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Table of Contents

 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
 
FORM 10-Q
(Mark One)
     
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2011
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from:                      to:                     
Commission file number: 001-33522
 
SYNTHESIS ENERGY SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
     
Delaware   20-2110031
(State of Incorporation)   (I.R.S. Employer Identification No.)
     
Three Riverway, Suite 300, Houston, Texas   77056
(Address of principal executive offices)   (Zip code)
 
Registrant’s telephone number, including area code: (713) 579-0600
Former name, former address and former fiscal year, if changed since last report: N/A
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 þ No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes o No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
             
Large accelerated filer o   Accelerated filer o   Non-accelerated filer o   Smaller reporting company þ
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o No þ
As of November 8, 2011 there were 50,860,845 shares of the registrant’s common stock, par value $.01 per share, outstanding.
 
 

 

 


 

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 Exhibit 31.1
 Exhibit 31.2
 Exhibit 32.1
 Exhibit 32.2
 EX-101 INSTANCE DOCUMENT
 EX-101 SCHEMA DOCUMENT
 EX-101 CALCULATION LINKBASE DOCUMENT
 EX-101 LABELS LINKBASE DOCUMENT
 EX-101 PRESENTATION LINKBASE DOCUMENT
 EX-101 DEFINITION LINKBASE DOCUMENT

 

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PART I
Item 1.  
Financial Statements
SYNTHESIS ENERGY SYSTEMS, INC.
(A Development Stage Enterprise)
Consolidated Balance Sheets
(In thousands)
(Unaudited)
                 
    September 30,     June 30,  
    2011     2011  
ASSETS
               
Current assets:
               
Cash and cash equivalents
  $ 27,675     $ 32,176  
Accounts receivable
    2,253       2,574  
Prepaid expenses and other currents assets
    1,258       1,382  
Inventory
    1,036       913  
 
           
 
               
Total current assets
    32,222       37,045  
 
               
Property, plant and equipment, net
    34,828       35,183  
Intangible asset, net
    1,190       1,226  
Investment in Yima joint ventures
    33,897       33,520  
Other long-term assets
    3,560       3,000  
 
           
 
               
Total assets
  $ 105,697     $ 109,974  
 
           
 
               
LIABILITIES AND EQUITY
               
Current liabilities:
               
Accrued expenses and accounts payable
  $ 6,680     $ 6,113  
Current portion of long-term bank loan
    2,423       2,380  
 
           
 
               
Total current liabilities
    9,103       8,493  
Long-term bank loan
    3,572       4,697  
 
           
 
               
Total liabilities
    12,675       13,190  
Equity:
               
Common stock, $0.01 par value: 200,000 shares authorized: 50,861 and 50,850 shares issued and outstanding, respectively
    509       509  
Additional paid-in capital
    205,131       205,055  
Deficit accumulated during development stage
    (116,452 )     (111,912 )
Accumulated other comprehensive income
    4,622       3,848  
 
           
Total stockholders’ equity
    93,810       97,500  
Noncontrolling interests in subsidiaries
    (788 )     (716 )
 
           
 
               
Total equity
    93,022       96,784  
 
           
 
               
Total liabilities and equity
  $ 105,697     $ 109,974  
 
           
See accompanying notes to the consolidated financial statements.

 

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SYNTHESIS ENERGY SYSTEMS, INC.
(A Development Stage Enterprise)
Consolidated Statements of Operations
(In thousands, except per share amounts)
(Unaudited)
                         
                    November 4, 2003  
    Three Months Ended     (inception) to  
    September 30,     September 30,  
    2011     2010     2011  
   
Revenue:
                       
Product sales and other — related parties
  $ 2,102     $ 1,417     $ 21,491  
Technology licensing and related services
    307       205       2,285  
Other
    86             607  
 
                 
Total revenue
    2,495       1,622       24,383  
 
                       
Costs and Expenses:
                       
Costs of sales and plant operating expenses
    3,204       1,307       30,788  
General and administrative expenses
    2,958       3,186       65,101  
Project and technical development expenses
    67       85       11,349  
Asset impairment losses
                9,075  
Stock-based compensation expense
    67       227       21,061  
Depreciation and amortization
    640       680       10,271  
 
                 
 
                       
Total costs and expenses
    6,936       5,485       147,645  
 
                 
 
                       
Operating loss
    (4,441 )     (3,863 )     (123,262 )
 
                       
Non-operating (income) expense:
                       
Equity in losses of joint ventures
    432       54       835  
Foreign currency gain
    (414 )     (255 )     (2,219 )
Interest income
    (37 )     (39 )     (3,085 )
Interest expense
    184       146       2,901  
 
                 
 
                       
Net loss
    (4,606 )     (3,769 )     (121,694 )
 
                       
Less: net loss attributable to noncontrolling interests
    66       27       5,242  
 
                 
 
                       
Net loss attributable to stockholders
  $ (4,540 )   $ (3,742 )   $ (116,452 )
 
                 
 
                       
Net loss per share:
                       
Basic and diluted
  $ (0.09 )   $ (0.08 )        
 
                   
 
                       
Weighted average common shares outstanding:
                       
Basic and diluted
    50,858       48,352          
 
                   
See accompanying notes to the consolidated financial statements.

 

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SYNTHESIS ENERGY SYSTEMS, INC.
(A Development Stage Enterprise)
Consolidated Statements of Cash Flows
(In thousands)
(Unaudited)
                         
                    November 4, 2003  
    Three Months Ended     (inception) to  
    September 30,     September 30,  
    2011     2010     2011  
   
Cash flows from operating activites:
                       
Net loss
  $ (4,606 )   $ (3,769 )   $ (121,694 )
Adjustments to reconcile net loss to net cash used in operating activities:
                       
Stock-based compensation expense
    67       227       21,061  
Depreciation of property, plant and equipment
    585       625       9,149  
Amortization of intangible and other assets
    55       55       1,122  
Equity in losses of joint ventures
    432       54       835  
Foreign currency gains
    (414 )     (255 )     (2,219 )
Loss (gain) on disposal of property, plant and equipment
    (12 )           141  
Asset impairment losses
                9,075  
Changes in operating assets and liabilities:
                       
Accounts receivable
    380       407       (2,065 )
Prepaid expenses and other current assets
    146       133       (540 )
Inventory
    (107 )     (93 )     (965 )
Other long-term assets
    (113 )     128       (753 )
Accrued expenses and payables
    479       (1,301 )     1,045  
 
                 
Net cash used in operating activities
    (3,108 )     (3,789 )     (85,808 )
 
                 
Cash flows from investing activities:
                       
Capital expenditures
    (19 )     (32 )     (38,049 )
Equity investment in joint ventures
    (156 )           (30,944 )
Purchase of marketable securities
                (45,000 )
Redemption of marketable securities
                45,000  
GTI license royalty — Yima joint ventures
                (1,500 )
ExxonMobil license royalty
                (1,250 )
Proceeds from sale of fixed assets
                7  
Restricted cash — redemptions of certificates of deposit
                (50 )
Amendment to GTI license rights
                (500 )
Purchase of land use rights
                (1,896 )
Receipt of Chinese governmental grant
                556  
Project prepayments
                (3,210 )
 
                 
Net cash used in investing activities
    (175 )     (32 )     (76,836 )
 
                 
Cash flows from financing activities:
                       
Payments on long-term bank loan
    (1,212 )     (1,149 )     (8,084 )
Proceeds from long-term bank loan
                12,081  
Proceeds from exercise of stock options, net
    (14 )     47       937  
Proceeds from issuance of common stock, net
                179,969  
Prepaid interest
                (276 )
Financing costs
                (143 )
Contributions from noncontrolling interest partners
                4,456  
Loans from shareholders
                11  
 
                 
Net cash provided by (used in) financing activities
    (1,226 )     (1,102 )     188,951  
 
                 
Net increase (decrease) in cash
    (4,509 )     (4,923 )     26,307  
Cash and cash equivalents, beginning of period
    32,176       42,573        
Effect of exchange rates on cash
    8       4       1,368  
 
                 
Cash and cash equivalents, end of period
  $ 27,675     $ 37,654     $ 27,675  
 
                 
See accompanying notes to the consolidated financial statements.

 

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Table of Contents

SYNTHESIS ENERGY SYSTEMS, INC.
(A Development Stage Enterprise)
Consolidated Statement of Equity
(In thousands)
(Unaudited)
                                                         
                            Deficit                    
                            Accumulated     Accumulated              
    Common Stock             During the     Other     Non-        
            Common     Additional     Development     Comprehensive     controlling        
    Shares     Stock     Paid-in Capital     Stage     Income     Interest     Total  
   
Balance at November 4, 2003 (inception)
    100,000     $     $     $     $     $     $  
Net loss for the period November 4, 2003 to June 30, 2004
                                         
 
                                         
Balance at June 30, 2004
    100,000                                      
 
                                         
Shares Forfeited in Merger
    (94,000 )                                    
Shares Issued in Merger
    21,000                                      
Net loss
                      (358 )                 (358 )
Investor contributions
          264       236                         500  
Conversion of debt to equity
          6       5                         11  
Net proceeds from private placement offering
    1,030       10       2,474                         2,484  
 
                                         
Balance at June 30, 2005
    28,030       280       2,715       (358 )                 2,637  
 
                                         
Net loss
                      (5,183 )                 (5,183 )
Net proceeds from private placement offering
    970       10       2,378                         2,388  
Stock-based compensation
                3,043                         3,043  
Adjustment related to return of shares
    (4,353 )     (44 )     44                          
 
                                         
Balance at June 30, 2006
    24,647       246       8,180       (5,541 )                 2,885  
 
                                         
Net loss
                      (13,142 )           (37 )     (13,179 )
Currency translation adjustment
                            175             175  
 
                                                     
Comprehensive loss
                                        (13,004 )
Contributions from noncontrolling interest partners
                                  492       492  
Net proceeds from private placement offering
    3,346       34       16,126                         16,160  
Stock-based compensation
                6,608                         6,608  
Shares issued for amended GTI license
    191       2       1,374                         1,376  
Shares issued upon option exercise by Union Charter Financial
    2,000       20       4,980                         5,000  
Stock grants to employees
    4             33                         33  
 
                                         
Balance at June 30, 2007
    30,188       302       37,301       (18,683 )     175       455       19,550  
 
                                         
Net loss
                      (27,442 )           (610 )     (28,052 )
Currency translation adjustment
                            1,390             1,390  
 
                                                     
Comprehensive loss
                                        (26,662 )
Contributions from noncontrolling interest partners
                                  3,124       3,124  
Stock-based compensation
                6,010                         6,010  
Exercise of stock options
    92       1       564                         565  
Shares issued for GTI reservation use fee
    278       3       2,497                         2,500  
Shares issued in public offerings
    17,451       174       148,226                         148,400  
Stock grants to employees
    2             19                         19  
 
                                         
Balance at June 30, 2008
    48,011       480       194,617       (46,125 )     1,565       2,969       153,506  
 
                                         
Net loss
                      (28,576 )           (703 )     (29,279 )
Currency translation adjustment
                            33       11       44  
 
                                                     
Comprehensive loss
                                        (29,235 )
Public offering costs
                (107 )                       (107 )
Stock-based compensation
                1,869                         1,869  
Exercise of stock options
    107       1       62                         63  
 
                                         
Balance at June 30, 2009
    48,118       481       196,441       (74,701 )     1,598       2,277       126,096  
 
                                         
Net loss
                      (21,748 )           (3,667 )     (25,415 )
Currency translation adjustment
                            237       1       238  
 
                                                     
Comprehensive loss
                                        (25,177 )
Contributions from noncontrolling interest partners
                                  839       839  
Stock-based compensation
                2,179                         2,179  
Exercise of stock options
    219       2       100                         102  
 
                                         
Balance at June 30, 2010
    48,337       483       198,720       (96,449 )     1,835       (550 )     104,039  
 
                                         
Net loss
                      (15,463 )           (157 )     (15,620 )
Currency translation adjustment
                            2,013       (9 )     2,004  
 
                                                     
Comprehensive loss
                                        (13,616 )
Stock-based compensation
                1,203                         1,203  
Exercise of stock options
    291       4       166                         170  
Net proceeds from issuance of common stock
    2,222       22       4,966                         4,988  
 
                                         
Balance at June 30, 2011
    50,850     $ 509     $ 205,055     $ (111,912 )   $ 3,848     $ (716 )   $ 96,784  
 
                                         
Net loss
                      (4,540 )           (66 )     (4,606 )
Currency translation adjustment
                            774       (6 )     768  
 
                                                     
Comprehensive loss
                                        (3,838 )
Stock-based compensation
                67                         67  
Exercise of stock options
    11             9                         9  
 
                                         
Balance at September 30, 2011
    50,861     $ 509     $ 205,131     $ (116,452 )   $ 4,622     $ (788 )   $ 93,022  
 
                                         
See accompanying notes to the consolidated financial statements.

 

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Table of Contents

SYNTHESIS ENERGY SYSTEMS, INC.
(A Development Stage Enterprise)
Notes to Consolidated Financial Statements
(Unaudited)
Note 1 — Summary of Significant Accounting Policies
(a) Organization and description of business
Synthesis Energy Systems, Inc. (“SES”), together with its wholly-owned and majority-owned controlled subsidiaries (collectively, the “Company”) is a development stage enterprise. The Company is a global energy and gasification technology company that provides products and solutions to the energy and chemical industries. The Company builds, owns and operates coal gasification plants that utilize its proprietary U-GAS® fluidized bed gasification technology to convert low rank coal and coal wastes into higher value energy products. The Company provides licenses, equipment components, engineering services and product offerings related to the U-GAS® technology. The Company’s headquarters are located in Houston, Texas.
(b) Basis of presentation and principles of consolidation
The consolidated financial statements for the periods presented are unaudited and reflect all adjustments, consisting of normal recurring items, which management considers necessary for a fair statement. Operating results for the three months ended September 30, 2011 are not necessarily indicative of results to be expected for the fiscal year ending June 30, 2012.
The consolidated financial statements are in U.S. dollars. Noncontrolling interests in consolidated subsidiaries in the consolidated balance sheets represents minority stockholders’ proportionate share of the equity in such subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto reported in the Company’s Annual Report on Form 10-K for the year ended June 30, 2011. Significant accounting policies that are new or updated from those presented in the Company’s Annual Report on Form 10-K for the year ended June 30, 2011 are included below. The consolidated financial statements have been prepared in accordance with the rules of the United States Securities and Exchange Commission (“SEC”) for interim financial statements and do not include all annual disclosures required by generally accepted accounting principles in the United States.
(c) Accounting for Variable Interest Entities (“VIEs”) and Financial Statement Consolidation Criteria
The joint ventures which the Company enters into may be considered VIEs. The Company consolidates all VIEs where it is the primary beneficiary. This determination is made at the inception of the Company’s involvement with the VIE and is continuously assessed. The Company considers qualitative factors and forms a conclusion that the Company, or another interest holder, has a controlling financial interest in the VIE and, if so, whether it is the primary beneficiary. In order to determine the primary beneficiary, the Company considers who has the power to direct activities of the VIE that most significantly impacts the VIE’s performance and has an obligation to absorb losses from or the right to receive benefits of the VIE that could be significant to the VIE. The Company does not consolidate VIEs where it is not the primary beneficiary. The Company accounts for these unconsolidated VIEs under the equity method of accounting and includes its net investment on its consolidated balance sheets. The Company’s equity interest in the net income or loss from its unconsolidated VIEs is recorded in non-operating (income) expense on a net basis on its consolidated statement of operations.
The Company has determined that the ZZ Joint Venture is a VIE and has determined that it is the primary beneficiary. In making the initial determination, the Company considered, among other items, the change in profit distribution between the Company and Hai Hua after 20 years. The expected negative variability in the fair value of the ZZ Joint Venture’s net assets was considered to be greater during the first 20 years of the ZZ Joint Venture’s life, which coincided with our original 95% profit/loss allocation, versus the latter 30 years in which the Company’s profit/loss allocation would be reduced to 10%. As the result of an amendment to the ZZ Joint Venture agreement in 2010, the profit distribution percentages will remain in place after the first 20 years, providing further support to the determination that the Company is the primary beneficiary. In addition, the Company considered whether the terms of the syngas purchase and sale agreement with Hai Hua contained a lease. The factors considered included (i) the Company’s ability to operate and control the plant during the initial 20 years; and (ii) whether it was more than remote that one or more parties other than Hai Hua would purchase more than a minor amount (considered to be 10%) of the plant’s output during the term of the syngas purchase and sale agreement. Because the Company determined that the syngas purchase and sale agreement did not contain a lease, the Company accounts for the revenues from that agreement in accordance with the Company’s revenue recognition policy for product sales.

 

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The following tables provide additional information on the ZZ Joint Venture’s assets and liabilities as of September 30, 2011 and June 30, 2011 which are consolidated within the Company’s consolidated balance sheets (in thousands):
                         
    September 30, 2011  
            ZZ Joint Venture        
    Consolidated     (1)     % (2)  
 
                       
Current assets
  $ 32,222     $ 3,681       11 %
Long-term assets
    73,475       37,264       51 %
 
                 
Total assets
  $ 105,697     $ 40,945       39 %
 
                 
 
                       
Current liabilities
  $ 9,103     $ 3,526       39 %
Long-term liabilities
    3,572       3,572       100 %
Equity
    93,022       33,847       36 %
 
                 
Total liabilities and equity
  $ 105,697     $ 40,945       39 %
 
                 
 
                       
    June 30, 2011  
            ZZ Joint Venture        
    Consolidated     (1)     % (2)  
 
                       
Current assets
  $ 37,045     $ 3,767       10 %
Long-term assets
    72,929       36,936       51 %
 
                 
Total assets
  $ 109,974     $ 40,703       37 %
 
                 
 
                       
Current liabilities
  $ 8,493     $ 3,486       41 %
Long-term liabilities
    4,697       4,697       100 %
Equity
    96,784       32,520       34 %
 
                 
Total liabilities and equity
  $ 109,974     $ 40,703       37 %
 
                 
(1)  
Amounts reflect information for ZZ Joint Venture and exclude intercompany items.
 
(2)  
ZZ Joint Venture’s percentage of the amount on the Company’s consolidated balance sheets.
The Company has determined that the Yima Joint Ventures are VIEs and that Yima, the joint venture partner, is the primary beneficiary since Yima has a 75% ownership interest in the Yima Joint Ventures and has the power to direct the activities of the VIE that most significantly influence the VIE’s performance.
The Company has determined that the GC Joint Venture is a VIE and has determined that it is the primary beneficiary since the Company has a 51% ownership interest in the GC Joint Venture and since there are no qualitative factors that would preclude the Company from being deemed the primary beneficiary. The Company consolidates the GC Joint Venture in its consolidated financial statements; however, as of September 30, 2011 and June 30, 2011, there were no significant assets or liabilities within the GC Joint Venture.
The Company has determined that SES Resource Solutions, Ltd. (“SRS”) that was formed in June 2011 is a VIE and that neither the Company nor Midas Resources AG control SRS since each have a 50% ownership interest in SRS and the control, risks and benefits of SRS are shared equally. SRS had no assets or liabilities as of September 30, 2011 or June 30, 2011.

 

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(d) Revenue Recognition
Revenue from sales of products, which includes the capacity fee and energy fee earned by the ZZ Joint Venture, and byproducts are recognized when the following elements are satisfied: (i) there are no uncertainties regarding customer acceptance; (ii) there is persuasive evidence that an agreement exists; (iii) delivery has occurred; (iv) the sales price is fixed or determinable; and (v) collectability is reasonably assured.
Technology licensing revenue is typically received and earned over the course of a project’s development. The Company may receive upfront licensing fee payments in addition to fees for engineering services that are integral to the initial transfer of its technology to a customer’s project. Typically, the majority of a license fee is received once project financing and equipment installation occur. Recognition of upfront licensing fee payments is deferred and recognized as a percentage of completion of the engineering services associated with the initial technology transfer. Further, such revenues are deferred until performance guarantee provisions have been met or until the license agreement is terminated. The Company recognizes revenue from engineering services under the percentage-of-completion method.
(e) Fair value measurements
Accounting standards require that fair value measurements be classified and disclosed in one of the following categories:
     
Level 1
 
Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;
 
   
Level 2
 
Quoted prices in markets that are not active, or inputs that are observable, either directly or indirectly, for substantially the full term of the asset or liability; and
 
   
Level 3
 
Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported by little or no market activity).
The carrying value of the Company’s other financial instruments including accounts receivable, accounts payable and long-term debt approximate their fair values.
The Company’s financial assets and liabilities are classified based on the lowest level of input that is significant for the fair value measurement. The following table summarizes the valuation of the Company’s financial assets and liabilities by pricing levels, as of September 30, 2011 and June 30, 2010 (in thousands):
                                 
    September 30, 2011  
    Level 1     Level 2     Level 3     Total  
Assets:
                               
Certificates of Deposit
  $     $ 50 (1)   $     $ 50  
Money Market Funds
          26,408 (2)           26,408  
 
                               
    June 30, 2011  
    Level 1     Level 2     Level 3     Total  
Assets:
                               
Certificates of Deposit
  $     $ 50 (1)   $     $ 50  
Money Market Funds
          29,372 (2)           29,372  
(1)  
Amount included in other current assets on the Company’s consolidated balance sheets.
 
(2)  
Amount included in cash and cash equivalents on the Company’s consolidated balance sheets.

 

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(f)  
Comprehensive income (loss)
The Company’s comprehensive income (loss) was as follows (in thousands):
                 
    Three Months Ended  
    September 30,  
    2011     2010  
Net loss, as reported
  $ (4,606 )   $ (3,769 )
Unrealized foreign currency translation adjustment
    768       555  
 
           
Comprehensive loss
    (3,838 )     (3,214 )
Less comprehensive loss attributable to noncontrolling interests
    72       28  
 
           
Comprehensive loss attributable to the Company
  $ (3,766 )   $ (3,186 )
 
           
Note 2 — Recently Issued Accounting Standards
In June 2011, the FASB issued new guidance on the presentation of comprehensive income. The new guidance allows an entity to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The new guidance eliminates the current option to report other comprehensive income and its components in the statement of changes in stockholders equity. This new guidance is effective for fiscal years beginning after December 15, 2011. The Company plans to adopt these requirements effective July 1, 2012.
Note 3 — Current Projects
Zao Zhuang Joint Venture
Joint Venture Agreement
On July 6, 2006, the Company entered into a cooperative joint venture contract with Shandong Hai Hua Coal & Chemical Company Ltd. (“Hai Hua”), which established Synthesis Energy Systems (Zao Zhuang) New Gas Company Ltd. (the “ZZ Joint Venture”), a joint venture company that has the primary purposes of (i) developing, constructing and operating a syngas production plant utilizing the U-GAS® technology in Zao Zhuang City, Shandong Province, China and (ii) producing and selling syngas and the various byproducts of the plant, including ash and elemental sulphur. The Company owns 96.1% of the ZZ Joint Venture and Hai Hua owns the remaining 3.9%. The Company consolidates the results of the ZZ Joint Venture in its consolidated financial statements.
Syngas Purchase and Sale Agreement
The ZZ Joint Venture is also party to a purchase and sale agreement with Hai Hua for syngas produced by the plant, whereby Hai Hua will pay the ZZ Joint Venture an energy fee and capacity fee, as described below, based on the syngas production. The syngas to be purchased by Hai Hua is subject to certain quality component requirements set forth in the contract. In late December 2008, the plant declared commercial operations status for purposes of the purchase and sale agreement. The energy fee is a per normal cubic meters, or Ncum, of syngas calculation based on a formula which factors in the monthly averages of the prices of design base coal, coke, coke oven gas, power, steam and water, all of which are components used in the production of syngas. The capacity fee is paid based on the capacity of the plant to produce syngas, factoring in the number of hours (i) of production and (ii) of capability of production as compared to the guaranteed capacity of the plant, which for purposes of the contract is 22,000 Ncum per hour of net syngas. Hai Hua is obligated to pay the capacity fee regardless of whether they use the gasification capacity, subject only to availability of the plant, quality of the syngas and exceptions for certain events of force majeure. Due to worldwide reductions in methanol prices, as well as reliability issues with respect to Hai Hua’s plant, Hai Hua has operated at a reduced rate of syngas consumption. Hai Hua has used approximately 35% to 45% of the syngas guarantee capacity since 2009.
Since May 2011, Hai Hua has not paid the capacity fees owed to the ZZ Joint Venture. The unpaid amount totaled approximately $1.5 million as of September 30, 2011. The plant has continued to operate and provide syngas to Hai Hua, and Hai Hua has paid other contractual obligations such as the energy fees and by-product sales due under the contract. The Company is continuing to work with Hai Hua on alternatives to resolve this issue. The Company did not recognize these capacity fee revenues and will not recognize any capacity fees until collection is reasonably assured.

 

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In April 2009, the ZZ Joint Venture entered into a Supplementary Agreement with Hai Hua, amending the terms of the purchase and sale agreement. The Supplementary Agreement was entered into to provide more clarity regarding the required syngas quality and volume to be delivered, recovery of the energy fee during turndown periods and operations coordination during unscheduled outages. Under the Supplementary Agreement, the syngas quality specification was amended to provide more clarity as to the minor constituents allowable in the syngas. For purposes of the Supplemental Agreement, syngas that meets these specifications is deemed “compliant gas” and syngas that does not meet these specifications is deemed “non-compliant gas.” The Supplementary Agreement also added a requirement for Hai Hua to pay the ZZ Joint Venture the capacity fee and 70% of the energy fee for all non-compliant gas which is taken by Hai Hua. However, if more than 50% of the syngas taken by Hai Hua during any operating day is non-compliant gas, all of the syngas for that day is deemed to be non-compliant gas for purposes of calculating the energy fee. In addition, the Supplementary Agreement accommodates periods of turndown operation by Hai Hua by establishing a minimum threshold gas off take volume of 7,500 Ncum per hour of net syngas for the purpose of calculating the energy fee during such periods. The Supplementary Agreement also provides that, to the extent Hai Hua has an unscheduled shutdown, and the plant continues to operate on standby during such period, Hai Hua is still required to pay the energy fee to the ZZ Joint Venture. In the event that the plant has an unscheduled shutdown and does not provide at least three hours prior notice to Hai Hua, the ZZ Joint Venture may be required to provide certain compensation to Hai Hua.
To date, Hai Hua has been unable to offtake the volume of syngas originally expected for the original plant design and the plant has incurred operating losses. The Company does not foresee this situation changing significantly in the near term. Because of this the ZZ Joint Venture is working on various arrangements to increase the syngas offtake volume. Such arrangements involve a combination of technical improvement to Hai Hua’s methanol unit, as well as restructuring the current business arrangement to create an integrated syngas to methanol operation. In addition, the ZZ Joint Venture is working on an agreement to sell additional syngas to Zao Zhuang Mining Group for their glycol plant which is under development near the ZZ Joint Venture plant. The Company is also evaluating alternative products and partnership structures for a possible expansion of the ZZ Joint Venture plant. The scope of the expansion is still under evaluation. The Company is in discussions with several potential partners on this expansion.
Due to the business climate, the recessionary trends that have significantly affected commodity prices including methanol, and the ZZ Joint Venture plant’s operating losses to-date, the Company believed an impairment assessment of the plant’s assets was warranted. As of September 30, 2011, the Company performed an analysis of this project and has determined that these assets were not impaired based upon management’s estimated cash flow projections for the project. If the Company is not successful in improving the ZZ Joint Venture’s profitability, or if management’s estimated cash flow projections for these assets decrease, or if Hai Hua continues to not make its required payments, the plant’s assets could become impaired.
Loan Agreement
On March 22, 2007, the ZZ Joint Venture entered into a seven-year loan agreement and received $12.6 million of loan proceeds pursuant to the terms of a Fixed Asset Loan Contract with the Industrial and Commercial Bank of China (“ICBC”) to complete the project financing for the ZZ Joint Venture. Key terms of the Fixed Asset Loan Contract with ICBC are as follows:
   
Term of the loan is seven years from the commencement date (March 22, 2007) of the loan;
   
Interest is adjusted annually based upon the standard rate announced each year by the People’s Bank of China, and as of September 30, 2011, the applicable interest rate was 6.6% and is payable monthly;
   
Principal payments of RMB 7.7 million (approximately $1.2 million based on current currency exchange rates) are due in March and September of each year beginning on September 22, 2008 and ending on March 31, 2014;
   
Hai Hua is the guarantor of the entire loan;
   
Assets of the ZZ Joint Venture are pledged as collateral for the loan;
   
Covenants include, among other things, prohibiting pre-payment without the consent of ICBC and permitting ICBC to be involved in the review and inspection of the ZZ Joint Venture plant; and
   
Subject to customary events of default which, should one or more of them occur and be continuing, would permit ICBC to declare all amounts owing under the contract to be due and payable immediately.

 

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As of September 30, 2011, the ZZ Joint Venture was in compliance with all covenants and obligations under the Fixed Asset Loan Contract.
Yima Joint Ventures
In August 2009, the Company entered into amended joint venture contracts with Yima Coal Industry (Group) Co., Ltd. (“Yima”), replacing the prior joint venture contracts entered into in October 2008 and April 2009. The joint ventures were formed for each of the gasification, methanol/methanol protein production, and utility island components of the plant (collectively, the “Yima Joint Ventures”). The parties obtained government approvals for the project’s feasibility study during the three months ended December 31, 2008 and for the project’s environmental impact assessment during the three months ended March 31, 2009, which were the two key approvals required to proceed with the project. The amended joint venture contracts provide that: (i) the Company and Yima contribute equity of 25% and 75%, respectively, to the Yima Joint Ventures; (ii) Yima will guarantee the repayment of loans from third party lenders for 50% of the project’s cost and, if debt financing is not available, Yima is obligated to provide debt financing via shareholder loans to the project until the project is able to secure third-party debt financing; and (iii) Yima will supply coal to the project from a mine located in close proximity to the project at a preferential price subject to a definitive agreement to be subsequently negotiated. In connection with entering into the amended contracts, the Company and Yima contributed their remaining cash equity contributions of $29.3 million and $90.8 million, respectively, to the Yima Joint Ventures during the three months ended September 30, 2009. The Company will also be responsible for its share of any cost overruns on the project. During the three months ended September 30, 2009, the Company incurred a charge of $0.9 million relating to consulting fees paid in connection with the closing and funding of the Yima project.
In exchange for their capital contributions, the Company owns a 25% interest in each joint venture and Yima owns a 75% interest. Notwithstanding this, in connection with an expansion of the project, the Company has the option to contribute a greater percentage of capital for the expansion, such that as a result, the Company would have up to a 49% ownership interest in the Yima Joint Ventures. The investment in the Yima Joint Ventures is accounted for using the equity method.
During the three months ended September 30, 2010, Yima expressed their intent to convert the existing project from methanol production to glycol production. Yima has communicated their belief that the prospect for strong economic performance of the plant can be improved by modifying the backend of the project to make glycol. In addition, Yima has acquired a nearby coal to methanol facility and is looking to diversify and sees glycol as a potentially more profitable alternative. The Company has indicated to Yima that it would be willing to support this scope change if both parties can agree upon appropriate modifications to the joint venture contracts that can improve the Company’s overall risk and return without requiring any additional capital investment from the Company. Yima’s project management team believes that the project’s syngas production facilities will be available during the third quarter of calendar 2012. The schedule for glycol production is currently awaiting government approvals.
The Yima Joint Ventures are in discussions with a potential fuel gas off-take customer for the sale of the initial syngas production. This would provide syngas sales until the syngas conversion to methanol or glycol is completed.
The Company is continuing to have discussions with Yima to restructure the agreements as necessary to achieve these goals.
Yima is the project management leader for the project and has indicated their belief that the change in the scope of the project would not delay this schedule; however, the construction of the methanol portion of the plant is on hold pending the revisions for the possible glycol production. Based on the project’s current scope of methanol only, the current estimate of the total required capital of the project is approximately $250 million. The remaining capital for the project is to be provided by project debt to be obtained by the Yima Joint Ventures. Yima has agreed to guarantee the project debt in order to secure debt financing from domestic Chinese banking sources. The Company has agreed to pledge to Yima its ownership interests in the joint ventures as security for its obligations under any project guarantee. In the event that the debt financing is not obtained, Yima has agreed to provide a loan to the joint ventures to satisfy the remaining capital needs of the project with terms comparable to current market rates at the time of the loan.

 

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The Yima Joint Ventures are governed by a board of directors consisting of eight directors, two of whom were appointed by the Company and six of whom were appointed by Yima. The joint ventures also have officers that are nominated by the Company, Yima and/or the board of directors pursuant to the terms of the joint venture contracts. The Company and Yima shall share the profits, and bear the risks and losses, of the joint ventures in proportion to our respective ownership interests. The term of the joint venture shall commence upon each joint venture company obtaining its business license and shall end 30 years after commercial operation of the plant.
The Company has included the $1.5 million payment paid to the Gas Technology Institute (“GTI”) in June 2009 toward future royalties due to GTI for the Yima Joint Ventures’ project as part of the Company’s investment in the Yima project. An additional future royalty payment of approximately $1.5 million will be due to GTI upon the commissioning of the gasifier equipment for the Yima project.
The Company’s equity in losses of the Yima Joint Ventures for the three months ended September 30, 2011 and 2010 were approximately $0.2 million and $54,000, respectively. The following table presents summarized unconsolidated financial information for the Yima Joint Ventures (in thousands):
                 
    Three Months Ended  
    September 30,  
    2011     2010  
Income statement data:
               
 
               
Revenue
  $     $  
Operating loss
    (993 )     (272 )
Net loss
    (839 )     (216 )
 
               
    September 30,     June 30,  
    2011     2011  
Balance sheet data:
               
 
               
Current assets
  $ 50,796     $ 64,120  
Noncurrent assets
    99,327       75,096  
Current liabilities
    6,937       10,916  
Noncurrent liabilities
    13,376        
SES Resource Solutions
SES Resource Solutions (“SRS”) is a joint venture owned 50% by us and 50% by Midas Resources AG (“Midas”), that was formed in June 2011 to provide additional avenues of commercialization for the Company’s U-GAS® technology. Key objectives of the joint venture are to identify and procure low cost, low rank coal resources for which the Company’s technology and the SRS’ know-how represent the best route to commercialization; to provide investment opportunities in both gasification facilities and coal resources; and to facilitate the establishment of gasification projects globally based on the Company’s technology. Terms of the SRS joint venture agreement include:
   
SRS has the exclusive right to promote our gasification technology for the purpose of securing low-cost coal resources in projects worldwide that have been approved by the board of directors of SRS;
   
Midas provides expertise to originate and execute the above projects;
   
the Company provides SRS with technology licenses and engineering development support for use in developing the joint integrated coal resource projects; and
   
SRS being managed by a four person board of directors, two of which are appointed by the Company and two of which are appointed by Midas.
   
the Company has agreed to provide up to $2.0 million in funding to SRS, although it has the ability to discontinue funding at any point in time. As of September 30, 2011, the Company had funded approximately $0.4 million to SRS.
   
revenue and profits are equally divided between the joint venture partners.

 

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The Company’s investment in SRS is accounted for using the equity method. The Company’s equity in losses of SRS for the three months ended September 30, 2011 was approximately $0.2 million. SRS has no assets or liabilities as amounts are funded by the Company as costs are incurred. The following table presents summarized unconsolidated income statement data for SRS (in thousands):
                 
    Three Months Ended  
    September 30,  
    2011     2010  
Income statement data:
               
 
               
Revenue
  $     $  
Operating loss
    (449 )      
Net loss
    (449 )      
Note 4 — GTI License Agreement
On November 5, 2009, the Company entered into an Amended and Restated License Agreement (the “New Agreement”) with GTI, replacing the Amended and Restated License Agreement between the Company and GTI dated August 31, 2006, as amended, or the Original Agreement. Under the New Agreement, the Company maintains its exclusive worldwide right to license the U-GAS® technology for all types of coals and coal/biomass mixtures with coal content exceeding 60%, as well as the non-exclusive right to license the U-GAS® technology for 100% biomass and coal/biomass blends exceeding 40% biomass. The New Agreement differs from the Old Agreement most critically by allowing the Company to sublicense U-GAS® to third parties for coal, coal and biomass mixtures or 100% biomass projects (subject to the approval of GTI, which approval shall not be unreasonably withheld), with GTI to share the revenue from such third party licensing fees based on an agreed percentage split (the “Agreed Percentage”). In addition, the prior obligation to fabricate and put into operation at least one U-GAS® system for each calendar year of the Original Agreement in order to maintain the license has been eliminated in the New Agreement.
In order to sublicense any U-GAS® system, the Company is required to comply with certain requirements set forth in the New Agreement. In the preliminary stage of developing a potential sublicense, the Company is required to provide notice and certain information regarding the potential sublicense to GTI and GTI is required to provide notice of approval or non-approval within ten business days of the date of the notice from the Company, provided that GTI is required to not unreasonably withhold their approval. If GTI does not respond within that ten business day period, they are deemed to have approved of the sublicense. The Company is required to provide updates on any potential sublicenses once every three months during the term of the New Agreement. The Company is also restricted from offering a competing gasification technology during the term of the New Agreement.
For each U-GAS® unit which the Company licenses, designs, builds or operates for itself or for a party other than a sublicensee and which uses coal or a coal and biomass mixture or biomass as the feed stock, the Company must pay a royalty based upon a calculation using the MMBtu per hour of dry syngas production of a rated design capacity, payable in installments at the beginning and at the completion of the construction of a project (the “Standard Royalty”). Although it is calculated using a different unit of measurement, the Standard Royalty is effectively the same as the royalty payable to GTI under the Original Agreement. If the Company invests, or has the option to invest, in a specified percentage of the equity of a third party, and the royalty payable by such third party for their sublicense exceeds the Standard Royalty, the Company is required to pay to GTI the Agreed Percentage of such royalty payable by such third party. However, if the royalty payable by such third party for their sublicense is less than the Standard Royalty, the Company is required to pay to GTI, in addition to the Agreed Percentage of such royalty payable by such third party, the Agreed Percentage of its dividends and liquidation proceeds from its equity investment in the third party. In addition, if the Company receives a carried interest in a third party, and the carried interest is less than a specified percentage of the equity of such third party, the Company is required to pay to GTI, in its sole discretion, either (i) the Standard Royalty or (ii) the Agreed Percentage of the royalty payable to such third party for their sublicense, as well as the Agreed Percentage of the carried interest. The Company will be required to pay the Standard Royalty to GTI if the percentage of the equity of a third party that the Company (a) invests in, (b) has an option to invest in, or (c) receives a carried interest in, exceeds the percentage of the third party specified in the preceding sentence.

 

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The Company is required to make an annual payment to GTI for each year of the term beginning December 31, 2010, with such annual payment due by the last day of January of the following year; provided, however, that the Company is entitled to deduct all royalties paid to GTI in a given year under the New Agreement from this amount, and if such royalties exceed the annual payment amount in a given year, the Company is not required to make the annual payment. The Company accrues the annual royalty expense ratably over the calendar year as adjusted for any royalties paid during year. The Company must also provide GTI with a copy of each contract that it enters into relating to a U-GAS® system and report to GTI with its progress on development of the technology every six months.
For a period of ten years, the Company and GTI are restricted from disclosing any confidential information (as defined in the New Agreement) to any person other than employees of affiliates or contractors who are required to deal with such information, and such persons will be bound by the confidentiality provisions of the New Agreement. The Company has further indemnified GTI and its affiliates from any liability or loss resulting from unauthorized disclosure or use of any confidential information that the Company receives.
The term of the New Agreement is the same as the Original Agreement, expiring on August 31, 2016, but may be extended for two additional ten-year periods at the Company’s option.
Note 5 — Stock-Based Compensation
As of September 30, 2011, the Company had outstanding stock option and restricted stock awards granted under the Company’s Amended and Restated 2005 Incentive Plan, as amended (the “Plan”), exercisable for 5,049,068 shares of common stock. As of September 30, 2011, 415,620 shares were authorized for future issuance pursuant to the Plan and approximately $1.2 million of expense with respect to non-vested stock-based awards had yet to be recognized.
Stock option activity during the three months ended September 30, 2011 was as follows:
         
    Shares of Common  
    Stock Underlying  
    Stock Options  
 
       
Outstanding at June 30, 2011
    6,563,344  
Granted
    315,000  
Exercised
    (10,625 )
Forfeited
    (40,250 )
 
     
Outstanding at September 30, 2011
    6,827,469  
 
     
Exercisable at September 30, 2011
    5,049,068  
 
     
The fair values for the stock options granted during the three months ended September 30, 2011 were estimated at the date of grant using a Black-Scholes-Morton option-pricing model with the following weighted-average assumptions.
         
Risk-free rate of return
    1.36 %
Expected life of award
    6.25 years  
Expected dividend yield
    0.00 %
Expected volatility of stock
    107 %
Weighted-average grant date fair value
  $ 1.36  
Note 6 — Net Loss Per Share
Historical net loss per share of common stock is computed using the weighted average number of shares of common stock outstanding. Basic loss per share excludes dilution and is computed by dividing net loss available to common stockholders by the weighted average number of shares of common stock outstanding for the period. Stock options are the only potential dilutive share equivalents the Company has outstanding for the periods presented. For the three months ended September 30, 2011 and 2010 and the period from November 4, 2003 (inception) to September 30, 2011, options to purchase common stock were excluded from the computation of diluted earnings per share as their effect would have been antidilutive as the Company incurred net losses during those periods.

 

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Note 7 — Risks and Uncertainties
Any future decrease in economic activity in China, India or in other regions of the world, in which the Company may in the future do business, could significantly and adversely affect its results of operations and financial condition in a number of other ways. Any decline in economic conditions may reduce the demand or prices from the products from our plants. In addition, the market for commodities such as methanol has been under significant pressure and the Company is unsure of how much longer this pressure will continue. As a direct result of these trends, the Company’s ability to finance and develop its existing projects, commence any new projects and sell its products could be adversely impacted. Credit markets in China have also continued to tighten recently, as inflation has caused the Chinese government to raise interest rates and there is evidence of similar trends in the Indian credit markets.
The Company will limit the development of any further projects until worldwide capital and debt markets improve and it has assurances that acceptable financing is available to complete such projects. In addition, as of September 30, 2011, Hai Hua is the Company’s only customer for syngas sales and as such, it is exposed to significant customer credit risk due to this concentration. In addition, as described under Note 3, Hai Hua has not made the capacity fee payments to the ZZ Joint Venture since April 2011. The unpaid amount totals approximately $1.5 million as of September 30, 2011. Although the Company is continuing to work with Hai Hua on alternatives to resolve the issue, there can be no assurances that the Company will collect these amounts. The Company’s revenue and results of operations would be adversely affected if Hai Hua continues to not pay the capacity fee or if it is unable to retain Hai Hua as a customer or secure new customers. The Company may need to shut down the ZZ Joint Venture plant for a period of time until it is able to either find an alternative purchaser of its production or a different use for the plant. There have also been recent announcements of a constricting credit market in China. Even if the Company does obtain the necessary capital for its projects, the Company could face other delays in its projects due to additional approval requirements or due to unanticipated issues in the commissioning of such a project. These factors could lead to, among other things, the impairment of the Company’s significant assets, including its assets in the ZZ Joint Venture and its investment in the Yima Joint Ventures, and an inability to develop any further projects.
The Company expects to continue for a period of time to have negative operating cash flows until it can generate sufficient revenues from its licensing and related service projects, as well as from the ZZ Joint Venture, the Yima Joint Ventures and other projects which are under development, to cover its general and administrative expenses and other operating costs. In addition, if the Company is not able to complete the ZJX/China Energy transaction, it will need to aggressively pursue additional partners in China and may need to reduce its operating expenses. The Company will also limit the development of any further projects until it has assurances that acceptable financing is available to complete the project. Despite this, the Company will continue to pursue the development of selective projects with strong and credible partners or off-takers where the Company believes equity and debt can be raised or where the Company believes it can attract a financial partner to participate in the project.
The Company can make no assurances that its business operations will develop and provide it with significant cash to continue operations. The Company may need to raise additional capital through equity and debt financing for any new projects that are developed, to support its existing projects and possible expansions thereof and for its corporate general and administrative expenses. The Company cannot provide any assurance that any financing will be available to the Company in the future on acceptable terms or at all. Any such financing could be dilutive to the Company’s existing stockholders. If the Company cannot raise required funds on acceptable terms, it may not be able to, among other things, (i) maintain its general and administrative expenses at current levels; (ii) negotiate and enter into new gasification plant development contracts; (iii) expand its operations; (iv) hire and train new employees; or (v) respond to competitive pressures or unanticipated capital requirements.
Note 8 — Litigation
The Company is a party to various legal proceedings including the one noted below. While management presently believes that the ultimate outcome of these proceedings will not have a material adverse effect on its financial position, overall trends in results of operations or cash flows, litigation is subject to inherent uncertainties, and unfavorable rulings or settlements could occur which could have a material adverse impact on the Company’s financial position and operating results.

 

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In September 2008, the Company was named as one of a number of defendants in a lawsuit filed in the U.S. District Court for the Central District of California, Southern Division, by Igor Olenicoff, one of its former stockholders, and a company he controls. Also named were Timothy E. Vail (our former CEO and one of the Company’s directors), David Eichinger (the Company’s former CFO), and another one of the Company’s former directors (collectively, the Company, Mr. Vail, Mr. Eichinger and the director are referred to as the “SES Defendants”), as well as UBS AG, Union Charter Ltd., and other persons who allegedly managed Mr. Olenicoff’s investments outside the U.S. The SES Defendants have been named in this lawsuit based primarily upon allegations that one of our former stockholders, Teflomi Trade & Trust, Inc., was a shell company formed for the purposes of holding Mr. Olenicoff’s assets overseas, and that the SES Defendants allegedly had knowledge of this arrangement. The claims initially asserted against the SES Defendants included, among others, securities fraud in violation of Rule 10b-5 under the Securities Act and the California state law equivalent, violations of the Racketeer Influenced and Corrupt Organizations Act, or RICO, common law fraud and negligent misrepresentation, breach of fiduciary duty, conspiracy and unfair business practices. On the SES Defendants’ motion, on July 31, 2009, the court issued an order dismissing the securities fraud claims as to each of the SES Defendants and the common law fraud, negligent misrepresentation claim and breach of fiduciary duty claims as to us, Mr. Vail and Mr. Eichinger. The court determined that certain other claims, including RICO, conspiracy and unfair business practices, were sufficiently pled and could proceed at this stage. Plaintiffs were given leave to amend and, on August 24, 2009, filed an amended complaint attempting to replead their securities fraud claims, and alleged a new claim for violation of the Uniform Commercial Code (the “UCC”). In response, on September 23, 2009, the SES Defendants filed a motion to dismiss the securities fraud and UCC claims. The court heard oral argument on the SES Defendants’ motion to dismiss, and on various other defendants’ motions to dismiss, on November 9, 2009. On March 16, 2010, the court issued an order on the pending motions to dismiss, dismissing the securities fraud and UCC claims as to each of the SES Defendants. Thus, the claims that remain as to the SES Defendants collectively include violations of RICO, RICO conspiracy, unfair business practices, conversion and civil conspiracy; the claims that remain as to the individually named director include fraudulent misrepresentation, constructive fraud, negligent misrepresentation and breach of fiduciary duty. The SES Defendants filed their answer to these claims on April 22, 2010. The parties are currently engaged in discovery related to those claims the court has allowed to remain in the case. Additionally, on August 15, 2011, the SES Defendants filed a motion for summary judgment or, in the alternative, summary adjudication as to each of the claims remaining against them, collectively, and the individually named director, separately. On October 18, 2011, the court issued an order denying this motion. The court also recently continued the trial date to May 8, 2012. The SES Defendants believe the claims alleged against them to be without merit and intend to continue to vigorously defend all claims which proceed to trial.
Governmental and Environmental Regulation
The Company’s operations are subject to stringent federal, state and local laws and regulations governing the discharge of materials into the environment or otherwise relating to environmental protection. Numerous governmental agencies, such as the U.S. Environmental Protection Agency (the “EPA”), and various Chinese authorities, issue regulations to implement and enforce such laws, which often require difficult and costly compliance measures that carry substantial administrative, civil and criminal penalties or may result in injunctive relief for failure to comply. These laws and regulations may require the acquisition of a permit before operations at a facility commence, restrict the types, quantities and concentrations of various substances that can be released into the environment in connection with such activities, limit or prohibit construction activities on certain lands lying within wilderness, wetlands, ecologically sensitive and other protected areas, and impose substantial liabilities for pollution resulting from our operations. The Company believes that it is in substantial compliance with current applicable environmental laws and regulations and it has not experienced any material adverse effect from compliance with these environmental requirements.
Note 9 — Share Purchase Agreement with ZJX
On March 31, 2011, the Company entered into a Share Purchase Agreement (the “Agreement”) with China Energy Industry Holdings Group Co, Ltd. (“China Energy”) and Zhongjixuan Investment Management Company Ltd. (“ZJX”). In August 2011, the Company agreed to extend the closing period of the Agreement through December 31, 2011. The terms and conditions of the Agreement are summarized below.
Issuance of Shares
On the closing date for the Agreement, the Company will issue 37,254,475 shares of Common Stock (the “Closing Shares”) in exchange for the Consideration. Within 20 business days after the accomplishment of the Milestone (as defined below), the Company will issue to China Energy additional shares of Common Stock (the “Milestone Shares”) which, when combined with the Closing Shares, equals 60.0% of the issued and outstanding Common Stock on a fully-diluted basis, including shares reserved for future issuance pursuant to the Plan, as of the date that the Milestone is achieved.

 

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For the purpose of the Agreement, the “Milestone” will be deemed to be achieved if the average closing price of the Common Stock for 20 consecutive trading days equals or exceeds $8.00 per share (the “Threshold Price”), provided that the 20 consecutive trading day period will begin upon the occurrence of both (i) ZJX/China Energy undertaking best endeavours to secure certain projects described in the Agreement; and (ii) the expiration of six months after the Closing Date.
In the event that the Milestone is not achieved within a five year period commencing on the Closing Date (such five years plus any extensions granted under the Agreement is referred to as the “Deadline”), and no Target Projects (as defined below) are secured by ZJX for the Company by the Deadline, the Company shall then have the sole discretion to extend or not extend the Deadline. If ZJX has secured Target Projects for the Company prior to the Deadline, but the Milestone has not been achieved by the Deadline, the Company shall agree to extend the period to achieve the Milestone by one year for each Target Project secured by ZJX for the Company, provided that the Deadline will not be extended beyond 10 years from the Closing Date. If the Deadline is not extended, ZJX/China Energy’s rights to the Milestone Shares shall be relinquished.
For the purpose of the above, a “Target Project” shall mean either (i) the execution of a joint venture agreement, and other ancillary and necessary documents, related to the formation of a project joint venture, or (ii) securing for the Company a coal resource project that is already in operation, a new coal chemical project or any other project that is approved by the Company’s board of directors (the “Board”), each with a total investment of at least RMB1.5 billion.
In the event that the Milestone is achieved but, pursuant to restriction or non-approval by any U.S. governmental agency or regulatory authority, (i) the issuance of the Milestone Shares to China Energy is prevented from occurring or (ii) the ownership of the Milestone Shares by China Energy is required to be divested, the Company shall be required to seek qualified third parties to purchase the right of China Energy to the Milestone Shares. If this does not occur within twelve (12) months of the date of the action of such U.S. governmental agency or competent regulatory authority, the Company shall compensate ZJX/China Energy for the Milestone Shares by making a payment in an amount equal to $2.00 per share for each Milestone Share, representing full satisfaction of any obligation of the Company to ZJX with respect to the Milestone Shares. Such payment may be made by the Company to China Energy in the form of cash or an equivalent amount of the Company’s assets in China.
Use of Proceeds
Subject to the discretion and approval of the Board, the Consideration, net of costs and expenses, is required to be applied to the following: (i) incorporation of a Company headquarters in China to consolidate the ownership of the Company’s investment projects in China and enhance the Company’s presence in China; (ii) investing in the expansion of the ZZ Joint Venture; (iii) investing in Phase I of the Company’s Yima Joint Ventures; (iv) acquiring an ownership interest in a coal mine that will provide coal to the Yima Joint Ventures; (v) investing in the GC Joint Venture; (vi) other Chinese projects that may be recommended to the Board from time to time; and (vii) other expenses of the operation and business of the Company in China.
ZJX will use reasonable endeavours to assist the Company to obtain third party funding (third party direct equity investment in projects or debt financing to the projects) to (a) cover funding needs of the above projects; (b) provide funding for the Company to invest in future phases of the Yima joint venture project; (c) invest in strategic coal resources in China connected to the Company’s projects; and (d) provide funding for the Company to invest in other projects in China not listed above and assist the Company to obtain third party investment in any of the Company’s other projects.
Other
Closing of the transaction with China Energy and ZJX is subject to approval by the Company’s stockholders and other customary closing conditions. In addition, ZJX notified the Company in August of its intent to complete its investment in partnership with Yima. ZJX has been working with Yima in order to complete Yima’s investment into China Energy. Once Yima completes its due diligence of the Company, documentation will be sent to the relevant Chinese authorities to obtain the necessary approvals so that Yima can proceed with its investment in China Energy and all parties can then move to closing the transactions contemplated by the Agreement.
The estimated fair value resulting from China Energy’s contingent right to receive the Milestone Shares will be reported as a liability on its consolidated balance sheet at closing of the transaction. This liability will be adjusted prospectively to reflect the change in the estimated fair value of the contingent right. Changes in the liability will be recorded in earnings of the respective period. The financial statement reporting of this liability is expected to have a material impact on the Company’s consolidated financial position and potentially have a material impact on its consolidated results of operations depending on the outcome of future valuations of the contingent right.

 

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In the event that the Milestone Shares are issued, all of the Company’s non-vested stock-based awards would become fully vested and immediately exercisable under the terms of the Plan.
Note 10 — Segment Information
The Company’s reportable operating segments have been determined in accordance with the Company’s internal management reporting structure and include the ZZ Joint Venture plant operations, technology licensing and related services, and corporate and other. The corporate and other segment includes the Company’s investment in the Yima Joint Ventures. The Company evaluates performance based upon several factors, of which a primary financial measure is segment operating income (loss).
The following table presents the revenue, operating loss and total assets by segment (in thousands):
                 
    Three Months Ended  
    September 30,  
    2011     2010  
Revenue:
               
ZZ Joint Venture plant
  $ 2,096     $ 1,417  
Technology licensing and related services
    307       205  
Corporate & other
    92        
 
           
Total revenue
  $ 2,495     $ 1,622  
 
           
 
               
Operating loss:
               
ZZ Joint Venture plant
  $ (1,712 )   $ (414 )
Technology licensing and related services
    (272 )     (568 )
Corporate & other
    (2,457 )     (2,881 )
 
           
Total operating loss
  $ (4,441 )   $ (3,863 )
 
           
 
               
    September 30,     June 30,  
    2011     2011  
Assets:
               
ZZ Joint Venture plant
  $ 40,945     $ 40,703  
Technology licensing and related services
    1,159       1,196  
Corporate & other
    63,593       68,075  
 
           
Total assets
  $ 105,697     $ 109,974  
 
           

 

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Item 2.  
Management’s Discussion and Analysis of Financial Condition and Results of Operations
You should read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and the related notes and other financial information included elsewhere in this quarterly report. Some of the information contained in this discussion and analysis or set forth elsewhere in this quarterly report, including information with respect to our plans and strategy for our business and related financing, include forward-looking statements that involve risks and uncertainties. You should review the “Risk Factors” section of our Annual Report on Form 10-K for the fiscal year ended June 30, 2011 for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis.
Business Overview
We are a global energy and gasification technology company that provides products and solutions to the energy and chemical industries. Our strategy is to create value by providing technology and equipment in regions where low rank coals and biomass feedstocks can be profitably converted into high value products through our proprietary U-GAS® fluidized bed gasification technology. We do this through providing a proprietary technology package whereby we license U-GAS® technology rights to third parties, deliver an engineered technology package and provide proprietary equipment components to customers who have contracted to own and operate projects. In addition, we may (i) integrate our U-GAS® technology package with downstream technologies to provide a fully integrated offering where we may invest in projects either directly or through an investment partner, (ii) partner with engineering, equipment and technology companies to provide our U-GAS® technology package into an integrated modular product offering, (iii) provide technology to enable coal resources to be integrated together with our U-GAS® technology where the coal resources may be of little value without our U-GAS® conversion technology, or (iv) acquire or partner with owners of these coal resources to create more value and opportunity for us through the integration of our technology with the coal resources.
We believe that we have several advantages over commercially available competing gasification technologies, such as entrained flow, fixed and moving bed gasification technologies, including our ability to use all ranks of coals (including low rank, high ash and high moisture coals, which are significantly cheaper than higher grade coals), many coal waste products and biomass feed stocks. In addition, U-GAS® technology’s advanced fluidized bed design is tolerant to changes in feedstock. These factors enable us to be a lower cost producer of synthesis gas, or syngas, a mixture of primarily hydrogen and carbon monoxide, which can then be used to produce other products. Depending on local market need and fuel sources, syngas can be used as a fuel gas in industrial applications or can be used to produce many products including power, synthetic natural gas, or SNG, methanol, dimethyl ether, or DME, glycol, ammonia, direct reduction iron, or DRI, gasoline and other transportation fuels, steam, and other byproducts (e.g., sulphur, carbon dioxide or ash).
Our principal operating activities are currently in China, however, we are developing opportunities in other countries including India, the U.S. and Australia, as well as other parts of Asia and Europe. Our ZZ Joint Venture project is our first commercial scale coal gasification plant and is located in Shandong Province, China. It has been in operation since February 2008 and in commercial operation since December 2008. Our Yima project is currently under construction in Henan Province, China.
The key elements of our business strategy include:
   
Executing on existing projects in China. We are continuing to implement operational measures to improve the financial performance of our ZZ Joint Venture plant in the near term, while also continuing to evaluate alternatives to better position the project to be commercially and financially successful in the future including the possible expansion of the plant to produce other products for other customers. We also intend to continue to leverage our success to date at the ZZ Joint Venture in our ongoing business development efforts, including through further visits from senior executives of possible customers and partners, as well as government officials, from China, India, Australia, Vietnam, and southern Africa. We are also continuing the ongoing construction of our Yima project, and are working to restructure our joint venture agreements to change the scope of the project from methanol to glycol production.

 

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Leveraging our proprietary technology through licensing, equipment sales and related services to increase revenues and position us for future growth. We provide a proprietary technology package whereby we license U-GAS® technology rights to third parties, deliver an engineered technology package and provide proprietary equipment components to customers who have contracted to own and operate projects. We intend to focus on developing opportunities for our proprietary technology package whereby we may (i) integrate our U-GAS® technology package with downstream technologies to provide a fully integrated offering where we may invest in projects either directly or through an investment partner or (ii) may partner with engineering, equipment and technology companies to provide our U-GAS® technology package into an integrated modular product offering, which may include coal or biomass feedstocks for units producing power and fuels such as SNG, methanol to gasoline, or MTG, diesel and ethanol as well as methanol for gasoline blending. We anticipate that we can increase revenues through collecting technology licensing fees and royalties, engineering and technical service fees, as well as equipment product sales sold to customers who have contracted to own and operate projects and desire to incorporate our proprietary technology. We also believe that our licensing activities will provide additional insight into project development activities, which may allow us to make selective equity investments in such projects in the future, develop integrated, modular product offerings, or take options in projects for which we provide a license.
   
Expanding our relationships with strong strategic partners. Our efforts have been initially focused on facilities producing syngas, methanol and DME in China. We are expanding our relationships with our current partners and developing new relationships, including through our transaction with ZJX and China Energy and through strategic joint venture initiatives in specific markets that will enable us to expand our business. Such strategic relationships may include an investment in projects either directly by us or through an investment partner where U-GAS® plants may supply syngas to strategic customers via long-term offtake agreements. For example, through our joint venture SES Resource Solutions, we are working with Midas Resource Partners AG, a coal resource consulting and project development firm, to collaborate on project origination and project development activities for integrated coal resource-gasification projects to incentivize third party investors to commit to providing financing for such projects. We are also developing new downstream coal-to-chemicals and coal-to-energy projects which may expand our initial focus to include facilities producing SNG, MTG, glycol, and power and reducing gas for the steel industry. We are exploring new markets for entry such as India, Australia, and other parts of Asia and Europe.
   
Developing value where we have a competitive advantage and have access of rights to feedstock resources. We believe that we have the greatest competitive advantage using our U-GAS® technology in situations where there is a ready source of low rank, low cost coal, coal waste or biomass to utilize as a feedstock. We are focusing our efforts in countries with large low rank coal resources such as India, China, Australia and South Africa. We are working to develop transactions that include securing options to these feedstock resources. For example, we are currently in discussions regarding development opportunities in Inner Mongolia, China where provincial authorities are willing to make available coal resources to the project owners, which adds protection from future coal cost increases, and can potentially lead to increased project revenue. In these cases, we may provide technology to add value to coal resources which may be of little value without our U-GAS® conversion technology, or may acquire or partner with owners of these resources to create more value and opportunity for us through the integration of our technology with the resources. Additionally, where strategic relationships and capital and/or financing is available, we may acquire an interest in such resources, including existing facilities or coal mines, where we could create value with our U-GAS® technology by securing direct access to feedstock.
   
Continue to develop and improve U-GAS® technology. We are continually seeking to improve overall plant availability, plant efficiency rates and fuel handling capabilities our U-GAS® gasification technology. We are continuing to work with our prospective customers to determine the suitability of their low rank coals for our U-GAS® technology through proprietary coal characterization testing as well as selective commercial scale testing in our ZZ Joint Venture plant. Additionally, we are growing our technology base through continued development of know-how with our engineering and technical staff, growing and protecting our trade secrets as a result of patenting improvements tested at our ZZ Joint Venture plant, and improvements resulting from integration of our technology with downstream processes. One example includes the development of our Fines Management System, or FMS, which we believe can maximize the utilization of low rank coal in our U-GAS®-based gasifiers, resulting in improved cost advantages. We have filed several patent applications relating to our improvements to the U-GAS® technology.
   
Grow earnings through increased revenues and control of expenses. We remain intently focused on control of our expenses while we grow revenues from our technology business. We believe our strategy will allow us to grow near term revenues to position us for sustainable long term growth. We intend to minimize project development expenses until we have assurances that acceptable financing is available to complete our projects. Until we have such assurances, our strategy will be to operate using current capital resources and leveraging the resources of our strategic relationship and/or financing partners.

 

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Results of Operations
We are in our development stage and therefore have had limited operations. We generated revenues of $2.5 million for the three months ended September 30, 2011 and $24.4 million since our inception in November 2003. We have sustained net losses of approximately $121.7 million since our inception. We have primarily financed our operations to date through private placements and two public offerings of our common stock.
Three Months Ended September 30, 2011 Compared to the Three Months Ended September 30, 2010
Revenue. Total revenue increased 54% to $2.5 million for the three months ended September 30, 2011 from $1.6 million for the three months ended September 30, 2010.
Product sales were $2.1 million for the three months ended September 30, 2011 compared to $1.4 million for the three months ended September 30, 2010 and were derived from the sale of syngas and byproducts produced at the ZZ Joint Venture plant to Hai Hua. The increase in revenue was due to higher syngas production volume at the plant offset, in part, by no capacity fee revenue. For the three months ended September 30, 2011 and 2010, the plant operated for 91% and 31% of the period, respectively. In May 2011, Hai Hua notified the ZZ Joint Venture plant that it will not continue payment of capacity fees beyond April 2011. The unpaid amount totaled approximately $0.9 million for the three months ended September 30, 2011 and totaled approximately $1.5 million cumulatively as of September 30, 2011. The plant has continued to operate and provide syngas to Hai Hua, and Hai Hua has paid other contractual obligations such as the energy fees and by-product sales due under the contract. The Company is continuing to work with Hai Hua on alternatives to resolve this issue. The Company did not recognize these capacity fee revenues and will not recognize any capacity fees until collection is reasonably assured.
Technology licensing and related services revenues for the three months ended September 30, 2011 and 2010 were $307,000 and $205,000, respectively, and were generated from coal testing at the ZZ Joint Venture plant, feasibility studies and other technical services provided in association with our technology licensing business.
Costs of sales and plant operating expenses. Costs of sales and plant operating expenses increased by $1.9 million to $3.2 million for the three months ended September 30, 2011 compared to $1.3 million for the three months ended September 30, 2010 and were comprised principally of coal consumption and electricity cost at the ZZ Joint Venture plant. The increase was due primarily to the increase in syngas production and coal and power price increases during the three months ended September 30, 2011.
General and administrative expenses. General and administrative expenses decreased by $0.2 million to $3.0 million during the three months ended September 30, 2011 compared to $3.2 million during the three months ended September 30, 2010. The decrease was primarily due to a reduction in consulting and travel expenses.
Project and technical development expenses. Project and technical development expenses decreased by $18,000 to $67,000 for the three months ended September 30, 2011 compared to $85,000 for the three months ended September 30, 2010.
Stock-based compensation expense. Stock-based compensation expense decreased by $160,000 to $67,000 for the three months ended September 30, 2011 compared to $0.2 million for the three months ended September 30, 2010. The decrease was principally due to forfeitures of certain stock option awards.
Depreciation and amortization. Depreciation and amortization expense was $0.6 million for the three months ended September 30, 2011 compared to $0.7 million for the three months ended September 30, 2010 and was primarily related to depreciation of our ZZ Joint Venture plant’s assets.

 

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Equity in losses of joint ventures. The equity in losses of joint ventures for the three months ended September 30, 2011 relates to our 25% share of the losses incurred by the Yima Joint Ventures and our 50% share of the losses incurred by the SRS joint venture. The losses of the Yima Joint Ventures related to non-capitalizable costs incurred during the design and construction phase. The losses of the SRS joint venture related to development costs including the value of Midas’ contributed services, consulting and travel expenses.
Foreign currency gain. Foreign currency gains increased $0.1 million to $0.4 million for the three months ended September 30, 2011 compared to $0.3 million for the three months ended September 30, 2010. The foreign currency gains have resulted from the appreciation of the Renminbi Yuan relative to the U.S. dollar and are generated on U.S. dollar denominated shareholder loans payable by our Chinese operations.
Interest expense. Interest expense was $0.2 million for both of the three-month periods ended September 30, 2011 and 2010. Our interest expense relates primarily to our long term debt comprised of the ZZ Joint Venture’s outstanding principal balance on its loan with the Industrial and Commercial Bank of China, or ICBC.
Liquidity and Capital Resources
We are in our development stage and have financed our operations to date through private placements of our common stock in 2005 and 2006 and two public offerings, one in November 2007 and one in June 2008. We have used the proceeds of these offerings primarily for the development of and investments in our joint ventures in China and to pay other development and general and administrative expenses. In addition, we entered into a loan agreement with ICBC in 2007 to fund a portion of the ZZ Joint Venture plant’s construction.
As of September 30, 2011, we had approximately $27.7 million in cash and cash equivalents and approximately $23.1 million of working capital available to us. During the three months ended September 30, 2011, we used approximately $3.1 million in operating activities, $0.2 million in investing activities, and $1.2 million in financing activities primarily for the scheduled semi-annual principal payment on the ZZ Joint Venture’s loan with ICBC. During the three months ended September 30, 2010, we used approximately $3.8 million in operating activities, $32,000 in investing activities, and $1.1 million in financing activities primarily for the scheduled semi-annual principal payment on the ZZ Joint Venture’s loan.
Share Purchase Agreement with ZJX
On March 31, 2011, we entered into a Share Purchase Agreement, or the Agreement, with China Energy Industry Holdings Group Co, Ltd., or China Energy, and Zhongjixuan Investment Management Company Ltd., or ZJX, pursuant to which we will issue on the closing date to China Energy 37,254,475 shares of our common stock, in exchange for approximately $83.8 million, or the Consideration. Within 20 business days after the accomplishment of the Milestone (as defined below), we shall further issue directly to China Energy an amount of shares of common stock which, when combined with the shares issued on the closing date, equals 60.0% of the outstanding common stock on a fully-diluted basis. In August 2011, we agreed to extend the closing period of the Agreement through December 31, 2011. The terms and conditions of the Agreement are summarized in Note 9 to the consolidated financial statements included herein.
Use of Proceeds
Subject to the discretion and approval of the Board, the Consideration, net of costs and expenses, is required to be applied to the following: (i) incorporation of a Company headquarters in China to consolidate the ownership of our investment projects in China and enhance our presence in China; (ii) investing in the expansion of our ZZ Joint Venture; (iii) investing in Phase I of our Yima Joint Ventures; (iv) acquiring an ownership interest in a coal mine that will provide coal to the Yima Joint Venture project; (v) investing in our Golden Concord Joint Venture; (vi) other Chinese projects that may be recommended to the Board from time to time; and (vii) other expenses of the operation and business of us in China.
ZJX will use reasonable endeavours to assist us to obtain third party funding (third party direct equity investment in projects or debt financing to the projects) to (a) cover funding needs of the above projects; (b) provide funding for us to invest in future phases of the Yima Joint Venture project; (c) invest in strategic coal resources in China connected to our projects; and (d) provide funding for us to invest in other projects in China not listed above and assist us to obtain third party investment in any of our other projects.

 

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Project Development
ZJX will use reasonable endeavours to create at least four project joint ventures, or the MJVs, in the areas of synthetic natural gas, methanol to gasoline; fertilizer; and electric power. Funding for each MJV is expected to be approximately RMB20 billion. Each MJV is expected to be funded with equity from a strategic investor plus project debt. We are anticipated to be part owner of each MJV through a targeted 35% carry provided by the strategic investor as part of our development of and provision of technology for the particular projects. ZJX will help us work with the strategic investors to obtain long term purchase commitments for each of the MJVs prior to the start of construction of each such project.
Closing of the transaction with China Energy and ZJX is subject to approval by our stockholders and other customary closing conditions. In addition, ZJX notified us in August of its intent to complete its investment in partnership with Yima. ZJX has been working with Yima in order to complete Yima’s investment into China Energy. Once Yima completes its due diligence of us, documentation will be sent to the relevant Chinese authorities to obtain the necessary approvals so that Yima can proceed with its investment in China Energy and all parties can then move to closing the transactions contemplated by the Agreement.
Other
We have included the $1.5 million payment paid to GTI in June 2009 toward future royalties due to GTI for the Yima Joint Ventures’ project as part of our investment in the Yima project. An additional future royalty payment of approximately $1.5 million will be due to GTI upon the commissioning of the gasifier equipment for the Yima project.
Zao Zhuang Joint Venture
Joint Venture Agreement
On July 6, 2006, we entered into a cooperative joint venture contract with Shandong Hai Hua Coal & Chemical Company Ltd., or Hai Hua, which established Synthesis Energy Systems (Zao Zhuang) New Gas Company Ltd., or the ZZ Joint Venture, a joint venture company that has the primary purposes of (i) developing, constructing and operating a syngas production plant utilizing the U-GAS® technology in Zao Zhuang City, Shandong Province, China and (ii) producing and selling syngas and the various byproducts of the plant, including ash and elemental sulphur. We own 96% of the ZZ Joint Venture and Hai Hua owns the remaining 4%. We consolidate the results of the ZZ Joint Venture in our consolidated financial statements.
Syngas Purchase and Sale Agreement
The ZZ Joint Venture is also party to a purchase and sale agreement with Hai Hua for syngas produced by the plant, whereby Hai Hua will pay the ZZ Joint Venture an energy fee and capacity fee, as described below, based on the syngas production. The syngas to be purchased by Hai Hua is subject to certain quality component requirements set forth in the contract. In late December 2008, the plant declared commercial operations status for purposes of the purchase and sale agreement. The energy fee is a per normal cubic meters, or Ncum, of syngas calculation based on a formula which factors in the monthly averages of the prices of design base coal, coke, coke oven gas, power, steam and water, all of which are components used in the production of syngas. The capacity fee is paid based on the capacity of the plant to produce syngas, factoring in the number of hours (i) of production and (ii) of capability of production as compared to the guaranteed capacity of the plant, which for purposes of the contract is 22,000 Ncum per hour of net syngas. Hai Hua is obligated to pay the capacity fee regardless of whether they use the gasification capacity, subject only to availability of the plant, quality of the syngas and exceptions for certain events of force majeure. Due to worldwide reductions in methanol prices, as well as operational issues with respect to Hai Hua’s plant, Hai Hua has operated at a reduced rate of syngas consumption. Hai Hua has used approximately 35% to 45% of the syngas guarantee capacity since 2009.
Since May 2011, Hai Hua has not paid the capacity fees owed to the ZZ Joint Venture. The unpaid amount totaled approximately $1.5 million as of September 30, 2011. The plant has continued to operate and provide syngas to Hai Hua, and Hai Hua has paid other contractual obligations such as the energy fees and by-product sales due under the contract. We are continuing to work with Hai Hua on alternatives to resolve this issue. We did not recognize these capacity fee revenues and we will not recognize any capacity fees until collection is reasonably assured.
In April 2009, the ZZ Joint Venture entered into a Supplementary Agreement with Hai Hua, amending the terms of the purchase and sale agreement. The Supplementary Agreement was entered into to provide more clarity regarding the required syngas quality and volume to be delivered, recovery of the energy fee during turndown periods and operations coordination during unscheduled outages. Under the Supplementary Agreement, the syngas quality specification was amended to provide more clarity as to the minor constituents allowable in the syngas. For purposes of the Supplementary Agreement, syngas that meets these specifications is deemed “compliant gas” and syngas that does not meet these specifications is deemed “non-compliant gas.” The Supplementary Agreement also added a requirement for Hai Hua to pay the ZZ Joint Venture the capacity fee and 70% of the energy fee for all non-compliant

 

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gas which is taken by Hai Hua. However, if more than 50% of the syngas taken by Hai Hua during any operating day is non-compliant gas, all of the syngas for that day is deemed to be non-compliant gas for purposes of calculating the energy fee. In addition, the Supplementary Agreement accommodates periods of turndown operation by Hai Hua by establishing a minimum threshold gas off take volume of 7,500 Ncum per hour of net syngas for the purpose of calculating the energy fee during such periods. The Supplementary Agreement also provides that, to the extent Hai Hua has an unscheduled shutdown, and the plant continues to operate on standby during such period, Hai Hua is still required to pay the energy fee to the ZZ Joint Venture. In the event that the plant has an unscheduled shutdown and does not provide at least three hours prior notice to Hai Hua, the ZZ Joint Venture may be required to provide certain compensation to Hai Hua.
In order to make up for the reduced energy fee, the ZZ Joint Venture entered into an additional agreement with Hai Hua whereby the cost of operating the plant’s air separation unit, or ASU, can be shared between the two parties based on the oxygen consumption of the respective parties over the relevant period. The ZZ Joint Venture began to provide oxygen to Hai Hua in September 2009. This cost sharing arrangement has increased the ZZ Joint Venture’s byproduct revenues and has reduced the operating costs of Hai Hua by allowing the parties to operate only one ASU instead of both parties operating their respective ASU’s at low capacity.
To date, Hai Hua has been unable to offtake the volume of syngas originally expected for the original plant design and the plant has incurred operating losses. We do not foresee this situation changing significantly in the near term. Because of this, the ZZ Joint Venture is working on various arrangements to increase the syngas offtake volume. Such arrangements involve a combination of technical improvement to Hai Hua’s methanol unit, as well as restructuring the current business arrangement to create an integrated syngas to methanol operation. In addition, the ZZ Joint Venture is working on an agreement to sell additional syngas to Zao Zhuang Mining Group for their glycol plant which is under development near the ZZ Joint Venture plant. We are also evaluating alternative products and partnership structures for a possible expansion of the ZZ Joint Venture plant. The scope of the expansion is still under evaluation. We are in discussions with several potential partners on this expansion.
Yima Joint Ventures
In August 2009, we entered into amended joint venture contracts with Yima Coal Industry (Group) Co., Ltd., or Yima, replacing the prior joint venture contracts entered into in October 2008 and April 2009. The joint ventures were formed for each of the gasification, methanol/methanol protein production, and utility island components of the plant, or collectively, the Yima Joint Ventures. We obtained government approvals for the project’s feasibility study during the three months ended December 31, 2008 and for the project’s environmental impact assessment during the three months ended March 31, 2009, which were the two key approvals required to proceed with the project. The amended joint venture contracts provide that: (i) we and Yima contribute equity of 25% and 75%, respectively, to the Yima Joint Ventures; (ii) Yima will guarantee the repayment of loans from third party lenders for 50% of the project’s cost and, if debt financing is not available, Yima is obligated to provide debt financing via shareholder loans to the project until the project is able to secure third-party debt financing; and (iii) Yima will supply coal to the project from a mine located in close proximity to the project at a preferential price subject to a definitive agreement to be subsequently negotiated. In connection with entering into the amended contracts, we and Yima have contributed our remaining cash equity contributions of $29.3 million and $90.8 million, respectively, to the Yima Joint Ventures during the three months ended September 30, 2009. We will also be responsible for our share of any cost overruns on the project. During the three months ended September 30, 2009, we incurred a charge of $0.9 million relating to consulting fees paid in connection with the closing and funding of the Yima project.
In exchange for the capital contributions, we own a 25% interest in each joint venture and Yima owns a 75% interest. Notwithstanding this, in connection with an expansion of the project, we have the option to contribute a greater percentage of capital for the expansion, such that as a result, we would have up to a 49% ownership interest in the Yima Joint Ventures. The investment in the Yima Joint Ventures is accounted for using the equity method.

 

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During the three months ended September 30, 2010, Yima expressed their intent to convert the existing project from methanol production to glycol production. Yima has communicated their belief that the prospect for strong economic performance of the plant can be improved by modifying the backend of the project to make glycol. In addition, Yima has acquired a nearby coal to methanol facility and is looking to diversify and sees glycol as a potentially more profitable alternative. We have indicated to Yima that we would be willing to support this scope change if both parties can agree upon appropriate modifications to the joint venture contracts that can improve our overall risk and return without requiring any additional capital investment from us. Yima’s project management team believes that the project’s syngas production facilities will be available during the third quarter of calendar 2012. All major civil work and buildings have been completed and all long-lead items have been ordered and are in fabrication. We completed a major operator training program for the Yima Joint Venture’s operators at our ZZ Joint Venture plant and have completed important engineering design, operability and hazard reviews for the gasification portion of the plant. The schedule for glycol production is currently awaiting government approvals.
The Yima Joint Ventures are in discussions with a potential fuel gas off-take customer for the sale of the initial syngas production. This would provide syngas sales until the syngas conversion to methanol or glycol is completed. We are continuing to have discussions with Yima to restructure the agreements as necessary to achieve these goals.
Yima is the project management leader for the project and has indicated their belief that the change in the scope of the project would not delay this schedule; however, the construction of the methanol portion of the plant is on hold pending the revisions for the possible glycol production. Based on the project’s current scope of methanol only, the current estimate of the total required capital of the project is approximately $250 million. The remaining capital for the project is to be provided by project debt to be obtained by the Yima Joint Ventures. Yima has agreed to guarantee the project debt and we expect this guarantee will allow debt financing to be obtained from domestic Chinese banking sources. We have agreed to pledge to Yima our ownership interests in the joint ventures as security for its obligations under any project guarantee. In the event that the debt financing is not obtained, Yima has agreed to provide a loan to the joint ventures to satisfy the remaining capital needs of the project with terms comparable to current market rates at the time of the loan.
The Yima Joint Ventures are governed by a board of directors consisting of eight directors, two of whom were appointed by us and six of whom were appointed by Yima. The joint ventures also have officers that are nominated by us, Yima and/or the board of directors pursuant to the terms of the joint venture contracts. We and Yima shall share the profits, and bear the risks and losses, of the joint ventures in proportion to our respective ownership interests. The term of the joint venture shall commence upon each joint venture company obtaining its business license and shall end 30 years after commercial operation of the plant.
SES Resource Solutions
SES Resource Solutions, Ltd., or SRS, is a joint venture owned 50% by us and 50% by Midas Resources AG, or Midas, that was created during fiscal 2011 to provide additional avenues of commercialization for our U-GAS® technology. Key objectives of the joint venture are to identify and procure low cost, low rank coal resources for which our technology and the SRS’ know-how represent the best route to commercialization; to provide investment opportunities in both gasification facilities and coal resources; and to facilitate the establishment of gasification projects globally based on our technology. In pursuing these objectives, the joint venture will seek to minimize the requirement for joint venture shareholder capital and maximize the use of third party financing.
Terms of the SRS joint venture agreement include:
   
SRS having the exclusive right to promote our gasification technology for the purpose of securing low-cost coal resources in projects worldwide that have been approved by the board of directors of SRS;
   
Midas providing expertise to originate and execute the above projects;
   
Us providing SRS with technology licenses and engineering development support for use in developing the joint integrated coal resource projects; and
   
SRS being managed by a four person board of directors, two of which were appointed by us and two of which were appointed by Midas.

 

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the Company has agreed to provide up to $2.0 million in funding to SRS, although it has the ability to discontinue funding at any point in time. As of September 30, 2011, the Company had funded approximately $0.4 million to SRS.
   
Revenue and profits are equally divided between the joint venture partners.
We and Midas intend to establish separate entities for specific projects to attract external funding for these entities and will derive revenue from licensing fees, service fees, equity participation and royalties.
GTI Agreements
License Agreement
On November 5, 2009, we entered into an Amended and Restated License Agreement, or the New Agreement, with GTI, replacing the Amended and Restated License Agreement between us and GTI dated August 31, 2006, as amended, or the Original Agreement. Under the New Agreement, we maintain our exclusive worldwide right to license the U-GAS® technology for all types of coals and coal/biomass mixtures with coal content exceeding 60%, as well as the non-exclusive right to license the U-GAS® technology for 100% biomass and coal/biomass blends exceeding 40% biomass. The New Agreement differs from the Old Agreement most critically by allowing us to sublicense U-GAS® to third parties for coal, coal and biomass mixtures or 100% biomass projects (subject to the approval of GTI, which approval shall not be unreasonably withheld), with GTI to share the revenue from such third party licensing fees based on an agreed percentage split, or the Agreed Percentage. In addition, the prior obligation to fabricate and put into operation at least one U-GAS® system for each calendar year of the Original Agreement in order to maintain the license has been eliminated in the New Agreement.
In order to sublicense any U-GAS® system, we are required to comply with certain requirements set forth in the New Agreement. In the preliminary stage of developing a potential sublicense, we are required to provide notice and certain information regarding the potential sublicense to GTI and GTI is required to provide notice of approval or non-approval within ten business days of the date of the notice from us, provided that GTI is required to not unreasonably withhold their approval. If GTI does not respond within that ten business day period, they are deemed to have approved of the sublicense. We are required to provide updates on any potential sublicenses once every three months during the term of the New Agreement. We are also restricted from offering a competing gasification technology during the term of the New Agreement.
For each U-GAS® unit which we license, design, build or operate for ourself or for a party other than a sublicensee and which uses coal or a coal and biomass mixture or biomass as the feed stock, we must pay a royalty based upon a calculation using the MMBtu per hour of dry syngas production of a rated design capacity, payable in installments at the beginning and at the completion of the construction of a project, or the Standard Royalty. Although it is calculated using a different unit of measurement, the Standard Royalty is effectively the same as the royalty payable to GTI under the Original Agreement. If we invest, or have the option to invest, in a specified percentage of the equity of a third party, and the royalty payable by such third party for their sublicense exceeds the Standard Royalty, we are required to pay to GTI the Agreed Percentage of such royalty payable by such third party. However, if the royalty payable by such third party for their sublicense is less than the Standard Royalty, we are required to pay to GTI, in addition to the Agreed Percentage of such royalty payable by such third party, the Agreed Percentage of our dividends and liquidation proceeds from our equity investment in the third party. In addition, if we receive a carried interest in a third party, and the carried interest is less than a specified percentage of the equity of such third party, we are required to pay to GTI, in our sole discretion, either (i) the Standard Royalty or (ii) the Agreed Percentage of the royalty payable to such third party for their sublicense, as well as the Agreed Percentage of the carried interest. We will be required to pay the Standard Royalty to GTI if the percentage of the equity of a third party that we (a) invest in, (b) have an option to invest in, or (c) receive a carried interest in, exceeds the percentage of the third party specified in the preceding sentence.
We are required to make an annual payment to GTI for each year of the term beginning December 31, 2010, with such annual payment due by the last day of January of the following year; provided, however, that we are entitled to deduct all royalties paid to GTI in a given year under the New Agreement from this amount, and if such royalties exceed the annual payment amount in a given year, we are not required to make the annual payment. We must also provide GTI with a copy of each contract that we enter into relating to a U-GAS® system and report to GTI with our progress on development of the technology every six months.

 

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For a period of ten years, we and GTI are restricted from disclosing any confidential information (as defined in the New Agreement) to any person other than employees of affiliates or contractors who are required to deal with such information, and such persons will be bound by the confidentiality provisions of the New Agreement. We have further indemnified GTI and its affiliates from any liability or loss resulting from unauthorized disclosure or use of any confidential information that we receive.
The term of the New Agreement is the same as the Original Agreement, expiring on August 31, 2016, but may be extended for two additional ten-year periods at our option.
Outlook
Our strategy is to create value by providing technology and equipment in regions where low rank coals and biomass feedstocks can be profitably converted into high value products through our proprietary U-GAS® fluidized bed gasification technology. We do this by providing a proprietary technology package whereby we license U-GAS® technology rights to third parties, deliver an engineered technology package and provide proprietary equipment components to customers who have contracted to own and operate projects. We anticipate that we can generate revenues through engineering and technical service fees, as well as licensing fees and royalties on products sold by our licensees that incorporate our proprietary technology without incurring the significant capital costs required to develop a plant. We also believe that our licensing activities will provide additional insight into project development activities, which may allow us to make selective equity investments in such projects in the future and afford opportunities to develop integrated, modular product offerings. Additionally, we are continuing to improve our technology in ways we believe will enhance our ability to further develop our licensing activities. For example, in December 2010, we successfully implemented our Fines Management System, or FMS, which is a new technology for which we have filed a patent that relates to recovering energy remaining in the fines resulting from the gasification process. Using FMS, we are now achieving over 90-day continuous runs on each single gasifier, which allows us to achieve very high availability of syngas due to our spare stem gasifier configuration. With FMS, we believe we can maximize the utilization of low rank coal in our U-GAS® -based gasifiers, and as a result, improve the cost advantages derived from using our technology.
We currently plan to use our available cash for (i) our general and administrative expenses; (ii) debt service related to the ZZ Joint Venture; (iii) working capital; (iv) project and third-party licensing and technical development expenses; (v) operating expenses of SRS; and (vi) general corporate purposes. The actual allocation and timing of these expenditures will be dependent on various factors, including changes in our strategic relationships, commodity prices and industry conditions, and other factors that we cannot currently predict. In particular, any future decrease in economic activity in China or in other regions of the world in which we may in the future do business could significantly and adversely affect our results of operations and financial condition. Additionally, markets for commodities such as methanol have been under significant recent pressure and we are unsure of how much longer methanol prices may remain depressed. Accordingly, our ability to finance and develop our existing projects, commence any new projects and sell products from our current operations could be adversely impacted.
We are pursuing possible U-GAS® licensing opportunities with third parties allowing us to build on our experience at the ZZ Joint Venture and our overall technological and engineering capabilities. We intend to place increased focus on development of licensing opportunities for our proprietary U-GAS® technology on a global basis with a particular focus on India, China, Australia and South Africa due to large low rank coal resources present in these areas. Having access to such resources may lead to new commercial opportunities and greater cost and operating efficiencies in existing or planned projects. For example, we have continued to work with Ambre Energy on developing a preliminary gasification design to support Ambre’s development of a planned coal-to-liquids project in Queensland, Australia, called ambreCTL. Ambre intends to integrate our technical study with its engineering work on the overall ambreCTL project. In addition, we are continuing to progress our relationship with Zuari Industries in India to develop projects with our technology.
We may (i) integrate our U-GAS® technology package with downstream technologies to provide a fully integrated offering where we may invest in projects either directly or through an investment partner, (ii) partner with engineering, equipment and technology companies to provide our U-GAS® technology package into an integrated modular product offering, (iii) provide technology to enable coal resources to be integrated together with our U-GAS® technology where the coal resources may be of little commercial value without our U-GAS® conversion technology, or (iv) acquire or partner with owners of these coal resources to create more value and opportunity for us through the integration of our technology with the coal resource. We understand the need to partner in certain markets, and plan to do so with companies that we believe can help us accelerate our business. Our partnering approach in some cases is country specific and in some cases is industry or segment specific. Additionally, where capital and/or financing is available, we may acquire an interest in such resources, including existing facilities or coal mines, where we could create value with our U-GAS® technology through securing greater access to feedstock.

 

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We believe our transaction with ZJX and China Energy when closed will further our business and strategic interests. We believe the transaction will allow us to leverage ZJX’s existing relationships with major Chinese companies, agencies, and institutions to raise additional capital and develop, permit, and construct additional projects, and to provide support to resolve any issues with our Yima Joint Ventures and ZZ Joint Venture projects, as well as other projects in China we may become involved in. If approved by our stockholders, the transaction will provide an immediate and substantial increase in our cash resources providing flexibility for our China business and the means to execute on portions of our business plan. We believe that the strengthened balance sheet resulting from the transaction and the show of support by a significant investor and partner will have a positive impact on our technology licensing business and help facilitate new commercial opportunities. Additionally, ZJX is prepared to assist us in securing long-term offtake contracts with several of China’s largest energy and commodity companies further enhancing our ability to finance our projects. In advance of the closing of the transactions, we have been working with ZJX to pursue opportunities that are intended to define their strategic collaboration post-closing, with a focus on SNG producing projects. We and ZJX have recently signed a Project Investment and Cooperation Agreement for joint development of an SNG project in Inner Mongolia and have an expression of intent from a Chinese state owned enterprise for SNG off-take. ZJX has been continuing to work with Yima in order to complete Yima’s investment into China Energy. Once Yima completes its due diligence of us, documentation will be sent to the relevant Chinese authorities to obtain the necessary approvals so that Yima can proceed with its investment in China Energy and all parties can then move to closing the transactions contemplated by the Agreement.
We are actively pursuing new project partners to invest in our ongoing development efforts and are investigating possibly implementing a different project scope and end product for our Yima Joint Ventures and may possibly be expanding both the size and scope of our ZZ Joint Venture plant. Our Yima project is currently under construction and Yima is the project management leader for the project. During the three months ended September 30, 2010, Yima indicated their intent to convert the existing project from methanol production to glycol production. Yima has expressed their belief that the prospect for strong economic performance of the plant can be improved by modifying the backend of the project to make glycol. In addition, Yima has acquired a nearby coal to methanol facility and is looking to diversify and sees glycol as a potentially more profitable alternative. We have indicated to Yima that we would be willing to support this scope change if both parties can agree upon appropriate modifications to the joint venture contracts that can improve our overall risk and return without requiring any additional capital investment from us. Yima’s project management team believes that the project’s syngas production facilities will be available in the third quarter of calendar 2012. Although the schedule for glycol production is currently under evaluation, Yima is taking steps to connect the syngas production facility with their east and west coal chemical zones to provide an outlet for syngas sales prior to glycol production. We are continuing to have discussions with Yima to restructure the agreements as necessary to achieve these goals.
We are of the view that by improving financial performance and reducing operating costs at the ZZ Joint Venture plant our overall financial performance can be improved. To date, Hai Hua has been unable to offtake the volume of syngas originally expected for the original plant design and the plant has incurred operating losses. We do not foresee this situation changing significantly in the near term. Because of this, the ZZ Joint Venture is working on various arrangements to increase the syngas offtake volume. Such arrangements involve a combination of technical improvement to Hai Hua’s methanol unit, as well as restructuring the current business arrangement to create an integrated syngas to methanol operation. In addition, the ZZ Joint Venture is working on an agreement to sell additional syngas to Zao Zhuang Mining Group for their glycol plant which is under development near the ZZ Joint Venture plant. We are also evaluating alternative products and partnership structures for a possible expansion of the ZZ Joint Venture plant. The scope of the expansion is still under evaluation. We are in discussions with several potential partners on this expansion.
In addition, our successful commercial-scale demonstration at the ZZ Joint Venture plant using lignite coal from the Inner Mongolia region of China was a significant milestone for us and our U-GAS® technology as it demonstrated our ability to efficiently process lignite coal. As a result of the lignite demonstration, we have seen an increase in visits to our ZZ Joint Venture plant from potential customers and partners. We intend to continue to leverage our success to date at the ZZ Joint Venture in our ongoing business development efforts, including through further visits from senior executives of possible customers and partners, as well as government officials. Despite our work with Hai Hua on improving financial performance and reducing costs, Hai Hua has not made the capacity fee payments to the ZZ Joint Venture since April 2011 as described under “—Results of Operation.” The unpaid amount totals approximately $1.5 million as of September 30, 2011. Although we are continuing to work with Hai Hua on alternatives to resolve the issue, there can be no assurances that we will collect these amounts. Hai Hua’s continued failure to make capacity fee payments could lead us to shut down the ZZ Joint Venture plant for a period of time until we are able to either find an alternative purchaser of our production or a different use for the plant.

 

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We believe that there is currently a shift in the coal gasification business toward the use of low quality, and therefore low cost, coals for coal-to-energy and chemicals projects and we believe that China is a good example of this new direction in coal gasification. In China, coal prices for high quality coals has risen dramatically over the past few years and these high coal prices have had a very negative impact on the margins of current coal gasification projects. In order to fuel its energy needs, China today is moving toward even larger coal based projects, which include several large scale coal-to-methane or SNG projects, as compared to previous coal-to-chemical projects. Due to current encouragement from the Chinese government, we believe there is potential in China for several of these projects, some of which currently are in various stages of planning. We believe many of these projects will be located in regions where very low cost lignite coals can be made available reducing production costs of SNG and enhancing the profitability of these kinds of projects. As we have determined with testing at our ZZ Joint Venture plant, our technology has the unique ability to efficiently process lignite and thus we believe it is very desirable for projects of the type the Chinese government appears to support. As evidence of this, we are in discussions regarding several projects in Inner Mongolia where the provincial government is making coal resources available to the project owners which adds protection for the project from future coal cost increases, as well as potentially increasing project revenues. In addition, we have been continuing to work with Midas in identifying other sources of low quality coals around the world, primarily in Asia, to develop additional projects for SRS utilizing our technology. In all of these types of projects, we believe that we have the opportunity to create more value from the U-GAS technology than licensing alone could bring us.
We expect to continue for a period of time to have negative operating cash flows until we can generate sufficient revenues from our licensing and related service projects, as well as from the ZZ Joint Venture, the Yima Joint Ventures and other projects which are under development, to cover our general and administrative expenses and other operating costs. In addition, if we are not able to complete the ZJX/China Energy transaction, we will need to aggressively pursue additional partners in China and may need to cut our operating expenses. We will also limit the development of any further projects until we have assurances that acceptable financing is available to complete the project. Despite this, we will continue to pursue the development of selective projects with strong and credible partners or off-takers where we believe equity and debt can be raised or where we believe we can attract a financial partner to participate in the project.
We can make no assurances that our business operations will develop and provide us with significant cash to continue operations. We may need to raise additional capital through equity and debt financing for any new projects that are developed, to support our existing projects and possible expansions, and to meet corporate general and administrative expenses. We cannot provide any assurance that any financing will be available to us in the future on acceptable terms or at all. Any such financing could be dilutive to our existing stockholders. If we cannot raise required funds on acceptable terms, we may not be able to, among other things, (i) maintain our general and administrative expenses at current levels; (ii) successfully develop our licensing and related service businesses; (iii) negotiate and enter into new gasification plant development contracts and licensing agreements; (iv) expand our operations; (v) hire and train new employees; or (vi) respond to competitive pressures or unanticipated capital requirements.
Critical Accounting Policies
The preparation of financial statements in accordance with U.S. generally accepted accounting principles, or GAAP, requires our management to make certain estimates and assumptions which are inherently imprecise and may differ significantly from actual results achieved. We believe the following are our critical accounting policies due to the significance, subjectivity and judgment involved in determining our estimates used in preparing our consolidated financial statements. We evaluate our estimates and assumptions used in preparing our consolidated financial statements on an ongoing basis utilizing historic experience, anticipated future events or trends and on various other assumptions that are believed to be reasonable under the circumstances. The resulting effects of changes in our estimates are recorded in our consolidated financial statements in the period in which the facts and circumstances that give rise to the change in estimate become known.
We believe the following describes significant judgments and estimates used in the preparation of our consolidated financial statements:

 

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Revenue Recognition
Revenue from sales of products, which includes the capacity fee and energy fee earned at the ZZ Joint Venture plant, and byproducts are recognized when the following elements are satisfied: (i) there are no uncertainties regarding customer acceptance; (ii) there is persuasive evidence that an agreement exists; (iii) delivery has occurred; (iv) the sales price is fixed or determinable; and (v) collectability is reasonably assured.
Technology licensing revenue is typically received and earned over the course of a project’s development. We may receive upfront licensing fee payments in addition to fees for engineering services that are integral to the initial transfer of our technology to a customer’s project. Typically, the majority of a license fee is received once project financing and equipment installation occur. Recognition of upfront licensing fee payments is deferred and recognized as a percentage of completion of the engineering services associated with the initial technology transfer. Further, such revenues are deferred until performance guarantee terms under the licensing agreement are met. We recognize revenue from engineering services under the percentage-of-completion method.
Impairment Evaluation of Long-Lived Assets
We evaluate our long-lived assets, such as property, plant and equipment, construction-in-progress, equity method investments and specifically identified intangibles, when events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. When we believe an impairment condition may have occurred, we are required to estimate the undiscounted future cash flows associated with a long-lived asset or group of long-lived assets at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities for long-lived assets that are expected to be held and used. We evaluate our operating plants as a whole. Production equipment at each plant is not evaluated for impairment separately, as it is integral to the assumed future operations of the plant. All construction and development projects are reviewed for impairment whenever there is an indication of potential reduction in fair value. If it is determined that it is no longer probable that the projects will be completed and all capitalized costs recovered through future operations, the carrying values of the projects would be written down to the recoverable value. If we determine that the undiscounted cash flows from an asset to be held and used are less than the carrying amount of the asset, or if we have classified an asset as held for sale, we estimate fair value to determine the amount of any impairment charge.
The following summarizes some of the most significant estimates and assumptions used in evaluating if we have an impairment charge.
Undiscounted Expected Future Cash Flows. In order to estimate future cash flows, we consider historical cash flows and changes in the market environment and other factors that may affect future cash flows. To the extent applicable, the assumptions we use are consistent with forecasts that we are otherwise required to make (for example, in preparing our other earnings forecasts). The use of this method involves inherent uncertainty. We use our best estimates in making these evaluations and consider various factors, including forward price curves for energy, fuel costs, and operating costs. However, actual future market prices and project costs could vary from the assumptions used in our estimates, and the impact of such variations could be material.
Fair Value. Generally, fair value will be determined using valuation techniques such as the present value of expected future cash flows. We will also discount the estimated future cash flows associated with the asset using a single interest rate representative of the risk involved with such an investment. We may also consider prices of similar assets, consult with brokers, or employ other valuation techniques. We use our best estimates in making these evaluations; however, actual future market prices and project costs could vary from the assumptions used in our estimates, and the impact of such variations could be material.
The evaluation and measurement of impairments for equity method investments such as our equity investment in the Yima Joint Ventures involve the same uncertainties as described for long-lived assets that we own directly. Similarly, our estimates that we make with respect to our equity and cost-method investments are subjective, and the impact of variations in these estimates could be material.

 

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ZZ Joint Venture Plant Impairment Analysis
The ZZ Joint Venture plant has operated at limited capacity and is expected to continue operating at reduced capacity due to the depressed methanol market and limited off-take by Hai Hua. The reduced capacity at the ZZ Joint Venture plant has contributed to the plant’s operating losses. In addition to funding these operating losses, we are funding the debt service for the ZZ Joint Venture. We are in the process of implementing operational measures, pursuing additional customers and evaluating strategies to reduce the ZZ Joint Venture’s losses and improve its financial performance including the possible expansion of the plant to produce other products and sharing in methanol production with Hai Hua. If an expansion of the ZZ Joint Venture plant were to be developed, we would expect to contribute our interest in the ZZ Joint Venture to the project. If we are not successful in improving the ZZ Joint Venture’s profitability, or if management’s estimated cash flow projections for these assets decrease, or if Hai Hua does not make its required payments, the plant’s assets could become impaired. As of September 30, 2011, we have determined that these assets were not impaired.
Despite our work with Hai Hua on improving financial performance and reducing costs, Hai Hua has not made the capacity fee payments to the ZZ Joint Venture since April 2011 as described under “—Results of Operation.” The unpaid amount totals approximately $1.5 million as of September 30, 2011. Although we are continuing to work with Hai Hua on alternatives to resolve the issue, there can be no assurances that we will collect these amounts. Hai Hua’s failure to make capacity fee payments could lead us to shut down the ZZ Joint Venture plant for a period of time until we are able to either find an alternative purchaser of our production or a different use for the plant.
Accounting for Variable Interest Entities and Financial Statement Consolidation Criteria
The joint ventures which we enter into may be considered variable interest entities, or VIEs. We consolidate all VIEs where we are the primary beneficiary. This determination is made at the inception of our involvement with the VIE. We consider both qualitative and quantitative factors and form a conclusion that we, or another interest holder, absorb a majority of the entity’s risk for expected losses, receive a majority of the entity’s potential for expected residual returns, or both. We do not consolidate VIEs where we are not the primary beneficiary. We account for these unconsolidated VIEs under the equity method of accounting and include our net investment in investments on our consolidated balance sheets. Our equity interest in the net income or loss from our unconsolidated VIEs is recorded in non-operating (income) expense on a net basis on our consolidated statement of operations.
We have determined that the ZZ Joint Venture is a VIE and that we are the primary beneficiary. In addition, we considered whether the terms of the syngas purchase and sale agreement with Hai Hua contained a lease. The factors considered included (i) our ability to operate and control the plant during the initial 20 years; and (ii) whether it was more than remote that one or more parties other than Hai Hua would purchase more than a minor amount (considered to be 10%) of the plant’s output during the term of the syngas purchase and sale agreement. Because we determined that the syngas purchase and sale agreement did not contain a lease, we account for the revenues from this agreement in accordance with our revenue recognition policy for product sales.
We have determined that the Yima Joint Ventures are VIEs and that Yima is the primary beneficiary since Yima has a 75% ownership interest in the Yima Joint Ventures.
We have determined that the GC Joint Venture is a VIE and that we are the primary beneficiary since we have a 51% ownership interest in the GC Joint Venture and since there are no qualitative factors that would preclude us from being deemed the primary beneficiary.
We have determined that SRS is a VIE and that neither we nor Midas is the primary beneficiary since we each have a 50% ownership interest in SRS and the control, risks and benefits of SRS are shared equally.
Recently Issued Accounting Standards
In June 2011, the FASB issued new guidance on the presentation of comprehensive income. The new guidance allows an entity to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The new guidance eliminates the current option to report other comprehensive income and its components in the statement of changes in stockholders equity. This new guidance is effective for fiscal years beginning after December 15, 2011. We plan to adopt these requirements effective July 1, 2012.

 

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Item 3.  
Quantitative and Qualitative Disclosure About Market Risk
Qualitative disclosure about market risk.
We are exposed to certain qualitative market risks as part of our ongoing business operations, including risks from changes in foreign currency exchange rates and commodity prices that could impact our financial position, results of operations and cash flows. We manage our exposure to these risks through regular operating and financing activities, and may, in the future, use derivative financial instruments to manage this risk. We have not entered into any derivative financial instruments to date.
Foreign currency risk
We conduct operations in China and our functional currency in China is the Renminbi Yuan. Our financial statements are expressed in U.S. dollars and will be negatively affected if foreign currencies, such as the Renminbi Yuan, depreciate relative to the U.S. dollar. In addition, our currency exchange losses may be magnified by exchange control regulations in China or other countries that restrict our ability to convert into U.S. dollars. The People’s Bank of China, the monetary authority in China, sets the spot rate of the Renminbi Yuan, and may also use a variety of techniques, such as intervention by its central bank or imposition of regulatory controls or taxes, to affect the exchange rate relative to the U.S. dollar. In the future, the Chinese government may also issue a new currency to replace its existing currency or alter the exchange rate or relative exchange characteristics by devaluation or revaluation of the Renminbi Yuan in ways that may be adverse to our interests.
Commodity price risk
Our business plan is to purchase coal and other consumables from suppliers and to sell commodities, such as syngas, methanol and other products. Coal is the largest component of our costs of product sales and in order to mitigate coal price fluctuation risk for future projects, we expect to enter into long-term contracts for coal supply or to acquire coal assets. For the sale of commodities from our projects, fixed price contracts will not be available to us in certain markets, such as China, which will require us to purchase some portion of our coal and other consumable needs, or sell some portion of our production, into spot commodity markets or under short term supply agreements. Hedging transactions may be available to reduce our exposure to these commodity price risks, but availability may be limited and we may not be able to successfully hedge this exposure at all. To date, we have not entered into any hedging transactions.
Interest rate risk
We are exposed to interest rate risk through our loan with ICBC. Interest under this loan is adjusted annually based upon the standard rate announced each year by the People’s Bank of China. As of September 30, 2011, the applicable interest rate was 6.6%. We could also be exposed to the risk of rising interest rates through our future borrowing activities. This is an inherent risk as borrowings mature and are renewed at then current market rates. The extent of this risk as to our ICBC loan, or any future borrowings, is not quantifiable or predictable because of the variability of future interest rates.
Customer credit risk
When our projects other than the ZZ Joint Venture plant progress to commercial production, we will be exposed to the risk of financial non-performance by customers. To manage customer credit risk, we intend to monitor credit ratings of customers and seek to minimize exposure to any one customer where other customers are readily available. As of September 30, 2011, Hai Hua, a related party, is our only customer for syngas sales and as such, we are exposed to significant customer credit risk due to this concentration. In addition, as described under “—Results of Operation,” Hai Hua has not made the capacity fee payments to the ZZ Joint Venture since April 2011. The unpaid amount totals approximately $1.5 million as of September 30, 2011. Although we are continuing to work with Hai Hua on alternatives to resolve the issue, there can be no assurances that we will collect these amounts. Our revenue and results of operations would be adversely affected if Hai Hua continues to not pay the capacity fee or if we are otherwise unable to retain Hai Hua as a customer and secure new customers and we may need to shut down the ZZ Joint Venture plant for a period of time until we are able to either find an alternative purchaser of our production or a different use for the plant.

 

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Item 4.  
Controls and Procedures
We maintain disclosure controls and procedures designed to ensure that information required to be disclosed in our annual and periodic reports is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s, or the SEC, rules and forms. In addition, we designed these disclosure controls and procedures to ensure that this information is accumulated and communicated to our management, including the Chief Executive Officer and Chief Accounting Officer, to allow timely decisions regarding required disclosures.
Our management, with the participation of the Chief Executive Officer and the Chief Accounting Officer, assessed the effectiveness of our disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended, or the Exchange Act, as of September 30, 2011. Based upon that evaluation, our Chief Executive Officer and Chief Accounting Officer have concluded that our disclosure controls and procedures were effective as of September 30, 2011.
Management’s Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP. Our internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of our assets that could have a material effect on the financial statements. Because of inherent limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Our management, with the participation of the Chief Executive Officer and the Chief Accounting Officer, evaluated the effectiveness of our internal control over financial reporting as of September 30, 2011 based on criteria set forth in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on our evaluation, management has concluded that we did maintain effective internal control over financial reporting as of September 30, 2011.
There were no changes in our internal control over financial reporting during the most recent fiscal quarter that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II
Item 1.  
Legal Proceedings.
We are a party to various legal proceedings including the one noted below. While management presently believes that the ultimate outcome of these proceedings will not have a material adverse effect on its financial position, overall trends in results of operations or cash flows, litigation is subject to inherent uncertainties, and unfavorable rulings or settlements could occur which could have a material adverse impact on our financial position and operating results.
In September 2008, we were named as one of a number of defendants in a lawsuit filed in the U.S. District Court for the Central District of California, Southern Division, by Igor Olenicoff, one of our former stockholders, and a company he controls. Also named were Timothy E. Vail (our former CEO and a former director), David Eichinger (our former CFO), and another one of our former directors (collectively, we, Mr. Vail, Mr. Eichinger and the director are referred to as the “SES Defendants”), as well as UBS AG, Union Charter Ltd., and other persons who allegedly managed Mr. Olenicoff’s investments outside the U.S. The SES Defendants have been named in this lawsuit based primarily upon allegations that one of our former stockholders, Teflomi Trade & Trust, Inc., was a

 

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shell company formed for the purposes of holding Mr. Olenicoff’s assets overseas, and that the SES Defendants allegedly had knowledge of this arrangement. The claims initially asserted against the SES Defendants included, among others, securities fraud in violation of Rule 10b-5 under the Securities Act and the California state law equivalent, violations of the Racketeer Influenced and Corrupt Organizations Act, or RICO, common law fraud and negligent misrepresentation, breach of fiduciary duty, conspiracy and unfair business practices. On the SES Defendants’ motion, on July 31, 2009, the court issued an order dismissing the securities fraud claims as to each of the SES Defendants and the common law fraud, negligent misrepresentation claim and breach of fiduciary duty claims as to us, Mr. Vail and Mr. Eichinger. The court determined that certain other claims, including RICO, conspiracy and unfair business practices, were sufficiently pled and could proceed at this stage. Plaintiffs were given leave to amend and, on August 24, 2009, filed an amended complaint attempting to replead their securities fraud claims, and alleged a new claim for violation of the Uniform Commercial Code (the “UCC”). In response, on September 23, 2009, the SES Defendants filed a motion to dismiss the securities fraud and UCC claims. The court heard oral argument on the SES Defendants’ motion to dismiss, and on various other defendants’ motions to dismiss, on November 9, 2009. On March 16, 2010, the court issued an order on the pending motions to dismiss, dismissing the securities fraud and UCC claims as to each of the SES Defendants. Thus, the claims that remain as to the SES Defendants collectively include violations of RICO, RICO conspiracy, unfair business practices, conversion and civil conspiracy; the claims that remain as to the individually named director include fraudulent misrepresentation, constructive fraud, negligent misrepresentation and breach of fiduciary duty. The SES Defendants filed their answer to these claims on April 22, 2010. The parties are currently engaged in discovery related to those claims the court has allowed to remain in the case. Additionally, on August 15, 2011, the SES Defendants filed a motion for summary judgment or, in the alternative, summary adjudication as to each of the claims remaining against them, collectively, and the individually named director, separately. On October 18, 2011, the court issued an order denying this motion. The court also recently continued the trial date to May 8, 2012. The SES Defendants believe the claims alleged against them to be without merit and intend to continue to vigorously defend all claims which proceed to trial.
Item 1A.  
Risk Factors.
None.
Item 2.  
Unregistered Sales of Equity Securities and Use of Proceeds.
None.
Item 3.  
Defaults Upon Senior Securities.
None.
Item 4.  
[Removed and Reserved.]
Item 5.  
Other Information.
None.
Forward-Looking Statements
This Quarterly Report on Form 10-Q includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Exchange Act. All statements other than statements of historical fact are forward-looking statements. Forward-looking statements are subject to certain risks, trends and uncertainties that could cause actual results to differ materially from those projected. Among those risks, trends and uncertainties are our early stage of development, our estimate of the sufficiency of existing capital sources, our ability to successfully develop our licensing business, our ability to raise additional capital to fund cash requirements for future investments and operations, our ability to reduce operating costs, the limited history and viability of our technology, the effect of the current international financial crisis on our business, commodity prices and the availability and terms of financing opportunities, our results of operations in foreign countries and our ability to diversify, our ability to maintain production from our first plant in the ZZ joint venture, our ability to complete the expansion of the ZZ project, our ability to obtain the necessary approvals and permits for our Yima project and other future projects, the estimated timetables for achieving mechanical completion and commencing commercial operations for the Yima project, our ability to negotiate the terms of the conversion of the Yima project from methanol to glycol, our ability to close the transaction with China Energy and ZJX, the sufficiency of internal controls and procedures and our ability to grow our business as a result of the ZJX and Zuari transactions as well as our joint venture with Midas Resource Partners. Although we believe that in making such forward-looking statements our expectations are based upon reasonable assumptions, such statements may be influenced by factors that could cause actual outcomes and results to be materially different from those projected. We cannot assure you that the assumptions upon which these statements are based will prove to have been correct.

 

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When used in this Form 10-Q, the words “expect,” “anticipate,” “intend,” “plan,” “believe,” “seek,” “estimate” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. Because these forward-looking statements involve risks and uncertainties, actual results could differ materially from those expressed or implied by these forward-looking statements for a number of important reasons, including those discussed under “Risk Factors” in our Annual Report on Form 10-K for the year ended June 30, 2011, as well as in “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and elsewhere in this Form 10-Q.
You should read these statements carefully because they discuss our expectations about our future performance, contain projections of our future operating results or our future financial condition, or state other “forward-looking” information. You should be aware that the occurrence of certain of the events described in this Form 10-Q could substantially harm our business, results of operations and financial condition and that upon the occurrence of any of these events, the trading price of our common stock could decline, and you could lose all or part of your investment.
We cannot guarantee any future results, levels of activity, performance or achievements. Except as required by law, we undertake no obligation to update any of the forward-looking statements in this Form 10-Q after the date hereof.
Item 6.  
Exhibits
         
Number   Description of Exhibits
       
 
  10.1    
Letter Agreement dated August 16, 2011 between Synthesis Energy Systems, Inc., China Energy Industry Holdings Group Co, Ltd. and Zhongjixuan Investment Management Company Ltd. (incorporated by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K filed on August 16, 2011).
       
 
  31.1 *  
Certification of Chief Executive Officer of Synthesis Energy Systems, Inc. pursuant to Rule 13a-14(a) promulgated under the Securities Exchange Act of 1934, as amended.
       
 
  31.2 *  
Certification of Chief Financial Officer of Synthesis Energy Systems, Inc. pursuant to Rule 13a-14(a) promulgated under the Securities Exchange Act of 1934, as amended.
       
 
  32.1 *  
Certification of Chief Executive Officer of Synthesis Energy Systems, Inc. pursuant to Rule 13a-14(b) promulgated under the Securities Exchange Act of 1934, as amended, and Section 1350 of Chapter 63 of Title 18 of the United States Code.
       
 
  32.2 *  
Certification of Chief Financial Officer of Synthesis Energy Systems, Inc. pursuant to Rule 13a-14(b) promulgated under the Securities Exchange Act of 1934, as amended, and Section 1350 of Chapter 63 of Title 18 of the United States Code.
 
*  
Filed herewith.

 

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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
         
  SYNTHESIS ENERGY SYSTEMS, INC.
 
 
Date: November 10, 2011  By:   /s/ Robert Rigdon    
    Robert Rigdon   
    President and Chief Executive Officer   
     
Date: November 10, 2011  By:   /s/ Kevin Kelly    
    Kevin Kelly   
    Chief Accounting Officer,
Controller and Secretary 
 

 

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