10QSB 1 hq10qsb063005.txt U.S. SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ---------------- FORM 10-QSB ---------------- (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2005 OR [_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission file number: 000-18980 HQ SUSTAINABLE MARITIME INDUSTRIES, INC. ========================================================== (Name of small business issuer in its charter) Delaware 3550 62-1407522 (State or jurisdiction of (Primary Std. Industrial (IRS Employer Incorporation or organization) Classification Code Number) ID Number) Wall Street Center, 14 Wall Street, 20th Floor, New York, New York 10005 Tel. (212) 618-1712 ========================================================== (Address and telephone number of principal executive offices) Securities registered under Section 12(b) of the Exchange Act: None Securities registered under Section 12(g) of the Exchange Act: Common Stock, $0.001 par value per share (Title of Class) Check whether the issuer: (i) 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 (ii) has been subject to such filing requirements for the past 90 days. Yes |X| No |_| As of June 30, 2005, there were 100,261,523 shares of the registrant's common stock outstanding. -------------------------------- TABLE OF CONTENTS -------------------------------- Page Numbers PART I - FINANCIAL INFORMATION Item 1. Financial Statements. o Condensed Consolidated Balance Sheets 2-3 o Condensed Consolidated Statements of Income 4 o Condensed Consolidated Statements of Cash Flows 5 o Notes to Condensed Consolidated Financial Statements 6-10 Item 2. Management Discussions & Analysis of Financial Condition and Results of Operations. 11-17 Item 3. Controls and Procedures 17 PART II - OTHER INFORMATION Item 1. Legal Proceedings 18 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 18 Item 3. Defaults Upon Senior Securities 18 Item 4. Submission of Matters to a Vote of Security Holders 18 Item 5 Other Information 18 Item 6. Exhibits 18
HQ SUSTAINABLE MARITIME INDUSTRIES, INC. AND SUBSIDIARIES (INCORPORATED IN THE STATE OF DELAWARE WITH LIMITED LIABILITY) CONDENSED CONSOLIDATED BALANCE SHEETS ASSETS June 30, 2005 December 31, 2004 (unaudited) (unaudited) ----------------- ----------------- CURRENT ASSETS Cash and cash equivalents $ 4,353,245 $ 4,551,505 Trade receivables, net of provision 6,937,921 5,406,172 Inventory 342,298 228,564 Prepayments 1,932 1,932 Due from related parties, net of provision 469,947 388,506 Advance to employees 219,677 27,918 Tax recoverable 81,602 81,602 ----------------- ----------------- TOTAL CURRENT ASSETS 12,406,622 10,686,199 ----------------- ----------------- OTHER ASSETS Deferred taxes 1,175,703 1,209,790 ----------------- ----------------- PROPERTY, PLANT AND EQUIPMENT, NET 8,548,631 9,029,673 ----------------- ----------------- VESSELS HELD FOR SALE -- -- ----------------- ----------------- TOTAL ASSETS $ 22,130,956 $ 20,925,662 ================= =================
The accompanying notes are in integral part of the consolidated financial statements. 2 HQ SUSTAINABLE MARITIME INDUSTRIES, INC. AND SUBSIDIARIES (INCORPORATED IN THE STATE OF DELAWARE WITH LIMITED LIABILITY) CONDENSED CONSOLIDATED BALANCE SHEETS LIABILITIES AND SHAREHOLDERS' EQUITY June 30, 2005 December 31, 2004 (unaudited) (unaudited) ----------------- ----------------- CURRENT LIABILITIES Accounts payable and accrued expenses $ 3,579,030 $ 4,204,630 Bank loans 4,457,831 4,457,831 Tax payable 130,198 -- Due to related parties 536,160 86,994 Due to directors 199,145 209,361 Convertible notes 255,422 255,422 ----------------- ----------------- TOTAL CURRENT LIABILITIES 9,157,786 9,214,238 ----------------- ----------------- OTHER LIABILITIES Promissory note 100,000 100,000 ----------------- ----------------- TOTAL LIABILITIES 9,257,786 9,314,238 ----------------- ----------------- SHAREHOLDERS' EQUITY Share capital 100,261 95,055 Additional paid-in capital 13,713,424 13,099,205 Reserves 1,326,467 1,146,316 Accumulated losses (2,266,982) (2,729,152) ----------------- ----------------- TOTAL SHAREHOLDERS' EQUITY 12,873,170 11,611,424 ----------------- ----------------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 22,130,956 $ 20,925,662 ================= ================= The accompanying notes are in integral part of the consolidated financial statements. 3
HQ SUSTAINABLE MARITIME INDUSTRIES, INC. AND SUBSIDIARIES (INCORPORATED IN THE STATE OF DELAWARE WITH LIMITED LIABILITY) CONDENSED CONSOLIDATED STATEMENTS OF INCOME (unaudited) Three Months Ended Six Months Ended June 30, 2005 June 30, 2004 June 30, 2005 June 30, 2004 ------------- ------------- ------------- ------------- SALES $ 6,515,755 $ 460,919 $ 9,532,641 $ 702,292 COST OF SALES 3,720,157 534,533 5,019,323 748,362 ------------- ------------- ------------- ------------- GROSS PROFIT/(LOSS) 2,795,598 (73,614) 4,513,318 (46,070) SELLING AND DISTRIBUTION EXPENSES 65,778 61,602 106,386 96,201 ADVERTISING 830,183 -- 1,831,002 -- GENERAL AND ADMINISTRATIVE EXPENSES 530,114 1,036,543 1,157,055 1,370,004 DEPRECIATION 240,769 79,313 481,041 158,678 PROVISION FOR DOUBTFUL ACCOUNTS -- 238,581 38,352 1,523,331 ------------- ------------- ------------- ------------- PROFIT /(LOSS) FROM OPERATIONS 1,128,754 (1,489,653) 899,482 (3,194,284) FINANCE COSTS 90,274 43,625 181,982 43,625 OTHER INCOME (208,402) (236,641) (208,985) (253,669) OTHER EXPENSES 52,170 54,518 119,879 183,095 ------------- ------------- ------------- ------------- PROFIT/(LOSS) BEFORE INCOME TAXES 1,194,712 (1,351,155) 806,606 (3,167,335) INCOME TAXES CURRENT 97,379 -- 130,198 -- DEFERRED 17,043 11,362 34,086 34,087 ------------- ------------- ------------- ------------- NET PROFIT/(LOSS) BEFORE MINORITY INTEREST 1,080,290 (1,362,517) 642,322 (3,201,422) MINORITY INTEREST -- 69,581 -- 337,944 ------------- ------------- ------------- ------------- NET PROFIT/(LOSS) ATTRIBUTABLE TO SHAREHOLDERS $ 1,080,290 $ (1,292,936) $ 642,322 $ (2,863,478) ============= ============= ============= ============= NET PROFIT/(LOSS) PER SHARE BASIC AND DILUTED $ 0.01 $ (0.02) $ 0.01 $ (0.09) ============= ============= ============= ============= WEIGHTED AVERAGE COMMON SHARE OUTSTANDING 99,320,179 64,128,752 97,766,208 32,076,876 ============= ============= ============= =============
The accompanying notes are in integral part of the consolidated financial statements. 4
HQ SUSTAINABLE MARITIME INDUSTRIES, INC. AND SUBSIDIARIES (INCORPORATED IN THE STATE OF DELAWARE WITH LIMITED LIABILITY) CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE SIX MONTHS ENDED JUNE 30, 2005 AND 2004 (unaudited) 2005 2004 ------------ ------------ CASH FLOWS FROM OPERATING ACTIVITIES: Net income/(loss) $ 642,322 $ (3,201,422) Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 481,041 158,678 (Increase)/decrease in assets: Inventory (113,733) 45,954 Trade receivables, net of provisions (1,531,749) 2,591,121 Prepayment -- 11,901 Advance to employee (191,760) -- Deferred taxes 34,087 34,087 Increase/(decrease) in liabilities: Accounts payable and accrued expenses (625,600) 501,131 Deposit received from customers -- (24,448) Taxes payable 130,198 -- ------------ ------------ Net cash from by operating activities (1,175,194) 117,002 ------------ ------------ CASH FLOWS FROM INVESTING ACTIVITIES: Acquisition of property, plant and equipment -- (1,060,752) ------------ ------------ Net cash from by investing activities -- (1,060,752) ------------ ------------ CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from common stock 619,425 2,943,310 Payment to directors (10,217) (42,752) Receive from/(payment to) related parties 367,726 (471,720) Repayment of bank loans -- (6,265,061) ------------ ------------ Net cash from by financing activities 976,934 (3,836,223) ------------ ------------ NET CHANGE IN CASH AND CASH EQUIVALENTS (198,260) (4,779,973) Cash and cash equivalents, beginning of period 4,551,505 11,037,780 ------------ ------------ Cash and cash equivalents, end of period $ 4,353,245 $ 6,257,807 ============ ============ SUPPLEMENTARY CASH FLOWS DISCLOSURES Interest paid $ 158,982 $ 132,153 ============ ============ Taxes paid $ -- $ -- ============ ============ SUPPLEMENTARY DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES Note payable in connection with acquisition of Jiahua Marine $ 100,000 $ 100,000 ============ ============
The accompanying notes are in integral part of the financial statements. 5 HQ SUSTAINABLE MARTIME INDUSTRIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS UNAUDITED JUNE 30, 2005 ------------------------------------------------------------------------------- NOTE 1 - BASIS OF PRESENTATION The unaudited condensed consolidated financial statements of HQ Sustainable Maritime Industries, Inc., or HQSM, have been prepared in accordance with generally accepted accounting principles for interim financial information and pursuant to the requirements for reporting on Form 10-QSB and Item 310(b) of Regulation S-B. Accordingly, they do not include all the information and footnotes required by accounting principles generally accepted in United States of America for complete financial statements. However, such information reflects all adjustments (consisting solely of normal recurring adjustments), which are, in the opinion of management, necessary for a fair statement of results for the interim periods. Results shown for interim periods are not necessarily indicative of the results to be obtained for a full fiscal year. The condensed consolidated balance sheet information as of December 31, 2004 was derived from the audited consolidated financial statements included in the Company's Annual Report Form 10-KSB. These interim financial statements should be read in conjunction with that report. NOTE 2 - NATURE OF COMPANY HQ Sustainable Maritime Industries, Inc. ("HQSM") was initially incorporated as Sharon Capital Corporation, or Sharon, on September 21, 1989 under the laws of the State of Nevada. Sharon was a "blind pool/blank check" corporation organized for the purpose of purchasing, merging with or acquiring a business or assets from another company. In July 1990, Sharon was changed to PEI, Inc., which was subsequently changed to Process Equipment, Inc. in November 1990. On March 17, 2004, Process Equipment, Inc., Process Equipment Acquisition Corporation, a Nevada corporation and wholly-owned subsidiary of Process Equipment, Inc., or PEAC, and Jade Profit Investment Limited, or Jade, a British Virgin Islands limited liability corporation, entered into an agreement and plan of merger. Pursuant to that agreement, Process Equipment, Inc., through PEAC, acquired Jade, and 84.42% ownership in Jade's subsidiary Hainan Quebec Ocean Fishing Co. Ltd, a People's Republic of China, limited liability corporation, which we refer to as HQOF. As a result of that transaction, HQOF became our main operating subsidiary. In April of 2004, pursuant to the above agreement and plan of merger, the board of directors of Process Equipment, Inc. and a majority of the stockholders approved a name change and change of domicile of that company to Delaware via a merger with the newly formed wholly-owned Delaware subsidiary, HQSM. The name change, change of domicile and merger became effective on May 19, 2004, with HQSM being the surviving entity in the merger and acquiring all the assets and liabilities of Process Equipment, Inc. On August 17, 2004, we have entered into a Purchase Agreement with Sino-Sult Canada (S.S.C.) Limited, a Canadian limited liability corporation ("SSC"), whereby we acquired Sealink Wealth Limited ("Sealink"), SSC's wholly owned subsidiary incorporated in the British Virgin Islands. That purchase agreement has been filed as an exhibit to our current report on Form 8K filed with the Commission on August 18, 2004. Sealink is the sole owner of Hainan Jiahua Marine Bio-Products Co. Ltd., a limited liability company existing in China ("Jiahua Marine") which is primarily engaged in the production and sales of marine bio-products and healthcare products in the PRC, as described in more detail in the above current report. Also as previously disclosed, in the same current report, SSC is owned by three of our current directors and executive officers who are also, together, indirect beneficial owners of the majority of our capital stock. 6 Further, as previously disclosed in the above current report, effective August 17, 2004, HQSM caused Jade Profit Investment Limited, its wholly-owned subsidiary, to acquire the minority equity interest equal to 15.58% that Jade did not already own in HQOF, HQSM's principal operating subsidiary. This purchase was effected by Jade pursuant to the Purchase Agreement, dated as of August 17, 2004, between Jade and Hainan Fuyuan Investment Company Limited, the holder of the minority equity interest of HQOF being acquired by Jade. Jade has previously obtained all requisite governmental approvals in the PRC in order to consummate this transaction. The Group is principally engaged in the vertically integrated business of aquaculture through co-operative supply agreements, ocean product harvesting, and processing and sales of farm-bred and ocean harvested aquatic products. The principal products of HQOF are cross-bred hybrid of tilapia and white-legged shrimp exporting, directly and indirectly, to the United States, Canada, Japan and European countries. The major market is for export. The Group has also engaged in the production and sales of marine bio-products and healthcare products in the PRC. The principal products of Hainan Jiahua Marine Bio-Product Company Limited (100% hold subsidiary of Sealink) are Shark Cartilage Capsule, Shark Liver Oil and Shark Liver (Soft gel). The major market is domestic in the PRC. NOTE 3 - 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 revenue and expenses during the reporting period. Actual results when ultimately realized could differ from those estimates. NOTE 4 - EARNINGS PER SHARE Basic earnings per share are computed by dividing income available to common shareholders by the weighted-average number of common shares outstanding during the period. Diluted earnings per share are computed similar to basic earnings per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potential common shares had been issued and if the additional common shares were dilutive. NOTE 5 - FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying value of financial instruments including cash and cash equivalents, receivables, accounts payable and accrued expenses and debt, approximates their fair value at June 30, 2005 and December 31, 2004 due to the relatively short-term nature of these instruments. NOTE 6 - FOREIGN CURRENCY CONVERSION The Company's financial information is presented in US dollars. People's Republic of China currency (Renminbi dollars) has been converted into US dollars at the exchange rate of 8.3 to 1. 7 NOTE 7 - INCOME TAXES Taxes are calculated in accordance with taxation rates currently effective in the PRC. The Company accounts for income taxes using the liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income in the period that includes the enactment date. A valuation allowance is provided for the amount of deferred tax assets that, based on available evidence, are not expected to be realized. The Company's subsidiaries registered in the PRC are subject to state and local income taxes within the PRC at the applicable tax rates on the taxable income as reported in their PRC statutory financial statements in accordance with the relevant income tax laws applicable to foreign enterprises. Jiahua Marine was subject to a tax rate of 7.5% during this quarter. Jiahua Marine is entitled to a two-year tax holiday from 2002 commencing with the first profit-making year. HQOF did not have any assessable profits for the six months ended June 30, 2005. The reconciliation of the effective income tax rate of the Company to the statutory income tax rate in the PRC for this quarter is as follows: Statutory tax rate 15.0% Tax holidays and concessions (7.5%) ---------- Effective tax rate 7.5% ========== Income taxes are calculated on a separate entity basis. Currently there is no tax benefit or burden recorded for the United States. 8
NOTE 8 - SEGMENTS No geographical segment analysis is provided for the six months ended June 30, 2005 and 2004, as less than 10% of consolidated revenues and less than 10% of consolidated income from operations is attributable to the segment other than the Mainland China. Business segment for the three months ended June 30, 2005 Aquaculture Health and Unallocated Product Bio-product Items Consolidation ------------- ------------- ------------- ------------- Sales to external customers 4,064,815 2,450,940 -- 6,515,755 ============================================================== General and administrative expenses 98,984 16,705 414,425 530,114 Depreciation 163,824 75,310 1,635 240,769 Selling expenses 48,582 17,196 -- 65,778 Advertising -- 830,183 -- 830,183 Finance costs 58,706 30,810 758 90,274 Profit before taxation 319,327 1,296,891 (421,506) 1,194,712 Taxation 17,043 97,379 -- 114,422 Profit for the period 302,284 1,199,512 (421,506) 1,080,290 ============================================================== Segment assets 13,304,542 8,318,610 507,804 22,130,956 ============================================================== Segment liabilities 5,562,967 2,303,695 1,391,124 9,257,786 ============================================================== Business segment for the six months ended June 30, 2005 Aquaculture Health and Unallocated Product Bio-product Items Consolidation ------------- ------------- ------------- ------------- Sales to external customers 5,157,310 4,375,331 -- 9,532,641 ============================================================== General and administrative expenses 246,666 52,783 857,606 1,157,055 Depreciation 327,648 150,621 2,772 481,041 Selling expenses 69,117 37,269 -- 106,386 Advertising -- 1,831,002 -- 1,831,002 Finance costs 116,484 62,030 3,468 181,982 Profit/(Loss) before taxation (59,599) 1,734,477 (868,272) 806,606 Taxation 34,086 130,198 -- 164,284 Profit/(Loss) for the period (93,685) 1,604,279 (868,272) 642,322 ============================================================== Segment assets 13,304,542 8,318,610 507,804 22,130,956 ============================================================== Segment liabilities 5,562,967 2,303,695 1,391,124 9,257,786 ==============================================================
No business segment is provided for the six months ended June 30, 2004 as no revenues and income from operations is attributable to business segment other than the vertically integrated business of aquaculture through processing and sales of farm-bred and ocean harvested aquatic products. 9
NOTE 9 - UNAUDITED PRO FORMA CONDENSED CONSOLIDATED FINANCIAL STATEMENTS On August 17, 2004, HQSM and Sealink, as the parent and management company of Jiahua Marine, consummated a Purchase Agreement whereby HQSM acquired all of the issued and outstanding capital stock of Sealink at consideration payable by HQSM in the following manner: $8,888,655 in the form of 12,698,078 shares of HQSM's common stock, $0.001 par value per share, up to but not exceeding 19.9% of the outstanding shares of HQSM's common stock, on a fully-diluted basis, to be delivered to SSC at closing, and (ii) the remaining balance of $11,111,345 to be payable in the form of a convertible promissory note (the "Note") issued by HQSM to SSC. This Note is included as Exhibit B to the Nutraceutical Purchase Agreement. The Note will accrue interest at the rate of 5% per annum and is convertible into: (1) one hundred thousand US Dollars (US$100,000) for 100,000 shares of HQSM's Series A preferred stock, $0.001 par value per share, (2) the remaining principal amount of the Note equal to US$11,011,345 into 15,730,493 shares of HQSM's common stock. The Note is convertible only upon completion of an audit of HQSM's acquisition of Sealink and Jiahua Marine, performed to the satisfaction of HQSM and receipt of all necessary shareholder consents and approvals. The $11,011,045 portion of the Note was converted in November, 2004. The Purchase Agreement is being accounted for as a recapitalization of Sealink whereby the historical financial information of Sealink becomes the historical financial information of the Registrant. The accompanying Unaudited Pro Forma Condensed Consolidated Statement of Income for the quarter ended June 30, 2004, has been prepared to reflect the acquisition as if it had occurred as of January 1, 2004. The accompanying pro forma information is presented for illustrative purposes only and is not necessarily indicative of the financial position or results of operations which would actually have been reported had the merger been in effect during the periods presented, or which may be reported in the future. Three months ended Six months ended June 30, 2004 June 30, 2004 ------------- ------------- USD (`000) USD (`000) Sales 3,100 5,266 Loss from operations 904 2,083 Net loss attributable to shareholder 890 1,966 ================================ Weighted average outstanding number of shares 69,770,366 69,770,366 as at December 31, 2004 Earning (loss) per share (0.01) (0.03)
10 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following is management's discussion and analysis of certain significant factors which have affected our financial position and operating results during the periods included in the accompanying consolidated financial statements, as well as information relating to the plans of our current management. This report includes forward-looking statements. Generally, the words "believes," "anticipates," "may," "will," "should," "expect," "intend," "estimate," "continue," and similar expressions or the negative thereof or comparable terminology are intended to identify forward-looking statements. Such statements are subject to certain risks and uncertainties, including the matters set forth in this report or other reports or documents we file with the Securities and Exchange Commission from time to time, which could cause actual results or outcomes to differ materially from those projected. Undue reliance should not be placed on these forward-looking statements which speak only as of the date hereof. We undertake no obligation to update these forward-looking statements. The following discussion and analysis should be read in conjunction with our consolidated financial statements and the related notes thereto and other financial information contained elsewhere in this Form 10-QSB. GENERAL OVERVIEW ---------------- The following Management's Discussion and Analysis ("MD&A") is intended to help the reader understand our Group. MD&A is provided as a supplement to, and should be read in conjunction with, our financial statements and the accompanying notes ("Notes"). PRELIMINARY NOTE REGARDING FORWARD-LOOKING STATEMENTS ----------------------------------------------------- You should read the following discussion of our financial condition and operations in conjunction with the consolidated financial statements and the related notes included elsewhere in this quarterly report. This quarterly report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These include statements about our expectations, beliefs, intentions or strategies for the future, which we indicate by words or phrases such as "anticipate," "expect," "intend," "plan," "will," "we believe," "our company believes," "management believes" and similar language. The forward-looking statements are based on our current expectations and are subject to certain risks, uncertainties and assumptions, including our ability to (1) obtain sufficient capital or a strategic business arrangement to fund our expansion plans; (2) build the management and human resources infrastructure necessary to support the growth of our business; (3) competitive factors and developments beyond our control; and (4) those other risk factors, uncertainties and assumptions that are set forth in the discussion under the headings captioned "Business," "Risk Factors," and "Management's Discussion and Analysis". Our actual results may differ materially from results anticipated in these forward-looking statements. We base the forward-looking statements on information currently available to us, and we assume no obligation to update or revise them, whether as a result of new information, future events or otherwise. In addition, our historical financial performance is not necessarily indicative of the results that may be expected in the future and we believe that such comparisons cannot be relied upon as indicators of future performance. 11 CRITICAL ACCOUNTING POLICIES AND ESTIMATES ------------------------------------------ The Company prepares its consolidated financial statements in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Management periodically evaluates the estimates and judgments made. Management bases its estimates and judgments on historical experience and on various factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates as a result of different assumptions or conditions. The following critical accounting policies affect the more significant judgments and estimates used in the preparation of the Company's consolidated financial statements. Inventories ----------- Inventories are stated at the lower of cost or net realizable value. Cost is calculated on the moving-average basis and includes all costs to acquire and other costs incurred in bringing the inventories to their present location and condition. The Company evaluates the net realizable value of its inventories on a regular basis and records a provision for loss to reduce the computed moving-average cost if it exceeds the net realizable value. Income Taxes ------------ Taxes are calculated in accordance with taxation principles currently effective in the PRC. The Company accounts for income taxes using the liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income in the period that includes the enactment date. A valuation allowance is provided for the amount of deferred tax assets that, based on available evidence, are not expected to be realized. Related Parties --------------- Parties are considered to be related if one party has the ability, directly or indirectly, to control the other party or exercise significant influence over the other party in making financial and operational decisions. Parties are also considered to be related if they are subject to common control or common significant influence. Related parties may be individuals or corporate entities. Revenue Recognition ------------------- In accordance with the provisions of Staff Accounting Bulletin No. 103, revenue is recognized when merchandise is shipped and title passes to the customer and collectibility is reasonably assured. 12 Concentration of Credit Risk ---------------------------- Financial instruments that potentially subject the Company to significant concentrations of credit risk consist primarily of trade accounts receivable. The Company performs ongoing credit evaluations with respect to the financial condition of its creditors, but does not require collateral. In order to determine the value of the Company's accounts receivable, the Company records a provision for doubtful accounts to cover probable credit losses. Management reviews and adjusts this allowance periodically based on historical experience and its evaluation of the collectibility of outstanding accounts receivable. Results of Operations - Three Months Ended June 30, 2005 as Compared to Three Months Ended June 30, 2004 One of our subsidiaries, Jiahua Marine was engaged in manufacturing and selling of health and bio-product. During the three months ended June 30, 2005, Jiahua Marine contributed $2,450,940 or 38% to the total sales of the Group. The gross profit ratio for this segment was around 82% and the major expenses for this segment were advertising, which was about 34% of the revenues. The net income contributed by this segment was $1,199,512 this quarter. Since Jiahua Marine was acquired by our Group in the third quarter of 2004, comparative figures for 2004 for this particular segment are not applicable. The other principal activity of the Group was the manufacturing and selling of aquatic products. The revenue contributed by this segment was $4,064,815 and $460,919 for the three months ended June 30, 2005 and 2004, respectively. The gross profit ratio of this segment was 18% for the three months ended June 30, 2005 compared with a gross loss ratio of 16% for the three months ended June 30, 2004. That segment's contribution to net income was a net profit of $302,284 for the current quarter while it showed a net loss of $1,292,936 for the corresponding quarter of 2004. Production was stopped in the first half of 2004 because the factory went under major renovations. For the three months ended June 30, 2005 revenue increased by $6,054,836 or 13 times to $6,515,755 from $460,919 as compared to the corresponding period of the prior year. The increase resulted from improved performance by both segments: the aquatic product segment saw its sales increasing by $3.6 million compared to the second quarter of 2004 as its activities resumed normal levels in 2005, and because 2004 production was almost stopped due to renovations experienced in that period. Furthermore, for the health and bio-product segment, since its operations were acquired in August 2004, there were no financials results in our Group for that segment in 2004. In 2005, the sales contributed by that segment in 2005 were $2.5 million. Cost of sales increased by $3,185,624 or 6 times to $3,720,157 from $534,533 for the three months ended June 30, 2005, as compared to the corresponding period of the prior year. Approximately 90% of the increase was due to the increased activities in the aquatic products segment as the company was in a reconstruction process in 2004. The balance of the increase was due to the acquisition of Sealink in August 2004. Selling and distribution expenses slightly increased by $4,176 or 7% to $65,778 for the three months ended June 30, 2005, as compared to the corresponding period of the prior year. The increase was in line with the Group's sales improvement compared with last year. 13 Advertising expenses increased by $830,183 from zero as compared to the corresponding period of the prior year. The primary factor responsible for the increase was that HQSM acquired Jiahua Marine (as part of its acquisition of Sealink) in August 2004, as Jiahua Marine requires significant advertising expenditures for the promotion of its pharmaceutical products in order to achieve customer recognition, which is consistent with industry practices. General and administrative expenses decreased by $506,429 or 49% to $530,114 as compared to the corresponding period of the prior year. In 2005, the level of such expenses came back to its normal level as in 2004, we incurred important expenses in our process of becoming a listed company. Depreciation increased by $161,456 or 2 times to $240,769 as compared to the corresponding period to the prior year. The increase was due to the effect in the current period of improvements in plant and machinery which were made in the first half of 2004 by HQOF, and additional assets purchased through the acquisition of Jiahua Marine in mid-August 2004. Provision for doubtful accounts decreased by $238,581 or 100% to zero from $238,581 as compared to corresponding period of the prior year. No provision was required in 2005 as receivable accounts are current. Finance costs increased to $90,274 from $43,625 for the three months ended June 30, 2005, as compared to the corresponding period of the prior year, a 107% or $46,649 increase. The increase is due to financing costs incurred in the health and bio-product segment during the current period which were not in the Group in 2004. Other income increased by $28,239 or 12% from $236,641 to $208,402 for the three months ended June 30, 2005. The other income mainly represents the bad debts recovered as the Group's credit control improved. Other expenses decreased from $54,518 for the three months ended June 30, 2004 to $52,170 for the three months ended June 30, 2005, a 4% or $2,348 decrease. The main reason of the decrease was the reduction of the insurance for the vessels and some sailors being released since the first quarter of 2005. Current income taxes increased from zero to $97,379 in the current period. Such increase was due to the fact that Jiahua Marine earned taxable income in 2005 and HQOF suffered a loss for the six months ended June 30, 2005 and 2004. Deferred income tax increased by $5,681 from $11,362 to $17,043 for the three months ended June 30, 2005. The increase is due to the temporary differences reversing in the current period. Minority interest decreased from $69,581 to zero. The change resulted from HQSM's acquisition of the 15.58% minority interest of HQOF in August 2004. The net income attributable to shareholders was $1,080,290 for the three months ended June 30, 2005, compared with a net loss attributable to shareholders of $1,292,936, a $2,373,226 increase. The increase was due to the higher sales and margin in the aquatic segment in 2005 compared to 2004, and the newly acquired bio-product segment and its effect in 2005. 14 Results of Operations - Six Months Ended June 30, 2005 as Compared to Six Months Ended June 30, 2004 One of our subsidiaries, Jiahua Marine was engaged in manufacturing and selling of health and bio-product. During the six months ended June 30, 2005, Jiahua Marine contributed $4,375,331 or 46% to the total revenue of the Group. The gross profit ratio for this segment was around 82% and the major expenses for this segment were advertising, which was about 42% of the sales. The net income was $1,604,279 for the half-year ended June 30, 2005. Since Jiahua Marine was acquired by our Group in the third quarter of 2005, comparative figures for 2004 for this particular segment are not applicable. The other principal activity of the Group remained to be manufacturing and selling of aquatic products. The revenue contributed by this segment was $5,157,310 and $702,292 for the six months ended June 30, 2005 and 2004, respectively. The gross profit ratio of this segment was 16% for the six months ended June 30, 2005 compared with a gross loss ratio of 7% for the six months ended June 30, 2004. This segment's contribution to net income was a net loss of $93,685 for the current period while it showed a net loss of $2,863,478 for the corresponding period of 2004. Production was stopped in the first half of 2004 because the factory went under major renovations during that period. For the six months ended June 30, 2005 revenue increased by $8,830,349 or 13 times to $9,532,641 from $702,292 for the corresponding period of the prior year. The increase resulted from a better performance by both segments: the aquatic product segment saw its sales increasing by $4.5 million compared to the corresponding period of 2004 as its activities resumed normal levels in 2005. The 2004 production was almost stopped due to renovations experienced in that period. Furthermore, for the health and bio-product segment, since its operations were acquired in August 2004, there were no operations in our Group for that segment in 2004. In 2005, the sales contributed by that segment were $4.4 million. Cost of sales increased by $4,270,961 or 6 times to $5,019,323 from $748,362 for the six months ended June 30, 2005, as compared to the corresponding period of the prior year. Approximately 88% of the increase was due to the increased activities in the aquatic products segment as the company was in a reconstruction process in 2004 while balance of the increase was due to the acquisition of Sealink in August 2004. Selling and distribution expenses increased by $10,185 or 11% to $106,386 for the six months ended June 30, 2005, as compared to the corresponding period of the prior year. The increase was in line with the Group's sales improving compared with last year. Advertising expenses increased by $1,831,002 from zero as compared to the corresponding period of the prior year. The primary factor responsible for the increase was that HQSM acquired Jiahua Marine (as part of its acquisition of Sealink) in August 2004, as Jiahua Marine requires significant advertising expenditures for the promotion of its pharmaceutical products in order to achieve customer recognition, which is consistent with industry practices. General and administrative expenses decreased by $212,949 or 16% to $1,157,055 as compared to the corresponding period of the prior year. In 2005, the level of such expenses came to back its normal level as in 2004, we incurred important expenses in our process of becoming a listed company. 15 Depreciation increased by $322,363 to $481,041 as compared to the corresponding period to the prior year. The increase was due to the effect in the current period of improvements in plant and machinery which were made in the first half of 2004 by HQOF, and additional assets purchased through the acquisition of Jiahua Marine in mid-August 2004. Provision for doubtful accounts decreased by $1,484,979 or 97% from $1,523,331 to $38,352 as compared to corresponding period of the prior year. No major provision was required in 2005 as receivable accounts are current. Finance costs increased to $181,982 from $43,625 for the six months ended June 30, 2005, as compared to the corresponding period of the prior year, a 3 times or $138,357 increase. The increase is due to financing costs incurred in the health and bio-product segment during the current period which were not in the Group in 2004. Other income increased by $44,684 or 18% from $253,669 to $208,985 for the six months ended June 30, 2005. The other income mainly represents the bad debts recovered as the Group's credit control improved. Other expenses decreased from $183,095 for the six months ended June 30, 2004 to $119,879 for the six months ended June 30, 2005, a 35% or $63,216 decrease. The main reason of the decrease was the reduction of the insurance for the vessels and some sailors being released since the first quarter of 2005. Current income taxes increased from zero to $130,198 in the current period. Such increase was due to the fact that Jiahua Marine earned taxable income in 2005 and HQOF suffered a loss for the six months ended June 30, 2005 and 2004. Minority interest decreased from $337,944 to zero. The change resulted from HQSM's acquisition of the 15.58% minority interest of HQOF in August 2004. The net income attributable to shareholders was $642,322 for the six months ended June 30, 2005, compared with a net loss attributable to shareholders of $2,863,478, a $3,505,800 increase. The increase was due to higher sales and margin in the aquatic segment in 2005 compared to 2004, and the newly acquired bio-product segment and its effect in 2005. LIQUIDITY AND CAPITAL RESOURCES ------------------------------- We have funded capital requirements through cash flow from operations. As of June 30, 2005 we had a cash balance of $ 4,353,245 and a working capital surplus of $3,248,836. This compares with a cash balance of $4,551,505 and a working capital surplus of $1,471,961 as of December 31, 2004. Management believes that, from time to time, we may attempt to raise financing through some combination of commercial bank borrowings or the private or public sale of equity or debt securities, in an effort to ensure that we have access to sufficient funds to meet our needs. However, future equity or debt financings may not be available to us at all, or, if available, may not be on favorable terms. We cannot assure you that these efforts, together with items described 16 above, will be sufficient to fund our growth, or that external funding will be available to us at favorable interest rates or at all. If we are unable to obtain financing in the future, we will continue to develop our business on a reduced scale based on our existing capital resources. On July 25, 2005, we executed a loan guarantee commitment letter with Alps Resources Bankers Inc. (Alps), a Florida corporation, for loan guarantees of up to an aggregate of USD 60 million, such loan to mature in five years from the date of issuance. Alps undertakes, pursuant to the agreement, to secure a bank guarantee from a Standard and Poor's A+ rated Bank The loan guarantees shall be in increments of USD 10 million each. The first loan guarantee closing is anticipated to be on August 15, 2005. No assurances can be given that we will exercise our right to this initial USD 10 million increment. Pursuant to the terms and conditions of the agreement with Alps, we will appoint two directors, designated by Alps, to our Board of Directors and will grant Alps ten million restricted shares of common stock. As a condition of the guarantee, and to secure the repayment of the guarantee, if exercised, Alps will have the right to receive, as collateral in the event of default, a block of control shares from the founders of HQSM. ITEM 3. CONTROL AND PROCEDURES. Evaluation of Disclosure Controls and Procedures We carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Principal Financial Officer, of the effectiveness of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Principal Financial Officer have concluded that our disclosure controls and procedures as of June 30, 2005 were effective to ensure that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. Changes in Internal Controls There have been no material changes in our internal controls over financial reporting or in other factors that could materially affect, or are reasonably likely to affect, our internal controls over financial reporting during the quarter ended June 30, 2005. 17 PART II - OTHER INFORMATION ITEM 1 - LEGAL PROCEEDINGS We are currently not involved in any litigation that we believe could have a materially adverse effect on our financial condition or results of operations. There is no action, suit, proceeding, inquiry or investigation before or by any court, public board, government agency, self-regulatory organization or body pending or, to the knowledge of the executive officers of our company or any of our subsidiaries, threatened against or affecting our company, our common stock, any of our subsidiaries or of our company's or our company's subsidiaries' officers or directors in their capacities as such, in which an adverse decision could have a material adverse effect. ITEM 2 - UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS During the period covered by this report, we have sold securities pursuant to the following transactions, all of which were exempt from the registration requirements of the Securities Act of 1933, as amended (the "Securities Act"). We plan to use the proceeds of all such issuances for working capital and general corporate purposes. In April 2005, we issued 148,000 shares of our common stock to Lucky Ventures Resources Limited in consideration of the financial consultant services rendered to us by that firm. Those securities were issued in reliance upon the exemption from registration provided in Section 4(2) of the Securities Act. In June 2005, we issued 99,999 shares of our common stock to three independent non-executive directors Jacques Vallee, Fred Bild and Daniel Too in consideration of $15,000 of remuneration. During the second quarter of 2005, we issued 1,888,665 shares of our common stock, pursuant to Regulation S promulgated under the Securities Act, to several parties for a gross consideration of $400,325 and net proceeds of $144,214 after payment of escrow, finders' and other fees. ITEM 3 - DEFAULTS UPON SENIOR SECURITES There have been no material defaults. ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters have been submitted to a vote of security holders during the period covered by this report. ITEM 5 - OTHER INFORMATION None. ITEM 6 - EXHIBITS 31.1 Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act. 31.2 Certification of Principal Financial and Accounting Officer Pursuant to Section 302 of the Sarbanes-Oxley Act. 32.1 Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act. 32.2 Certification of Principal Financial and Accounting Officer Pursuant to Section 906 of the Sarbanes-Oxley Act. 18 SIGNATURES Pursuant to the requirements of Section 13 or 15(b) of the Securities Exchange Act of 1934, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of New York, New York, on August 12, 2005. Dated: August 12, 2005 HQ SUSTAINABLE MARITIME INDUSTRIES, INC. By: /s/ Norbert Sporns -------------------------------------------- Name: Norbert Sporns Title: Chief Executive Officer and President