2006, and the related consolidated
statements of operations and other comprehensive income, stockholders' equity,
and cash flows for the years ended December 31, 2006 and 2005. These
consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the
consolidated financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as well
as evaluating the overall consolidated financial statement presentation. We
believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of China
Natural Gas, Inc. and subsidiaries as of December 31, 2006, and the consolidated
results of their operations and their consolidated cash flows for the years
ended December 31, 2006 and 2005, in conformity with U.S. generally accepted
accounting principles.
/s/ Kabani & Company, Inc.
Certified Public Accountants
Los Angeles, California
March 12, 2007
F-1
CHINA NATURAL GAS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
AS OF DECEMBER 31, 2006
ASSETS
------
CURRENT ASSETS:
Cash & cash equivalents $ 5,294,213
Accounts receivable 569,037
Other receivable 813,839
Inventories 285,537
Advances 1,660,974
Prepaid expense and other current assets 305,524
-------------
Total current assets 8,929,124
PROPERTY AND EQUIPMENT, net 17,193,728
CONSTRUCTION IN PROGRESS 2,343,499
-------------
TOTAL ASSETS $ 28,466,351
=============
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
CURRENT LIABILITIES:
Accounts payable & accrued expense $ 406,212
Other payables 2,145,924
Unearned revenue 284,011
-------------
Total current liabilities 2,836,147
-------------
STOCKHOLDERS' EQUITY:
Preferred stock, $0.0001 per share;
authorized 5,000,000 shares; none issued -
Common stock, $0.0001 per share;
authorized 30,000,000 shares; -
issued and outstanding 24,210,183 2,421
Additional paid in capital 18,223,911
Accumulative other comprehensive income 839,452
Statutory reserve 750,886
Retained earnings 5,813,534
-------------
Total stockholders' equity 25,630,204
-------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 28,466,351
=============
The accompanying notes are an integral part of
these consolidated financial statements
F-2
CHINA NATURAL GAS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME AND OTHER COMPREHENSIVE INCOME
FOR THE YEARS ENDED DECEMBER 31, 2006 AND 2005
December 31,
2006 2005
------------- -------------
Net revenue
Natural gas revenue $ 13,713,145 $ 1,687,154
Construction / installation revenue 5,115,645 3,163,545
------------- -------------
Total revenue 18,828,790 4,850,699
Cost of sales
Natural gas cost 7,663,060 1,293,585
Construction / installation cost 2,054,940 1,110,452
------------- -------------
9,718,000 2,404,037
------------- -------------
Gross profit 9,110,790 2,446,662
Operating expenses
Selling expenses 1,308,464 474,855
General and administrative expenses 1,287,735 500,228
------------- -------------
Total operating expenses 2,596,199 975,083
------------- -------------
Income from operations 6,514,591 1,471,579
Non-operating income (expense):
Interest income 41,109 2,131
Other expense (79,021) (671)
------------- -------------
Total non-operating income (expense) (37,912) 1,460
------------- -------------
Income before income tax 6,476,679 1,473,039
Income tax 1,025,584 220,956
------------- -------------
Net income 5,451,095 1,252,083
Other comprehensive income
Foreign currency translation gain 610,705 228,175
------------- -------------
Comprehensive Income $ 6,061,800 $ 1,480,258
============= =============
Weighted average shares outstanding
Basic and diluted 23,872,936 16,269,528
============= =============
Earnings per share
Basic and diluted $ 0.23 $ 0.08
============= =============
Basic and diluted are the same because there is no anti-dilutive effect
The accompanying notes are an integral part of these
consolidated financial statements
F-3
CHINA NATURAL GAS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2006 AND 2005
Accumulative
Additional Other Total
Common Stock Paid Comprehensive Statutory Retained Stockholders'
Shares Amount in Capital Income Reserve Earnings Equity
----------- ----------- ----------- ----------- ----------- ----------- -----------
Balance January 1, 2005 9,275,362 $ 928 $ 4,831,468 $ 572 $ 3,457 $ (142,215) $ 4,694,210
Shares issued for cash 6,724,638 672 3,503,788 - - - 3,504,460
Recapitalization on
reverse acquisition 4,204,088 420 (3,798) - - - (3,378)
Cumulative translation adjustment - - - 228,175 - - 228,175
Net Income for the year
ended December 31, 2005 - - - - - 1,252,083 1,252,083
Transfer to statutory reserve - - - - 166,265 (166,265) -
----------- ----------- ----------- ----------- ----------- ----------- -----------
Balance December 31, 2005
20,204,088 2,020 8,331,458 228,747 169,722 943,603 9,675,550
Shares issued for cash 3,714,428 371 10,399,629 - - - 10,400,000
Offering costs - - (1,557,147) - - - (1,557,147)
Exercise of warrants for cash 291,667 30 1,049,971 - - - 1,050,001
Cumulative translation adjustment - - - 610,705 - - 610,705
Net Income for the year
ended December 31, 2006 - - - - - 5,451,095 5,451,095
Transfer to statutory reserve - - - - 581,164 (581,164) -
----------- ----------- ----------- ----------- ----------- ----------- -----------
Balance December 31, 2006 24,210,183 $ 2,421 $18,223,911 $ 839,452 $ 750,886 $ 5,813,534 $25,630,204
=========== =========== =========== =========== =========== =========== ===========
The accompanying notes are an integral part of these
consolidated financial statements
F-4
CHINA NATURAL GAS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2006 AND 2005
Years Ended December 31,
2006 2005
------------- -------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 5,451,095 $ 1,252,083
Adjustments to reconcile net income to net cash
provided by operating activities:
Loss on disposal of property - 971
Depreciation and amortization 731,723 347,923
(Increase) / decrease in assets:
Accounts receivable (550,831) (1,011)
Other receivable (636,262) (132,553)
Inventories (233,582) 2,234
Advances (1,611,967) (12,773)
Prepaid expense and other current assets (282,103) (15,441)
Contract in progress - 381,315
Increase / (decrease) in current liabilities:
Accounts payable & accrued expense 201,661 92,427
Other payables 1,352,866 662,950
Unearned revenue (28,882) (642,254)
Due to affiliate (8,194) -
------------- -------------
Net cash provided by operating activities 4,385,524 1,935,871
------------- -------------
CASH FLOWS FROM INVESTING ACTIVITIES
Payment on purchase of property and equipment (9,192,482) (3,170,629)
Cash acquired in reverse merger transaction - 86
Additions to construction in progress (545,987) (1,700,792)
Additions to Intangible assets - (1,096)
Proceeds from disposal of property - 610
------------- -------------
Net cash used in investing activities (9,738,469) (4,871,821)
------------- -------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Stock issued for cash 10,400,000 3,504,460
Proceeds from exercise of warrants 1,050,001 -
Payment of offering costs (1,557,147) -
------------- -------------
Net cash provided by in financing activities 9,892,854 3,504,460
------------- -------------
Effect of exchange rate changes on cash and cash equivalents 78,680 44,116
NET INCREASE IN CASH & CASH EQUIVALENTS 4,618,589 612,626
CASH & CASH EQUIVALENTS, BEGINNING OF YEAR 675,624 62,998
------------- -------------
CASH & CASH EQUIVALENTS, END OF YEAR $ 5,294,213 $ 675,624
============= =============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Interest paid $ - $ -
============= =============
Income taxes paid $ - $ 969
============= =============
The accompanying notes are an integral part of these
consolidated financial statements
F-5
China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
For the Years Ended December 31, 2006 and 2005
Note 1 - Organization and Basis of Presentation
Organization and Line of Business
Xi'an Xilan Natural Gas Co, Ltd. ("XXNGC") was incorporated on January 8, 2000
in Xi'an city in the Shaanxi province, China. The core business of XXNGC is
distribution of natural gas to commercial, industrial and residential customers,
construction of pipeline networks, and installation of natural gas fittings and
parts for end-users. XXNGC has an exclusive permit to provide gas utility
service in Lantian County, Lintong and Baqiao District of Xi'an city, China.
On December 6, 2005, XXNGC entered into and closed a share purchase agreement
with Coventure International, Inc. ("Coventure"), a public shell in the United
States of America. Pursuant to the purchase agreement, Coventure acquired all of
the issued and outstanding capital stock of XXNGC in exchange for 16,000,000
(post-split) shares of Coventure's common stock.
Concurrently with the closing of the purchase agreement and as a condition
thereof, Coventure entered into an agreement with John Hromyk, its President and
Chief Financial Officer, pursuant to which Mr. Hromyk returned 23,884,712
(post-split) shares of Coventure's common stock for cancellation. Upon
completion of the foregoing transactions, Coventure had an aggregate of
20,204,088 (post-split) shares of common stock issued and outstanding.
As a result of the merger, XXNGC's stockholders own approximately 80% of the
combined company and the directors and executive officers of XXNGC became the
directors and executive officers of the Coventure. Accordingly, the transaction
has been accounted for as a reverse acquisition of Coventure by XXNGC resulting
in a recapitalization of XXNGC rather than as a business combination. XXNGC is
deemed to be the purchaser and surviving company for accounting purposes.
Accordingly, its assets and liabilities are included in the balance sheet at
their historical book values and the results of operations of XXNGC have been
presented for the comparative prior period. The historical cost of the net
liabilities of Coventure that were acquired was $3,378. Pro forma information is
not presented as the financial statements of Coventure are insignificant. In
addition, Coventure changed it name to China Natural Gas, Inc. (hereafter
referred to as the "Company") and the stockholders approved a stock dividend of
three shares for each share held, which has been accounted for as a four to one
forward stock split. All shares and per share data have been restated
retrospectively.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of China
Natural Gas, Inc. and its wholly owned subsidiaries, XXNGC, Shaanxi Natural Gas
Equipment Co., Ltd (incorporated in February 2006) and Shaanxi Jingbian
Liquefied Natural Gas Co., Ltd (incorporated in October 2006). All inter-company
accounts and transactions have been eliminated in consolidation.
F-6
China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
For the Years Ended December 31, 2006 and 2005
Basis of Presentation
The accompanying consolidated financial statements have been prepared in
conformity with accounting principles generally accepted in the United States of
America. The Company's functional currency is the Chinese Renminbi; however the
accompanying consolidated financial statements have been translated and
presented in United States Dollars ($).
Foreign Currency Translation
As of December 31, 2006 and 2005, the accounts of the Company were maintained,
and their consolidated financial statements were expressed in the Chinese Yuan
Renminbi (CNY). Such consolidated financial statements were translated into U.S.
Dollars (USD) in accordance with Statement of Financial Accounts Standards
("SFAS") No. 52, "Foreign Currency Translation," with the CNY as the functional
currency. According to the Statement, all assets and liabilities were translated
at the exchange rate on the balance sheet date, stockholder's equity are
translated at the historical rates and statement of operations items are
translated at the weighted average exchange rate for the year. The resulting
translation adjustments are reported under other comprehensive income in
accordance with SFAS No. 130, "Reporting Comprehensive Income."
Note 2 - Summary of Significant Accounting Policies
Use of Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
Cash and Cash Equivalents
Cash and cash equivalents include cash on hand and cash in bank.
Accounts Receivable and Other Receivable
Accounts receivable are recorded at net realizable value consisting of the
carrying amount less an allowance for uncollectible accounts, as needed. The
Company allowance for uncollectible accounts is not significant.
The Company maintains reserves for potential credit losses on accounts
receivable. Management reviews the composition of accounts receivable and
analyzes historical bad debts, customer concentrations, customer credit
worthiness, current economic trends and changes in customer payment patterns to
evaluate the adequacy of these reserves. Reserves are recorded primarily on a
specific identification basis. The Company's management determined that all
receivables are good and there is no need of reserve for bad debts as on
December 31, 2006.
F-7
China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
For the Years Ended December 31, 2006 and 2005
As of December 31, 2006, total other receivable was $813,839, including $478,118
in advances to employees and $335,721 to other unrelated companies. These
receivables are unsecured, interest free, due on demand, and all current.
Advances
The Company advances to certain vendors (for purchase of its material and
equipment) and a consultant. The advances are interest free and unsecured.
Inventory
Inventory is stated at the lower of cost, as determined on a first-in, first-out
basis, or market. Management compares the cost of inventories with the market
value, and allowance is made for writing down the inventories to their market
value, if lower. Inventory consists of material used in the construction of
pipelines and natural gas.
Property and Equipment
Property and equipment are stated at cost. Expenditures for maintenance and
repairs are charged to earnings as incurred; additions, renewals and betterments
are capitalized. When property and equipment are retired or otherwise disposed
of, the related cost and accumulated depreciation are removed from the
respective accounts, and any gain or loss is included in operations.
Depreciation of property and equipment is provided using the straight-line
method for substantially all assets with estimated lives as follows:
Office equipment 5 years
Operating equipment 5-20 years
Vehicles 5 years
Buildings 30 years
At December 31, 2006, the following are the details of the property and
equipment:
Office equipment $ 73,636
Operating equipment 13,219,979
Vehicles 1,210,552
Buildings 4,559,003
----------------
19,063,170
Less accumulated depreciation 1,869,442
----------------
$ 17,193,728
================
Depreciation expense for the years ended December 31, 2006 and 2005 was
$731,497and $347,923, respectively.
Long-Lived Assets
F-8
China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
For the Years Ended December 31, 2006 and 2005
Effective January 1, 2002, the Company adopted Statement of Financial Accounting
Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived
Assets" ("SFAS 144"), which addresses financial accounting and reporting for the
impairment or disposal of long-lived assets and supersedes SFAS No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
be Disposed Of," and the accounting and reporting provisions of APB Opinion No.
30, "Reporting the Results of Operations for a Disposal of a Segment of a
Business." The Company periodically evaluates the carrying value of long-lived
assets to be held and used in accordance with SFAS 144. SFAS 144 requires
impairment losses to be recorded on long-lived assets used in operations when
indicators of impairment are present and the undiscounted cash flows estimated
to be generated by those assets are less than the assets' carrying amounts. In
that event, a loss is recognized based on the amount by which the carrying
amount exceeds the fair market value of the long-lived assets. Loss on
long-lived assets to be disposed of is determined in a similar manner, except
that fair market values are reduced for the cost of disposal. Based on its
review, the Company believes that, as of December 31, 2006 there were no
significant impairments of its long-lived assets.
Construction In Progress
Construction in progress consist of the cost of constructing fixed assets for
the Company's use. The major cost of construction in progress relates to
material, labor and overhead.
Contracts In Progress
Contracts in progress consist of the cost of constructing pipelines for
customers. The major cost of construction relates to material, labor and
overhead. Revenue from construction and installation of pipelines is recorded
when the contract is completed and accepted by the customers. The construction
contracts are usually completed within one to two months time. As of December
31, 2006, the Company has no contracts in progress.
Fair Value of Financial Instruments
Statement of financial accounting standard No. 107, Disclosures about fair value
of financial instruments, requires that the Company disclose estimated fair
values of financial instruments. The carrying amounts reported in the statements
of financial position for current assets and current liabilities qualifying as
financial instruments are a reasonable estimate of fair value.
Revenue Recognition
The Company's revenue recognition policies are in compliance with Staff
accounting bulletin (SAB) 104. Revenue is recognized when services are rendered
to customers when a formal arrangement exists, the price is fixed or
determinable, the delivery is completed, no other significant obligations of the
Company exist and collectibility is reasonably assured. Payments received before
all of the relevant criteria for revenue recognition are satisfied are recorded
as unearned revenue. Revenue from gas sales is recognized when gas is pumped
through pipelines to the end users. Revenue from construction and installation
of pipelines is recorded when the contract is completed and accepted by the
customers. The construction contracts are usually completed within one to two
months time.
F-9
China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
For the Years Ended December 31, 2006 and 2005
Unearned Revenue
Unearned revenue represents prepayments by customers for gas purchases and
advance payments on construction and installation of pipeline contracts. The
Company records such prepayment as unearned revenue when the payments are
received.
Advertising Costs
The Company expenses the cost of advertising as incurred or, as appropriate, the
first time the advertising takes place. Advertising costs for the years ended
December 31, 2006 and 2005 were insignificant.
Stock-Based Compensation
The Company accounts for its stock-based compensation in accordance with
Statement of Financial Accounting Standards ("SFAS") No. 123R, "Share-Based
Payment, an Amendment of Financial Accounting Standards Board ("FASB") Statement
No. 123." The Company recognizes in the statement of operations the grant-date
fair value of stock options and other equity-based compensation issued to
employees and non-employees. The Company did not grant any options and no
options were cancelled or exercised during the period ended December 31, 2006
and 2005. As of December 31, 2006, there were no options outstanding.
Income Taxes
The Company utilizes SFAS No. 109, "Accounting for Income Taxes," which requires
the recognition of deferred tax assets and liabilities for the expected future
tax consequences of events that have been included in the financial statements
or tax returns. Under this method, deferred income taxes are recognized for the
tax consequences in future years of differences between the tax bases of assets
and liabilities and their financial reporting amounts at each period end based
on enacted tax laws and statutory tax rates applicable to the periods in which
the differences are expected to affect taxable income. Valuation allowances are
established, when necessary, to reduce deferred tax assets to the amount
expected to be realized. At December 31, 2006, there was no significant book to
tax differences. There is no difference between book depreciation and tax
depreciation as the Company uses the same method for both book and tax.
Local PRC Income Tax
Pursuant to the tax laws of China, general enterprises are subject to income tax
at an effective rate of 33%. The Company is in the natural gas industry whose
development is encouraged by the government. According to the income tax
regulation, any company engaged in the natural gas industry enjoys a favorable
tax rate. Accordingly, the Company's income is subject to a reduced tax rate of
15%.
A reconciliation of tax at United States federal statutory rate to provision for
income tax recorded in the financial statements is as follows:
F-10
China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
For the Years Ended December 31, 2006 and 2005
For the Years
Ended December 31,
2006 2005
-------- --------
Tax provision (credit) at statutory rate 34% (34%)
Foreign tax rate difference (15%) 19%
Change in valuation allowance - 15%
-------- --------
19% -
======== ========
Basic and Diluted Earning Per Share
Earning per share is calculated in accordance with the Statement of Financial
Accounting Standards No. 128 ("SFAS No. 128"), "Earnings per share". SFAS No.
128 superseded Accounting Principles Board Opinion No.15 (APB 15). Net earning
per share for all periods presented has been restated to reflect the adoption of
SFAS No. 128. Basic net earning per share is based upon the weighted average
number of common shares outstanding. Diluted net earning per share is based on
the assumption that all dilutive convertible shares and stock options were
converted or exercised. At December 31, 2006, the Company had outstanding
1,140,286 warrants. The average stock price for the year ended December 31, 2006
was less than the exercise price of the warrants; therefore, the warrants are
not factored into the diluted earning per share calculation as they are
anti-dilutive.
Statement of Cash Flows
In accordance with Statement of Financial Accounting Standards No. 95,
"Statement of Cash Flows," cash flows from the Company's operations is
calculated based upon the local currencies. As a result, amounts related to
assets and liabilities reported on the statement of cash flows will not
necessarily agree with changes in the corresponding balances on the balance
sheet. The Company paid $0 and $0 for interest and $229,547 and $969 for income
taxes during the years ended December 31, 2006 and 2005 respectively.
Segment Reporting
Statement of Financial Accounting Standards No. 131 ("SFAS 131"), "Disclosure
About Segments of an Enterprise and Related Information" requires use of the
"management approach" model for segment reporting. The management approach model
is based on the way a company's management organizes segments within the company
for making operating decisions and assessing performance. Reportable segments
are based on products and services, geography, legal structure, management
structure, or any other manner in which management disaggregates a company. SFAS
131 has no effect on the Company's consolidated financial statements as the
Company consists of one reportable business segment. All revenue is from
customers in People's Republic of China. All of the Company's assets are located
in People's Republic of China.
F-11
China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
For the Years Ended December 31, 2006 and 2005
Recent Pronouncements
In February 2006, FASB issued SFAS No. 155, "Accounting for Certain Hybrid
Financial Instruments". SFAS No. 155 amends SFAS No 133, "Accounting for
Derivative Instruments and Hedging Activities", and SFAF No. 140, "Accounting
for Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities". SFAS No. 155, permits fair value remeasurement for any hybrid
financial instrument that contains an embedded derivative that otherwise would
require bifurcation, clarifies which interest-only strips and principal-only
strips are not subject to the requirements of SFAS No. 133, establishes a
requirement to evaluate interest in securitized financial assets to identify
interests that are freestanding derivatives or that are hybrid financial
instruments that contain an embedded derivative requiring bifurcation, clarifies
that concentrations of credit risk in the form of subordination are not embedded
derivatives, and amends SFAS No. 140 to eliminate the prohibition on the
qualifying special-purpose entity from holding a derivative financial instrument
that pertains to a beneficial interest other than another derivative financial
instrument. This statement is effective for all financial instruments acquired
or issued after the beginning of the Company's first fiscal year that begins
after September 15, 2006. The Company has not evaluated the impact of this
pronouncement its financial statements.
In March 2006, FASB issued SFAS No. 156, "Accounting for Servicing of Financial
Assets - an amendment to FASB Statement No. 140." The new standard requires
recognition of servicing assets in connection with any obligation to service a
financial asset arising from 1) a servicing contract entered into as part of a
transfer of assets meeting the requirements for sale accounting, 2) the transfer
of assets to a special purpose entity in a guaranteed mortgage securitization
where the transferor retains a controlling interest in the securitized asset, or
3) an acquisition or assumption of obligations to service financial assets not
related to the servicer or its consolidated affiliates. The servicing assets and
liabilities must be measured at fair value initially, if practicable, and the
assets or liabilities must either be amortized or recorded at fair value at each
reporting date. The statement allows a one-time reclassification for entities
with servicing rights and subsequently requires separate presentation of
servicing assets and liabilities at fair value in the statement of financial
position. This statement is effective for the first fiscal year beginning after
September 15, 2006, with earlier adoption permitted. The Company does not expect
this implementation to have a material effect on our consolidated financial
statements.
In September 2006, FASB issued SFAS 157 `Fair Value Measurements'. This
Statement defines fair value, establishes a framework for measuring fair value
in generally accepted accounting principles (GAAP), and expands disclosures
about fair value measurements. This Statement applies under other accounting
pronouncements that require or permit fair value measurements, the Board having
previously concluded in those accounting pronouncements that fair value is the
relevant measurement attribute. Accordingly, this Statement does not require any
new fair value measurements. However, for some entities, the application of this
Statement will change current practice. This Statement is effective for
financial statements issued for fiscal years beginning after November 15, 2007,
and interim periods within those fiscal years. The management is currently
evaluating the effect of this pronouncement on financial statements.
In September 2006, FASB issued SFAS 158 `Employers' Accounting for Defined
Benefit Pension and Other Postretirement Plans--an amendment of FASB Statements
No. 87, 88, 106, and 132(R)' This Statement improves financial reporting by
requiring an employer to recognize the overfunded or underfunded status of a
defined benefit postretirement plan (other than a multiemployer plan) as an
asset or liability in its statement of financial position and to recognize
changes in that funded status in the year in which the changes occur through
comprehensive income of a business entity or changes in unrestricted net assets
of a not-for-profit organization. This Statement also improves financial
reporting by requiring an employer to measure the funded status of a plan as of
the date of its year-end statement of financial position, with limited
exceptions. An employer with publicly traded equity securities is required to
initially recognize the funded status of a defined benefit postretirement plan
and to provide the required disclosures as of the end of the fiscal year ending
after December 15, 2006. An employer without publicly traded equity securities
is required to recognize the funded status of a defined benefit postretirement
plan and to provide the required disclosures as of the end of the fiscal year
ending after June 15, 2007. However, an employer without publicly traded equity
securities is required to disclose the following information in the notes to
financial statements for a fiscal year ending after December 15, 2006, but
before June 16, 2007, unless it has applied the recognition provisions of this
Statement in preparing those financial statements. The requirement to measure
plan assets and benefit obligations as of the date of the employer's fiscal
year-end statement of financial position is effective for fiscal years ending
after December 15, 2008. The management is currently evaluating the effect of
this pronouncement on financial statements.
F-12
China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
For the Years Ended December 31, 2006 and 2005
In February of 2007 the FASB issued SFAS 159, "The Fair Value Option for
Financial Assets and Financial Liabilities--Including an amendment of FASB
Statement No. 115." The statement permits entities to choose to measure many
financial instruments and certain other items at fair value. The objective is to
improve financial reporting by providing entities with the opportunity to
mitigate volatility in reported earnings caused by measuring related assets and
liabilities differently without having to apply complex hedge accounting
provisions. The statement is effective as of the beginning of an entity's first
fiscal year that begins after November 15, 2007. The company is analyzing the
potential accounting treatment.
FASB Staff Position on FAS No. 115-1 and FAS No. 124-1 ("the FSP"), "The Meaning
of Other-Than-Temporary Impairment and Its Application to Certain Investments,"
was issued in November 2005 and addresses the determination of when an
investment is considered impaired, whether the impairment on an investment is
other-than-temporary and how to measure an impairment loss. The FSP also
addresses accounting considerations subsequent to the recognition of
other-than-temporary impairments on a debt security, and requires certain
disclosures about unrealized losses that have not been recognized as
other-than-temporary impairments. The FSP replaces the impairment guidance on
Emerging Issues Task Force (EITF) Issue No. 03-1 with references to existing
authoritative literature concerning other-than-temporary determinations. Under
the FSP, losses arising from impairment deemed to be other-than-temporary, must
be recognized in earnings at an amount equal to the entire difference between
the securities cost and its fair value at the financial statement date, without
considering partial recoveries subsequent to that date. The FSP also required
that an investor recognize other-than-temporary impairment losses when a
decision to sell a security has been made and the investor does not expect the
fair value of the security to fully recover prior to the expected time of sale.
The FSP is effective for reporting periods beginning after December 15, 2005.
The adoption of this statement will not have a material impact on our
consolidated financial statements.
F-13
China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
For the Years Ended December 31, 2006 and 2005
FASB Interpretation 48 prescribes a recognition threshold and a measurement
attribute for the financial statement recognition and measurement of a tax
position taken or expected to be taken in a tax return. Benefits from tax
positions should be recognized in the financial statements only when it is more
likely than not that the tax position will be sustained upon examination by the
appropriate taxing authority that would have full knowledge of all relevant
information. The amount of tax benefits to be recognized for a tax position that
meets the more-likely-than-not recognition threshold is measured as the largest
amount of benefit that is greater than fifty percent likely of being realized
upon ultimate settlement. Tax benefits relating to tax positions that previously
failed to meet the more-likely-than-not recognition threshold should be
recognized in the first subsequent financial reporting period in which that
threshold is met or certain other events have occurred. Previously recognized
tax benefits relating to tax positions that no longer meet the
more-likely-than-not recognition threshold should be derecognized in the first
subsequent financial reporting period in which that threshold is no longer met.
Interpretation 48 also provides guidance on the accounting for and disclosure of
tax reserves for unrecognized tax benefits, interest and penalties and
accounting in interim periods. Interpretation 48 is effective for fiscal years
beginning after December 15, 2006. The change in net assets as a result of
applying this pronouncement will be a change in accounting principle with the
cumulative effect of the change required to be treated as an adjustment to the
opening balance of retained earnings on January 1, 2007, except in certain cases
involving uncertainties relating to income taxes in purchase business
combinations. In such instances, the impact of the adoption of Interpretation 48
will result in an adjustment to goodwill. While the Company analysis of the
impact of adopting Interpretation 48 is not yet complete, it do not currently
anticipate it will have a material impact on the Company's consolidated
financial statements.
In September 2006, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 108, "Considering the Effects of Prior Year
Misstatements when Quantifying Misstatements in Current Year Financial
Statements," ("SAB 108"),which provides interpretive guidance on the
consideration of the effects of prior year misstatements in quantifying current
year misstatements for the purpose of a materiality assessment. The Company
adopted SAB 108 in the fourth quarter of 2006 with no impact on its consolidated
financial statements.
Note 3 - Other Payables
Other payable consists of the following as of December 31, 2006:
Other accounts payable $ 228,817
Welfare payable 19,679
Tax payable 1,866,688
Other levies 30,740
---------------
$ 2,145,924
===============
Note 4 - Stockholders' Equity
Common stock
F-14
China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
For the Years Ended December 31, 2006 and 2005
On January 6, 2006 and January 9, 2006, the Company entered into securities
purchase agreements with four accredited investors and completed the sale of
$5,380,000 of units. The units contained an aggregate of 1,921,572 shares of
common stock and 523,055 common stock purchase warrants. Each common stock
purchase warrant is exercisable for a period of three years at an exercise price
of $3.60 per share. Pursuant to the terms of the warrant, each investor has
contractually agreed to restrict its ability to exercise the warrants to an
amount which would not exceed the difference between the number of shares of
common stock beneficially owned by the holder or issuable upon exercise of the
warrant held by such holder and 9.9% of the outstanding shares of common stock
of the Company.
In connection with the offering, the Company paid a placement fee of 10% of the
proceeds in cash, together with non-accountable expenses in the amount of 3% of
the proceeds, in cash. In addition, the placement agent was issued warrants to
purchase 298,888 shares of common stock on the same terms and conditions as the
investors. The warrants issued to the placement agent are being treated as a
cost of raising capital. The warrants were valued using the Black Scholes
pricing model; however, recording the value of the warrants in the financial
statements has no impact as the value of the warrants is both debited and
credited to additional paid in capital.
On January 10, 2006 through January 13, 2006, the Company entered into
securities purchase agreements with four accredited investors and completed the
sale of $2,195,198 of units. The units contained an aggregate of 783,999 shares
of common stock and 213,422 common stock purchase warrants. Each common stock
purchase warrant is exercisable for a period of three years at an exercise price
of $3.60 per share. Pursuant to the terms of the warrant, each investor has
contractually agreed to restrict its ability to exercise the warrants to an
amount which would not exceed the difference between the number of shares of
common stock beneficially owned by the holder or issuable upon exercise of the
warrant held by such holder and 9.9% of the outstanding shares of common stock
of the Company.
In connection with the offering, the Company paid a placement fee of 10% of the
proceeds in cash, together with non-accountable expenses in the amount of 3% of
the proceeds, in cash. In addition, the placement agent was issued warrants to
purchase 121,955 shares of common stock on the same terms and conditions as the
investors. The warrants issued to the placement agent are being treated as a
cost of raising capital. The warrants were valued using the Black Scholes
pricing model; however, recording the value of the warrants in the financial
statements has no impact as the value of the warrants is both debited and
credited to additional paid in capital.
On January 17, 2006, the Company entered into securities purchase agreements
with an accredited investor and completed the sale of $2,824,802 of units. The
units contained an aggregate of 1,008,857 shares of common stock and 274,633
common stock purchase warrants. Each common stock purchase warrant is
exercisable for a period of three years at an exercise price of $3.60 per share.
Pursuant to the terms of the warrant, each investor has contractually agreed to
restrict its ability to exercise the warrants to an amount which would not
exceed the difference between the number of shares of common stock beneficially
owned by the holder or issuable upon exercise of the warrant held by such holder
and 9.9% of the outstanding shares of common stock of the Company.
In September 2006, the Company received $1,050,001 from the exercise of 291,667
warrants.
Warrants
F-15
China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
For the Years Ended December 31, 2006 and 2005
Following is a summary of the warrant activity:
Weighted
Average Aggregate
Warrants Exercise Intrinsic
outstanding Price Value
Outstanding, December 31, 2005 - - -
Granted 1,431,953 $3.60
Forfeited - -
Exercised (291,667) $3.60
------------
Outstanding, December 31, 2006 1,140,286 $3.60 $ 0
============
Following is a summary of the status of warrants outstanding at December 31,
2006:
Outstanding Warrants Exercisable Warrants
Average
Remaining
Exercise Contractual Average Exercise
Price Number Life Price Number
$3.60 1,140,286 2.03 $3.60 1,140,286
Note 5 - Employee Welfare Plan
The Company has established its own employee welfare plan in accordance with
Chinese law and regulations. The Company makes annual contributions of 14% of
all employees' salaries to employee welfare plan. The total expense for the
above plan was $51,765 and $13,275 for the years ended December 31, 2006 and
2005, respectively.
Note 6 - Statutory Common Welfare Fund
As stipulated by the Company Law of the People's Republic of China (PRC) as
applicable to Chinese companies with foreign ownership, net income after
taxation can only be distributed as dividends after appropriation has been made
for the following:
i. Making up cumulative prior years' losses, if any;
F-16
China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
For the Years Ended December 31, 2006 and 2005
ii. Allocations to the "Statutory surplus reserve" of at least 10% of
income after tax, as determined under PRC accounting rules and
regulations, until the fund amounts to 50% of the Company's
registered capital;
iii. Allocations of 5-10% of income after tax, as determined under PRC
accounting rules and regulations, to the Company's "Statutory common
welfare fund", which is established for the purpose of providing
employee facilities and other collective benefits to the Company's
employees; and
iv. Allocations to the discretionary surplus reserve, if approved in the
shareholders' general meeting.
The Company has appropriated $581,164 and $166,265 as reserve for the statutory
surplus reserve and welfare fund for the years ended December 31, 2006 and 2005,
respectively.
Note 7 - Earnings Per Share
Earnings (loss) per share for the years ended December 31, 2006 and 2005 is
determined by dividing net income (loss) for the periods by the weighted average
number of both basic and diluted shares of common stock and common stock
equivalents outstanding. There were no common stock equivalents that were
dilutive during the year ended December 31, 2006 and 2005; accordingly, basic
and diluted earning per share were the same for all periods presented.
Note 8 - Current Vulnerability Due to Certain Concentrations
For the years ended December 31, 2006 and 2005, the Company purchased all of the
natural gas for resale from one vendor, Shaanxi Natural Gas Co., Ltd., a
government owned enterprise. No amount was owing to this vendor at December 31,
2006. The Company has had annual agreements with Shaanxi Natural Gas that
requires the Company to purchase a minimum amount of natural gas. For the years
ended December 31, 2006 and 2005 the minimum purchases were 2.36 million and
1.60 million cubic meters, respectively. In the past, contracts were renewed on
an annual basis. However, as the volume of usage has increased, Shaanxi Natural
Gas has revised their policies, and contract terms are now six months and
subject to review prior to renewal. The Company's management reports that it
does not expect any issues or difficulty in continuing to renew the supply
contracts going forward. Price points for natural gas are strictly controlled by
the government and have remained stable over the past 3 years.
For the year ended December 31, 2006, two suppliers accounted for 27.3% and
17.6% of the total equipment purchased by the Company and for the year ended
December 31, 2005, two suppliers accounted for 51.5% and 13.3% of the total
equipment purchased by the Company.
Four customers accounted for 46.5%, 18.1%, 7.7% and 6.1% of the Company's
installation revenue for the year ended December 31, 2006 and four customers
accounted for 34.7%, 21.2% , 14.0% and 10.8% of the Company's installation
revenue for the years ended December 31, 2005.
F-17
China Natural Gas, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
For the Years Ended December 31, 2006 and 2005
The Company's operations are carried out in the People's Republic of China.
Accordingly, the Company's business, financial condition and results of
operations may be influenced by the political, economic and legal environments
in the People's Republic of China, by the general state of the People's Republic
of China`s economy. The Company's business may be influenced by changes in
governmental policies with respect to laws and regulations, anti-inflationary
measures, currency conversion and remittance abroad, and rates and methods of
taxation, among other things.
Note 9 - Commitments and Contingencies
The Company is obligated to contribute $10,000,000 as registered capital of
Xilan Natural Gas Equipment Company, a 100% subsidiary of CHNG incorporated
under the laws of PRC in February, 2006. The Company has already made a capital
contribution of $6,480,000 and the Company remains obligated to contribute the
additional $3,520,000 by February 2008.
F-18
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
No.
ITEM 8A. CONTROLS AND PROCEDURES
As of the end of the period covered by this report, we conducted an
evaluation, under the supervision and with the participation of our chief
executive officer and principal financial officer of our disclosure controls and
procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) of the Exchange
Act). Based upon this evaluation, our chief executive officer and principal
financial officer concluded that our disclosure controls and procedures are
effective to ensure that information required to be disclosed by us in the
reports that we file or submit under the Exchange Act is recorded, processed,
summarized and reported, within the time periods specified in the Commission's
rules and forms. There was no change in our internal controls or in other
factors that could affect these controls during our last fiscal year that has
materially affected, or is reasonably likely to materially affect, our internal
control over financial reporting.
ITEM 8B. OTHER INFORMATION
In 2006, the Company, through its wholly-owned subsidiary, Xilan Liquefied
Natural Gas Ltd, entered into an agreement with China National Petroleum
Corporation, a government owned entity ("CNPC") pursuant to which CNPC will
supply 150,000,000 cubic meters of natural gas annually upon the completion of
our LNG project.
In 2006, the Company, through its wholly-owned subsidiary Xian Xilan Natural Gas
Co. entered into a five-year contract with China Petrochemical to supply the
Company 350,000 cubic meters of CNG daily and to supply the Company with CNG for
a Company owned filling station in Henan Province.
PART III
ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE
WITH SECTION 16(a) OF THE EXCHANGE ACT.
Below are the names and certain information regarding our executive
officers and directors:
Director
Name Age Position Since
--------------------------------------------------------------------------------
Qinan Ji........................ 49 Chief Executive Officer 2005
and Chairman of the Board
Xiaogang Zhu.................... 52 Chief Financial Officer
Zhiqiang Wang................... 67 Director 2006
Patrick McManus................. 54 Director 2006
James Garner.................... 60 Director 2006
Officers are elected annually by the Board of Directors, at our annual meeting,
to hold such office until an officer's successor has been duly appointed and
qualified, unless an officer sooner dies, resigns or is removed by the Board.
30
Background of Executive Officers and Directors
Qinan Ji, Chairman of the Board of Directors - Mr. Ji joined Xilan as the
Chairman of the Board of Directors in 2005. In 1996, he founded the Anxian Hotel
in Weinan City in Shaanxi Province. In 2001, he formed the Xian Sunway
Technology and Industry Co., Ltd. He has more than 20 years experience in the
energy and petroleum industries in operational, administrative, management and
government relations roles. He received a Bachelors of Economic Management from
North West University (Shaanxi).
Xiaogang Zhu, Chief Financial Officer - Mr. Zhu joined Xilan as Chief Financial
Officer in January 2005. He spent 16 years working at the Ministry of General
Logistics most recently as manager of the finance department. From September
2000 to December 2004, Mr. Zhu was the Vice General Manager and CFO of Xian
Dapeng Biotech Co., Ltd. He received a Bachelors of Accounting from Xian
Jiaotong University.
Zhiqiang Wang, Vice Chairman of the Board of Directors - Mr. Wang was the former
head of energy industry regulations from 1992 to 2002 as well as the Vice Mayor
of the city of Xi'An, China's largest western city with a population of 8
million, in which position he was in charge of regulating and licensing the
city's energy and natural gas businesses. From 2002 until his retirement in
2004, Mr. Wang was the Chief Executive Officer of Xi'An Municipal Government
Construction Company where he was in charge of the city's major construction
projects. Since 2004, Mr. Wang has been an independent advisor to the Company.
Mr. Wang graduated from the Northwest College of Law in 1962.
Patrick McManus, Director - Mr. McManus brings over 25 years of experience in
business, finance and law to China Natural Gas. He was elected Mayor of the City
of Lynn, Massachusetts in 1992 and served in this position until his retirement
to the private practice of law and accounting in 2002. While serving the City of
Lynn as its Mayor, he was elected a member and trustee of the Executive
Committee of the U.S. Conference of Mayors (USCM) with responsibility for
developing policy for the USCM. He also served as the Chairman of the USCM
Science and Technology Subcommittee, the Urban Water Council, and the USCM Audit
Committee. Mayor McManus started his career in business with the General
Electric Company in 1979, and was a Professor of Business and Finance at Salem
State College in Massachusetts. Mayor McManus has extensive business and
political expertise on China. He was instrumental in establishing a close
alliance as well as coordinating a regular exchange of visits by members of the
U.S. Conference of Mayors and the China Association of Mayors. Mr. McManus has
been a Certified Public Accountant since 1985. Mr. McManus received his Juris
Doctorate from Boston College Law School and an M.B.A from Suffolk University.
Mr. McManus currently serves on the board of directors of Bodisen Biotech, Inc.
and Harbin Electric, Inc.
31
James A. Garner, Director, Chairman of Nominating Committee - Mr. Garner brings
over 30 years of experience in business and political contacts to China Natural
Gas. He served as Mayor of Hempstead, New York for 16 years until his retirement
to the private sector in April 2005. He has won national recognition and awards
from national agencies such as the U.S. Housing & Urban Development Agency and
the American Planning Association (APA). Mayor Garner was elected the 61st
President of the United States Conference of Mayors in June 2003 and served the
Conference for one year traveling worldwide and advocating the needs of U.S.
cities. Mr. Garner holds a Bachelor of Science Degree from Adelphi University
and an Honorary Degree of Doctorate of Civil Law from Molloy College. He was
recently appointed to the United States Small Business Administration's National
Advisory Council.
Board of Directors.
Our Directors are elected by the vote of a plurality in interest of the
holders of our voting stock and hold office for a term of one year or until a
successor has been elected and qualified.
A majority of the authorized number of directors constitutes a quorum of
the Board for the transaction of business. The directors must be present at the
meeting to constitute a quorum. However, any action required or permitted to be
taken by the Board may be taken without a meeting if all members of the Board
individually or collectively consent in writing to the action.
There are no family relationships, or other arrangements or understandings
between or among any of the directors, executive officers or other person
pursuant to which such person was selected to serve as a director or officer.
Our directors, executive officers and control persons have not been involved in
any of the following events during the past five years:
1. any bankruptcy petition filed by or against any business of which such
person was a general partner or executive officer either at the time of
the bankruptcy or within two years prior to that time;
2. any conviction in a criminal proceeding or being subject to a pending
criminal proceeding (excluding traffic violations and other minor
offenses);
3. being subject to any order, judgment, or decree, not subsequently
reversed, suspended or vacated, of any court of competent jurisdiction,
permanently or temporarily enjoining, barring, suspending or otherwise
limiting his involvement in any type of business, securities or banking
activities; or
4. being found by a court of competent jurisdiction (in a civil action),
the Commission or the Commodity Futures Trading Commission to have
violated a federal or state securities or commodities law, and the
judgment has not been reversed, suspended, or vacated.
32
Corporate Governance Matters
Audit Committee:
On March 27, 2006, the Board of Directors established an Audit Committee and
appointed Patrick McManus as the committee's sole member.
Audit Committee Financial Expert:
Our board of directors has not yet appointed a member who qualifies as an "audit
committee financial expert" as defined in Item 401(e) of Regulation S-B, and is
"independent" as the term is used in Item 7(d)(3)(iv) of Schedule 14A under the
Exchange Act.
Compensation Committee
On March 27, 2006, the Board of Directors established a Compensation Committee
and appointed James Garner as the Committee's sole member.
Code of Ethics
On June 14, 2006, the Company adopted a Code of Ethics that applies to all
officers, directors and employees of the Company.
COMPLIANCE WITH SECTION 16(a) OF THE SECURITIES EXCHANGE ACT OF 1934
Section 16(a) of the Securities Exchange Act of 1934, as amended, requires our
executive officers and directors and persons who own more than 10% of a
registered class of our equity securities to file with the Securities and
Exchange Commission initial statements of beneficial ownership, reports of
changes in ownership and annual reports concerning their ownership of our common
stock and other equity securities, on Forms 3, 4 and 5 respectively. Executive
officers, directors and greater than 10% shareholders are required by the
Securities and Exchange Commission regulations to furnish our Company with
copies of all Section 16(a) reports they file.
To the Company's knowledge, based solely on a review of the copies of the
reports furnished to the Company, all executive officers, directors and greater
than 10% shareholders filed the required reports in a timely manner.
Directors Compensation
The following Director Compensation Table summarizes the compensation of our
directors for services rendered to the Company during the year ended December
31, 2006:
Ji Qinan, CEO of the Company, does not receive any compensation for his service
as a director.
33
Zhiqiang Wang was appointed as a director in September 2006; his compensation
was $4,500 annually.
Minquing Lu, former CEO and director of the Company, resigned from both
positions in May 22, 2006. Mr. Lu did not receive any compensation for his
service as a director in 2006.
The Company did not pay any other compensation to these directors in 2006.
DIRECTORS COMPENSATION TABLE
----------------------------------------------------------------------------------------
Name Fees Stock Options All Other Total ($)
Earned Awards ($) Awards ($) Compensation
or Paid ($)
in Cash
($)
----------------------------------------------------------------------------------------
James Garner $24,000 $0 $0 $0 $24,000
----------------------------------------------------------------------------------------
Patrick McManus $24,000 $24,000
----------------------------------------------------------------------------------------
Ji Qinan $0 $0 $0 $0 $0
----------------------------------------------------------------------------------------
Minquing Lu $0 $0 $0 $0 $0
----------------------------------------------------------------------------------------
Zhiqiang Wang $4,500 $0 $0 $0 $4,500
----------------------------------------------------------------------------------------
ITEM 10. EXECUTIVE COMPENSATION
The following table sets forth all compensation paid in respect of our
Chief Executive Officer and those executive officers who received compensation
in excess of $100,000 per year (collectively, the "Named Executive Officers")
for our last completed fiscal year.
SUMMARY COMPENSATION TABLE
Non-Stock
Incentive
Stock Option Plan All Other
Name and Principal Position Year Salary ($) Bonus ($) Awards ($) Awards ($) Comp. ($) Comp. ($) Total ($)
--------------------------------------------------------------------------------------------
Qinan Ji, Chief Executive Officer 2006 15,000 -- -- -- -- -- 15,000
and Chairman of the Board
Xiaogang Zhu, Chief Financial Officer 2006 10,000 -- -- -- -- -- 10,000
Minqing Lu, former Chief 2006 4,150 -- -- -- -- -- 4,150
Executive Officer and Director
(1)Minqing Lu stepped down as the Company's Chief Executive Officer and Director
on May 22, 2006. Mr. Lu's annual salary was $10,000.
34
Equity Compensation Plan Information
There has been no common stock authorized for issuance with respect to any
equity compensation plan as of the fiscal year ended December 31, 2006.
Employment Agreements
There are currently no employment agreements between the Company and any
of its named executive officers.
Outstanding Equity Awards at Fiscal Year End
There has been no outstanding equity awards at fiscal year ended December
31, 2006.
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
The following table sets forth certain information, as of April 13, 2007
with respect to the beneficial ownership of the outstanding common stock by (i)
any holder of more than five (5%) percent; (ii) each of our executive officers
and directors; and (iii) our directors and executive officers as a group. Except
as otherwise indicated, each of the stockholders listed below has sole voting
and investment power over the shares beneficially owned.
-----------------------------------------------------------------------------
Number of Percentage
Shares of Shares
Beneficially Beneficially
Name of Beneficial Owner (1) Owned Owned (2)
-----------------------------------------------------------------------------
Executive Officers and Directors
--------------------------------
Qinan Ji 5,931,596(3) 24.5%
-----------------------------------------------------------------------------
Xiaogang Zhu -- --
-----------------------------------------------------------------------------
All officers and directors
as a group (2 persons) 5,931,596(3) 24.5%
-----------------------------------------------------------------------------
5% holders
----------
Yangling Bodisen Biotech
Development Co, Ltd.
c/o New York Global Group, Inc.
14 Wall Street, 12th Floor
New York, NY 10005 2,063,768(4) 8.5%
-----------------------------------------------------------------------------
Xiang Ji 1,456,232 6.0%
-----------------------------------------------------------------------------
Xian Sunway Technology &
Industry Co., Ltd 2,875,364(3) 11.9%
-----------------------------------------------------------------------------
35
(1) Except as otherwise indicated, the address of each beneficial owner is c/o
Xian Xilan Natural Gas Co., Ltd., 19th Floor, Building B, Van Metropolis, Tang
Yan Road, Hi-Tech Zone, Xian, Shaanxi Province, China.
(2) Applicable percentage ownership is based on 24,210,183 shares of common
stock outstanding as of April 13, 2007, together with securities exercisable or
convertible into shares of common stock within 60 days of April 13, 2007 for
each stockholder. Beneficial ownership is determined in accordance with the
rules of the Securities and Exchange Commission and generally includes voting or
investment power with respect to securities. Shares of common stock that are
currently exercisable or exercisable within 60 days of April 13, 2007 are deemed
to be beneficially owned by the person holding such securities for the purpose
of computing the percentage of ownership of such person, but are not treated as
outstanding for the purpose of computing the percentage ownership of any other
person.
(3) Of which 2,875,364 shares are owned by Xian Sunway Technology & Industry
Co., Ltd. Qinan Ji owns 42.1% of Xian Sunway and may be deemed to beneficially
own such shares.
(4) As set forth in the Schedule 13D filed with the SEC on December 23, 2005.
No Director, executive officer, affiliate or any owner of record or
beneficial owner of more than 5% of any class of voting securities of the
Company is a party adverse to the Company or has a material interest adverse to
the Company.
Securities Authorized for Issuance Under Equity Compensation Plans
The Company had no equity compensation plans as of the fiscal year ended
December 31, 2006.
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
None
ITEM 13. EXHIBITS
Exhibits:
Exhibit
Number Description of Exhibit
3.1 Articles of Incorporation (incorporated by reference to same exhibit
filed with the Company's Form 10SB Registration Statement filed
September 15, 2000, SEC file no. 000-31539).
3.2 Certificate of Ownership of Coventure international Inc. and China
Natural Gas, Inc., dated December 12, 2005
3.3 Registrant's Amended and Restated By-Laws (incorporated by reference
to exhibit 3.1 filed with the Company's Form 8K Registration Statement
filed June 16, 2006, SEC file no. 000-31539).
10.1 Share Purchase Agreement made as of December 6, 2005 among Coventure
International Inc., Xian Xilan Natural Gas Co., Ltd. and each of
Xilan's shareholders. (incorporated by reference to the exhibits to
Registrants Form 8-K filed on December 9, 2005).
10.2 Return to Treasury Agreement between Coventure International Inc. and
John Hromyk, dated December 6, 2005. (incorporated by reference to the
exhibits to Registrants Form 8-K filed on December 9, 2005).
10.3 Purchase Agreement made as of December 19, 2005 between China Natural
Gas, Inc. and John Hromyk (incorporated by reference to the exhibits
to Registrants Form 8-K filed on December 23, 2005).
36
10.4 Form of Securities Purchase Agreement (incorporated by reference to
the exhibits to Registrants Form 8-K filed on January 12, 2006).
10.5 Form of Common Stock Purchase Agreement (incorporated by reference to
the exhibits to Registrants Form 8-K filed on January 12, 2006).
10.6 Form of Registration Rights Agreement (incorporated by reference to
the exhibits to Registrants Form 8-K filed on January 12, 2006).
10.8 CNG Product Purchase and Sale Agreement between Xian Xilan Natural
Gas Co., Ltd. and Zhengzhou Zhongyou Hengran Petroleum Gas Co., Ltd.
made as of July 20, 2006, (translated from the original mandarin).
14.1 Code of Ethics adopted by the Company on June 14, 2006 (incorporated
by reference to the exhibits to Registrants Form 8-K filed on June 16,
2006).
21.1 List of Subsidiaries.
31.1 Certification of Principal Executive Officer pursuant to Rule 13a-14
and Rule 15d-14(a), promulgated under the Securities and Exchange Act
of 1934, as amended
31.2 Certification of Principal Financial Officer pursuant to Rule 13a-14
and Rule 15d 14(a), promulgated under the Securities and Exchange Act
of 1934, as amended
32.1 Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002 (Chief Executive
Officer)
32.2 Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002 (Chief Financial
Officer)
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The following table shows the fees paid or accrued for the audit and other
services provided by our independent auditors for 2006 and 2005.
2006 2005
---------------------
Audit fees
Kabani & Company, Inc. .......................... $ 72,500 $ 40,000
Manning Elliott ................................. -- $ 14,750
Audit-related fees ................................... -- --
Tax fees ............................................. -- $ 1,775*
All other fees ....................................... $ 10,000** --
Total fees paid or accrued to our
principal accountants ............................. $ 82,500 $ 56,525
* The aggregate fees billed for professional services rendered by Manning
Elliott for tax compliance services in fiscal year 2005 was $1,775. No fees were
billed for tax advice or tax planning. The fees billed related to the
preparation of income tax returns.
** The fees billed related to the preparation of our Registration Statement on
Form SB-2 (333-131738) filed with the SEC on February 10, 2006.
The Audit Committee has considered whether the provision of non-audit services
is compatible with maintaining the principal accountant's independence.
37
SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the registrant
caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
Date: April 16, 2007
CHINA NATURAL GAS, INC.
By: /s/ Qinan Ji
---------------------------
Qinan Ji
Chief Executive Officer
(Principal Executive Officer)
By: /s/ Xiaogang Zhu
---------------------------
Xiaogang Zhu
Chief Financial Officer
(Principal Financial and Accounting Officer)
In accordance with the Exchange Act, this report has been signed below by
the following persons on behalf of the registrant and in the capacities and on
the dates indicated.
President and Chief Executive April 16, 2007
Officer and Director
/s/ Qinan Ji (Principal Executive Officer)
------------------------------
Qinan Ji
/s/ Zhiqiang Wang Director April 16, 2007
------------------------------
Zhiqiang Wang
/s/ Patrick McManus Director April 16, 2007
------------------------------
Patrick McManus
/s/ James A. Garner Director April 16, 2007
------------------------------
James A. Garner
Chief Financial Officer April 16, 2007
/s/ Xiaogang Zhu (Principal Accounting Officer)
------------------------------
Xiaogang Zhu
38