UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

_____________________________

FORM 20-F/A

(Amendment No. 1)

_____________________________

OR

For the fiscal year ended September 30, 2011

OR

OR

Date of event requiring this shell company report:

Commission file number

Lizhan Environmental Corporation
(Exact name of Registrant as Specified in its Charter)

Cayman Islands
(Jurisdiction of Incorporation or Organization)

No. 716, Qifu Road, Wutong Street, Tongxiang

Zhejiang Province, 314500, People’s Republic of China
(Address of Principal Executive Offices)

Tel: (86) 573-88986299 Fax: (86)-573-88986399

(Name, Telephone, E-mail and/or Facsimile Number and Address of Company Contact Person)

Securities registered or to be registered pursuant to Section 12(b) of the Act:

Securities registered or to be registered pursuant to Section 12(g) of the Act:

None
(Title of Class)

Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act:

None
(Title of Class)

The number of outstanding shares of each of the issuer’s classes of capital or common stock as of March 30, 2012 was: 13,643,750 ordinary shares, par value $0.32 per share.

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes   No ý 

If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

Yes ý  No  

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days:

Yes   No  

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes ý  No  

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer         Accelerated filer       Non-accelerated filer ý 

Indicate by check mark which basis of accounting the registrant has used to prepare the financial statements included in this filing:

ý U.S. GAAP   International Financial Reporting Standards as issued by the International Accounting
Standards Board     Other  

If “Other” has been checked in response to the previous question, indicate by check mark which financial statement item the registrant has elected to follow: Item 17     Item 18  

If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes   No ý 

 Explanatory Note

This Annual Report on Form 20-F/A (“Form 20-F/A”) is being filed as Amendment No.1 to our Annual Report on Form 20-F for the year ended September 30, 2011, which was originally filed with the Securities and Exchange Commission (the “SEC”) on April 12, 2012. This Form 20-F/A amends and restates Item 15. Controls and Procedures.

LIZHAN ENVIRONMENTAL CORPORATION
FORM 20-F ANNUAL REPORT
TABLE OF CONTENTS

Page

ii

CERTAIN INFORMATION

In this annual report on Form 20-F, unless otherwise indicated, “we,” “us,” “our,” the “Company” and “Lizhan” refer to Lizhan Environmental Corporation, a company organized in the Cayman Islands, its predecessor entities and its subsidiaries.

Unless the context indicates otherwise, all references to “China” and the “PRC” refer to the People’s Republic of China.  All references to “Renminbi” or “RMB” are to the legal currency of the People’s Republic of China and all references to “U.S. dollars,” “dollars” and “$” are to the legal currency of the United States (“U.S”). This annual report contains translations of Renminbi amounts into U.S. dollars at specified rates solely for the convenience of the reader. We make no representation that the Renminbi or U.S. dollar amounts referred to in this report could have been or could be converted into U.S. dollars or Renminbi, as the case may be, at any particular rate or at all. On March 30, 2012, the cash buying rate announced by the People’s Bank of China was RMB 6.2943 to $1.00.

FORWARD-LOOKING STATEMENTS

This report contains “forward-looking statements” for purposes of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 that represent our beliefs, projections and predictions about future events. All statements other than statements of historical fact are “forward-looking statements,” including any projections of earnings, revenue or other financial items, any statements of the plans, strategies and objectives of management for future operations, any statements concerning proposed new projects or other developments, any statements regarding future economic conditions or performance, any statements of management’s beliefs, goals, strategies, intentions and objectives, and any statements of assumptions underlying any of the foregoing. Words such as “may”, “will”, “should”, “could”, “would”, “predicts”, “potential”, “continue”, “expects”, “anticipates”, “future”, “intends”, “plans”, “believes”, “estimates” and similar expressions, as well as statements in the future tense, identify forward-looking statements.

These statements are necessarily subjective and involve known and unknown risks, uncertainties and other important factors that could cause our actual results, performance or achievements, or industry results, to differ materially from any future results, performance or achievements described in or implied by such statements. Actual results may differ materially from expected results described in our forward-looking statements, including with respect to correct measurement and identification of factors affecting our business or the extent of their likely impact, and the accuracy and completeness of the publicly available information with respect to the factors upon which our business strategy is based or the success of our business.

Forward-looking statements should not be read as a guarantee of future performance or results, and will not necessarily be accurate indications of whether, or the times by which, our performance or results may be achieved. Forward-looking statements are based on information available at the time those statements are made and management’s belief as of that time with respect to future events, and are subject to risks and uncertainties that could cause actual performance or results to differ materially from those expressed in or suggested by the forward-looking statements. Important factors that could cause such differences include, but are not limited to, those factors discussed under the headings “Risk Factors”, “Operating and Financial Review and Prospects,” and elsewhere in this report.

ITEM 1.       Identity of Directors, Senior Management and Advisors

1.A.         Directors and Senior Management

Not Applicable.

1.B.         Advisors

Not Applicable.

1.C.         Auditors

Not Applicable.

ITEM 2.       Offer Statistics and Expected Timetable

Not Applicable.

ITEM 3.                KEY INFORMATION

3.A.         Selected Financial Data

The following selected financial information should be read in connection with, and is qualified by reference to, our consolidated financial statements and their related notes and the section entitled “Operating and Financial Review and Prospects” included elsewhere in this annual report. The consolidated statements of income data for the fiscal years ended September 30, 2009, 2010 and 2011 and the balance sheet data as of September 30, 2010 and 2011 are derived from audited consolidated financial statements included elsewhere in this annual report. The balance sheet data as of September 30, 2009 have been derived from audited financial statements that are not included in this annual report. The consolidated statement of income data for the fiscal years ended September 30, 2007 and 2008 and the balance sheet data as of September 30, 2007 and 2008 have been derived from financial statements that are not included in this annual report. The consolidated income and balance sheet data as of, and for the year ended, September 30, 2007 reflect our operations and financial condition from December 6, 2005, which was the date Lizhan Textile (Zhejiang) Co., Ltd. ("Lizhan Textile"), was formed, through September 30, 2007. Until production activities commenced in November 2007, Lizhan Textile was engaged in research and development activities. Our historical results for any prior period are not necessarily indicative of results to be expected in any future period.

3.A.3.     Exchange Rates

3.B.         Capitalization and Indebtedness

Not Applicable. 

3.C.         Reasons For The Offer And Use Of Proceeds

Not Applicable.

3.D.         Risk Factors

You should carefully consider the risks described below in evaluating our business. If any of the following risks were to occur, our business, results of operations and financial condition could be harmed. In that case, you might lose all or part of your investment in our ordinary shares. You should also refer to the other information set forth in this annual report, including our consolidated financial statements and the related notes and the section entitled “Operating and Financial Review and Prospects.”

We have a limited operating history which provides limited reference for you to evaluate our ability to achieve our business objectives.

We were formed in August 2009 as a Cayman Islands exempted limited liability company. We have two operating subsidiaries; Lizhan Textile, which was formed in the PRC as a limited liability company on December 6, 2005, and Hongzhan (Zhejiang) New Material Co. Ltd., or Hongzhan, which was formed in the PRC as a wholly foreign owned enterprise on December 8, 2009. Lizhan Textile did not generate significant revenues prior to our 2008 fiscal year and Hongzhan operated at a loss as of September 30, 2011 .  Our financial condition, results of operations and future success will depend on our ability to continue to operate and expand our business profitably and to achieve significant economies of scale. Our company has a limited operating history, is subject to the risks and uncertainties associated with early stage companies and prior to our 2008 fiscal year operated at a loss. Accordingly, you will have a limited basis on which to evaluate our ability to achieve our business objectives. We cannot assure you that we will be able to operate our expanded business profitably. If we fail to achieve our business objectives, then we may not be able to realize our expected revenue growth, maintain our existing revenue levels or operate at a profit. Even if we do realize our business objectives, our business may not be profitable in the future.

Our operations are cash intensive, and our business could be adversely affected if we fail to maintain sufficient levels of liquidity and working capital.

During the past three fiscal years, we spent a significant amount of cash on our operational and investment activities, principally to procure raw materials for our products, to construct our Colgre Product (formerly known as “Evergreen LZ Collagen” or “Evergreen Products” as described below under “Item 4B. Business Overview – Our Products – Colgre Products”) facilities and to acquire capital equipment. We financed operational and investment activities mainly from cash generated from operations, bank loans and proceeds from bank acceptance notes. If we fail to generate sufficient cash flow from these sources, we may not have sufficient liquidity to fund our operating costs and our business could be adversely affected.

Our short-term and long-term loans are from Chinese banks and are generally secured by our buildings, land use rights, and guarantees provided by our Chairman Mr. Liu and other unrelated parties. The term of all short-term loans is one year or less. Historically, we have rolled over such loans on an annual basis. However, we may not have sufficient funds available to pay all of our borrowings upon maturity. Failure to roll over our short-term borrowings at maturity or to service our debt could result in the imposition of penalties, including increases in interest rates, legal actions against us by our creditors, or even insolvency.

Management anticipates that our existing capital resources and current and expected bank loans, and bank acceptance notes will be adequate to satisfy our liquidity requirements for the next twelve months. However, if available liquidity is not sufficient to meet our operating and loan obligations as they come due, our plans include considering pursuing alternative financing arrangements, reducing expenditures as necessary, or limiting our plans for expansion to meet our cash requirements. However, there is no assurance that, if required, we will be able to raise additional capital, reduce discretionary spending or efficiently limit our expansion to provide the required liquidity. Currently, the capital markets for small capitalization companies are extremely difficult and banking institutions have become stringent in their lending requirements. Accordingly, we cannot be sure of the availability or terms of any third party financing. If we are unable to raise additional financing, we may be unable to implement our long-term business plan, develop or enhance our products, take advantage of future opportunities or respond to competitive pressures on a timely basis, if at all. In addition, a lack of additional financing could force us to substantially curtail or cease operations.

The capital we  raised in November 2010  is insufficient to meet our capital needs, and we may be required to curtail or significantly reduce our expansion plans.

In November 2010, we raised $10.0 million in an initial public offering. We used the proceeds of such offering to install Colgre Product production lines. However, the capital we raised in our initial public offering was insufficient to meet our capital needs for this expansion.  Consequently, we required additional capital to expand the production capacity of our Colgre Products and develop a distribution network for our Colgre Products. There can be no assurance that financing will be available in amounts or on terms acceptable to us, if at all. The inability to obtain additional capital may reduce our ability to develop our business. If we are unable to obtain additional financing, we will likely be required to curtail or significantly reduce our expansion plans. Further, in the event that we were to raise equity in the future to finance future growth, any such additional equity financing may involve substantial dilution to our then existing shareholders.

We do not satisfy the NASDAQ Global Market’s requirements for continued listing and we may not satisfy the NASDAQ Capital Market’s listing requirements. If we cannot satisfy these requirements, NASDAQ could delist our ordinary shares.

Our ordinary shares are currently listed on the NASDAQ Global Market under the symbol LZEN. On April 9, 2012, we applied to transfer the listing of our ordinary shares to the NASDAQ Capital Market, as we no longer meet the listing requirements for the NASDAQ Global Market. NASDAQ is currently reviewing our application.

We received two letters, dated October 11, 2011 and October 12, 2011, from the NASDAQ Stock Market stating that for the previous 30 consecutive business days, the bid price of our ordinary shares closed below the minimum $1.00 per share and the market value of our publicly held ordinary shares (“MVPHS”) was below the minimum of $5,000,000, both requirements for continued listing on the NASDAQ Global Market pursuant to NASDAQ Marketplace Rules 5450(a)(1) (the “Minimum Bid Price Rule”) and 5450(b)(1) (the “MVPHS Rule”), respectively.

In accordance with NASDAQ Marketplace Rules 5810(c)(3)(A) and 5810(c)(3)(D), we were provided a grace period of 180 calendar days, or until April 9, 2012, to regain compliance by maintaining a closing bid price of at least $1.00 per share and a closing MVPHS of $5,000,000 or more for a minimum of ten consecutive business days. As of April 9, 2012, we did not regain compliance with the Minimum Bid Price Rule or the MVPHS Rule. NASDAQ notified us that our ordinary shares could be delisted from the NASDAQ Global Market, but that pursuant to NASDAQ rule 5810(c)(3)(A)(ii), we were eligible for additional time by applying for a transfer of our ordinary shares to the NASDAQ Capital Market.

 On April 9, 2012, we applied to transfer the listing of our ordinary shares from the NASDAQ Global Market to the NASDAQ Capital Market. We believe that we satisfy the requirements for initial listing on the NASDAQ Capital Market (except for the bid price requirement). We will be required to meet the continued listing requirement for market value of publicly held shares and all other initial listing standards, with the exception of the bid price requirement. We will, however, have to provide written notice of our intention to cure the minimum bid price requirement during the following 180 day period. 

            There can be no assurance that our application to the NASDAQ Capital Market will be approved or that any appeal would be granted by the Listing Qualifications Panel.

Price inflation in China could affect our results of operation if we are unable to pass along raw material price increases to our customers.

Inflation in China has recently increased.  China's consumer price index, the broadest measure of inflation, rose 4.9% in January 2011 from the level in January 2010. Because we purchase raw materials from suppliers in China, price inflation has recently caused an increase in the cost of our raw materials.  Price inflation could affect our results of operation if we are unable to pass along raw material price increases to customers.  In addition, for fiscal year ended 2011, due to increased inflation, the cost of improving our production and manufacturing processes has increased.  Our first production line is not functioning at its full capacity and due to technical difficulties we will require additional capital to improve the manufacturing and production process for our Colgre Products. We believe that approximately $500,000 in additional capital will be required to improve the production process for our Colgre Products in order to operate at full capacity and meet customer demand for 2012. In addition, if inflation continues to rise in China, China could lose its competitive advantage as a low-cost manufacturing venue, which could in turn lessen some of the competitive advantages of our being based in China. Accordingly, increased inflation in China may weaken our competitiveness domestically or in international markets.

Our inability to manage our growth may have a material adverse effect on our business, results of operations and financial condition.

Our growth strategy may not be successful for the following reasons:

·          Our ability to obtain additional capital for growth is subject to a variety of uncertainties, including our operating results, our financial condition, general market conditions for capital raising activities, and economic conditions in China.

·           Our profitability will be adversely affected by the additional costs and expenses associated with the operation of new facilities, increased marketing and sales support activities, technological improvement projects, the recruitment of new employees, the upgrading of our management, operational and financial systems, procedures and controls, and the training and management of our growing employee base. Failure to manage our growth and enlarged business effectively could have a material adverse effect on our business, financial condition and results of operations. We expect our future growth to place significant demands on both our management and our resources. This will require us to continuously evolve and improve our operational, financial and internal controls across our organization. In particular, continued expansion increases the challenges we face in:

·             recruiting, training and retaining sufficient skilled technical, sales and management personnel; 

·             adhering to our high quality and process execution standards; 

·             maintaining high levels of customer satisfaction; 

·             creating and managing economies of scale;   

·             maintaining and managing costs to correspond with timeliness of revenue recognition; and 

·              developing and improving our internal administrative infrastructure, including our financial, operational and communication systems, processes and controls. 

Any inability to manage our growth may have a material adverse effect on our business, results of operations and financial condition.

In the event that we encounter difficulties in developing or selling our Colgre Products or if our customers are not satisfied with our Colgre Products, our business and financial condition may be materially and adversely affected.

Outside of research and development testing, we have never mass produced our Colgre Products. In the event that we encounter difficulties in, or failures with respect to, the installation of machinery and personnel, the manufacture or sale of these products or the development of a new nationwide distribution network, our business and financial condition may be materially and adversely affected. For example, we initially anticipated that our first production line for our Colgre Products would be producing quality fabric at full capacity in 2010. We expected mass production would begin in November 2010, however, production  was delayed due to certain technical modifications to parts of the manufacturing equipment. Further, the fabric produced did not meet the high quality standards of our customers. Although we have experienced delays in producing our Colgre Products and we have not sold as much product as initially anticipated, in June 2011, we completed installation of several additional pieces of equipment for the first production line and subsequently produced approximately 25,000 meters of Colgre Products. Of the 25,000 meters of fabric produced, 15,000 meters were shipped to one of our customers in September, 2011 and the remaining 10,000 meters were shipped to the same customer in October, 2011.  We are currently modifying the first production line and we intend to improve the first production line by making modifications to the existing equipment and adding new equipment. Even if we improve our production line, our customers may not be satisfied with our Colgre Products or a market for the Colgre Products may not fully develop. Any such difficulties or failures could result in financial losses that could have a material adverse effect on our business, cause the price of our ordinary shares to decline and delay or prevent further production or sale of our Colgre Products.

If we fail to offer products that our customers or consumers find attractive, the demand for our products may be limited.

In order for our business to be successful, our product offerings must be useful to consumers, well made and affordable. We may not be successful in offering products that meet these requirements in the future. If our products become less popular with our customers or consumers, or if new products do not become popular with our customers or consumers, or if demand generally for products such as ours decreases or fails to grow, our sales may decline or we may be required to offer our products at lower prices. If customers buy fewer of our products, or if we have to reduce our prices, our net sales would decline and our operating results would be affected adversely.

We believe that our future growth will be substantially dependent on the continued increase in sales growth of existing core products, such as our ultrasuede and synthetic leather powder products and our Colgre Products, while at the same time maintaining or increasing our current gross margin rates. During fiscal year 2009, we launched, and increased rapidly, the production and sales of our recycled leather flocked fabric products, which consist of fabrics that are flocked with recycled leather powder that improve the texture of the fabric. Our recycled leather flocked fabric products are higher margin products and are more environmentally friendly than other purely chemical-based products. During June 2011, we completed the installation of several pieces of equipment for our Colgre Product production line and we intend to improve this first production line by modifying the existing equipment.  We may not be able to increase the growth of existing core products or successfully introduce our Colgre Products or other new products, or to maintain or increase our gross margin rates in future periods. Failure to do so may adversely affect our business.

Moreover, in order to meet our strategic goals, we must successfully identify, obtain supplies of, and offer our customers high quality products on a continuous basis. These products must appeal to a wide range of residential and commercial consumers whose preferences may change in the future. If we misjudge either the market for our products or our customers’ or consumers’ purchasing habits, we may be faced with significant excess inventories for some products and missed opportunities for products we choose not to stock. In addition, our sales may decline or we may be required to sell our products at lower prices. This would adversely affect our business.

We intend to improve our Colgre Product production lines and introduce additional production lines, which, among other things, may continue to divert our resources and may cause our margins to suffer.

Our goal over the next several years will be to improve production and sales of our Colgre Products. This process has diverted, and could continue to divert, resources, including the focus of our management, from the operation of our business. In addition, our attention to our new obligations as a U.S. reporting company, has diverted, and may in the future divert the focus of our management from the operation of our business and from the installation of our Colgre Product production lines. The anticipated improvements to production and expansion of our Colgre Products will increase our costs and potentially decrease operating margins before production is operating at full capacity and revenue is generated, which could, individually or in the aggregate, negatively impact our business, financial condition and results of operations.

Our plans to develop a nationwide network for our Colgre Products in the future entail numerous risks which could materially and adversely affect our business and financial condition.

Currently, many of our domestic customers are located in close proximity to our facilities. We deliver our products directly to the manufacturing facilities of these customers. However, our long-term business strategy relies in large part on establishing a nationwide distribution network throughout the PRC for our Colgre Products. Risks affecting our expansion include challenges caused by geographic distance, cultural differences, compliance with regulations which differ from those to which we are accustomed, expertise and performance of potential distributors and the inability to effectively enforce contractual or other legal rights. These risks could result in increased and unbudgeted costs associated with servicing new markets, which could in turn materially and adversely affect our business and financial condition.

Our revenues and profitability could be impacted because of our dependence on cost efficient raw materials.

Our ability to continue to obtain raw materials is subject to the continued reliability and viability of our suppliers. We launched the production of recycled leather flocked fabric in fiscal year 2009, which are flocked with recycled leather scrap, a lower cost material. Our Colgre Products are also manufactured from recycled leather scrap.  The number of recycled leather scrap suppliers that we use is currently relatively small.  If we are unable to obtain adequate or timely deliveries of required raw materials from certain suppliers, we may be unable to find a replacement that is capable of manufacturing sufficient quantities of our products on a timely basis and at a reasonable cost. This could cause us to lose sales, incur additional costs, delay new product introductions or suffer harm to our reputation and could negatively impact our revenues. Furthermore, if we are unable to obtain our raw materials, and in particular leather scrap, at cost efficient levels, our ability to generate profits may be harmed.

We are subject to various risks and uncertainties that might affect our ability to procure quality raw materials.

Our performance depends on our ability to procure low cost, high quality raw materials, including leather scrap, polyurethane, ultrasuede grey cloth, backing fabric and resin, on a timely basis from our suppliers. Our supplies are subject to certain risks, including availability of raw materials, labor disputes, inclement weather, natural disasters, and general economic and political conditions, which might limit the ability of our suppliers to provide us with low cost, high quality merchandise on a timely basis. Furthermore, for these or other reasons, one or more of our suppliers might not adhere to our quality control standards, and we might not identify the deficiency before the materials are shipped to us or our customers. Our suppliers’ failure to supply quality materials at a reasonable cost on a timely basis could reduce our net sales, damage our reputation and have an adverse effect on our financial condition.

We may have to increase the number of our suppliers of raw materials in the future to meet growing production demands. Despite our efforts to control our supply of raw materials and maintain good relationships with our suppliers, we could lose one or more of our suppliers at any time. The loss of one or more key suppliers could increase our reliance on higher cost or lower quality supplies, which could negatively affect our profitability. In addition, if we have to increase the number of our suppliers in the future to meet growing production demands, we may not be able to locate new suppliers who could provide us with sufficient materials to meet our needs. Any interruptions to, or decline in, the amount or quality of our raw materials supply could materially disrupt our production and adversely affect our business and financial condition and financial prospects.

Because our sales and profitability fluctuate on a seasonal basis, our results of operations may fluctuate from quarter to quarter.

Our production and sales slow considerably during and around the Chinese New Year, which usually occurs during the quarter ended March 31, as a result of the closing of our facilities and the facilities of many of our customers for the New Year’s celebration, as well as the shutting down of our steamers for an annual inspection by local authorities. In addition, our sales volume declines during summer due to the slow demand from the international markets while consumer spending is generally slower for furniture and garments.  Consequently, our results of operations may fluctuate from quarter to quarter.  In addition, any significant decrease in sales during the remainder of the year would have a material adverse effect on our business, our financial condition and our results of operations.

We face intense competition, and if we are unable to compete effectively we may not be able to maintain profitability.

The synthetic leather industry is highly fragmented but highly competitive. We compete with many other companies located in the PRC and internationally that manufacture fabrics similar to ours. Many of our competitors are larger companies with greater financial resources than us. In addition, we expect that as demand in the PRC and in other foreign countries for high quality, low cost synthetic leather and other fabric products continue to grow, new competitors will enter the market. In light of the many competitive challenges facing us, we may not be able to compete successfully. Increased competition could adversely affect our net sales in the future. Moreover, increased competition may result in potential or actual litigation between us and our competitors relating to such activities as competitive sales practices, relationships with key suppliers and customers or other matters. As a result, increased competition may adversely affect our future financial performance or reputation.

Any loss or limitations on our rights to use intellectual property licensed from third parties could have a material adverse effect on our business, operating results and financial condition.

We currently have an exclusive long-term license to use the key patents and patent applications which protects the technology to be used in the manufacture of our Colgre Products. We are, and will continue to be, reliant upon the owner of this patent to protect his intellectual property rights to this technology. While we are not aware of any disputes between the patent owner and us or any third party, the patent owner may determine not to protect his intellectual property rights that we license from him and we may be unable defend such intellectual property rights on our own or we may have to undertake costly litigation to defend the intellectual property rights of the patent owner. Upon the termination of the license agreement for this patent, we may no longer continue to have proprietary rights to the intellectual property that we license from the patent owner. Any loss or limitations on our right to use the intellectual property licensed from the patent owner could have a material adverse effect on our business, operating results and financial condition. In addition, in many countries, the patent owner may be limited to monetary relief and may be unable to enjoin infringement, which could materially diminish the value of the patent.

We are subject to third party claims of intellectual property infringement, which could have a material adverse effect on our business, results of operations and financial condition.

From time to time in the course of our business, we are subject to claims of patent infringement or other intellectual property infringement. Additional infringement claims may be asserted against us in the future. We may also be required to change our methodologies so as not to use any allegedly infringed intellectual property, which may not be technically or commercially feasible and may cause us to expend significant resources. Any claims or litigation relating to intellectual property infringement, whether we ultimately win or lose, could be time-consuming and costly and/or injure our reputation, which could have a material adverse effect on our business, results of operations and financial condition.

We may lose our competitive advantage, and our operations may suffer, if we fail to prevent the loss, misappropriation of, or disputes over, our intellectual property.

We rely on a combination of patents, trademarks, trade secrets and confidentiality agreements to protect our intellectual property rights. Our manufacturing processes are based on technology developed primarily in-house by our research and development and engineering personnel. While we are not aware of any infringement on our intellectual property, our ability to compete successfully and to achieve future revenue growth will depend, in significant part on our ability to protect our proprietary technology and operate without infringing upon the intellectual property rights of others. The legal regime in China for the protection of intellectual property rights is still in an early stage of development. Intellectual property protection became a national effort in China in 1979 when China adopted its first statute on the protection of trademarks. Since then, China has adopted its patent law, trademark law and copyright law and promulgated related regulations. China has also acceded to various international treaties and conventions in this area, such as the Paris Convention for the Protection of Industrial Property, Patent Cooperation Treaty, Madrid Agreement and its Protocol Concerning the International Registration of Marks. In addition, when China became a party to the World Trade Organization in 2001, China amended many of its laws and regulations to comply with the Agreement on Trade-Related Aspects of Intellectual Property Rights. Despite many laws and regulations promulgated, and other efforts made, by China over the past several years in an attempt to protect intellectual property rights, intellectual property rights may not be as expansive or certain in China as they would in many Western countries, including the U.S. Furthermore, enforcement of such laws and regulations in China has not been fully developed. Neither the administrative agencies nor the court systems in China are equipped as their counterparts in developed countries to deal with violations or handle the nuances and complexities between compliant technological innovation and non-compliant infringement.

Our revenues are highly dependent on a limited number of customers and the loss of any one of our major customers could materially and adversely affect our growth and our revenues.

During the years ended September 30, 2009, and 2010 and 2011, our five largest customers contributed approximately 74.9%, 79.1% and 70.4% of our total sales, respectively. As a result of our reliance on a limited number of customers, we may face pricing and other competitive pressures which may have a material adverse effect on our growth and our revenues. The volume of work performed for specific customers is likely to vary from year to year, especially since we are not the exclusive provider for many of our customers. In addition, there are a number of factors, other than our performance, that could cause the loss of a customer or a substantial reduction in the products that we provide to any customer and that may not be predictable. For example, our customers may decide to reduce spending on our products. The loss of any one of our major customers, a decrease in the volume of sales to these customers or a decrease in the price at which we sell our products to them could materially adversely affect our growth and our revenues and harm our reputation in the industry. Moreover, the loss of any one of our major customers could require us to initiate involuntary attrition, which in turn could have a material adverse effect on our attrition rate and make it more difficult for us to attract and retain professionals in the future, which could further materially adversely affect our growth and our revenues. In addition, this customer concentration may subject us to perceived or actual leverage that our customers may have given their relative size and importance to us. If our customers seek to negotiate their agreements on terms less favorable to us and we accept such unfavorable terms, such unfavorable terms may have a material adverse effect on our business, financial condition and results of operations. Accordingly, unless and until we diversify and expand our customer base, our future success will significantly depend upon the timing and volume of business from our largest customers and the financial and operational success of these customers.

Our customers may decide to discontinue purchasing our products, which could materially and adversely affect our growth and our revenues.

Our customers typically retain us through non-exclusive contracts or purchase orders. These agreements typically do not include any commitment by our customers to give us a specific volume of business beyond the particular transaction set forth in the agreement. In addition, the purchase orders that we entered into, including the contracts we entered into June 2011 with respect to our Colgre Products, generally provide that the customer is not required to purchase the products specified in the purchase order if the products do not meet the customers’ quality requirements or other specifications. Our business is dependent on the decisions and actions of our customers, which are outside our control. Decisions by existing customers to refuse to purchase our Colgre Products or existing products due to the failure of such products to meet the customer’s demands, or discontinue purchasing our products, even temporarily, could materially and adversely affect our growth and our revenues.

Our customers operate in a limited number of industries. Factors that adversely affect these industries may materially and adversely affect our business, results of operations and financial condition.

We derive a large portion of our revenues from customers which operate in a limited number of industries. For example, in fiscal years 2009, 2010, and 2011, we derived approximately 97%, 98% and 98.5% of our revenues from our customers in the furniture manufacturing industries. We also sell our products to customers in the upholstery fabric and furniture manufacturing industries and are currently developing nylon taffeta to enable us to sell our products to the apparel industry .  Any significant decrease in spending for our products by customers in these industries or in the other industries from which we derive significant revenues in the future may reduce the demand for our products. For instance, if economic conditions weaken in any of these industries, our clients may reduce or postpone their spending for our products significantly which may negatively affect our revenue and profitability. The loss of, or any significant decline in business from, one or more of our major customers would lead to a significant decline in our revenue and gross profit, particularly if we are unable to make corresponding reductions in our expenses in the event of any such loss or decline. Further, any significant decrease in the growth of the industries into which we intend to expand, or significant consolidation in those industries, or any decrease in growth or consolidation in other industry segments in which we operate, may reduce the demand for our products, which may materially and adversely affect our business, results of operations and financial condition.

If our customers’ businesses are not successful, the volume of purchases and the prices that they are willing to pay for our products may diminish, which could harm our business, results of operations and financial condition.

The success of our business depends on the success of our customers’ businesses. If our customers are not successful, for any reason, the amount of volume of purchases and the prices that they are willing to pay for our products may diminish. Our customers’ decisions about how much money to budget for our products is directly impacted by their own financial success and forecasts of their own customers’ needs. If our customers’ products or services are not sufficiently utilized by their own customers, they may choose to reduce the volume of purchases of our products, which could cause our revenue to decline, which could in turn harm our business, results of operations and financial condition.

In addition, the continuing debt crisis in certain European countries could cause the value of the Euro to deteriorate, reducing the purchasing power of our European customers. Financial difficulties experienced by our suppliers and customers, could result in product delays and inventory issues; risks to accounts receivable could also include delays in collection and greater bad debt expense.

If our customers experience financial difficulties, we could have difficulty recovering amounts owed to us from these customers.

We sell our products to customers that have in the past, and may in the future, experience financial difficulties, particularly in light of the recent global economic downturn. If our customers experience financial difficulties, we could have difficulty recovering amounts owed to us from these customers. While we perform credit evaluations and adjust credit limits based upon each customer’s payment history and credit worthiness, such programs may not be effective in reducing our exposure to credit risk. We evaluate the collectability of accounts receivable, and based on these evaluations may need to make adjustments, to the allowance for doubtful accounts for expected losses. Actual bad debt write-offs may differ from our estimates, which may have a material adverse effect on our financial condition, operating results and cash flows. Our suppliers may also experience financial difficulties, which could result in our having difficulty sourcing the materials and components we use in producing our products. If we encounter such difficulties, we may not be able to produce our products for our customers in a timely fashion which could have an adverse effect on our results of operations, financial condition and cash flows.

Public perception that products developed from our materials may be marketed as genuine leather or that our processing is not environmentally friendly, whether justified or not, could have a material adverse effect on our business, financial condition and results of operations.

Our products are not genuine leather but are designed to look and feel like leather. We and, to our knowledge, our customers, do not market our fabrics or the end products developed from our fabrics as genuine leather. However, we cannot be certain that all manufacturers and marketers of products made from our fibers will refrain from marketing such products as genuine leather. In addition, certain of our products are manufactured from recycled materials and certain of our manufacturing processes are conducted using environmentally friendly methods. Public perception that products developed from our materials are being marketed as genuine leather or that our processing is not environmentally friendly, whether justified or not, could lead to reduced demand for our products, impair our reputation, involve us in litigation, damage our brand names and otherwise have a material adverse effect on our business, financial condition and results of operations.

Our revenues, expenses and profits are difficult to predict and can vary significantly from quarter to quarter. This could cause the trading price of our ordinary shares to decline.

Our quarterly operating results may vary significantly from quarter to quarter. Therefore, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied upon as an indication of our future performance. It is possible that in the future some of our quarterly results of operations may be below the expectations of market analysts and our investors, which could lead to a significant decline in the trading price of our ordinary shares.

As a large part of our revenues in any quarter are derived from existing customers, revenue growth can vary due to project starts and stops and customer specific situations. Factors which affect the fluctuation of our revenues, expenses and profits include:

·              changes in prices of our raw materials, with higher prices leading to reduced operating income; 

·              variations, expected or unexpected, in the duration, size, timing and scope of purchase orders, particularly with our key customers; 

·              the effect of facility closings during and around the Chinese New Year;

·              changes in our pricing policies or those of our customers or competitors; 

·              unanticipated cancellations, non-renewal of our contracts by our customers, contract terminations or deferrals of deliveries; 

·              the effect of hiring patterns, unanticipated attrition and the time required to train and productively utilize our new employees; 

·              changes in compensation, which may reduce our gross profit for the quarter in which they are effected; 

·              the size and timing of expansion of our facilities and opening new facilities; 

·              our inability to manage costs, including those related to our raw materials, personnel, infrastructure and facilities; 

·              exchange rate fluctuations; and 

·              general economic conditions. 

A portion of our expenses, particularly those related to personnel and facilities, are fixed in advance of any particular quarter. As a result, unanticipated variations in the number and timing of our purchase orders or prices of our raw materials may cause significant variations in our operating results in any particular quarter. There are also a number of factors besides our performance that are not within our control that could cause significant fluctuations in our operating results from quarter to quarter.

We expect to undertake strategic acquisitions, joint ventures and alliances, which may prove to be difficult to integrate and manage or may not be successful, and may result in increased expenses or write-offs.

We expect over time to pursue strategic acquisitions, joint ventures and alliances to enhance our capabilities and expand our industry expertise, technical expertise and geographic coverage. It is possible that we may not identify suitable acquisition candidates or alliance or joint venture partners, or if we do identify suitable candidates or partners, we may not complete those transactions on terms commercially acceptable to us or at all. The inability to identify suitable acquisition targets, joint ventures or alliances, or our inability to complete such transactions, may adversely affect our ability to compete and grow.

These types of transactions involve numerous risks, including:

·             difficulties in integrating operations, systems, technologies, accounting methods and personnel; 

·             difficulties in supporting and transitioning clients of our acquired companies or strategic partners; 

·             disruption of our ongoing business; 

·             diversion of financial and management resources from existing operations; 

·             risks of entering new markets; 

·             potential loss of key employees; and 

·             inability to generate sufficient revenue to offset transaction costs and expenses. 

Further, any such transaction that we attempt, whether or not completed, or any media reports or rumors with respect to any such transactions, may materially and adversely affect the value of our ordinary shares.

We may finance future transactions through debt financing or the issuance of our equity securities or a combination of the foregoing. Acquisitions financed with the issuance of our equity securities could be dilutive, which could affect the market price of our ordinary shares. Acquisitions financed with debt could require us to dedicate a substantial portion of our cash flow to principal and interest payments and could subject us to restrictive covenants. Acquisitions also frequently result in the recording of goodwill and other intangible assets that are subject to potential impairments in the future that could harm our financial results. Our inability to identify suitable acquisition targets, strategic investments or partnership or alliance candidates, or to complete such transactions, may negatively affect our competitiveness and growth prospects. Moreover, if we fail to properly evaluate acquisitions, alliances or investments, we may not achieve the anticipated benefits of those transactions, and we may incur costs in excess of what we had anticipated.

Our success depends in large part upon our senior management and key personnel. Our inability to attract and retain these individuals could materially and adversely affect our business, results of operations and financial condition.

We are highly dependent on our senior management and other key employees, including Mr. Jianfeng Liu and Mr. Liwen Zhang. Mr. Liu is the founder of our company and has more than 20 years of experience in our industry. Mr. Zhang, our Chief Scientist, is the lead researcher responsible for our Colgre Products. The skills, knowledge and experience of these individuals, as well as other members of our senior management team, are critical to the growth of our company. Our future performance will be dependent upon the continued service of members of our senior management and key employees. We do not maintain key man life insurance for any of the members of our management team or other key personnel. Competition for senior management in our industry is intense, and we may not be able to retain our senior management and key personnel or attract and retain new senior management and key personnel in the future, which could materially and adversely affect our business, results of operations and financial condition.

Because we have not yet procured business or product liability insurance, and we may not be able to procure business or product liability insurance in the future, we may not be protected from certain risks that are customarily covered by business or product liability insurance in the U.S.

We have not procured product liability or general liability insurance for our business because the insurance industry in China is still in the early stages of its development. To the extent that we suffer a loss of a type which would normally be covered by product liability or general liability insurance in the U.S. we would incur significant expenses in defending any action against us and in paying any claims that result from a settlement or judgment against us. Product liability claims and product recalls may divert the attention of our management and could have a material adverse effect on the demand for our products and on our business, goodwill and reputation. Furthermore, adverse publicity could result in a loss of consumer confidence in our products.

We do not presently maintain business disruption insurance. Any disruption in the operations of our production facility would damage our business and disrupt our production and have a material adverse effect on our business, financial position and on our results of operations.

Our business could be materially and adversely affected by power shortages, natural disasters, terrorist attacks or other events in the PRC. For example, in early 2008, parts of the PRC suffered a wave of strong snow storms that severely impacted public transportation systems and the power supply in those areas. In May 2008, Sichuan Province in the PRC suffered a strong earthquake measuring approximately 8.0 on the Richter scale that caused widespread damage and casualties. The May 2008 Sichuan earthquake may have a material adverse effect on the general economic conditions in the areas affected by the earthquake. In July 2008, explosive devices were detonated on several buses in Kunming, Yunnan Province of the PRC, which resulted in disruptions to public transportation systems in Kunming and casualties. Any future natural disasters, terrorist attacks or other events in the PRC could cause a reduction in usage of, or other severe disruptions to, public transportation systems and could have a material adverse effect on our business and results of operations.

While we have property damage insurance and automobile insurance, we do not carry business disruption insurance, which is not readily available in the PRC. Any disruption of the operations in our production facility would have a significant negative impact on our ability to manufacture and deliver products, which would cause a potential diminution in sales, the cancellation of orders, damage to our reputation and potential lawsuits.

Risks Related to Doing Business in China

China’s energy policies could have an adverse impact on our operations.

The Chinese authorities reduce energy usage from time to time, such as during the summer months when the usage of electricity is high. During the third quarter of 2011, we experienced intermittent power supply disruptions as a result of mandatory power restrictions imposed by the local government of Tongxiang City. We purchased and installed three backup power generators and secured additional diesel supplies, which we used to maintain full operations on the days when electricity from the grid was  not available.   In addition, the Tongxiang Environmental Thermoelectricity Co., Ltd. in Tongxiang City completely shut down its steam production from January 20, 2011 to February 12, 2011 to complete maintenance of its equipment. This mandatory maintenance occurs every three or four years at the local government’s discretion. Steam production has returned to normal since Tongxiang Environmental Thermoelectricity Co., Ltd completed its repairs on February 13, 2011. Additional energy use restrictions could be imposed in the future. Any additional restrictions could adversely impact our results of operations in future periods.

Our operations and assets in China are subject to significant political and economic uncertainties.

Changes in PRC laws and regulations, or their interpretations, or the imposition of confiscatory taxation, restrictions on currency conversion, imports and sources of supply, devaluations of currency or the nationalization of other expropriation of private enterprises could have a material adverse effect on our business, results of operations and financial condition. Under the current political leadership in the PRC, the Chinese government has been pursuing economic reform policies that encourage private economic activity and greater economic decentralization in many industries, including ours. There is no assurance, however, that the Chinese government will continue to pursue these policies with respect to the Chinese economy generally or our industry in particular, or that it will not significantly alter these policies from time to time without notice.

Most of our revenues are denominated in Renminbi, which is not freely convertible for capital account transactions and may be subject to exchange rate volatility.

We are exposed to the risks associated with foreign exchange controls and restrictions in China, as our revenues are primarily denominated in Renminbi, which is currently not freely exchangeable. The PRC government imposes control over the convertibility between Renminbi and foreign currencies. Under the PRC foreign exchange regulations, payments for “current account” transactions, including remittance of foreign currencies for payment of dividends, profit distributions, interest and operation-related expenditures, may be made without prior approval but are subject to procedural requirements. Strict foreign exchange control continues to apply to “capital account” transactions, such as direct foreign investment and foreign currency loans. These capital account transactions must be approved by or registered with the PRC State Administration of Foreign Exchange, or “SAFE”. Further, any capital contribution by an offshore shareholder to its PRC subsidiaries should be approved by the Ministry of Commerce in China or its local counterparts. We cannot assure you that we are able to meet all of our foreign currency obligations to remit profits out of China or to fund operations in China.

On August 29, 2008, SAFE promulgated the Circular on the Relevant Operating Issues concerning the Improvement of the Administration of Payment and Settlement of Foreign Currency Capital of Foreign- invested Enterprises, or “Circular 142”, to regulate the conversion by foreign invested enterprises, or FIEs, of foreign currency into Renminbi by restricting how the converted Renminbi may be used. Circular 142 requires that Renminbi converted from the foreign currency-dominated capital of a FIE may only be used for purposes within the business scope approved by the applicable government authority and may not be used for equity investments within the PRC unless specifically provided for otherwise. In addition, SAFE strengthened its oversight over the flow and use of Renminbi funds converted from the foreign currency-dominated capital of a FIE. The use of such Renminbi may not be changed without approval from SAFE, and may not be used to repay Renminbi loans if the proceeds of such loans have not yet been used. Compliance with Circular 142 may delay or inhibit our ability to complete such transactions, which could affect our ability to expand business.

Fluctuation in the value of the Renminbi and of the U.S. dollar may have a material adverse effect on investments in our ordinary shares.

Any significant revaluation of the Renminbi may have a material adverse effect on the U.S. dollar equivalent amount of our revenues and financial condition as well as on the value of, and any dividends payable on, our ordinary shares in foreign currency terms. For instance, a decrease in the value of Renminbi against the U.S. dollar could reduce the U.S. dollar equivalent amounts of our financial results, the value of your investment in our ordinary shares and the dividends we may pay in the future, if any, all of which may have a material adverse effect on the prices of our common shares. All of our revenues are denominated in Renminbi. Any further appreciation of Renminbi against U.S. dollars may result in significant exchange losses.

Prior to 1994, Renminbi experienced a significant net devaluation against most major currencies, and there was significant volatility in the exchange rate during certain periods. Upon the execution of the unitary managed floating rate system in 1994, the Renminbi was devalued by 50% against the U.S. dollar. Since 1994, the Renminbi to U.S. dollar exchange rate has largely stabilized. On July 21, 2005, the People’s Bank of China announced that the exchange rate of U.S. dollar to Renminbi would be adjusted from $1 to RMB8.27 to $1 to RMB8.11, and it ceased to peg the Renminbi to the U.S. dollar. Instead, the Renminbi would be pegged to a basket of currencies, whose components would be adjusted based on changes in market supply and demand under a set of systematic principles. On September 23, 2005, the PRC government widened the daily trading band for Renminbi against non-U.S. dollar currencies from 1.5% to 3.0% to improve the flexibility of the new foreign exchange system. Since the adoption of these measures, the value of Renminbi against the U.S. dollar has fluctuated on a daily basis within narrow ranges, but overall has further strengthened against the U.S. dollar. In June 2010, the Chinese government announced its intention to allow the Renminbi to fluctuate within the 2005 parameters. There remains significant international pressure on the PRC government to further liberalize its currency policy, which could result in a further and more significant appreciation in the value of the Renminbi against the U.S. dollar. The Renminbi may be revalued further against the U.S. dollar or other currencies, or may be permitted to enter into a full or limited free float, which may result in an appreciation or depreciation in the value of the Renminbi against the U.S. dollar or other currencies.

China’s legal system is different from those in some other countries.

China is a civil law jurisdiction. Under the civil law system, prior court decisions may be cited as persuasive authority but do not have binding precedential effect. Although progress has been made in the promulgation of laws and regulations dealing with economic matters, such as corporate organization and governance, foreign investment, commerce, taxation and trade, China’s legal system remains less developed than the legal systems in many other countries. Furthermore, because many laws, regulations and legal requirements have been recently adopted, their interpretation and enforcement by the courts and administrative agencies may involve uncertainties. Sometimes, different government departments may have different interpretations. Licenses and permits issued or granted by one government authority may be revoked by a higher government authority at a later time. Government authorities may decline to take action against unlicensed operators which may work to the disadvantage of licensed operators, including us. The PRC legal system is based in part on government policies and internal rules (some of which may not be published on a timely manner or at all) that may have a retroactive effect. We may even not be aware of our violation of these policies and rules until some time after the violation. Changes in China’s legal and regulatory framework, the promulgation of new laws and possible conflicts between national and provincial regulations could result in fines, the revocation of a business or other license, the restructuring of our ownership or the discontinuation of all, or a portion, of our business. In addition, any litigation in China may result in substantial costs and diversion of resources and management attention.

Contract drafting, interpretation and enforcement in China involve significant uncertainty, which could leave us vulnerable to legal disputes and challenges related to our contracts.

We have entered into numerous contracts governed by PRC law, many of which are material to our business. As compared with contracts in the U.S., contracts governed by PRC law tend to contain less detail and are not as comprehensive in defining contracting parties’ rights and obligations. As a result, contracts in China are more vulnerable to disputes and legal challenges. In addition, contract interpretation and enforcement in China is not as developed as in the U.S., and the result of any contract dispute is subject to significant uncertainties. Therefore, we cannot assure you that we will not be subject to disputes under our material contracts, and if such disputes arise, we cannot assure you that we will prevail.

If our land use rights are revoked, we would have no operational capabilities.

Under Chinese law land is owned by the state or rural collective economic organizations. The state issues to the land users the land use right certificate. Land use rights can be revoked and the land users forced to vacate at any time when redevelopment of the land is in the public interest. The public interest rationale is interpreted quite broadly and the process of land appropriation may be less than transparent. Each of our facilities relies on these land use rights as the cornerstone of their operations, and the loss of such rights would have a material adverse effect on our company.

PRC regulations relating to the establishment of offshore companies by PRC residents may subject our PRC resident shareholders to personal liability and limit our ability to inject capital into the PRC subsidiaries, limiting our subsidiaries’ ability to distribute profits to us or otherwise adversely affect us.

SAFE issued the Notice on Issues Relating to the Administration of Foreign Exchange in Fund-raising and Reverse Investment Activities of Domestic Residents Conducted via Offshore Special Purpose Companies, or “Notice 75,” on October 21, 2005, which became effective as of November 1, 2005 and the operating procedures in May 2007, collectively the SAFE Rules. According to the SAFE Rules, prior registration with the local SAFE branch is required for PRC residents to establish or to control an offshore company for the purposes of financing that offshore company with assets or equity interests in an onshore enterprise located in the PRC. An amendment to registration or filing with the local SAFE branch by such PRC resident is also required for the injection of equity interests or assets of an onshore enterprise in the offshore company or overseas funds raised by such offshore company, or any other material change involving a change in the capital of the offshore company. The SAFE rules define “PRC residents” to include both legal persons and natural persons who either hold legal PRC identification documents, or who habitually reside in China due to economic interests or needs. If any PRC resident fails to file its SAFE registration for an existing offshore enterprise, any dividends remitted by the onshore enterprise to its overseas parent after October 21, 2005 will be considered to be an evasion of foreign exchange purchase rules, and the payment of the dividend will be illegal. As a result, both the onshore enterprise and its actual controlling persons can be fined. In addition, failure to comply with the registration procedures may result in restrictions on the relevant onshore enterprise, including prohibitions on the payment of dividends and other distributions to its offshore parent or affiliate and capital inflow from the offshore enterprise. The PRC resident shareholders of the offshore enterprise may also be subject to penalties under Chinese foreign exchange administration regulations.

To date, the required filings pursuant to SAFE Rules are underway for shareholders of Lizhan. Mr. Liu has completed his SAFE filing procedure. We have requested our shareholders and beneficial owners who may be subject to SAFE Rules to make the necessary applications, filings and amendments as required under SAFE Rules. We have advised these shareholders and beneficial owners to comply with the relevant requirements. However, we cannot provide any assurance that all of our shareholders and beneficial owners who may be PRC residents will comply with our request to make or obtain any applicable registrations or comply with other requirements required by SAFE Rules. The failure or inability of our PRC resident shareholders or beneficial owners to make any required registrations or comply with other requirements may subject such shareholders or beneficial owners to fines and legal sanctions and may also limit our ability to contribute additional capital into or provide loans to our PRC subsidiaries, limit the ability of our PRC subsidiaries to pay dividends or otherwise distribute profits to us, or otherwise adversely affect us.

In March 2007, SAFE promulgated the Detailed Rules for the Implementation of the Measures for the Administration of Individual Foreign Exchange, and the Operating Rules on the Foreign Exchange Administration of the Evolvement of Domestic Individuals in the Employee Stock Ownership Plans and Share Option Schemes of Overseas Listed Companies, or “Circular 78.” Under Circular 78, where PRC domestic individuals are involved in the employee stock ownership plans or share option schemes of overseas listed companies, such plans or schemes must be submitted to competent foreign exchange administration authorities for approval, and the PRC employees shall entrust its agent or the affiliates or branches of the overseas listed company to apply to competent authorities for purchasing certain amount of foreign exchange at certain times each year, in order to purchase the stock or exercise its option right under the employee stock ownership plans or the share option schemes within the amounts approved by the authorities. In addition, the PRC employees involved must declare the progress of such plans or schemes to the administration authorities periodically. All the proceeds obtained by such employees from the overseas listed company through the employee stock ownership plans or the share option schemes, or from sale of the shares of such overseas listed company, after deducting relevant fees and costs incurred overseas, shall be remitted to the domestic account of the employees in full amount. We have adopted the Lizhan 2010 Stock Option Plan. However, as of the date of this annual report, no employee share option has been granted. If we or our PRC employees fail to comply with the provisions of Circular 78, we and/or our PRC employees may be subject to fines and legal sanctions imposed by the SAFE or other PRC government authorities. If our PRC employees fail to obtain the approval from or make relevant registrations with SAFE or its local branches, it will prevent us from conducting the share option schemes or the stock ownership plans for our PRC employees. In addition, it may impose cost on us for obtaining the approval from SAFE or its local branches in connection with the foreign exchange registration.

The discontinuation of any preferential tax treatment currently available to us and the increase in the enterprise income tax in the PRC could in each case result in a decrease in our profits and materially and adversely affect our results of operations.

Prior to January 1, 2008, the basic enterprise income tax rate for foreign invested enterprises in the PRC was 33.0%, while the PRC government provided various incentives, including reduced tax rates, to foreign-invested enterprises and domestic companies operating in a national level economic and technological development zone. In addition, Lizhan Textile qualifies for a tax holiday during which it is entitled to an exemption from enterprise income tax for two years commencing from its first profit-making year of operation and a 50% reduction of enterprise income tax for the following three calendar years. In connection therewith, Lizhan Textile was fully exempt from income tax in each of the years ended December 31, 2008 and 2009 and has been subject to enterprise income tax at a reduced rate of 12.5% since the year ended December 31, 2009. The tax holiday expires on December 31, 2012.

On March 16, 2007, the National People’s Congress approved and promulgated a tax law, the PRC Enterprise Income Tax Law, or “EIT Law,” which took effect on January 1, 2008. Under the EIT Law, foreign-invested enterprises and domestic companies are subject to a uniform tax rate of 25%. On December 26, 2007, the State Council issued the Notice of the State Council Concerning Implementation of Transitional Rules for Enterprise Income Tax Incentives, or “Circular 39.” Based on Circular 39, enterprises that enjoyed a preferential tax rate of 15% in accordance with previous laws, regulations and relevant regulatory documents are eligible for a graduated rate increase to 25% over a five-year transition period beginning January 1, 2008. For those enterprises which currently enjoy tax holidays, such tax holidays will continue until their expiration in accordance with previous tax laws, regulations and relevant regulatory documents. While the new tax law equalizes the tax rates for foreign-invested enterprises and domestic companies, preferential tax treatment would continue to be given to companies in certain encouraged sectors and to those classified as high and new technology enterprises enjoying special support from the state.

We may not be able to continue receiving this preferential tax treatment after the tax holiday expires on December 31, 2012, which may cause an increase in our income tax expense, thereby reducing our net income and adversely affect our results of operations.

Under the EIT Law, we may be classified as a “resident enterprise” of the PRC. Such classification could result in unfavorable tax consequences to us and our non-PRC shareholders.

Under the EIT Law, an enterprise established outside of China with “de facto management bodies” within China is considered a “resident enterprise,” meaning that it can be treated in a manner similar to a Chinese enterprise for enterprise income tax purposes, although the dividends paid to one resident enterprise from another may qualify as “tax-exempt income.” The implementing rules of the EIT Law define de facto management as “substantial and overall management and control over the production and operations, personnel, accounting, and properties” of the enterprise. The EIT Law and its implementing rules are relatively new and ambiguous in terms of some definitions, requirements and detailed procedures, and currently no official interpretation or application of this new “resident enterprise” classification is available; therefore, it is unclear how tax authorities will determine tax residency based on the facts of each case.

If the PRC tax authorities determine that we are a “resident enterprise” for PRC enterprise income tax purposes, a number of unfavorable PRC tax consequences could follow. First, we may be subject to enterprise income tax at a rate of 25% on our worldwide taxable income, as well as PRC enterprise income tax reporting obligations. Second, although under the EIT Law and its implementing rules, dividends paid to us from our PRC subsidiaries through our sub-holding companies may qualify as “tax-exempt income,” we cannot guarantee that such dividends will not be subject to withholding tax. Finally, the new “resident enterprise” classification could result in a situation in which a 10% PRC tax is imposed on dividends we pay to our non-PRC shareholders and gains derived by our non-PRC shareholders from transferring our shares, if such income is considered PRC-sourced income by the relevant PRC authorities.

Our PRC subsidiaries are held directly by Resources, which is an entity organized under the law of Hong Kong. According to Article 10 of the arrangement between Mainland China and the Hong Kong Special Administrative Region, or HKSAR, on the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income, when a Hong Kong resident enterprise holds more than 25% percent of the shares of a company, the Hong Kong resident enterprise pays income tax amounting to 5% of the dividends paid. When a Hong Kong resident enterprise holds 25% or less of the shares of a company, the Hong Kong resident enterprise pays income tax amounting to no more than 10% of the dividends paid.

If any such PRC taxes apply to our non-PRC shareholders, a non-PRC shareholder may be entitled to a reduced rate of PRC taxes under an applicable income tax treaty and/or a foreign tax credit against such shareholder’s domestic income tax liability (subject to applicable conditions and limitations). You should consult with your own tax advisors regarding the applicability of any such taxes, the effects of any applicable income tax treaties, and any available foreign tax credits.

Changes in PRC government policy on foreign investment in China may adversely affect our business and results of operations.

Both of our PRC subsidiaries are foreign investment enterprises. As foreign invested enterprises, our wholly owned subsidiaries are subject to restrictions on foreign investment imposed by PRC laws from time to time. For instance, under the Foreign Investment Industrial Guidance Catalogue (“Catalogue”), some industries are categorized as sectors which are encouraged, restricted or prohibited for foreign investment. According to the latest version of this Catalogue, our business does not belong to the prohibited or the restricted category. As this Catalogue is updated every few years, there can be no assurance that the PRC government will not change its policies in a manner that would cause part or all of our business to fall within the restricted or prohibited categories. If any of our business activities become prohibited, or if we cannot obtain approval from relevant approval authorities to engage in business activities which become restricted for foreign investors, we may be forced to sell or restructure our business activities which have become restricted or prohibited for foreign investment. If we are forced to adjust our corporate structure or business line as a result of changes in government policy on foreign investment, our business, financial condition and results of operations may be materially and adversely affected.

Restrictions on currency exchange may limit our ability to receive and use our revenues effectively, which could materially and adversely affect our business and financial condition.

Substantially all of our revenues and operating expenses are denominated in Renminbi and U.S. dollars. The Renminbi is currently freely convertible under the “current account,” which includes dividends, trade and service-related foreign exchange transactions, but not under the “capital account,” which includes foreign direct investment and loans. Currently, our PRC subsidiaries may purchase foreign exchange for settlement of “current account transactions,” including payment of dividends to Resources, without the approval of the SAFE. Our PRC subsidiaries may also retain foreign exchange in its current account, subject to a ceiling approved by the SAFE, to satisfy foreign exchange liabilities or to pay dividends. However, we cannot assure you that the relevant PRC governmental authorities will not limit or eliminate our PRC subsidiaries’ abilities to purchase and retain foreign currencies in the future. Since a significant amount of our future revenues will be denominated in Renminbi, the existing and any future restrictions on currency exchange may limit our ability to utilize capital generated in Renminbi to fund our business activities outside of China, if we were to have any in the future, or expenditures denominated in foreign currencies. Foreign exchange transactions under the capital account are subject to limitations and require registration with or approval by the relevant PRC governmental authorities. In particular, if we finance our PRC subsidiaries by foreign currency loans, those loans cannot exceed certain statutory limits and must be registered with the SAFE, and if we finance our PRC subsidiaries by capital contributions using, for instance, proceeds from our initial public offering, those capital contributions must be approved by the local authority, such as Tongxiang Foreign Trade and Economic Cooperation Bureau and Zhejiang Foreign Trade and Economic Cooperation Bureau. In addition, because of the regulatory issues related to foreign currency loans to, and foreign investment in, domestic PRC enterprises, we may not be able to finance our PRC operating companies’ operations by loans or capital contributions. We cannot assure you that we can obtain these governmental registrations or approvals on a timely basis, if at all. These limitations could affect the ability of these entities to obtain foreign exchange through debt or equity financing, and could adversely affect our business and financial conditions.

China’s regulation of loans and direct investment by non-Chinese holding companies to Chinese entities may delay or prevent us from making loans or additional capital contributions to our Chinese operating subsidiaries, which could materially and adversely affect our business and financial condition.

As a non-Chinese holding company of Chinese operating subsidiaries, we may make loans to our Chinese subsidiaries, or we may make additional capital contributions to our Chinese subsidiaries. Any loans we make to our Chinese subsidiaries are subject to regulations in China. For example, loans by us to our Chinese subsidiaries, which are foreign-invested enterprises, to finance their activities cannot exceed statutory limits and must be registered with SAFE or its local counterparts.

We may also decide to finance our subsidiaries by means of capital contributions. These capital contributions must be approved by China’s Ministry of Commerce or its local counterpart. We may not be able to obtain these government approvals on a timely basis, if at all, with respect to future capital contributions by us to our Chinese subsidiaries. If we fail to receive such approvals, our ability to use the proceeds of an offering and to capitalize our operations in China may be negatively affected, which could adversely affect our business, results of operations and financial condition.

Any failure to comply with PRC environmental laws may require us to incur significant costs.

We carry on our business in an industry that is subject to PRC environmental protection laws and regulations. These laws and regulations require enterprises engaged in manufacturing and construction that may cause environmental waste to adopt effective measures to control such waste. In addition, such enterprises are required to pay fines, or to cease operations entirely under extreme circumstances, should they discharge waste substances. The Chinese government may also change the existing laws or regulations or impose additional or stricter laws or regulations, compliance with which may cause us to incur significant capital expenditures, which we may be unable to pass on to our customers through higher prices for our products.

We must comply with the Foreign Corrupt Practices Act.

We are required to comply with the U.S. Foreign Corrupt Practices Act, which prohibits companies whose shares are listed on a U.S. securities exchange from making prohibited payments to foreign officials for the purpose of obtaining or retaining business. Corruption, extortion, bribery, pay-offs, theft and other fraudulent practices occur from time to time in mainland China. If any of our non-U.S. listed competitors that are not subject to the Foreign Corrupt Practices Act engage in these practices, they may receive preferential treatment and secure business from government officials in a way that is unavailable to us. Furthermore, although we inform our personnel that such practices are illegal, we cannot assure you that our employees or other agents will not engage in illegal conduct for which we might be held responsible under U.S. law. If our employees or other agents are found to have engaged in such practices, we could suffer severe penalties.

Because our funds are held in banks that do not provide insurance, the failure of any bank in which we deposit our funds could affect our ability to continue in business.

Banks and other financial institutions in the PRC do not provide insurance for funds held on deposit. As a result, in the event of a bank failure, we may not have access to funds on deposit. Depending upon the amount of money we maintain in a bank that fails, our inability to have access to our cash could impair our operations, and, if we are not able to access funds to pay our suppliers, employees and other creditors, we may be unable to continue in business.

The Chinese government exerts substantial influence over the manner in which we must conduct our business activities.

The Chinese central government and local governments have exercised, and continue to exercise, substantial control over virtually every sector of the Chinese economy through regulation and state ownership. Our ability to operate in China may be harmed by changes in national or local laws and regulations, including those relating to taxation, the environment, labor and employee benefits and land use rights. The central or local governments may impose stricter regulations or stricter interpretations of existing regulations that would require additional expenditures and efforts on our part to ensure our compliance with such regulations or interpretations. Accordingly, government actions in the future, including any decision not to continue to support recent economic reforms, could have a significant effect on economic conditions in China or particular regions thereof, and could require us to divest ourselves of any interest we hold in Chinese properties. In addition, if the PRC government were to eliminate export processing zones, restrict the transportation of goods in and out of the country, adopt policies favoring competitors or impose other restrictions on our operations, the impact may be significant. A reversal of current liberalizations of foreign exchange controls by the Chinese government could be disruptive and costly to our export sales.

If relations between the U.S. and China worsen, investors may be unwilling to hold or buy our stock and our stock price may decrease.

At various times during recent years, the U.S. and China have had significant disagreements over political and economic issues. Controversies may arise in the future between these two countries. Any political or trade controversies between the U.S. and China, whether or not directly related to our business, could reduce the price of our ordinary shares.

Changes in PRC laws and regulations on labor and employee benefits may adversely affect our business and results of operations.

As we conduct a significant portion of our business through our PRC subsidiaries, we are subject to PRC laws and regulations on labor and employee benefits. In recent years, the PRC government has implemented policies to strengthen the protection of employees and obligate employers to provide more benefits to their employees. In addition, an employment contract law came into effect in China on January 1, 2008. The PRC employment contract law and related legislations require more benefits to be provided to employees, such as an increase in pay or compensation for termination of employment contracts. As a result, we expect to incur higher labor costs, which would have an adverse impact on our business and results of operations.

Risks Related to Our Ordinary Shares

The market price for our ordinary shares may be volatile.

The market price for our ordinary shares is likely to be highly volatile and subject to wide fluctuations in response to various factors, including the following:

·              actual or anticipated fluctuations in our quarterly operating results and revisions to our expected results;

·              changes in financial estimates by securities research analysts; 

·              conditions in the markets for our products; 

·              changes in the economic performance or market valuations of companies specializing in our industry or our customers or their industries; 

·              announcements by us or our competitors of new products, acquisitions, strategic relationships, joint ventures or capital commitments; 

·              addition or departure of our senior management and key personnel; 

·              fluctuations of exchange rates between the Renminbi and the U.S. dollar; 

·              litigation related to our intellectual property; 

·              release or expiry of lock-up or other transfer restrictions on our outstanding ordinary shares; and 

·              sales or perceived potential sales of our ordinary shares. 

In addition, the securities market has from time to time, and to an even greater degree since the last quarter of 2007, experienced significant price and volume fluctuations that are not related to the operating performance of particular companies. These market fluctuations may also have a material adverse effect on the market price of our ordinary shares. Furthermore, in the past, following periods of volatility in the market price of a public company’s securities, shareholders have frequently instituted securities class action litigation against that company. Litigation of this kind could result in substantial costs and a diversion of our management’s attention and resources.

We are a Cayman Islands Company and because judicial precedent regarding the rights of shareholders is more limited under Cayman Islands law than U.S. law, you may have less protection of your shareholders rights than you would under U.S. law.

We are incorporated under the laws of the Cayman Islands. Our corporate affairs are governed by our memorandum and articles of association, the Companies Law (2010 Revision) of the Cayman Islands (as amended from time to time) and the common law of the Cayman Islands. The rights of shareholders to take action against our directors and us, the rights of minority shareholders to institute actions, and the fiduciary responsibilities of our directors to us are to a large extent governed by the common law of the Cayman Islands. The common law of the Cayman Islands is derived in part from comparatively limited judicial precedent in the Cayman Islands as well as from English common law, the latter of which has persuasive, but not binding, authority on a court in the Cayman Islands. The rights of our shareholders and the fiduciary responsibilities of our directors under Cayman Islands law are not as clearly established as they would be under statutes or judicial precedent in some jurisdictions in the U.S. In particular, the Cayman Islands has a less developed body of securities laws than the U.S. In addition, some U.S. jurisdictions, such as Delaware, have more fully developed and judicially interpreted bodies of corporate law than the Cayman Islands. Furthermore, shareholders of Cayman Islands companies may not have standing to initiate a shareholder derivative action in a federal court in the U.S. As a result, our public shareholders may have more difficulties in protecting their interests based on actions taken by management, members of the board of directors (the “Board”) or controlling shareholders than they would as shareholders of a U.S. company.

As a result of all of the above, our shareholders may have more difficulty in protecting their interests in the face of actions taken by management, our directors or principal shareholders than they would as a shareholder of a U.S. company.

Your ability to bring an action against us or against our directors and executive officers, or to enforce a judgment against us or them, will be limited.

We are not incorporated in the U.S. We conduct our business outside the U.S., and substantially all of our assets are located outside the U.S. Most of our directors and executive officers are non-U.S. citizens and reside, and substantially all of the assets of those persons are located, outside the U.S. As a result, it may be difficult or impossible for you to bring an action against us or against these individuals in the U.S. in the event that you believe that your rights have been infringed under U.S. securities laws or otherwise. Even if you are successful in bringing an action of this kind, the laws of the Cayman Islands or the PRC may render you unable to enforce a judgment against our assets or the assets of our directors and executive officers.

If we fail to maintain an effective system of internal controls, we may be unable to accurately report our financial results or prevent fraud, and investor confidence and the market price of our ordinary shares may be adversely affected.

Our reporting obligations as a public company place a significant strain on our management, operational and financial resources and systems for the foreseeable future. We are required to implement financial and disclosure control procedures and corporate governance practices that enable us to comply with the Sarbanes-Oxley Act of 2002 and related Securities and Exchange Commission (“SEC”) rules. If we are unable to implement solutions to any weaknesses in our existing internal controls and procedures, or if we fail to maintain an effective system of internal controls in the future, we may be unable to accurately report our financial results or prevent fraud and investor confidence and the market price of our ordinary shares may be adversely impacted.

We may engage external Sarbanes-Oxley consultants to advise us on Sarbanes-Oxley compliance issues. Section 404 requires us to perform an evaluation of our internal controls over financial reporting and file annual management assessments of their effectiveness with the SEC. The management assessment to be filed is required to include a certification of our internal controls by our chief executive officer and chief financial officer. In addition to satisfying requirements of Section 404, we may also make improvements to our management information system to computerize certain manual controls, establish a comprehensive procedures manual for U.S. generally accepted accounting principles (“GAAP”) financial reporting, and increase the headcount in the accounting and internal audit functions with professional qualifications and experience in accounting, financial reporting and auditing under U.S. GAAP.

We may not be able to pay any dividends on our ordinary shares.

Under Cayman Islands law, we may only pay dividends out of our profits or our share premium account subject to our ability to service our debts as they become due in the ordinary course of business. Our ability to pay dividends will therefore depend on our ability to generate sufficient profits. We cannot give any assurance that we will declare dividends of any amounts, at any rate or at all in the future. We have not paid any dividends in the past. Future dividends, if any, will be at the discretion of our Board, subject to the approval of our shareholders, and will depend upon our results of operations, our cash flows, our financial condition, the payment of our subsidiaries of cash dividends to us, our capital needs, future prospects and other factors that our directors may deem appropriate. You should refer to the “Dividend Policy” section in this annual report for additional information regarding our current dividend policy for additional legal restrictions on the ability of our PRC subsidiaries to pay dividends to us.

We incur increased costs as a result of being a public company in the U.S., which could reduce our profits.

We are subject to the reporting obligations of the SEC, which many consider to be more stringent, rigorous and expensive than operating a privately held company. In particular:

·              We incur additional costs in order to comply with U.S. corporate governance requirements, including requirements under the Sarbanes-Oxley Act of 2002, as well as new rules implemented by the SEC and the Financial Industry Regulatory Authority, or FINRA. We expect these requirements will increase our legal compliance costs and will make some compliance activities more time consuming and costly. 

·              We incur additional costs in implementing and verifying internal control procedures as required by section 404 of the Sarbanes-Oxley Act of 2002 and the rules and regulations thereunder. We expect these requirements will increase our accounting and financial costs. 

·              We are required under U.S. rules and regulations to retain our independent directors that serve on our Board. We may encounter difficulty in retaining, or in the future attracting, qualified independent directors to serve on our Board and our audit committee, in particular. We will also incur substantial costs to maintain directors and officers insurance. 

If we fail to retain, or attract as necessary, independent directors, we may be subject to SEC enforcement proceedings and delisting by the securities exchange on which our ordinary shares are listed at the time. As a result, we will incur greater costs for legal, accounting and other services and, in turn, will increase our operating expenses and reduce our profits.

Mr. Liu, our Chairman, has the ability to exercise significant control over us, and whose interests may conflict with your interests as a shareholder.

Mr. Jianfeng Liu, who is our Chairman, President and Chief Executive Officer, beneficially owns 62.4%  of our outstanding ordinary shares. As a result, Mr. Liu has the ability to exercise significant influence over our management, including over matters requiring shareholder approval or approval by our Board. This could delay, defer or prevent a change in control, impede a merger, consolidation, take-over or other business combination involving us, or discourage a potential acquirer from making a tender offer or otherwise attempting to obtain control of us. In addition, Mr. Liu has entered into several related party transactions with our company, including guaranteeing our banks loans, transferring patents to us, purchasing our ordinary shares and selling materials to us. See Item 7 below. Conflicts of interest between these dual relationships may arise. We cannot assure you that when conflicts of interest arise, Mr. Liu will act in the best interests of our company or that conflicts of interest will be resolved in our favor.

If we are classified as a passive foreign investment company, our U.S. shareholders may suffer adverse tax consequences.

Generally, if for any taxable year, after applying certain look-through rules, 75% or more of our gross income is passive income, or at least 50% of our assets are held for the production of, or produce, passive income, we may be characterized as a passive foreign investment company, or PFIC, for U.S. federal income tax purposes. This characterization could result in adverse U.S. tax consequences to our shareholders who are U.S. taxpayers, including gain realized on the disposition of our ordinary shares being treated as ordinary income rather than capital gain income and in punitive interest charges being applied to such sales proceeds. Rules similar to those applicable to dispositions apply to amounts treated as “excess distributions.”

We do not believe that we were a PFIC for the years ended September 30, 2010 or September 30, 2011 and currently anticipate that we will not be a PFIC for the current fiscal year based upon our estimates of the values of our assets. However, because PFIC status is based on the composition of our income and assets for the entire taxable year, it is not possible to determine whether we will become a PFIC for the current year until after the close of the year. Therefore, we may become a PFIC for the year ending September 30, 2012 or in any future taxable year. U.S. shareholders should consult with their own U.S. tax advisors with respect to the U.S. tax consequences of investing in our ordinary shares. See “Taxation — U.S. Federal Income Taxation of U.S Holders—Passive Foreign Investment Company Status and Significant Tax Consequences.”

If equity research analysts do not publish research or reports about our company or if they issue unfavorable commentary or downgrade our ordinary shares, the price of our ordinary shares could decline.

The trading market for our ordinary shares will rely in part on the research and reports that equity research analysts publish about us and our company. We do not control these analysts. The price of our ordinary shares could decline if one or more equity analysts downgrade our ordinary shares or if they issue other unfavorable commentary, or cease publishing reports, about us or our company.

item 4.    INFORMATION ON THE COMPANY

4A.          History and Development of the Company

Lizhan Textile

Our wholly owned subsidiary, Lizhan Textile, is an operating company whose principal activities are the manufacture, distribution and marketing of synthetic leather and other fabrics. Lizhan Textile mainly produces and sells recycled flocked leather. Lizhan Textile was established as a wholly foreign-owned enterprise in the PRC on December 6, 2005. We conduct all of our current operations through Lizhan Textile.

Until 2009, when our company underwent a corporate restructuring prior to of our initial public offering in November 2010, Lizhan Textile was wholly owned by Illigate Development Limited, or Illigate, a company incorporated in the British Virgin Islands (“BVI”) on September 26, 2005. Illigate is wholly owned by Mr. Jianfeng Liu, our Chief Executive Officer and Chairman.

Corporate Restructuring

Prior to our initial public offering, we underwent a corporate restructuring in the second half of 2009 and early 2010, as follows:

Li Zhan Resources Recycling Technology Development Company Limited, or Resources, was incorporated on September 3, 2009 as a limited liability company in Hong Kong. Resources was initially wholly owned by Mr. Liu. On September 15, 2009, Resources acquired 100% of the equity interests in Lizhan Textile from Illigate in exchange for approximately $3.6 million. This change in ownership of Lizhan Textile was approved by the local PRC government on October 12, 2009. Consequently, Resources is an intermediate holding company that directly owns 100% of Lizhan Textile.

Lizhan was incorporated on August 31, 2009 as a limited liability company in the Cayman Islands. Lizhan was initially incorporated under the name Illigate Environment Resources Technology Company Limited and on January 12, 2010, we changed its name to Lizhan. On August 31, 2009, Lizhan issued 10,937,500 ordinary shares to Mr. Jianfeng Liu, which represented 100% of the issued and outstanding shares of Lizhan Environmental, in exchange for $3.5 million.

On November 9, 2009, Lizhan acquired 100% of the equity interest in Resources from Mr. Liu in exchange for nominal consideration. Consequently, Lizhan owns 100% of Resources directly and 100% of Lizhan Textile indirectly through Resources.

Hongzhan

Hongzhan is our second main operating subsidiary and mainly engages in the manufacture and selling of our Colgre Products. 

On December 8, 2009, Resources established a new wholly-owned subsidiary named Hongzhan (Zhejiang) New Material Co. Ltd., or Hongzhan, which is a wholly foreign owned enterprise in the PRC. On February 8, 2010, Resources entered into a share transfer agreement with an entity named Eminent Benefit Holdings Limited, or Eminent, which is wholly owned by Liwen Zhang, a key employee of ours since February 2010. Pursuant to this agreement, as amended on February 10, 2010, Resources transferred a 13% equity interest in Hongzhan to Eminent. In exchange for the 13% interest in Hongzhan, valued at $650,000 (13% of the registered capital of Hongzhan), Liwen Zhang transferred to Resources and Hongzhan two patents and one patent application related to our Colgre Products in satisfaction of the $650,000 payment owed by Mr. Zhang pursuant to the share transfer agreement. These patents were subsequently transferred to Lizhan Textile in August 2010 subject to the approval by the local State Intellectual Property Office of the PRC or SIPO. Lizhan Textile has licensed the use of the patents to Hongzhan for no consideration. The license to Hongzhan has been approved by the local SIPO .  Following the share transfer, Resources owns 87% of the outstanding shares of Hongzhan and Eminent owns the remaining 13%.

Our Shareholders

From the date of our inception until December 14, 2009, Mr. Liu, our chairman, owned all of the issued and outstanding ordinary shares of Lizhan.

On December 14, 2009, Mr. Liu transferred 1,562,500 ordinary shares of Lizhan to Infinite Harvest International Limited (“Infinite”), for no consideration. Infinite is a company formed under the laws of the BVI. Liu Yang, son of Mr. Jianfeng Liu, owns 60% of the outstanding shares of Infinite. The remaining 40% of the outstanding shares of Infinite is held by two PRC residents that are unaffiliated with our company or any of our directors and officers. In addition, on December 14, 2009, Mr. Liu transferred 218,750 ordinary shares to Mr. Liu’s son, Liu Yang, and 125,000 ordinary shares to Mr. Liu’s son, Liu Hai, for no consideration.

On January 12, 2010, we issued 206,250 shares to Mr. Liu for a purchase price of approximately $4.80 per share.

On January 12, 2010, Mr. Liu transferred 6,612,500 ordinary shares of Lizhan to Illigate, a BVI company wholly owned by Mr. Liu, for no consideration. In addition, in December 2009 and January 2010, Mr. Liu transferred an aggregate of 2,625,000 ordinary shares of Lizhan to unaffiliated third parties that reside in the PRC, Hong Kong and BVI for an aggregate purchase price of $4.2 million, which purchase price was paid in January 2009. These individuals, together with Liu Yang and Liu Hai, are collectively referred to as “other shareholders” in the organization chart on page 6 below.

Reverse Stock Split

On September 14, 2010, we effectuated a consolidation of every 1.6 ordinary shares in our authorized share capital into one ordinary share. Upon the consolidation, every 1.6 ordinary shares were consolidated into one ordinary share. As a result, the number of our authorized shares comprising our authorized share capital of $10,000,000 was reduced from 50,000,000 to 31,250,000, the number of outstanding ordinary shares was reduced from 17,830,000 to 11,143,750 in the aggregate, the par value of our ordinary shares was increased from $0.20 per share to $0.32 per share and the number of ordinary shares available under our stock option plan was reduced from 3,000,000 to 1,875,000. Any fractional share issued as a result of the reverse split was rounded up.

Organizational Structure Chart

The following chart reflects our organizational structure as of September 30, 2011:

Capital Expenditures

We incurred capital expenditures of approximately $9.4 million, $16.6 million and $1.2 million for the years ended September 30, 2011, 2010 and 2009, respectively, primarily in connection with purchases of land use rights, property, plant and equipment and construction of our facilities, leasehold improvements and investment in equipment, technology and operating systems. These capital expenditures were financed by the cash flow generated by our operations and from bank financing. The capital expenditures incurred in the twelve months ended September 30, 2009 exclude machinery valued at $1,294,186 which we received pursuant to an asset transfer contract with one of our largest customers.

We believe that our capital expenditures in fiscal year 2012 will be incurred primarily in connection with improving our production lines for our Colgre Products. We expect to finance these capital expenditures by using short-term bank borrowings and bank facilities.

Registered office

The address of our registered office in the Cayman Islands is: Scotia Centre, 4 ^th Floor, P.O. BOX 2804, George Town, Grand Cayman KY1-112, Cayman Islands. The telephone number of the registered office is (284) 494-4840.

4B.          Business Overview

Overview

We are principally engaged in the production and sale of synthetic leather from leather scrap products and other materials, such as chemical-based leather products. We are also involved in research and development related to the production of synthetic leather. We own an extensive range of finishing processes to manufacture synthetic leather and other fabrics. Recycled leather flocked products accounted for approximately 74.4% of our revenue in the twelve months ended September 30, 2011 and our Colgre Products accounted for approximately 0.5% of our revenue in the twelve months ended September 30, 2011.

We conduct all of our business activities through our operating subsidiaries, Lizhan Textile and Hongzhan. Our production facilities are strategically located in Tongxiang, Zhejiang Province, which is in close proximity to many leather product manufacturers whose production facilities are located in Tongxiang, Haining and Wenzhou, all of which are situated in Zhejiang Province, which collectively are considered as one of the most important leather industry clusters in China. 

Our products are used in various consumer applications, as we sell our products to furniture manufacturers, as well as fabric distributors. In fiscal years 2009, 2010 and 2011 we derived approximately 97%, 98% and 98.5% of our revenues from our customers in the furniture manufacturing industry. We sell domestically in China and export to the U.S. and other countries, including Nicaragua, Germany, Belgium, France and South Korea. During the twelve months ended September 30, 2011, 2010 and 2009, approximately 33.9%, 22.9%, 37.3% of our revenues, respectively, were generated from export sales. The solid reputation that we believe our management team has developed over the past eleven years in the synthetic leather industry in China, including an established track record for consistently providing quality products at competitive prices, has enabled us to develop and expand our customer base. However, our company has a limited operating history and you will have a limited basis on which to evaluate our ability to achieve our business objectives. In addition, we expect our future growth to place significant demands on our management and resources.

Our primary raw materials are leather scrap, ultrasuede grey cloth, backing fabric, polyurethane and resin, which we acquire almost entirely from local suppliers. The manufacturing process of each of our products generally involves various steps, including stamping, polyurethane dry coating, embossing, printing, recycled leather powder electrostatic flocking and tufting.

In November 2010 we closed our initial public offering, pursuant to which issued 2,500,000 ordinary shares at a price of $4.00 per share.  We received net proceeds of approximately $7.5 million from the offering.

Our Products

We currently manufacture and sell the following types of products:

·                      Synthetic leather fabrics, which consist of ultrasuede and recycled leather flocked fabric; and

·                      Microfiber towel fabrics; and

·                      Tufted fabrics

·                      Colgre Products

·                      Flocking powder, suede fabric, short hair velvet and beehive punched cotton.

The following table provides a breakdown of the revenues generated by each of our product types during the twelve months ended September 30, 2009, 2010 and 2011, respectively, expressed in U.S. dollars and as a percentage of total revenues :  

Synthetic Leather Fabric Products

We currently produce the following types of synthetic leather fabric products:

·              Ultrasuede products, which consist of non-woven fabric embedded with tiny polyester fibers and which have a soft and lush surface resembling suede leather.

·              Recycled leather flocked fabric products, which consist of fabrics that are flocked with recycled leather powder that improve the texture of the fabric.

·              Microfiber towel products, which consist of fine synthetic fibers that are woven into textiles whose texture and drape resemble that of natural fiber cloth materials.

·              Other fabrics, consist of flocking powder, suede fabric, short hair velvet and beehive punched cotton.

Ultrasuede Products

Ultrasuede Products are non-woven fabrics made from 100% polyester superfine fiber and polyurethane foamed materials. The product feels like natural deerskin.

Recycled Leather Flocked Fabric Products

Leather scrap, functioning as the reinforcing filler, is flocked into the polyurethane fabric to create this thermoplastic polymer composite. The resulting fabric has better tensile strength and the aesthetic appearance of genuine leather. The fabric is a higher margin product and is more environmentally friendly than other purely chemical-based products.

During fiscal year 2009, we launched, and increased rapidly, the production and sales of our recycled leather flocked fabric products, which consist of fabrics that are flocked with recycled leather powder that improve the texture of the fabric.

Compared to chemical based synthetic leather, recycled leather has better vapor permeability and a more comfortable handle because the leather powder contained in these products has the same macrostructure and microstructure as natural leather. Recycled leather is also more biodegradable and as a result is more environmentally friendly.

Microfiber towel products consists of fine synthetic fibers that are woven into textiles whose texture and drape resemble that of natural fiber cloth materials. These products are more advantageous than natural fiber cloth materials because of their enhanced washability, breathability, and water repellency.

Colgre Products

Our Colgre Products were formerly known as Evergreen LZ Collagen Fiber Leather. For marketing purposes, in August, 2011 ,  management decided to change the name of the Evergreen LZ Collagen Fiber Leather Products to “Colgre Products.”

Colgre Products are manufactured by using a new leather processing technology which utilizes genuine leather and its scraps to generate a new class of imitation leather derived from natural fiber. The technology enables dissembling collagen fibers and recomposing or weaving the collagen fiber bundles according to the natural leather structure. These products are expected to be suitable for applications in furniture, shoes, eco-fashion apparel, radiation proof clothing and luggage and bags. We sell and expect to continue to sell these products to furniture manufacturers. 

Compared to genuine leather, the reconstituted leather of the Colgre Products is produced according to industrialized specifications in thickness and size, and will therefore be homogenous and consistent in density. Thus, it has resulted in a much lower cut scrap rate than our other products. Produced from leather scrap, Colgre  Products are environmentally friendly.

Compared to chemical based synthetic leather ,  Colgre Products do not contain any adhesive. Rather, its mechanical properties are derived from collagen fiber. We believe chemical processes of fiber separation are more prevalent in the industry’s research and development efforts and are inferior due to the negative environmental impact. In addition, compared to leather powder, leather fiber can form fabric which carries higher leather content and a closer look and feel to genuine leather in the subsequent step.

Colgre Products are resistant to fire, tearing and cracking, and have better vapor permeability and handling. Colgre Products are expected to be superior to synthetic leathers because synthetic leathers imitate the surface appearance of leather only, without achieving the leather quality. We believe that our process of collagen fiber extraction is innovative, as it involves a simple and environmentally clean physical process. Samples of our Colgre Products have been tested by Intertek Services, a global product testing, certification and inspection company. Our products passed various measures related to product safety and eco-friendliness.

In January 2011 we completed construction of the manufacturing facility for our Colgre Products. The construction of this facility was delayed due to technical adjustments that needed to be made to certain equipment used in the production of the Colgre Products, which we purchased from a U.S. vendor. The equipment we purchased did not produce products with the appropriate quality or sufficient quantity of products. We are in the process of improving the production line and specifically, we are making changes to the equipment. We believe that once we make the necessary improvements, we will be able to increase production capacity and provide quality Colgre Products to our customers.

In June 2011, we launched the first production line for our Colgre Products. At the time of our Initial Public Offering in 2010, we planned to launch pilot production of the first Colgre Product production line in November 2010 and to generate cash flows from these new products in December 2010. In addition, we anticipated launching pilot production of the second line in January 2011 and to launch large scale production of this line in February 2011. We also anticipated beginning  installation of production lines 3 and 4 in fiscal year 2011. At that point, we believed that our aggregate production capacity would be 5,000 meters per day of Colgre Products. As of September 30, 2011, we did not meet our previous goals for production capacity and we only achieved production capacity of approximately 1,000 meters of fabric per day. As of September 30, 2011, we shipped approximately 15,000 meters of Colgre Products to one of our customers. Due to a failure in the equipment, as discussed above, we were not able to meet our previous goals of production capacity.

We are currently working to improve the equipment by making modifications and adjustments so that we can achieve maximum production capacity of 5,000 meters per day. We expect to achieve production capacity of 5,000 meters of fabric per day once we are able to make the appropriate technical adjustments and modifications to the equipment. In addition, we expect that the improvements will cost approximately $500,000. As of September 30, 2011, we had production capacity of 1,000 meters per day and we shipped approximately 15,000 meters of Colgre Products. We currently have increased production capacity to 3,000 meters per day.

Seasonality

Our production and sales slow considerably during and around the Chinese New Year, which usually occurs during the quarter ended March 31, as a result of the closing of our facilities and the facilities of many of our customers for the New Year’s celebration, as well as the shutting down of our steamers for an annual inspection by local authorities. In addition, our sales volume declines during summer due to the slow demand from the international markets while consumer spending is generally slower for furniture and garments.  Consequently, our results of operations may fluctuate from quarter to quarter.  In addition, any significant decrease in sales during the remainder of the year would have a material adverse effect on our business, our financial condition and our results of operations.

Our Raw Materials and Supply

Raw Materials

Our raw materials consist primarily of leather scrap and chemical fiber based materials, including ultrasuede grey cloth, polyurethene and resin.

Leather scrap

For the production of recycled leather flocked fabric, we mainly source the leather scrap formed after the tanning processing and prior to the coating process from leather manufacturers. For the production of the Colgre Products, technically, we may use any form of leather scrap sourced from either leather or leather goods manufacturers.

The leather scrap which we recycle comes from a variety of sources, and our suppliers include individuals and private enterprises in the PRC engaged in the business of collecting leather scrap and manufacturers of leather and leather products.

Our production facilities are strategically located in Tongxiang, Zhejiang Province, which is in close proximity to many leather product manufacturers whose production facilities are located in Tongxiang, Haining and Wenzhou, all of which are situated in Zhejiang Province. Consequently, leather scrap is readily available to us in large supplies. Leather manufacturers prefer to recycle, rather than dispose of, their leather scrap because recycling is more environmentally friendly and less costly to leather manufacturers.

Manufacturing synthetic and imitation leather products from leather scrap is a relatively new development in our industry. In fiscal year 2009, we began manufacturing our recycled leather flocked fabric products. The Colgre Products that we produce are manufactured from collagen fibers extracted from leather scrap. Both recycled flocked leather products and our Colgre Products are made from leather scrap, however, the manufacturing processes are different. The main difference between the recycled flocked leather products and our Colgre Products is that the Colgre Products look and feel more like genuine leather. Other products that we produce, including ultrasuede and other fabric products, are purely synthetic and are not produced from leather scrap.

The quality of products manufactured from leather scrap is higher than pure chemical fabrics. Consequently, consumers are willing to pay more for these products, resulting in higher margins. In addition, the costs associated with the manufacture of products manufactured from leather scrap is significantly lower than the costs associated with the manufacture of genuine leather products. Furthermore, these products are considered more environmentally friendly because they are manufactured from recycled leather scrap.

Our Supply Sources

Our business depends on obtaining a reliable supply of the raw materials described above. Because of the diversity of available sources of these raw materials, we believe that our raw materials are in adequate supply and will continue to be so in the future. We purchased almost all of our raw materials from Chinese suppliers in the years ended September 30, 2010 and 2011, respectively. Other than resin, which we procure from third party distributors, we generally procure our raw materials directly from chemical or fabric manufacturers.

We generally enter into non-exclusive contracts or purchase orders with suppliers and do not have long-term agreements with them. We negotiate pricing with our suppliers on an arm’s length basis prior to the delivery of these supplies to us, based upon the prevailing market prices at such time. We generally make payments to our suppliers within sixty days following the date of delivery. As we increase the scale of our production, we may need to establish a more diverse supplier network while attempting to continue to leverage our purchasing power to obtain favorable pricing and delivery and payment terms.

During the fiscal years ended September 30, 2010 and 2011, payments made to our five largest suppliers accounted for 41.8% and 57.2% of our total cost of supplies, respectively, and our single largest supplier accounted for 12.5%  and 15.1% of our total cost of supplies, respectively.

Our major suppliers for the year ended September 30, 2011 included the following:

Our major suppliers for the year ended September 30, 2010 included the following:

Manufacturing

We currently manufacture all of our products in our original facility, except that our Colgre Products are manufactured in our second facility, which was built in January 2011. Both facilities are located in Tongxiang County, Zhejiang Province, China.

Production Process

The manufacturing process of each of our products generally involves various steps, including:

·              Stamping, which is the process through which images are transferred to the fabric by means of a chemically treated transfer paper, combined with heat and pressure. Stamping is a more environmental friendly process than conventional printing.

·              Polyurethane dry coating, which is the process through which images are coated onto the release paper by using non-water-soluble resin before being transferred to the fabric.

·              Embossing, which is the process through which a design is heat-pressed onto the surface of the fabric to create a series of raised marks.

·              Printing, which is the process that dyes the fabric with the engraved roller being pressed onto the fabric.

·              Recycled leather powder electrostatic flocking. In this process, the embedded materials of leather powder flock, which is a powder that is produced from leather scrap, are applied to the backing fabric as an adhesive layer.

·             Tufting, which is the process that furnishes the fabric with a short cluster of elongated strands.

The technology and procedures used in the above processes vary amongst the different products that we manufacture and depend upon the product specifications prescribed by a particular customer. In addition, since our inception, our production facilities have included recycling technologies to capture, treat and recycle air, waste water and dimethyl formamide (DMF), which are produced during the manufacturing process.

The manufacturing process of our Colgre Products involves various steps, including the formation of collagen fiber from leather scrap and the construction of the fiber into web in order to form the fabric. Genuine leather and its scraps are utilized as Colgre Product’s raw materials to generate collagen fiber which is long enough to be spun and woven. The technology enables the dissembling of collagen fibers and recomposing or weaving the collagen fiber bundles according to the natural leather structure. The composition of the product is 100% genuine leather fiber and it is the same as genuine ecological leather in terms of the composition and structure. The utilization rate for our Colgre Products is far beyond that of genuine leather.

Quality Control

Consistent with our continuing commitment to quality, we impose rigorous quality control standards at various stages in the production process. Since September 2011, our facility has maintained the following certifications:

·              ISO9001:2008 certification in quality management systems granted by the China Quality Mark Certification Group, a comprehensive certification and training body providing certification, training and other conformity assessment; and

·              ISO14001:2004 certification in environmental management granted by the International Certification Network (IQNet and CQM), an organization dedicated to the creation of standards and offers certification services around the world, with respect to the design and production of synthetic sofa fabrics, genuine flocked leather and stamping fabrics and the production of tufted fabrics, as well as related management activities.

We have also been certified by the International Organization of Standardization. In addition, we set our own production standards based on certain international industry standards, including the American Four-Point Standards, and the National Light Diesel Standard. In addition, we strictly comply with various PRC national quality standards with respect to the manufacture of furniture leather, polyurethane dry coating process for artificial leather, and the national general safety technical code for textile products, all of which have been established by the General Administration of Quality Supervision, Inspection and Quarantine of China.

Facilities - Original Products and Colgre Products

The following table provides information about (1) the construction and production capacity in our original factory, in which we manufacture all of our products, except for our Colgre Products, and (2) the construction and production capacity of our Colgre Products factory, in which we manufacture all of our Colgre products:

(1)      Capacity refers to the maximum annual amount that we can concurrently produce with respect to our key production processes when we operate at full production and our standard fabric products are generally at the width of 140cm.

(2)      The first Colgre Product production line currently has production capacity of 3,000 meters per day. As of September 30, 2011, our Colgre Product Production line had production capacity of approximately 1,000 meters per day and approximately 25,000 meters were produced at year end, 15,000 meters of which were shipped to customers for the year ended September 30, 2011 .   

(3)      Manufacturing space refers to the number of square meters of floor space, including floor space on multiple stories, that we use to manufacture our products.

(4)      Site area refers to the number of square meters of land on which the facility is located.

(5)      Our expected production capacity for our Colgre Products will depend on whether the improvements we make to the production line function properly and produce the desired quality and quantity of Colgre Products. Currently we have production capacity of 3,000 meters of Colgre Products per day, which is an improvement as of September 30, 2011. Assuming improvements are made properly, we hope to have production capacity of 5,000 meters per day.

Equipment Suppliers

Our production facilities use innovative equipment and machinery manufactured by international and domestic equipment vendors. We seek to ensure the quality of our equipment and machinery, and safeguard our technical know-how, by utilizing a small number of equipment vendors. Our management team has had long-term business relationships with many of these equipment vendors and we are satisfied with the quality of their equipment.

In June 2008, one of our largest customers provided us with tufting equipment valued at approximately $1.3 million in exchange for a two-year supply agreement for our products. Pursuant to this agreement, we agreed not to sell tufted fabrics to any other customers in the U.S. until March 2011. After March 2011, we are permitted to sell tufted fabrics to other customers in the U.S.

Our Customers

We sell domestically in China, generally to furniture manufacturers and we export to distributors and manufacturers in the U.S. and other foreign countries, such as Italy, the Netherlands and Russia. Our products are sold directly or indirectly to furniture manufacturers and fabric distributors. Due to our decreased production capacity for Colgre Products for the year ended September 30, 2011, we could not provide other customers, such as garment and auto upholstery manufacturers with our Colgre Products. Once we improve production capacity for our Colgre Products, we hope to penetrate the apparel and auto upholstery industry, particularly manufacturers of hand bags and luggage. Approximately 33.9% of the revenues that we generated in fiscal year 2011 were generated by sales to distributors, or resellers, located outside of China that sell our products to fabric manufacturers and the remaining 66.1% were generated by sales to manufacturers and resellers located in China. Some of our domestic customers manufacture furniture or upholstery fabric in China and then export their products to the U.S. and other international markets.

The following table sets forth the percentage of revenues generated from sales to our domestic Chinese and export customers for the periods indicated:

According to a 2009 report issued by the China Investment Consulting Company (the “OCN Report”), in recent years, production of synthetic leather fabric, microfiber and tufted fabric products in the U.S. and other developed countries has declined. This decline has been attributed to the increasing labor costs and operational costs incurred in the manufacture of these products in these countries. Consequently, manufacturers in these countries are relying more on imported synthetic leather fabric products. In an attempt to take advantage of this trend, we have broadened our customer base over time, both in the PRC, and, more notably, in the international markets.

We generally obtain sales orders from customers three to four weeks in advance of delivery. The total sales volume, pricing, product specifications, delivery schedule and method of delivery are provided in these sales orders. Generally, our customers are required to pay us on 60 to 90 day credit terms, depending on our business relationship with the customer, the customer’s credit history and prevailing market conditions.

Our production facilities are strategically located in Tongxiang, Zhejiang Province, which is in close proximity to many leather product manufacturers whose production facilities are located in Tongxiang, Haining and Wenzhou, all of which are situated in Zhejiang Province. The majority of our domestic customers are located in these regions. For our domestic customers, we ship our products directly from our production facilities to the customers’ manufacturing facilities or, in the case of customers that distribute our products to manufacturers, to the customers’ distribution facilities. For our export customers, we ship our goods on the Free On Board (FOB) term from major ports in China to the customers’ respective destinations.

During the fiscal years ended September 30, 2010 and 2011, sales made to our five largest customers accounted for 79.1% and 70.4% of our total sales, respectively, and our three largest customers accounted for 30.4%, 17.3% and 15.6% of our total sales during fiscal year 2010, respectively, and our two largest customers accounted for 38.6% and 12.5% of our total sales during fiscal year 2011, respectively.

Sales and Marketing

We seek to expand our customer base by:

·             direct sales communications with our largest customers;

·             sales through distributors to new customer bases;

·             referrals from existing customers; and

·             participation in domestic and international trade shows and conferences.

Historically, we have not spent a significant amount of capital on advertising.

We have an internal sales team of 20 employees located in our Tongxiang facility. Our sales personnel regularly contact our customers and visit them in person to obtain feedback on our products, to gather additional relevant market information and to build long-term relationships with our existing customers.

Our long-term plan is to increase our marketing and distribution activities for our synthetic and imitation leather fabrics and other fabrics, as well as to increase public awareness of recycled leather as an eco-friendly alternative to chemical fiber-based and leather fabrics using various methods, including advertising and media outlets. In the near future, as we expand our customer base to include manufacturers of apparel, we intend to hire additional sales representatives to market our fabric to this customer base.

Research and Development Activities

We have 15 full-time professionals in our research and development division that have developed innovative technology that is instrumental in controlling our production costs, increasing our operational efficiency and enhancing our ability to develop eco-friendly production processes. Our combination proprietary production technology enables us to use lower-cost materials, including leather scrap, in place of the higher-value and non-recyclable chemical fiber based materials.

One of our key employees, Mr. Liwen Zhang, who is also a minority shareholder of our Hongzhan operating subsidiary, is the original owner of four Chinese patents, seventeen international patents and eight international patent applications related to technologies utilized in the manufacture of our Colgre Products. Three of the Chinese patents have been transferred to us and the remaining patents and patent applications, all of which are related to the technologies that are critical to the production of the Colgre Products, have been licensed to us for our exclusive use until 2024. Mr. Zhang has managed the research and development process on these patents and related production technologies since 2003. Mr. Zhang and four other researchers joined our company in February 2010.

We plan to continue our research and development efforts to strengthen our leading position in our industry. For example, we are currently developing nylon taffeta, a new polyurethene leather material that is used for apparel manufacturing purposes.

We will focus our research and development efforts primarily on our Colgre Products going forward. In 2010, we entered into a three-year joint research and development agreement with Sichuang University in China, under which we will establish a genuine leather fiber research lab to focus on developing the applications and products for our Colgre Products and nylon taffeta. All research results that are jointly developed pursuant to this relationship will belong to both parties. We will have the exclusive right to produce, sell and export products based on these results. However, we will be obligated to pay a percentage of any sales of any of these products to Sichuang University.

Intellectual Property

General

We believe that we have been able to harness our technology and know-how to develop a distinct competitive advantage by recycling leather scrap to produce eco green fabrics which are more similar to genuine  leather in quality than our existing products. We rely on a combination of patents, trademarks, trade secrets and confidentiality agreements to protect our intellectual property rights. Our manufacturing processes are based on technology developed primarily in-house by our research and development and engineering personnel.

With respect to proprietary know-how that is not patentable and processes for which patents are difficult to enforce, we rely on, among other things, trade secret protection and confidentiality agreements to safeguard our interests. All of our research and development personnel have entered into confidentiality and proprietary information agreements with us. These agreements address intellectual property protection issues and require our associates to assign to us all of the inventions, designs and technologies they develop during the course of employment with us. We are not aware of any material infringement of our intellectual property rights.

Patents — Ownership Rights

Patents Relating to Our Original Product Line

As described in the chart below, we currently own a total of nine patents relating to our original products, which include five “Design” patents and four “New Utility Model” patents. We acquired these nine patents and one additional pending “Invention” patent application from Mr. Jianfeng Liu, who is our Chairman, President and Chief Executive Officer.

Actual examination times for design patent applications in China vary, but examinations of patents similar to those currently under examination have taken approximately one year. The following table describes the patents and patent applications relating to our existing products:

Patents Relating to Colgre Products

In February 2010, we acquired a five-person research and development team led by Liwen Zhang, as well as ownership rights to two Chinese “Invention” patents, and one patent application for “spun lace,” which had been granted to Liwen Zhang, relating to our Colgre Products (the “Licensed Patents”).  The patent application for “spun lace,” however, has been withdrawn by Mr. Zhang and the recycled leather and composition process method has replaced and improved the prior spun lace application.

The Licensed Patents are directed to an invention to provide a yarn of collagen fiber of animal leather, and a manufacturing process thereof in that yarn is manufactured by using animal skins or leathers and leftover materials thereof as well as wasted leathers. The present invention provides for a yarn having higher tensile strength and better resistance to abrasion than those of the natural fiber yarns, and having higher water absorption, greater comfort, and better flame-retardant properties than those of synthetic fiber yarns. This technology that is most essential to the front-end manufacturing process of our Colgre Products has been patented in eighteen countries, including China, Canada, South Africa, Germany and the United Kingdom. Applications for patent protection with respect to this key technology have also been submitted in eight other countries, including the U.S. The Licensed Patents have been licensed to us exclusively until 2024.

The Licensed Patents are intended to protect the technologies, including machinery and processes, developed by Liwen Zhang’s team, to produce collagen fiber from animal leather, which is the most essential front-end manufacturing process in the production of our Colgre Products. We believe that the patents that we own and the Licensed Patents differentiate our Colgre Products as an environmentally friendly and economical alternative to existing synthetic and genuine leather fabrics.

In September 2010 we submitted an application to obtain an “Invention” patent in the PRC (as described in the below chart) pursuant to the Patent Cooperation Treaty, related to the process of our Colgre Products. We expect that the patent will be granted sometime in 2012 .  

Trademarks

We currently use the registered trademark “Illigate”.

We have been granted the trademark “Evergreen LZ” and we are in the process of obtaining a trademark for “Colgre.”

Competition

We believe that the principal competitive factors needed to compete in the synthetic fabric industry in China are as follows:

·              Cost control and pricing. Manufacturers must have the ability to control the costs of raw materials and other operational expenses in order to control the pricing of their products. Consequently, manufacturers must have the ability to use economies of scale to secure competitive pricing from suppliers of raw materials.

·              Technology.  Manufacturers must have the ability to install eco-friendly technology that allows them to produce their fabrics from low-cost raw materials such as leather scrap.

·              Barriers to entry. Manufacturers must have the technical knowledge, local market knowledge and established relationships with suppliers and customers to support the development of new products and the growth of commercially viable production facilities.

·              Logistics and services. A manufacturer’s ability to compete is dependent upon the geographic location of its production facilities in relation to the manufacturing facilities of customers and suppliers, and the ability to manage the logistics and delivery of its products.

The synthetic fabric industry in China is very large and fragmented. Our ability to compete against other national and international enterprises is, to a significant extent, dependent on our ability to distinguish our products from those of our competitors by providing large volumes of high quality products that appeal to consumers’ preferences at competitive prices. Our local competitors generally consist of small-scale manufacturers, many of whom develop a range of finishing processes which is not as broad as ours and utilize production technology which is not as advanced as some of our patented technology. Some of our competitors have been in business longer than we have and are more established. Our competitors may provide products comparable or superior to those we provide, and our competitors may adapt more quickly than we do to evolving industry trends or changing market requirements.

China represents a potentially lucrative market for international competitors, many of whom may seek to enter the PRC market in the future. However, to date, potential international competitors have purchased products from domestic Chinese manufacturers such as ours and have little or no presence of their own in the PRC market.

Insurance

We maintain various insurance policies to safeguard against risks and unexpected events. We provide social security insurance, including pension insurance, unemployment insurance, work related injury insurance, maternity insurance and medical insurance to approximately 32% of our employees, in accordance with PRC regulations. We also maintain insurance for our plants, machinery, equipment, inventories and motor vehicles. However, we do not maintain product liability insurance for our products.

Governmental Regulations

Environmental Matters

Our manufacturing facilities are subject to various pollution control regulations with respect to noise, water and air pollution and the disposal of waste and hazardous materials. We are also subject to periodic inspections by local environmental protection authorities.

The major environmental regulations applicable to us include:

·             the Environmental Protection Law of the PRC;

·             the Law of PRC on the Prevention and Control of Water Pollution;

·             Implementation Rules of the Law of PRC on the Prevention and Control of Water Pollution;

·             the Law of PRC on the Prevention and Control of Air Pollution;

·             Implementation Rules of the Law of PRC on the Prevention and Control of Air Pollution;

·             the Law of PRC on the Prevention and Control of Solid Waste Pollution; and

·             the Law of PRC on the Prevention and Control of Noise Pollution.

We are periodically inspected by local environmental protection authorities. Our operating subsidiaries have received certifications from the relevant PRC government agencies in charge of environmental protection indicating that their business operations are in material compliance with the relevant PRC environmental laws and regulations. We are not currently subject to any pending actions alleging any violations of applicable PRC environmental laws. To date, the Company’s cost of compliance has been insignificant. The Company does not believe the existence of these environmental laws, as currently written and interpreted, will materially hinder or adversely affect the Company’s business operations; however, there can be no assurances of future events or changes in laws, or the interpretation of laws, governing our industry.

The Chinese authorities have recently mandated a significant reduction of energy usage in an effort to meet the targets for energy consumption and emissions set by the 12th Five Year Plan, which plan concludes on December 31, 2015. As a result, we were informed by local government officials in July 2011 that we would be restricted from using electrical power in our original facility for approximately 36 days from July to September, although our Colgre Product facility was unaffected because it had been designated as a priority project by the local government. In response to this policy, we obtained three power generators to provide us with the energy needed to run our original facility when electrical power is restricted. If the power generators are unable to generate sufficient energy for our facility when electrical power is restricted, the results of our operations would be affected during that time. In addition, the Tongxiang Environmental Thermoelectricity Co., Ltd. in Tongxiang City completely shut down its steam production from January 20, 2011 to February 12, 2011 to complete maintenance of its equipment. This mandatory maintenance occurs every three or four years at the local government’s discretion. Steam production has returned to normal. Tongxiang Environmental Thermoelectricity Co., Ltd completed its repairs on February 13, 2011. Additional energy use restrictions could be imposed in the future. Additional energy use restrictions could be imposed in the future. Any additional restrictions could adversely impact our results of operations in future periods.

Circular 75 Compliance and Approval

SAFE issued the Notice on Issues Relating to the Administration of Foreign Exchange in Fund-raising and Reverse Investment Activities of Domestic Residents Conducted via Offshore Special Purpose Companies, or “Notice 75,” on October 21, 2005, which became effective as of November 1, 2005 and the operating procedures in May 2007, collectively the SAFE Rules. According to the SAFE Rules, prior registration with the local SAFE branch is required for PRC residents to establish or to control an offshore company for the purposes of financing that offshore company with assets or equity interests in an onshore enterprise located in the PRC. An amendment to registration or filing with the local SAFE branch by such PRC resident is also required for the injection of equity interests or assets of an onshore enterprise in the offshore company or overseas funds raised by such offshore company, or any other material change involving a change in the capital of the offshore company. The SAFE rules define “PRC residents” to include both legal persons and natural persons who either hold legal PRC identification documents, or who habitually reside in China due to economic interests or needs. If any PRC resident fails to file its SAFE registration for an existing offshore enterprise, any dividends remitted by the onshore enterprise to its overseas parent after October 21, 2005 will be considered to be an evasion of foreign exchange purchase rules, and the payment of the dividend will be illegal. As a result, both the onshore enterprise and its actual controlling persons can be fined. In addition, failure to comply with the registration procedures may result in restrictions on the relevant onshore enterprise, including prohibitions on the payment of dividends and other distributions to its offshore parent or affiliate and capital inflow from the offshore enterprise. The PRC resident shareholders of the offshore enterprise may also be subject to penalties under Chinese foreign exchange administration regulations.

To date, the required filings pursuant to SAFE Rules are underway for our shareholders of Lizhan. Mr. Liu has completed his SAFE filing procedure. We have requested our shareholders and beneficial owners who may be subject to SAFE Rules to make the necessary applications, filings and amendments as required under SAFE Rules. We have advised these shareholders and beneficial owners to comply with the relevant requirements. It is our understanding that these shareholders are in the process of making the required filings. However, we cannot provide any assurance that all of our shareholders and beneficial owners who may be PRC residents will comply with our request to make or obtain any applicable registrations or comply with other requirements required by SAFE Rules. The failure or inability of our PRC resident shareholders or beneficial owners to make any required registrations or comply with other requirements may subject such shareholders or beneficial owners to fines and legal sanctions and may also limit our ability to contribute additional capital into or provide loans to our PRC subsidiaries, limit the ability of our PRC subsidiaries to pay dividends or otherwise distribute profits to us, or otherwise adversely affect us.

Regulation on Employment

On June 29, 2007, the National People’s Congress promulgated the Labor Contract Law of PRC, or the Labor Law, which became effective as of January 1, 2008. On September 18, 2008, the PRC State Council issued the PRC Labor Contract Law Implementation Rules, which became effective as of the date of issuance.

Pursuant to the Labor Law and its implementation rules, employers must execute written labor contracts with full-time employees. All employers must compensate their employees with wages equal to at least the local minimum wage standards. All employers are required to establish a system for labor safety and sanitation, strictly abide by state rules and standards and provide employees with workplace safety training. Violations of the Labor Law may result in the imposition of fines and other administrative liabilities. Criminal liability may arise for serious violations.

In addition, employers in China are obliged to provide employees with welfare schemes covering pension insurance, unemployment insurance, maternity insurance, work-related injury insurance, medical insurance and housing funds.

Tort Liability Law

The Tort Liability Law of the People’s Republic of China, which was passed during the 12th Session of the Standing Committee of the 11th National People’s Congress on December 26, 2009, states that manufacturers are liable for damages caused by defects in their products and sellers are liable for damages caused by defects attributable to their fault. If the defects are caused by the fault of third parties such as the transporter or storekeeper, manufacturers and sellers are entitled to claim for compensation from these third parties after paying the compensation amount.

4C.          Organizational Structure

See “—History and Development of the Company” above in subsection A of Item 4 for a description of our organizational structure.

4D.          Property, Plants and Equipment

Lizhan Textile : Lizhan Textile owns 3 factory buildings with a total area of 18,967 square meters; 1 office building with a total area of 2,568 square meters; 1 staff dormitory and canteen building of 4,632 square meters. The above-mentioned properties were put into service in 2007. The comprehensive design production capacity of the existing production lines for Lizhan Textile is 15 million meters per year (which is the production line for our original products). Our annual production output has reached 12 million meters, or 77.6% of the production capacity for the year ended September 30, 2011. Our production capacity could be increased to 17 million meters to meet market demands under current conditions without additional capital investment and without extending the working hours of the equipment.

Hongzhan : For the production of our Colgre Products, Hongzhan has 3 factory buildings with a total area of 30,000 square meters. We have experienced technical difficulties with the equipment used to produce our Colgre Products in our newly constructed factory. We will require approximately $500,000 to improve the equipment for production line one so that the machinery and production will function at full capacity. We intend to finance the improvements through our use of short-term and long-term borrowings. As of September 30, 2011, we spent $20.1 million on construction of manufacturing facility, land and the installation and equipments for the first and part of the second production line and we had production capacity of approximately 1,000 meters a day for Colgre Products. We currently have production capacity of approximately 3,000 meters per day of Colgre Products and we expect to produce 5,000 meters per day once we invest the capital and improve the equipment for production line one. In addition, Hongzhan leases a facility which has a total area of 32,301 square meters, including 10,800 square meters for the buildings located at the facility, which are used for administrative offices and accommodations.

ITEM 4A.             UNRESOLVED STAFF COMMENTS

Not Applicable

item 5.                OPERATING AND FINANCIAL REVIEW AND PROSPECTS

The following discussion and analysis should be read in conjunction with our consolidated financial statements, the notes to those financial statements and other financial data that appear elsewhere in this annual report. In addition to historical information, the following discussion contains forward-looking statements based on current expectations that involve risks and uncertainties. Actual results and the timing of certain events may differ significantly from those projected in such forward-looking statements due to a number of factors, including those set forth in “Risk Factors” and elsewhere in this report. Our consolidated financial statements are prepared in conformity with U.S. GAAP.

5A.          Operating Results

Overview

General

Lizhan is an innovative green materials manufacturer that designs high quality recycled leather and synthetic leather in China. Our products are utilized worldwide in the furniture manufacturing industry. Lizhan owns and exclusively licenses a broad range of patents for its recycled leather products and its other synthetic leather products. Our Colgre Products have been patented in eighteen countries, including China, Canada, South Africa, Germany and the United Kingdom.  Our production facilities are strategically located in Tongxiang, Zhejiang Province, which is in close proximity to many leather product manufacturers whose production facilities are located in Tongxiang, Haining and Wenzhou, all of which are situated in Zhejiang Province, which collectively are considered as one of the most important leather industry clusters in China. We believe that we are one of only a few Chinese synthetic fabric manufacturers that own an extensive range of finishing processes to manufacture synthetic leather and other fabrics, ranging from products which are manufactured entirely from chemical-based materials, such as our microfiber fabrics, to products such as recycled leather flocked fabric, which are flocked with recycled genuine leather scrap. Recycled leather flocked fabric products accounted for approximately 74.4% of our revenue for the year ended September 30, 2011.

Our business depends on obtaining a reliable supply of various raw materials, including leather scrap, ultrasuede grey cloth, polyurethane, backing fabric, and resin. Because of the diversity of available sources of these raw materials, we believe that our raw materials are in adequate supply and will continue to be so in the future. To minimize purchasing costs, we use fewer than five primary suppliers for each of our raw materials. However, as we expand our operations and require greater supplies of leather scrap products, we may not be able to procure a sufficient supply of these materials at a competitive price, which could have an adverse effect on our results of operations, financial condition and cash flows.

Our products are used in various consumer applications, as we sell our products to furniture manufacturers, as well as fabric distributors. We sell domestically in China and export to the U.S. and other countries, including Italy, the Netherlands and Russia. During the twelve months ended September 2011 and 2010, approximately 33.9% and 22.9% of our revenues, respectively, were generated from export sales. The solid reputation that our management team has developed over the past ten years in the synthetic leather industry in China, including an established track record for consistently providing quality products at competitive prices, has enabled us to develop and expand our customer base. However, our company has a limited operating history and you will have a limited basis on which to evaluate our ability to achieve our business objectives. In addition, we expect our future growth to place significant demands on our management and resources.

According to the OCN Report, in recent years, production of synthetic fabric in developed countries has declined. This decline has been attributed to the increasing labor costs and operational costs incurred in the manufacture of these products in these countries. Consequently, manufacturers in these countries are relying more on imported synthetic leather fabric products. Our strategy is to take advantage of this trend and to sell our products to more international customers. For example, although our sales to domestic customers decreased, our sales to international customers increased from 2010 to 2011. Sales to domestic PRC customers decreased by approximately 32.8% from $35.7 million to $24 million during the years ended September 30, 2010 and 2011, respectively, and sales to international customers increased by 16.0% from $10.6 million to $12.3 million, during the years ended September 30, 2010 and 2011.

We expect that once we improve the production process for our Colgre Products, the success and development of such products will have a positive impact on the environment and on our results of operations.  It is important that we focus our attention and invest capital to improve the Colgre Product production line. The technology used in producing our Colgre Products is beneficial to the environment. For example, the production of leather produces large amounts of solid waste, otherwise known as leather scraps. Leather scraps contain heavy metals which pollute the environment. The Colgre Product technology provides for an environmentally safe way to dispose of leather scraps in that the leather scraps are used to produce the Colgre Products. In addition, we expect that our Colgre Products will contribute to the conservation of resources in the world because collagen fiber (the raw material used in the production process) is the best natural spinnable form of fiber. Collagen fiber is also a cheaper raw material than other raw materials used for producing leather products. The recycling of leather scraps can replace part of the cotton and man-made chemical fibers, reduce the use of cotton cultivation, and thereby reduce the development and utilization of natural resources. Lastly, we expect that once the production lines are improved and working at full capacity, the Colgre Products will be manufactured more efficiently than genuine leather. 

Important Factors Affecting our Results of Operations

We believe that the significant factors that affect our financial condition and results of operations are as follows:

·          Expansion of our production capacity and increase of production volume . Our revenues largely depend on our production capacity and production volume. The operations at our original facility commenced in November 2007 and expanded over time. As of September 30, 2011, our original facility had the design capacity to produce 15  million meters of fabrics annually. We produced and sold approximately 14.0 million meters  and 12.0  million meters of fabric during the twelve months ended September 30, 2010 and 2011, respectively. Our revenues and net income decreased during the past period attributable to a decrease in sales and an increase in operational costs. Specifically, we generated revenues of $46.3 million and $36.3 million, and generated net income of $8.2 million and $1.6 million during the twelve months ended September 30, 2010 and 2011, respectively. During fiscal year 2011, we completed the construction of our Colgre Products facility and  we completed installation of several pieces of equipment for our first production line of the Colgre Products manufacturing line.

·          Demand for our original products . In fiscal year 2009, we launched the production and sales of our recycled leather flocked fabric products which are flocked with leather scrap. We have seen a rapid increase in the demand of this product from our customers, and anticipate that this product will continue expanding and account for an increasingly significant percentage of our total revenues in fiscal year 2011. During the year ended September 30, 2010 and the year ended September 30, 2011, this product accounted for 73.9% and 74.4% of total revenue, respectively. In addition, as we have gotten more experienced in the production and sales of this product, our gross margin has increased as a result of higher average selling price and better production yield. During the year ended September 30, 2010 and the year ended September 30, 2011, our gross margin for this product was 28.1% and 19.1%, respectively.

·     Product mix and effect on gross margin . Our gross margin in any given period will be directly impacted by our product mix. We believe that we are one of only a few Chinese synthetic fabric manufacturers that own an extensive range of finishing processes to manufacture synthetic leather and other fabrics, ranging from purely chemical-based products, such as our microfiber fabrics, to products such as recycled leather flocked fabric, which are flocked with recycled genuine leather. We manufacture products based on customer orders. Orders may have unique specifications and may vary on selling prices, production costs and gross margins. Our selling price and gross margin may decline if our competitors lower their prices and we respond by reducing prices to compete more effectively. Alternatively, we may increase our selling price and gross margin when we introduce new or enhanced products or when there are products which few manufacturers can produce. As a result, new products, such as recycled leather flocked material, generally generate higher selling prices and profit margins. Mature products such as ultrasuede generate lower selling prices and gross margins. Our increased revenue exposure from new products will lead to higher overall gross margin. During the years ended September 30, 2010 and 2011, our gross margin was 24.3% and 18.5%, respectively. The gross margin decreased during fiscal 2011 mainly as a result of increased product mix and rising costs for raw materials, labor and energy, partially offset by sales price increases.

·          Raw materials prices. Raw material is the most important aspect of our production cost. During fiscal years 2010 and 2011, direct material costs accounted for approximately 91% and 87.6% of our total cost of sales, respectively. As a result, price fluctuations in raw materials impact our gross profits and results of operations. Our production requires substantial quantities of various raw materials. The market for certain of our principal raw materials, in particular polyurethane base and microfiber cloth, may fluctuate over time based on market conditions. For instance, the cost of our raw materials increased significantly during the year ended September 30, 2011 and this trend may continue in the near future unless the PRC government is successful in implementing measures to slow recent increases in inflation. In addition, we outsource when we foresee capacity constraint or on certain processes which are required by the customers that we don’t yet handle in-house. Our material costs increase as we increase the level of outsourcing. During a period of volatile material costs, it is industry practice for manufacturers to place advanced orders with a committed quantity and price to ensure an ample supply of raw materials within an expected pricing range, and to pass onto customers a portion of the cost fluctuations, which practice we have adopted. We account for inventory for raw materials at cost and any adjustment required to value inventory at the lower of cost or market is made at the year-end and not at interim periods. However, because we keep inventory on hand for relatively short periods of time, we believe that differences between cost and market are not significant.

·          Adequate supply of raw materials . Many of our current suppliers have longstanding relationships with us. These long-standing supplier relationships provide us with a competitive advantage in China. Many of our current suppliers are located in Zhejiang Province, PRC, in close proximity to our facilities. We also purchase leather scrap, which is a lower cost material, in bulk quantities from leather manufacturers. To date, we have been able to obtain these products in sufficient amounts and at competitive prices. During the year ended September 30, 2011, we procured raw materials from over 100 suppliers overall. During the year ended September 30, 2011, our largest supplier accounted for 15.1 % of our total cost of sales, and our top five largest suppliers accounted for 57% of our total cost of sales, collectively.

Seasonality

Our production and sales slow considerably during and around the Chinese New Year, which usually occurs during the quarter ended March 31, as a result of the closing of our facilities and the facilities of many of our customers for the New Year’s celebration, as well as the shutting down of our steamers for an annual inspection by local authorities. In addition, our sales volume declines during summer due to the slow demand from the international markets while consumer spending is generally slower for furniture and garments.  Consequently, our results of operations may fluctuate from quarter to quarter.  In addition, any significant decrease in sales during the remainder of the year would have a material adverse effect on our business, our financial condition and our results of operations.

Taxation

Under the current laws of the Cayman Islands, we are not subject to any income or capital gains tax, and any dividend payments we may make are not subject to any withholding. Under the prevailing laws of Hong Kong, there is no witholding tax on capital gains and dividend payments by our Hong Kong subsidiary. Hong Kong profits tax will only apply if our Hong Kong subsidiary carries on business in Hong Kong and derives a Hong Kong sourced profit from such business. Our operating subsidiaries in the PRC are subject to the PRC enterprise income tax, or EIT. Each of our operating subsidiaries files its own separate tax return on a calendar year basis.

According to the relevant laws and regulations in the PRC, foreign invested enterprises established prior to January 1, 2008 were entitled to full exemption from income tax for two years beginning from the first year when the enterprises become profitable and have accumulative profits, and a 50% income tax reduction for the subsequent three years. Lizhan Textile was entitled to the EIT exemption in the company fiscal years ended September 30, 2008 and 2009, and is subject to 50% income tax reduction during the period from January 1, 2010 to September 30, 2012. Hongzhan is subject to a uniformed tax rate of 25% beginning in 2010.

Set out in the following table are the EIT rates for our two PRC Operating Companies from 2008 to 2013:

Foreign Currency Translation

Our financial statements are expressed in U.S. dollars but the functional currency of our operating subsidiary is RMB and Hong Kong dollars. Our results of operations are translated at average exchange rates during the relevant financial reporting periods, assets and liabilities are translated at the unified exchange rate at the end of these periods and equity is translated at historical exchange rates. Adjustments resulting from the process of translating the local currency financial statements into U.S. dollars are included in determining comprehensive income.

Results of Operations

The following tables set forth key components of our results of operations for the periods indicated, in dollars and as a percentage of revenue.

Table of Contents

Comparison of Year Ended September 30, 2011 and September 30, 2010

Net Sales . We generate revenues from sales of our synthetic leather and other fabrics. During the year ended September 30, 2011, we had revenues of approximately $36.3 million as compared to revenues of approximately $46.3 million during year ended September 30, 2010, a decrease of approximately $10.0 million, or 21.6%. Sales in fiscal year 2011 were negatively impacted by decreased customer orders by domestic and international customers and tighter credit markets. We produced and sold 14.0 million meters and 12.0 million meters of fabrics during the years ended September 30, 2010 and 2011, respectively.

The following table provides a breakdown of revenues of each of our product types during the years September 30, 2011, 2010 and 2009:  

We generated revenues of approximately $27.1 million from sales of our recycled leather flocked fabric products in the year ended September 30, 2011, the production of which we launched during the fiscal year ended September 30, 2009. This product is flocked with genuine leather and the quality of these products is better than purely chemical-based synthetic products. As a result, the price that customers are willing to pay for this product is higher, resulting in higher revenues and gross margins. In addition, the production of these products is more environmentally friendly than the production of products made from non-recycled raw materials.

The following table sets forth the percentage of revenues generated from sales to our domestic Chinese and export customers for the periods indicated:

During the year ended September 30, 2011, our domestic customer base decreased and our international customer base remained the same. We had 27 international customers and 125 domestic customers as of September 30, 2011 and 27 international and 189 domestic customers as of the year ended September 30, 2010 . 

While sales to domestic PRC customers decreased by approximately 32.8% during the year ended September 30, 2011, sales to international customers increased by approximately 16.3% during the year ended September 30, 2011.

Comparison of Year Ended September 30, 2011 to September 30, 2010

Cost of Sales . Cost of sales were approximately $29.6 million during the year ended September 30, 2011, as compared to approximately $35.0 million during the year ended September 30, 2010, representing a decrease of 15.4% or approximately $5.4 million. This decrease resulted from a reduction in customer orders and the impact of the global financial crisis. In addition, our depreciation expenses for our plants and machinery slightly increased to approximately $0.8 million in the year ended September 30, 2011 from approximately $0.7 million in the year ended September 30, 2010. As a percentage of net revenues, cost of revenue increased from 75.7% to 81.5% during the year ended September 30, 2011.

Gross Profit and Gross Margin . Our gross profit decreased 39.8% to approximately $6.8 million during the year ended September 30, 2011, from approximately $11.3 million for the same period in 2010. For the years ended September 30, 2011 and 2010, our gross margin was 18.5% and 24.3% respectively. The decline was primarily a result of adjustment of product mix and rising cost of raw materials, labor and energy costs which more than offset pricing adjustments. In addition, the sales price of the recycled leather flocked material has increased. However, during the third and fourth quarters, we experienced an increase in the costs of producing these materials as a result of increased prices for raw materials.

General and Administrative Expenses . General and administrative expenses totaled approximately $4.5 million for the year ended September 30, 2011, as compared to approximately $2.1 million for the year ended September 30, 2010, representing an increase of 114.3%. This increase was primarily attributable to expenses incurred in connection with operating as a public company and expenses in connection with the cost of establishing our operating subsidiary, Hongzhan. In addition to the increased payment of salaries and related expenses to our employees as a result of inflation adjustment.

Research and Development Expenses . Research and development expenses totaled $92,522  for the year ended September 30, 2011, as compared to $136,398 for year ended September 30, 2010, a decrease of 32.2%. This decrease was attributable to the expense of our Colgre Products included in the cost of goods.  

Selling and Marketing Expenses . Selling and marketing expenses totaled $845,221 for the year ended September 30, 2011, as compared to $634,544 for the year ended September 30, 2010, an increase of 33.2%. This increase was attributable primarily to increased marketing and promotion activities, staffing costs and other costs relating to selling and marketing activities.

Operating Income . As a result of the foregoing, operating income for the year ended September 30, 2011 was approximately $1.3 million, a decrease of 85% as compared to approximately $8.4 million for the same period in 2010.

Other Income (expenses), net . Our other income (expenses), net for the year ended September 30, 2011 totaled $533,511, compared to other income of $673,350 for the previous year. Our other income and expenses for the year ended September 30, 2011 comprise revenue of $112,923 from an exclusive distribution rights arrangement with one of our largest customers, government grants of $1.1 million which were awarded to us by the local PRC government as an incentive to increase our Colgre Products , scrap sales of $7,118, other miscellaneous income of $9,785, the exchange loss of $156,543, interest income of $14,572 and interest expenses of $411,920 and other expenses of $174,007. Other income (expenses), net for the year ended September 30, 2010 comprise revenue of $649,484 from an exclusive distribution rights arrangement with one of our largest customers, government grants of $440,826 which were awarded to us by the local PRC government as an incentive to increase our exports, scrap sales of $14,034, other miscellaneous income of $35,101, exchange loss of $49,788, interest income of $26,721, interest expense of $300,609 and other expenses of $142,419.

Provision for Income Taxes . We incurred income tax expenses of $405,755 and $912,249 in fiscal years ended September 30, 2011 and 2010, respectively. Beginning in calendar year 2010, Lizhan Textile became subject to an income tax rate of 12.5%.

Net Income . As a result of the foregoing, our net income totaled approximately $1.6 million for the year ended September 30, 2011, as compared to approximately $8.2 million for the year ended September 30, 2010, a decrease of 80.5%.

Comparison of Year Ended September 30, 2010, and September 30, 2009

Cost of Sales . Cost of sales was approximately $35.0 million during the year ended September 30, 2010, as compared to approximately $17.9 million during the year ended September 30, 2009, representing an increase of 96.1% or approximately $17.2 million. This increase resulted from the increase in volume sold during this period. In addition, our depreciation expenses for our plants and machinery increased to approximately $0.7 million in the year ended September 30, 2010 from approximately $0.5 million in the year ended September 30, 2009 as a result of new equipment purchased for our original facility. As a percentage of net revenues, cost of revenue decreased from 82.7% to 75.7% during the year ended September 30, 2010.

Gross Profit and Gross Margin . Our gross profit increased 201.2% to approximately $11.3 million during the year ended September 30, 2010, from approximately $3.7 million for the same period in 2009. The increase was primarily attributable to increased sales and change of product mix. For the years ended September 30, 2010 and 2009, our gross margin was 24.3% and 17.3%, respectively. The rise of gross profit margin in 2010 is due to the maturity of our production technique for our recycled leather flocked products, which resulted in increased product yield and decreased costs. In addition, the sales price of the recycled leather flocked material has increased. However, during the third and forth quarters, we experienced an increase in the costs of producing these materials as a result of increased prices for raw materials.

General and Administrative Expenses . General and administrative expenses totaled approximately $2.1 million for the year ended September 30, 2010, as compared to approximately $1.1 million for the year ended September 30, 2009, representing an increase of 100.3%. This increase was primarily attributable to expenses incurred in connection with the retention and payment of advisors in connection with our listing as a US public company, in addition to the increased payment of salaries and related expenses to our employees as a result of new hires in fiscal year 2010.

Research and Development Expenses . Research and development expenses totaled $136,398 for the year ended September 30, 2010, as compared to $64,991 for year ended September 30, 2009, an increase of 109.9%. This increase was attributable to the payment of salaries and related expenses to additional employees during the year ended September 30, 2010, as we expanded the size of our research and development staff efforts during that time.

Selling and Marketing Expenses . Selling and marketing expenses totaled $634,544 for the year ended September 30, 2010, as compared to $322,133 for the year ended September 30, 2009, an increase of 97.0%. This increase was attributable primarily to increased advertising and promotion activities, staffing costs and other costs relating to selling and marketing activities.

Operating Income . As a result of the foregoing, operating income for the year ended September 30, 2010 was approximately $8.4 million, an increase of 264.6% as compared to approximately $2.3 million for the same period in 2009.

Other Income (expenses), net . Our other income (expenses), net for the year ended September 30, 2010 totaled $673,350, compared to other expenses of $428,041 for the previous year. Other income (expenses), net for the year ended September 30, 2010 comprise revenue of $649,484 from an exclusive distribution rights arrangement with one of our largest customers, government grants of $440,826 which were awarded to us by the local PRC government as an incentive to increase our exports, scrap sales of $14,034, other miscellaneous income of $35,101, exchange loss of $49,788, interest income of $26,721, interest expense of $300,609 and other expenses of $142,419. Our other income and expenses for the year ended September 30, 2009 comprise revenue of $539,244 from an exclusive distribution rights arrangement with one of our largest customers, government grants of $26,367 which were awarded to us by the local PRC government as an incentive to increase our exports, scrap sales of $44,937, the exchange loss of $24,963, interest income of $19,972 and interest expenses of $166,186 and other expenses of $11,330.

We recognized $539,244 of the value of the machines we received as revenue for the year ended September 30, 2009.

Provision for Income Taxes . We incurred income tax expenses of $912,249 and $0 in fiscal years ended September 30, 2010 and 2009, respectively. Beginning in calendar year 2010, Lizhan Textile became subject to an income tax rate of 12.5%.

Net Income . As a result of the foregoing, our net income totaled approximately $8.2 million for the year ended September 30, 2010, as compared to approximately $2.7 million for the year ended September 30, 2009, an increase of 199.7%.

5.B.         Liquidity and Capital Resources

General

Our primary capital needs have been, and we expect will continue to be, to fund the working capital requirements necessitated by our sales growth, including purchasing raw materials from suppliers, adding new products and increasing our Colgre Products production capacity. Our primary sources of financing have been cash generated from bank loans and bank acceptance notes from banks in China, proceeds from bank acceptance notes. We expect to continue to finance our operations and working capital needs in 2012 from these sources.

We had a working capital deficiency of approximately $6.3 million and $8.2 million at September 30, 2011 and 2010, respectively. We used approximatelly $8.6 million of cash for operations at September 30, 2011. Our activities have been primarily financed through bank loans. We intend to raise additional capital through bank loans to fund our operations. However, we do not have any formal commitments or arrangements to advance or loan funds. There is no legal obligation for either management or significant stockholders to provide additional future funding. There is no assurance that we will be able borrow additional funds and or raise any equity.

 As of September 30, 2011 we spent $20.1 million on the construction of our colgre manufacturing facility, land and the installation and equipment for the first and part of the second production line of our Colgre Products. The cost of improving production line one so that it will work at full capacity is expected to be approximately $500,000. We intend to use cash generated from operations and additional financing to meet this capital requirement . 

As of September 30, 2011, we repaid our short-term loans in the aggregate amount of approximately $22.0 million. Our short-term loans as of September 30, 2011 amounted to approximately $21.0 million in the aggregate and long-term loans currently amounted to $3.7 million in the aggregate.

We believe that term loans enhance our working capital position in the near future and will give us greater flexibility in managing the growth of our company, including investment in our production lines for our Colgre Product. We anticipate repaying our newly obtained long-term loans by using cash generated from our operations.

As discussed above, we have a working capital deficiency and we used approximately $8.6 million of cash for operations. These conditions raise substantial doubt about our ability to continue as a going concern. Management’s plans in regard to these matters are more fully described in Note 2 in the Consolidated Financial Statements.

If available liquidity is not sufficient to meet our operating and loan obligations as they come due or to fund our growth plans, our plans include pursuing alternative financing arrangements or reducing expenditures as necessary to meet our cash requirements. However, there is no assurance that we will be able to raise additional capital or reduce discretionary spending to provide required liquidity. Currently, the capital markets for small capitalization companies are extremely difficult. Accordingly, we cannot be sure of the availability or terms of any alternative financing arrangements.

Cash and Restricted Cash

The following table sets forth a summary of cash and restricted cash at the end of the periods indicated:

Restricted cash represents bank deposits held as collateral for bank acceptance notes, and will be released at the expiration date of the bank acceptance notes. The bank acceptance notes generally mature in periods ranging from three to six months and bear bank charges calculated as 0.05% of the face value of the notes, which are generally at a lower rate than the banks’ interest rate. As security for the bank acceptance notes, we have been required to place deposits equal to 50% of the note amounts with the banks and other pledge and guarantee.

Restricted cash fluctuated during these periods in proportion to the balance of the bank acceptance notes.

Cash Flow

The following table sets forth a summary of our net cash flow information for the periods indicated:

Operating Activities

Net cash used in and provided by operating activities were approximately $8.6 million and $7.6 million for the years ended September 30, 2011 and 2010, respectively. We experienced a substantial decrease in net income, from $1.6 million in the year ended September 30, 2011 compared to $8.2 million in the year ended September 30, 2010. There were significant increases in inventory, income tax and value added tax and, in addition, our security deposit and prepaid rent for Hongzhan’s plant contributed to the decreases in net cash provided by operating activities.

A primary factor affecting our operating cash flow is the timing of cash receipts from product sales and payments for purchase of materials in the ordinary course of business. A majority of our cash receipts are collected with a credit period of 60 to 90 days. We generally pay our suppliers in 60 days and, from time to time, with 3-month bank acceptance notes. Going forward, we expect cash provided from operating activities to continue to be a major source of liquidity for us, and we expect the future trend to continue to be affected by the factors described above.

Our accounts receivable balances as of September 30, 2010 and 2011 were $7.3 million and $6.3 million, respectively. The accounts receivable turnover days, which we define as our average receivable balances during the period divided by sales and multiplied by the number of days in the period, were 46 days and 68 days, respectively, in fiscal years 2010 and 2011. Average accounts receivable days increased because longer collection time due to tighten credit markets globally. Our credit period granted to customers is generally 60 to 90 days, depending on our business relationship with the customer, the customer’s credit history and prevailing market conditions.

Our inventory balances as of September 30, 2010 and 2011 were $4.7 million and $13.0 million, respectively, among which raw material inventory was $1.5 million and $1.7 million, respectively. The increase of our inventory balances in 2011 is a result of changes in our product mix, increasing complexity of our manufacturing process and higher quality requirements from our customers. We added polyurethene, coating, printing, sprouting, water washing and trimming to our existing process, which greatly increased work in process. Some customers required onsite inspection before shipment, which increased the time finished products stayed in our warehouse. Also, higher quality requirements from our customers led to higher returned products.  In addition, we purchased more raw materials to reduce the impact of price increases.

Our accounts payable and bank acceptance notes payable, collectively, as of September 30, 2010 and 2011, were $10.3 million and $10.26 million, respectively. Both items are derived from our trade related procurement. Notes payable refers to the balance of bank acceptance notes which finance the purchase of our raw materials and is commonly used by Chinese companies to obtain bank financing with a lower financing cost. We generally make payments to our suppliers within sixty days following the date of delivery either in cash or with 3-month bank acceptance notes. Our days payables, which we define as the average payable balances during the period divided by cost of goods sold and multiplied by the number of days in the period, increased from 67 days in 2010 to 97 days in 2011.

Investing Activities

For the year ended September 30, 2011, approximately $9.5 million was used in investing activities as compared to approximately $15.7 million used in investing activities for the same period in 2010, reflecting a decrease in payments for the purchase of plants and equipment and the purchase of land use rights.

The purchases of property, plant and equipment were primarily made in connection with the expansion of our manufacturing facilities. We expect investing activities over the next several years to increase significantly from previous levels as we execute our plan to install new production lines for our Colgre Products. See “Capital Expenditures” below.

Financing Activities

Net cash provided by financing activities for the year ended September 30, 2011 was approximately $16.6 million as compared to approximately $9.9 million in the same period in 2010. The increase in cash provided by financing activities was primarily due to increased proceeds from short-term bank loans and bank acceptance notes and sales of common stock, partially offset by the repayment of bank acceptance notes and an increase in repayments of short-term bank loans.

As of September 30, 2011, we maintained working capital facilities of $24.7 million with various banks in China. We are generally not subject to any operational or financial covenants under these working capital facilities.  However, our loan from China Construction Bank in the amount of $5.3 million provides that our debt-to-asset ratio may not exceed 70% for more than three months, our debt-to-equity ratio may not exceed 50% and any investment in another company may not exceed 20% of our shareholders’ equity. As of September 30, 2011, we had applied $9.4 million of the credit facilities for production facilities on existing products and the project related to Colgre Products.

Capital Expenditures

We incurred capital expenditures of approximately $9.4 million and $16.7 million for and the years ended September 30, 2011 and 2010, respectively, primarily in connection with purchases of land use rights, property, plant and equipment and construction of our facilities, leasehold improvements and investment in equipment, technology and operating systems. These capital expenditures were financed by the cash flow generated by our operations and from bank financing.

We believe that our capital expenditures in 2012 will be incurred primarily in connection with increasing production capacity at our Colgre Products facility.

We expect to finance these capital expenditures by using cash on hand, internal cash flow to be generated by operations, short-term and long-term bank borrowings and bank facilities.

Loan Facilities

We operate in a capital  intensive industry which requires significant amounts of investment, and we fund a portion of this investment through long-term and short-term bank debt, which are denominated in RMB. Our subsidiaries have generally entered into individual credit facilities in order to finance production of our products and for general corporate purposes. We anticipate repaying our short-term and long-term loans by using cash generated from our operations.

The durations until maturity of our long-term loans outstanding on September 30, 2011, ranged from one to two years, and they are generally repaid by RMB, due on maturity. We generally pay interest on these facilities which bear interest ranging from 5.656% to 6.435%. The obligations under our long-term loan facilities are mainly secured by our buildings and land use rights. Our subsidiaries have provided guarantees and Mr. Liu has provided personal guarantees for our obligations under our long-term loans. During 2010 and 2011, we drew down $9.7 million and we repaid approximately $6.1 million of our long-term indebtedness.

The durations until maturity of our short-term loan facilities outstanding on September 30, 2011, do not exceed twelve months, and they are generally repaid by RMB, due on maturity. We generally pay interest on these facilities at a fixed rate, ranging from 5 .656% to 18.04%. The obligations under our short-term loan facilities are secured by the Company’s buildings, plants, machinery and equipment and land use rights. In addition, Mr. Liu has personally guaranteed the amounts loaned. During 2010 and 2011, we drew down loans totaling $28.4 million and we repaid $21.9 million of our short-term indebtedness, which included $2.0 million to China Citic Bank, $8.4 million to Jiaxing City Commercial Bank, $5.1 million to China Construction Bank, $0.8 million to Hang Zhou Bank and $5.6 million to China Industry and Commercial Bank.

As of September 30, 2011, we had approximately 22 outstanding loan facilities with a combined outstanding balance of $24.7 million. For a description of our loan facilities as of September 30, 2011, please see Note 14 to our financial statements in this annual report.

During 2012, we plan to repay approximately $3.68 million of our long-term debt outstanding as of September 30, 2011 and $20.98 million of our short-term debt. During 2011, we entered into new loan facilities in amount of $ 38.2 million, as further described below.  

During 2011, the long term loans in the amount of $1.56 million from Jiaxing City Commercial Bank and $2.12 million from China Construction Bank were converted from short-term loans to long term loans.

As of September 30, 2011, our outstanding short- term  and long-term bank loans which are all classified as current, were as follows:

Short-Term Loans:   We have entered into loan agreements with several banks in the PRC to obtain fixed-rate term loans with maturities not exceeding 12 months.