10QSB 1 hq10qsb093005.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 SEPTEMBER 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) 7305 Marie-Victorin, Suite 100, Brossard, Quebec, Canada, J4W 1A6 Tel. (450) 465 3474 ------------------------------------------------- (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 September 30, 2005, there were 107,817,527 shares of the registrant's common stock outstanding. -------------------------------- TABLE OF CONTENTS -------------------------------- Page Numbers ------------ PART I - FINANCIAL INFORMATION Item 1. Financial Statements. |_| Condensed Consolidated Balance Sheets 2-3 |_| Condensed Consolidated Statements of Income 4 |_| Condensed Consolidated Statements of Cash Flows 5 |_| Notes to Condensed Consolidated Financial Statements 6-11 Item 2. Management Discussions & Analysis of Financial Condition and Results of Operations. 13-19 Item 3. Controls and Procedures 20 PART II - OTHER INFORMATION Item 1. Legal Proceedings 21 Item 2. Unregistered Sales of Equity securities and Use of Proceeds 21 Item 3. Defaults Upon Senior Securities 21 Item 4. Submission of Matters to a Vote of Security Holders 21 Item 5 Other Information 22 Item 6. Exhibits and Reports on Form 8-K 22 1
HQ SUSTAINABLE MARITIME INDUSTRIES, INC. AND SUBSIDIARIES (INCORPORATED IN THE STATE OF DELAWARE WITH LIMITED LIABILITY) CONDENSED CONSOLIDATED BALANCE SHEETS ASSETS ------ September 30, 2005 December 31, 2004 (Unaudited) (Audited) ------------------ ------------------ CURRENT ASSETS Cash and cash equivalents $ 4,265,370 $ 4,551,505 Trade receivables, net of provision 8,845,415 5,406,172 Inventory 1,033,826 228,564 Prepayments 75,960 1,932 Due from related parties, net of provision 456,874 388,506 Advance to employees 130,304 27,918 Tax recoverable 21,231 81,602 ------------------ ------------------ TOTAL CURRENT ASSETS 14,828,980 10,686,199 ------------------ ------------------ OTHER ASSETS Deferred taxes 1,185,804 1,209,790 Deferred cost 180,000 -- ------------------ ------------------ TOTAL OTHER ASSETS 1,365,804 1,209,790 ------------------ ------------------ PROPERTY, PLANT AND EQUIPMENT, NET 8,310,039 9,029,673 ------------------ ------------------ VESSELS HELD FOR SALE -- -- ------------------ ------------------ TOTAL ASSETS $ 24,504,823 $ 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 ------------------------------------ September 30, 2005 December 31, 2004 (Unaudited) (Audited) ------------------ ------------------ CURRENT LIABILITIES Accounts payable and accrued expenses $ 3,973,252 $ 4,204,630 Bank loans 4,562,269 4,457,831 Tax payable 210,946 -- Due to related parties 554,409 86,994 Due to directors 98,606 209,361 Convertible notes 255,422 255,422 ------------------ ------------------ TOTAL CURRENT LIABILITIES 9,654,904 9,214,238 ------------------ ------------------ OTHER LIABILITIES Promissory note 100,000 100,000 ------------------ ------------------ TOTAL LIABILITIES 9,754,904 9,314,238 ------------------ ------------------ SHAREHOLDERS' EQUITY Share capital 107,817 95,055 Additional paid-in capital 14,009,722 13,099,205 Reserves 1,574,674 1,146,316 Exchange difference 234,296 -- Accumulated losses (1,176,590) (2,729,152) ------------------ ------------------ TOTAL SHAREHOLDERS' EQUITY 14,749,919 11,611,424 ------------------ ------------------ TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 24,504,823 $ 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 Nine Months Ended September 30, September 30, September 30, September 30, 2005 2004 2005 2004 ------------- ------------- ------------- ------------- SALES $ 8,512,981 $ 7,665,287 $ 18,045,622 $ 8,367,579 COST OF SALES 5,065,821 4,575,381 10,085,144 5,323,743 ------------- ------------- ------------- ------------- GROSS PROFIT 3,447,160 3,089,906 7,960,478 3,043,836 SELLING AND DISTRIBUTION EXPENSES 51,862 124,775 158,247 220,976 ADVERTISING 845,960 542,409 2,676,962 542,409 GENERAL AND ADMINISTRATIVE EXPENSES 497,576 848,254 1,654,630 2,218,258 DEPRECIATION 238,593 255,656 719,635 414,334 PROVISION FOR DOUBTFUL ACCOUNTS (RECOVERY) 197,226 (2,284,953) 26,594 (1,015,291) ------------- ------------- ------------- ------------- PROFIT FROM OPERATIONS 1,615,943 3,603,765 2,724,410 663,150 FINANCE COSTS 96,474 136,361 278,457 179,986 OTHER EXPENSES 25,268 68,551 145,147 251,646 ------------- ------------- ------------- ------------- PROFIT BEFORE INCOME TAXES 1,494,201 3,398,853 2,300,806 231,518 INCOME TAXES CURRENT 138,360 -- 268,558 -- DEFERRED 17,241 165,303 51,327 199,390 ------------- ------------- ------------- ------------- NET PROFIT BEFORE MINORITY INTEREST 1,338,600 3,233,550 1,980,921 32,128 MINORITY INTEREST -- -- -- 337,944 ------------- ------------- ------------- ------------- NET PROFIT ATTRIBUTABLE TO SHAREHOLDERS $ 1,338,600 $ 3,233,550 $ 1,980,921 $ 370,072 ============= ============= ============= ============= NET PROFIT PER SHARE BASIC AND DILUTED $ 0.01 $ 0.05 $ 0.02 $ 0.01 ============= ============= ============= ============= WEIGHTED AVERAGE COMMON SHARE OUTSTANDING - BASIC 100,874,941 70,031,231 99,332,094 44,820,674 ============= ============= ============= ============= WEIGHTED AVERAGE COMMON SHARE OUTSTANDING - DILUTED 102,693,123 70,031,231 101,150,276 44,820,674 ============= ============= ============= =============
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 NINE MONTHS ENDED SEPTEMBER 30, 2005 AND 2004 (UNAUDITED) 2005 2004 ------------ ------------ CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 1,980,921 $ 32,128 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 719,634 414,334 (Increase)/decrease in assets: Inventory (805,262) (351,590) Trade receivables, net of provisions (3,439,243) 3,942,164 Prepayment (74,028) 4,262 Advance to employee (102,386) (9,308) Deferred taxes 23,986 199,390 Increase/(decrease) in liabilities: Accounts payables and accrued expenses (231,378) (865,226) Deposit received from customers 271,317 (28,661) Taxes payable -- -- ------------ ------------ Net cash from by operating activities (1,656,439) 3,337,493 ------------ ------------ CASH FLOWS FROM INVESTING ACTIVITIES: Acquisition of property, plant and equipment and construction in progress -- (1,062,149) Cash received from acquisition -- 1,205,193 ------------ ------------ Net cash from by investing activities -- 143,044 ------------ ------------ CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from common stock 923,278 415,000 (Payment to)/received from directors (110,756) 14,334 Receive from related parties 399,047 601,888 Capital expenditure -- (3,771,623) Purchase of minority interest from shareholders -- 397,910 Deferred guarantee cost for future financing (180,000) -- Inception/(Repayment) of loans 104,438 (6,265,061) ------------ ------------ Net cash from by financing activities 1,136,008 (8,607,552) ------------ ------------ NET CHANGE IN CASH AND CASH EQUIVALENTS (520,431) (5,127,015) EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS 234,296 -- Cash and cash equivalents, beginning of period 4,551,505 11,037,780 ------------ ------------ Cash and cash equivalents, end of period $ 4,265,370 $ 5,910,765 ============ ============ SUPPLEMENTARY CASH FLOWS DISCLOSURES Interest paid $ 256,578 $ 850,799 ============ ============ 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 SEPTEMBER 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 September 30, 2005 and December 31, 2004 due to the relatively short-term nature of these instruments. 7 NOTE 6 - FOREIGN CURRENCY CONVERSION The Company's financial information is presented in US dollars. The Group uses the average exchange rate for the period and the exchange rate at the balance sheet date to translate its operating results and financial position respectively. Any translation gains and losses are recorded in exchange reserve as a component of shareholders' equity. 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. HQOF and Jiahua Marine were subject to a tax rate of 7.5% during this quarter. HQOF and Jiahua Marine were entitled to a two-year tax exempted and three-year half tax rate holiday from 2001 and 2002 commencing with the first profit-making year, respectively. 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 nine months ended September 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 September 30, 2005 Aquaculture Health and Unallocated Product Bio-product Items Consolidation ----------- ----------- ----------- ------------- Sales to external customers 5,919,597 2,593,384 -- 8,512,981 ======================================================== General and administrative expenses 71,702 21,228 404,646 497,576 Depreciation 161,026 76,161 1,406 238,593 Selling expenses 36,449 15,413 -- 51,862 Advertising -- 845,960 -- 845,960 Provision for doubtful accounts -- 197,226 -- 197,226 Finance costs 65,463 30,673 338 96,474 Profit before taxation 860,607 1,023,963 (390,369) 1,494,201 Taxation 78,802 76,799 -- 155,601 Profit for the period 781,805 947,164 (390,369) 1,338,600 ======================================================== Segment assets 14,360,429 9,566,388 578,006 24,504,823 ========================================================= Segment liabilities 5,711,106 2,527,907 1,555,891 9,794,904 ======================================================== Business segment for the nine months ended September 30, 2005 Aquaculture Health and Unallocated Product Bio-product Items Consolidation ----------- ----------- ----------- ------------- Sales to external customers 11,076,907 6,968,715 -- 18,045,622 ======================================================== General and administrative expenses 318,368 74,010 1,262,252 1,654,630 Depreciation 488,674 226,783 4,178 719,635 Selling expenses 105,566 52,681 -- 158,247 Advertising -- 2,676,962 -- 2,676,962 Provision for doubtful accounts -- 26,594 -- 26,594 Finance costs 181,947 92,703 3,807 278,457 Profit/(Loss) before taxation 801,008 2,758,439 (1,258,641) 2,300,806 Taxation 112,888 206,997 -- 319,885 Profit/(Loss) for the period 688,120 2,551,442 (1,258,641) 1,980,921 ======================================================== Segment assets 14,360,429 9,566,388 578,006 24,504,823 ======================================================== Segment liabilities 5,711,106 2,527,907 1,555,891 9,794,904 ======================================================== 9 Business segment for the three months ended September 30, 2004 Aquaculture Health and Unallocated Product Bio-product Items Consolidation ----------- ----------- ----------- ------------- Sales to external customers 6,477,639 1,187,648 -- 7,665,287 ========================================================= General and administrative expenses 189,191 (45,685) 704,748 848,254 Depreciation 205,543 48,680 1,433 255,656 Selling expenses 112,834 11,941 -- 124,775 Advertising -- 542,409 -- 542,409 Provision for doubtful accounts (2,284,953) -- -- (2,284,953) Finance costs 61,055 8,233 67,073 136,361 Profit/(Loss) before taxation 3,682,011 499,429 (782,587) 3,398,853 Taxation 165,303 -- -- 165,303 Profit/(Loss) for the period 3,516,708 499,429 (782,587) 3,233,550 ========================================================= Segment assets 13,116,228 7,966,945 2,088,577 23,171,750 ========================================================= Segment liabilities 5,588,320 2,435,113 11,747,361 19,770,794 ========================================================= Business segment for the nine months ended September 30, 2004 Aquaculture Health and Unallocated Product Bio-product Items Consolidation ----------- ----------- ----------- ------------- Sales to external customers 7,179,931 1,187,648 -- 8,367,579 ========================================================= General and administrative expenses 902,274 (45,685) 1,361,669 2,218,258 Depreciation 363,266 48,680 2,388 414,334 Selling expenses 209,035 11,941 -- 220,976 Advertising -- 542,409 -- 542,409 Provision for doubtful accounts (1,015,291) -- -- (1,015,291) Finance costs 66,690 8,233 105,063 179,986 Profit/(Loss) before taxation 1,201,209 499,429 (1,469,120) 231,518 Taxation 199,390 -- -- 199,390 Profit/(Loss) for the period 1,001,819 499,429 (1,469,120) 32,128 ========================================================= Segment assets 13,116,228 7,966,945 2,088,577 23,171,750 ========================================================= Segment liabilities 5,588,320 2,435,113 11,747,361 19,770,794 =========================================================
10
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 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 September 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 Nine months ended September 30, 2004 September 30, 2004 ------------------ ------------------ USD (`000) USD (`000) Turnover 10,203 13,302 Profit / (Loss) from operations 402 (502) Net income attributable to shareholder 2,420 1,530 ======================================= Weighted average outstanding number of shares as at December 31, 2004 69,770,366 69,770,366 Earnings per share 0.03 0.02
11 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. 12 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 and net realizable value. Cost is calculated on the weighted 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 weighted 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. 13 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 September 30, 2005 as Compared to Three Months Ended September 30, 2004 One of our subsidiaries, Jiahua Marine (which was acquired in August 2004) was engaged in manufacturing and selling of health and bio-product. During the three months ended September 30, 2005 and 2004, Jiahua Marine contributed sales of $2,593,384 and $1,187,648 to the Group respectively. The gross profit ratio for this segment was about 85% for both periods and the major expense was advertising, corresponding to about 33% and 46% of revenue for the three months ended September 30, 2005 and 2004 respectively. The net income contributed by this segment was $947,164 and $499,429 for the three months ended September 30, 2005 and 2004 respectively. The other principal activity of the Group was the manufacturing and selling of aquatic products. The revenue contributed by this segment was $5,919,597 and $6,477,639 for the three months ended September 30, 2005 and 2004, respectively. The gross profit ratio of this segment was at 21% and 28% for the three months ended September 30, 2005 and 2004, respectively. This segment contributed $781,805 and $3,516,708 to net income for the three months ended September 30, 2005 and 2004, respectively; in 2004, there was a non-recurring recovery of bad debt which affected results materially. For the three months ended September 30, 2005 revenue increased by $847,694 or 11% to $8,512,981. This compares to $7,665,287 for the corresponding period of prior year. The increase resulted from improved performance by the health and bio-product segment in 2005; the sales in the aquatic product segment decreased by $0.6 million compared to the third quarter of 2004 but it was covered by the increase in sales of health and bio-product at $1.4 million. In third quarter of 2004, the production in the aquaculture product segment resumed from major renovations of our factory during the first half of 2004, as customers required more products after the long renovations period of 2004. . The 2005 increase of revenue from the health and bio-product segment was due to the fact that in the current quarter, sales included three months of operating results of Jiahua Marine, compared to one and a half month of operating results in 2004 as Jiahua Marine was acquired in August 17, 2004. Cost of sales increased by $490,440 or 11% to $5,065,821 from $4,575,381 for the three months ended September 30, 2005, as compared to the corresponding period of the prior year. Approximately 78% of the increase was due to the increased activities in the health and bio-product segment as that segment operated since the acquisition of Jiahua Marine from August 2004. The overall percentage of increase in cost of sale is almost the same as that of revenue, supporting a stable gross profit ratio in our company. 14 Selling and distribution expenses decreased by $72,913 or 58% to $51,862 for the three months ended September 30, 2005, as compared to the corresponding period of the prior year. The decrease was the result of better cost control in the current quarter. Advertising expenses increased by $303,551 or 56% from $542,409 as compared to the corresponding period of 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, representing one and a half month of advertising expenses for last year compared to three months of advertising expenses in current quarter. General and administrative expenses decreased by $350,678 or 41% to $497,576 as compared to the corresponding period of the prior year. In 2004, our company went public which required a high level of resources to be allocated to that activity. In 2005, management improved their cost control to reduce the expenses to current level. Depreciation decreased by $17,063 or 7% to $238,593 as compared to the corresponding period of prior year. The decrease was caused by several assets being fully depreciated in last quarter, thus requiring less depreciation in 2005 compared to the corresponding period of the 2004. Provision for doubtful accounts increased to $197,226 in the current quarter from a recovery of $2,284,953 for the corresponding quarter of previous year. The 2004 expense was the result of providing conservatively the slow paying customers as application of our Group policy. Profit from operations, before considering the bad debt recovery of the 2004 third quarter, improved from $1,318,812 in 2004 to $1,615,943, an increase of 22% or $297,131. The improvement is related to higher volume and gross profit in 2005 compared to 2004, added to better control of our costs. Finance costs decreased to $96,474 from $136,361 for the three months ended September 30, 2005 as compared to the corresponding period of the prior year, a 29% or $39,887 decrease. The decrease was mainly due to the interest on debenture issued at acquisition of Jiahua Marine in August 2004, which was almost totally paid since. Other expenses decreased from $68,551 for the three months ended September 30, 2004 to $25,268 for the three months ended September 30, 2005, a 63% or $43,283 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. Profit before income taxes decreased to $1,494,201 in the current 2005 quarter from $3,398,853 in the comparative 2004 quarter, a 56% reduction over 2004. That decrease was the result of a bad debt recovery in 2004 which was not repeated in 2005. Without considering that unusual bad debt recovery, profit before income taxes would be higher in the current 2005 quarter by approximately $380,000 over the same quarter of 2004. That improvement of $380,000 in 2005 is the result of an overall higher volume and gross profit in the 2005 quarter, added to better controls of our costs. Current income taxes increased from zero to $138,360 in the current period. Such increase was due to the fact that Jiahua Marine and HQOF earned taxable income for the three months ended September 30, 2005 while Jiahua Marine was under two years tax-free holiday and HQOF suffered a loss for the three months ended September 30, 2004. 15 Deferred income tax decreased by $148,062 from $165,303 to $17,241 for the three months ended September 30, 2005. The decrease was due to the temporary differences arising from provision for bad debts and the bad debts recovery recorded in 2004. The net income attributable to shareholders decreased by $1,894,950 or 59% to $1,338,600. The decrease was due to the non-recurring bad debt recovery of 2004 of approximately $2.3 million. 16 Results of Operations - Nine Months Ended September 30, 2005 as Compared to Nine Months Ended September 30, 2004 One of our subsidiaries, Jiahua Marine was engaged in manufacturing and selling of health and bio-products. During the nine months ended September 30, 2005 and 2004, Jiahua Marine contributed $6,968,715 and $ 1,187,648 to the revenue of the Group, respectively. The increase in volume is due to the integration of Jiahua Marine from acquisition date of August 2004. The gross profit ratio for this segment was around 85% for both periods and the major expense for this segment was advertising, corresponding to about 38% and 46% of sales for the nine months ended September 30, 2005 and 2004, respectively. The net profit of this segment was $2,551,442 and $499,249 for the nine months ended September 30, 2005 and 2004 respectively. The increase was due to Jiahua Marine being acquired in August 2004. The other principal activity of the Group remained to be manufacturing and selling of aquatic products. The revenue contributed by this segment was $11,076,907 and $7,179,931 for the nine months ended September 30, 2005 and 2004, respectively. The gross profit ratio of this segment was 18% for the nine months ended September 30, 2005 compared to gross profit ratio of 28% for the nine months ended September 30, 2004. This segment's contribution to net income was $688,120 for the current period while it showed a net profit of $1,001,819 for the corresponding period of 2004. Since the production was stopped in the first half of 2004 because of major renovations in the factory in that period, the profit of 2004 was due essentially to the recovery of bad debt in that period. For the nine months ended September 30, 2005 revenue increased by $9,678,043 or 116% to $18,045,622 from $8,367,579 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 increase by $3.9 million compared to the corresponding period of 2004 as its activities resumed normal levels in 2005. The production of the first half of 2004 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 was one and a half month of activities in our Group for that segment in 2004 compared to nine months for 2005. This segment saw its sales increasing by $5.8 million compared to the corresponding period of 2004. Cost of sales increased by $4,761,401 or 89% to $10,085,144 from $5,323,743 for the nine months ended September 30, 2005, as compared to the corresponding period of the prior year. Approximately 78% 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 Jiahua Marine in August 2004. Selling and distribution expenses decreased by $62,729 or 28% to $158,247 for the nine months ended September 30, 2005, as compared to the corresponding period of the prior year. The decrease was the result of better cost control in current period. Advertising expenses increased by $2,134,553 from $542,409 as compared to the corresponding period of 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 neutraceutical products to achieve customer recognition which is consistent with industry practices. 17 General and administrative expenses decreased by $563,628 or 25% to $1,654,630 as compared to the corresponding period of the prior year. In 2004, our Company went public which required a high level of financial resources to be allocated to that activity. Also, in 2005, management improved costs resulting in the decrease in such expenses in 2005. Depreciation increased by $305,301 to $719,635 as compared to the corresponding period to the previous 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 increased to $26,594 for the 9 months period of 2005 from a recovery of $1,015,291 for the corresponding period of 2004. The increase was the result of providing conservatively the slow paying customers as application of our Group policy. Profit from operations, before considering the bad debt recovery of the 2004 nine months period, improved from a loss of $352,141 in 2004 to a profit of $2,724,410 in 2005, an improvement of $3,076,551. The improvement is mostly related to higher volume and gross profit in 2005 compared to 2004, resulting from the acquisition of Hainan Jiahua in August 2004 and to HQOF having resumed its normal level of activities in the third quarter of 2004. Finance costs increased to $278,457 from $179,986 for the nine months ended September 30, 2005 as compared to the corresponding period of the prior year, a 55% or $98,471 increase. The increase was due to financing costs incurred in the health and bio-product segment in 2005, which were inexistent in the Group in 2004 as Jiahua Marine was acquired in August 2004. Other expenses decreased from $251,646 for the nine months ended September 30, 2004 to $145,147 for the nine months ended September 30, 2005, a 42% or $106,499 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. Profit before income taxes increased to $2,300,806 for the 9 months period ending September 30th, 2005, from a profit of $231,518 for the corresponding period of 2004. That improvement is the result of higher sales volume with better margins in 2005 resulting from the acquisition of Hainan Jiahua having an effect for 9 months in 2005, and also to the activities of HQOF having resumed its normal levels after the renovation period of 2004. Current income taxes increased from zero to $268,558 in the current period as compared to the corresponding period of 2004. Such increase was due to the fact that Jiahua Marine and HQOF earned taxable income for the nine months period ended September 30, 2005 while Jiahua Marine was under a two years tax holiday in 2004 and HQOF suffered a loss for the nine months period ended September 30, 2004. Deferred income tax decreased by $148,063 from $199,390 to $51,327 for the nine months ended September 30, 2005. The decrease was due to the temporary differences arising from provision for bad debts and the bad debts recovery recorded in 2004. 18 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 $1,980,921 for the nine months ended September 30, 2005, compared with a net profit attributable to shareholders of $370,072, a $1,610,849 or 4 times increase. The increase was due to higher sales and related margins in the aquatic segment in 2005 compared to 2004, and the newly acquired bio-product segment having taken its full effect in 2005. 19 LIQUIDITY AND CAPITAL RESOURCES ------------------------------- In 2005, we have funded our capital requirements through cash flow generated from operations and issuance of share capital. As of September 30, 2005 we had a cash balance of $ 4,265,370 and a working capital surplus of $5,174,076. 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 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. SUBSEQUENT EVENT In October 2005, our Company entered into an agreement with Amalgamated Resources Holdings Inc (Alps), a Florida based corporation, in order to obtain from Alps loan guarantees of up to $70 millions. Our Company, only upon exercise of those guarantees, committed to appoint two representatives of Alps to our Board of Directors; also, upon exercise of those guarantees, Alps will receive as collateral a block of control shares from the founders of our Company. No assurances can be given that our Company will exercise their rights in that respect. The funds are intended to be used to execute the roadmap announced earlier this year by our Company. 20 ITEM 3. CONTROL AND PROCEDURES. We maintain disclosure controls and procedures that are designed to ensure that information that is required to be disclosed in the Securities Exchange Act of 1934 reports are recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and that such information is accumulated and communicated to our management to allow timely decisions regarding required disclosure. At the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and President and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934, as amended. Based upon this evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective under Rule 13a-15. There were no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the end of the period covered by this report, including any significant deficiencies or material weaknesses of internal controls that would require corrective action. 21 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 July 2005, we issued 1,000,000 Class A shares of our common stock to Andrea Cortellazi and Proactive Computer Services Inc as consideration of services related to obtaining the financial guarantees recently provided to us. In August 2005 we issued 1,200,000 shares of our common stock to Lucky Ventures Resources Limited in consideration of financial consulting services provided 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 September 2005, we issued 3,300,000 shares of our common stock to Wang Guoliang, Shui Hong Enterprises Limited and Wu Zhi Quan in consideration of the consulting services rendered to us by those parties. Those securities were issued in reliance upon the exemption from registration provided in Section 4(2) of the Securities Act. During the third quarter of 2005, we issued 2,056,004 shares of our common stock, pursuant to Regulation S promulgated under the Securities Act, to several parties for a gross consideration of $344,128 and net proceeds of $123,854 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. 22 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. 23 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 November 14, 2005. Dated: November 14, 2005 HQ SUSTAINABLE MARITIME INDUSTRIES, INC. By: /s/ Norbert Sporns ------------------------------------- Name: Norbert Sporns Title: Chief Executive Officer and President 24