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SORL AUTO PARTS INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

August 14, 2014

The following is management's discussion and analysis of certain significant factors that have affected our financial position and operating results during the periods included in the accompanying consolidated unaudited financial statements, as well as information relating to the plans of our current management. The following discussion and analysis should be read in conjunction with our consolidated unaudited financial statements and the related notes thereto and other financial information contained elsewhere in this Form 10-Q.



FORWARD-LOOKING STATEMENTS

This quarterly report on Form 10-Q includes forward-looking statements. Any statements contained in this report that are not statements of historical fact may be deemed to be forward-looking statements. Generally, the words "believe," "anticipate," "may," "will," "should," "expect," "intend," "estimate," "continue," and similar expressions, or the negative thereof, or comparable terminology, are intended to identify forward-looking statements. Such statements are subject to certain risks and uncertainties, including the matters set forth in this report or other reports or documents we file with SEC from time to time, which could cause actual results or outcomes to differ materially from those anticipated. Some of the factors that could cause actual results to differ include: our ability to effectively implement our business strategy; our ability to handle downward pricing pressures on our products; our ability to accurately or effectively plan our production or supply needs. For a discussion of these and all other known risks and uncertainties that could cause actual results to differ from those contained in the forward-looking statements, see "Risk Factors" in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2013, which is available on the SEC's website at www.sec.gov. Undue reliance should not be placed on these forward-looking statements that speak only as of the date hereof. We undertake no obligation to revise or update these forward-looking statements. 18 OVERVIEW

The Company manufactures and distributes automotive brake systems and other key safety-related components to automotive original equipment manufacturers, or OEMs, and the related aftermarket both in China and internationally for use primarily in different types of commercial vehicles, such as trucks and buses, and in passenger vehicles. Management believes that it is the largest manufacturer (by sales volume) of automotive brake systems in China for commercial vehicles such as trucks and buses.



CRITICAL ACCOUNTING POLICIES AND ESTIMATES

For a summary of our accounting policies and estimates, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations-Critical Accounting Policies and Estimates" in our Annual Report on Form 10-K for the Year ended December 31, 2013.

See Note K to the attached Unaudited Consolidated Financial Statements for the information regarding changes in taxation by the government of China.

Results of Operations



Results of operations for the three months ended June 30, 2014 as compared to the three months ended June 30, 2013.

Sales Three Months ended Three Months ended June 30, 2014June 30, 2013 (U.S. dollars in millions)

Commercial Vehicle Brake Systems $ 53.9 82.0 % $ 46.9 81.6 % Passenger Vehicle Brake Systems $ 11.8 18.0 % $ 10.6

18.4 % Total $ 65.7 100.0 % $ 57.5 100.0 %

Net sales were $65,723,746 and $57,511,004 for the three months ended June 30, 2014 and 2013, respectively, an increase of $8.2 million or 14.3%. The increase was due to the increased sales to China market and international market. The sales from Commercial Vehicle Brake Systems increased by $7.0 million or 14.9%, to $53.9 million for the second fiscal quarter of 2014, compared to $46.9 million for the same period of 2013. Our high quality, low cost products continued to generate higher sales and further penetrated the commercial vehicle market, which impacted the sales of the Commercial Vehicle Brake Systems. 19

The sales from Passenger Vehicle Brake Systems increased by $1.2 million or 11.3%, to $11.8 million for the second fiscal quarter of 2014, compared to $10.6 million for the same period of 2013. The increase was mainly due to the increase of the passenger vehicle sales in China in the second fiscal quarter of 2014, which increased by 12.3% to 4.76 million units from 4.24 million units for

the same period last year.



A breakdown of net sales revenue for China OEM market, China aftermarket and international market for the second fiscal quarter of the 2014 and 2013, respectively, is set forth below:

Three Three Months Percent Months Percent ended of ended of Percentage June 30, 2014 Total Sales June 30, 2013 Total Sales Change (U.S. dollars in million) China OEM market $ 31.9 48.6 % $ 30.6 53.2 % 4.2 % China Aftermarket $ 15.4 23.4 % $ 12.8 22.3 % 20.3 % International market $ 18.4 28.0 % $

14.1 24.5 % 30.5 % Total $ 65.7 100.0 % $ 57.5 100.0 % 14.3 % Considering the decline of the production and sales of the commercial vehicles in the second fiscal quarter of 2014 in the automobile industry, the OEM manufacturers were facing higher pressure from market this year. Therefore, they paid more attention to the quality and cost controls. Compared with some smaller auto parts manufacturers, we had better quality and cost controls on our products. As a result, our sales to the China OEM market increased by 4.2% from the second fiscal quarter of 2013, to $31.9 million. This increase is in contrast to the 14.4% decline in unit truck sales in Chinese automobile industry during the second fiscal quarter of 2014. Our sales to the China aftermarket increased by $2.6 million or 20.3%, to $15.4 million for the second fiscal quarter of 2014, compared to $12.8 million for the same period of 2013. The reasons of the increase are: (1) Our large portfolio of products, with more new products, for the aftermarket provides us with a competitive advantage, enabling us to further penetrate and capture additional share in this segment; (2) To increase our market share, we did product promotion (price adjustment) in the second fiscal quarter of 2014; and (3) Accelerated urbanization and the Chinese government's increased support for public transportation favor our expansion in the bus aftermarket. We will continue with our strategies to further optimize our sales network and to help further penetrate into new markets. Our export sales increased by $4.3 million or 30.5%, to $18.4 million for the second fiscal quarter of 2014, as compared to $14.1 million for the same period of 2013. A part of our strategy is to strengthen and extend our distribution networks to increase our exposure with end users. The increase in export sales was mainly due to our broadened customer base.



Cost of Sales and Gross Profit

Cost of sales for the three months ended June 30, 2014 were $47,209,861 an increase of $6,520,956 or 16.0% from $40,688,905 for the three month period ended June 30, 2013. Our gross profit increased by 10.1% from $16,822,099 for the second quarter of 2013 to $18,513,885 for the three month period ended

June 30, 2014.

Gross margin decreased to 28.2% from 29.3% for the three month period ended June 30, 2014 compared with the same period of 2013. One of the reasons of the decrease is that, to strengthen our competitiveness and increase our market share, we started the price promotion in the aftermarket in the second fiscal quarter of 2014. The increased labor cost also decreased our gross margin for the three month period ended June 30, 2014. We intend to focus in 2014 on increasing production efficiency, improving the technologies of products, and improving our product portfolio, to help us to maintain or increase our gross profit margins. 20 Cost of sales from Commercial Vehicle Brake Systems for the three months period ended June 30, 2014 were $38.7 million, an increase of $5.5 million or 16.6% from $33.2 million for the same period last year. The gross profit from Commercial Vehicle Brake Systems increased by 10.9% from $13.7 million for three month period ended June 30, 2013 to $15.2 million for the three month period ended June 30, 2014. Gross margin from Commercial Vehicle Brake Systems decreased to 28.2% from 29.2% for the three months period ended June 30, 2014 compared to the three month period ended June 30, 2013. Cost of sales from Passenger Vehicle Brake Systems for the three months period ended June 30, 2014 were $8.5 million, an increase of $1.0 million or 13.3% from $7.5 million for the three month period ended June 30, 2013. The gross profit from Passenger Vehicle Brake Systems increased by 6.5% from $3.1 million for the three month period ended June 30, 2013 to $3.3 million for the three month period ended June 30, 2014. Gross margin from Passenger Vehicle Brake Systems decreased to 28.0% from 29.2% for the three months ended June 30, 2014, as compared with the same period in 2013.



Selling and Distribution Expenses

Selling and distribution expenses were $6,473,111 for the three months ended June 30, 2014, as compared to $4,911,344 for the same period of 2013, an increase of $1,561,767 or 31.8%.

The increase was mainly due to increased freight expense and packaging expenses. As a percentage of sales revenue, selling expenses increased to 9.8% for the three months ended June 30, 2014, as compared to 8.5% for the same period in 2013.

General and Administrative Expenses

General and administrative expenses were $4,710,874 for the three months ended June 30, 2014, as compared to $5,220,131 for the same period of 2013, a decrease of $509,257 or 9.8%. The decrease was mainly due to the decrease in allowance for doubtful accounts. In the second fiscal quarter of 2014, as compared to the same period in 2013, our allowance for doubtful accounts decreased, because we had less overdue account receivables. As a percentage of sales revenue, general and administrative expenses decreased to 7.2% for the three months ended June 30, 2014, as compared to 9.1% for the same period in 2013.



Research and Development Expenses

Research and development expenses include payroll, employee benefits, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development costs. For the three months ended June 30, 2014, research and development expenses were $2,200,558, as compared to $1,617,147 for the same period of 2013, an increase of $583,411. Other Operating Income Other operating income was $549,130 for the three months ended June 30, 2014, as compared to $632,105 for the three months ended June 30, 2013, a decrease of $82,975. The decrease was mainly due to a decrease in sales of raw material scraps for the three months ended June 30, 2014.



Depreciation and Amortization

Depreciation and amortization expense decreased to $1,879,071 for the three months ended June 30, 2014, compared with that of $1,809,808 for the same period of 2013, an increase of $69,263. The increase in depreciation and amortization expense was primarily due to the addition of purchased production equipment. 21 Financial Expenses Financial expenses mainly consist of interest expenses, the financing expenses associated with our capital lease transaction and exchange loss. The financial expenses for the three months ended June 30, 2014, decreased by $13,036 to $479,058 from $492,094 for the same period of 2013, which was mainly due to the decreased interest expense related to bank loans and discounted bank and trade acceptance notes. Income Tax The Joint Venture is registered in the PRC, and is therefore subject to state and local income taxes within the PRC at the applicable tax rate on the taxable income as reported in the PRC statutory financial statements in accordance

with relevant income tax laws. The Company increased its investment in the Joint Venture as a result of its financing in December, 2006. In accordance with the Income Tax Law of the People's Republic of China on Foreign-invested Enterprises and Foreign Enterprises, the Joint Venture was eligible for additional preferential tax treatment for the years 2007 and 2008. In those years, the Joint Venture was entitled to an income tax exemption on all pre-tax income generated by the Company above its pre-tax income generated in the year 2006. This tax exemption was superseded as a result of the Joint Venture having been awarded the "High-Tech Enterprise" certificate by the Chinese government. The High-Tech Enterprise certificate is valid for three years and provides for a reduced tax rate for years 2009 through 2011. The Company used a tax rate of 25% for the first three quarters of 2012. In December 2012, the Joint Venture passed the re-assessment of the High-Tech Enterprise certificate by the government, according to the relevant PRC income tax laws. Accordingly, it continues to be taxed at a 15% rate in 2012 through 2014. Income tax expense was $651,210 for the three months ended June 30, 2014, as compared to $539,334 for the three months ended June 30, 2013. The increase was mainly due to increased pre-tax income.



Net Income Attributable to Non-Controlling Interest in Subsidiaries

Noncontrolling interest in subsidiaries represents a 10% noncontrolling interest in Ruian and 40% noncontrolling interest in SIH, in each case held by our Joint Venture partners. Net income attributable to noncontrolling interest in subsidiaries amounted to $447,621 and $512,138 for the second fiscal quarter ended June 30, 2014 and 2013, respectively.



Net Income Attributable to Stockholders

The net income attributable to stockholders for the fiscal quarter ended June 30, 2014, increased by $97,682, to $4,132,474 from $4,034,792 for the fiscal quarter ended June 30, 2013 due to increased net income, which was caused by increased sales. The main factors contributing to our sales increase in the fiscal quarter ended June 30, 2014 include expansion of our portfolio of products and our adoption of product promotion strategy. Earnings per share ("EPS"), both basic and diluted, for the fiscal quarter ended June 30, 2014

and 2013, were both $0.21. 22



Results of operations for the six months ended June 30, 2014 as compared to the six months ended June 30, 2013.

Sales Six months ended Six months ended June 30, 2014June 30, 2013 (U.S. dollars in millions)

Commercial Vehicle Brake Systems $ 93.9 81.2 % $ 80.9 81.9 % Passenger Vehicle Brake Systems $ 21.8 18.8 % $ 17.9

18.1 % Total $ 115.7 100.0 % $ 98.8 100.0 % Net sales were $115,717,035 and $98,829,164 for the six months ended June 30, 2014 and 2013, respectively, an increase of $16.9 million or 17.1%. The increase was due to the increased sales to China market and international market. The sales from Commercial Vehicle Brake Systems increased by $13.0 million or 16.1%, to $93.9 million for the six months ended June 30, 2014, compared to $80.9 million for the same period of 2013. Due to the recovery of the commercial vehicle market in the six months ended June 30, 2014, the sales from the OEM market increased, which impacted the sales of the Commercial Vehicle Brake Systems. The sales from Passenger Vehicle Brake Systems increased by $3.9 million or 21.8%, to $21.8 million for the six months ended June 30, 2014, compared to $17.9 million for the same period of 2013. The increase was mainly due to the increase of the passenger vehicle sales in China in the first six months of 2014, which was increased by 11.2% to 9.63 million units from 8.67 million units for the same period last year.



A breakdown of net sales revenues for China OEM markets, China aftermarket and international market for the six months ended June 30, 2014 and 2013, respectively, is set forth below:

Six Percent months Percent Six months of ended of ended Total June 30, Total Percentage June 30, 2014 Sales 2013 Sales Change (U.S. dollars in million) China OEM market $ 60.5 52.3 % $ 53.4 54.0 % 13.3 % China Aftermarket $ 25.9 22.4 % $ 22.0 22.3 % 17.7 % International market $ 29.3 25.3 % $ 23.4 23.7 % 25.2 % Total $ 115.7 100.0 % $ 98.8 100.0 % 17.1 % Considering the decline of the production and sales of the commercial vehicles in the six months of 2014 in the automobile industry, the OEM manufacturers were facing higher pressure from market this year. Therefore, they paid more attention to the quality and cost controls. Compared with some smaller auto parts manufacturers, we had better quality and cost controls on our products. As a result, our sales to the China OEM market increased by 13.3% from the six months ended June 30, 2014, to $60.5 million. Our sales to the China aftermarket increased by $3.9 million or 17.7%, to $25.9 million for the six months ended June 30, 2014, compared to $22.0 million for the same period of 2013. The reasons of the increase are: (1) Our large portfolio of products, with more new products for the aftermarket provides us with a competitive advantage, enabling us to further penetrate and capture additional share in this segment; (2) To increase our market share, we did product promotion (price adjustment) in the second fiscal quarter of 2014; and (3) Accelerated urbanization and the Chinese government's increased support for public transportation favor our expansion in the bus aftermarket. We will continue with our strategies to further optimize our sales network and to help further penetrate into new markets. 23 Our export sales increased by $5.9 million or 25.2%, to $29.3 million for the six months ended June 30, 2014, as compared to $23.4 million for the same period of 2013. A part of our strategy is to strengthen and extend our distribution networks to increase our exposure with end users. The increase in export sales was mainly due to our broadened customer base.



Cost of Sales and Gross Profit

Cost of sales for the six months ended June 30, 2014 were $81,816,214, an increase of $12,032,972 or 17.2% from $69,783,242 for the same period last year. Our gross profit increased by 16.7% from $29,045,922 for the six months ended June 30, 2013 to $33,900,821 for the same period of 2014. Gross margin decreased to 29.4% from 29.5% for the six months ended June 30, 2014, as compared with the same period of 2013. One of the reasons of the decrease is that, to strengthen our competitiveness and increase our market share, we started the price promotion in the aftermarket in the second fiscal quarter of 2014. The increased labor cost also decreased our gross margin for the six month period ended June 30, 2014. We intend to focus in 2014 on increasing production efficiency, improving the technologies of products, and improving our product portfolio, to help us to maintain or increase our gross profit margins. Cost of sales from Commercial Vehicle Brake Systems for the six months ended June 30, 2014 were $66.4 million, an increase of $9.3 million or 16.3% from $57.1 million for the same period of 2013. The gross profit from Commercial Vehicle Brake Systems increased by 15.5% from $23.8 million for the six months ended June 30, 2013 to $27.5 for the same period of 2014. Gross margin from Commercial Vehicle Brake Systems decreased to 29.3% from 29.4% for the six months ended June 30, 2014 compared with the same period of 2013. Cost of sales from Passenger Vehicle Brake Systems for the six months ended June 30, 2014 were $15.4 million, an increase of $2.7 million or 21.3% from $12.7 million for the same period of 2013. The gross profit from Passenger Vehicle Brake Systems increased by 23.1% from $5.2 for the six months ended June 30, 2013 to $6.4 for the same period of 2014. Gross margin from Passenger Vehicle Brake Systems increased to 29.4% from 29.1% for the six months ended June 30, 2014, as compared with the same period in 2013.



Selling and Distribution Expenses

Selling and distribution expenses were $12,178,605 for the six months ended June 30, 2014, as compared to $9,319,843 for the same period of 2013, an increase of $2,858,762 or 30.7%. The increase was mainly due to increased freight expense and packaging expenses. As a percentage of sales revenue, selling expenses increased to 10.5% for the six months ended June 30, 2014, as compared to 9.4% for the same period in 2013.



General and Administrative Expenses

General and administrative expenses were $9,027,028 for the six months ended June 30, 2014, as compared to $9,383,277 for the same period of 2013, a decrease of $356,249 or 3.8%. The decrease was mainly due to the decrease in allowance for doubtful accounts. In the second fiscal quarter of 2014, as compared to the same period in 2013, our allowance for doubtful accounts decreased, because we had less overdue account receivables. As a percentage of sales revenue, general and administrative expenses decreased to 7.8% for the six months ended June 30, 2014, as compared to 8.1% for the same period in 2013. 24



Research and Development Expenses

Research and development expenses include payroll, employee benefits, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development costs. For the six months ended June 30, 2014, research and development expenses were $3,691,757, as compared to $3,007,611 for the same period of 2013, an increase of $684,146. Other Operating Income

Other operating income was $925,262 for the six months ended June 30, 2014, as compared to $835,892 for the six months ended June 30, 2013, an increase of $89,370. The increase was mainly due to an increase in sales of raw material scrap for the six months ended June 30, 2014.



Depreciation and Amortization

Depreciation and amortization expenses increased to $3,732,381 for the six months ended June 30, 2014, compared with that of $3,625,115 for the same period of 2013, an increase of $107,266. The increase in depreciation and amortization expenses was primarily due to the purchase of production equipment. Financial Expenses Financial expenses mainly consist of interest expenses, the financing expense associated with our capital lease transaction and exchange losses. The financial expenses for the six months ended June 30, 2014, decreased by $299,397 to $1,138,941 from $1,438,338 for the same period of 2013, which was mainly due to decreased exchange losses and interest expense. Income Tax The Joint Venture is registered in the PRC, and is therefore subject to state and local income taxes within the PRC at the applicable tax rate on the taxable income as reported in the PRC statutory financial statements in accordance

with relevant income tax laws. The Company increased its investment in the Joint Venture as a result of its financing in December, 2006. In accordance with the Income Tax Law of the People's Republic of China on Foreign-invested Enterprises and Foreign Enterprises, the Joint Venture was eligible for additional preferential tax treatment for the years 2007 and 2008. In those years, the Joint Venture was entitled to an income tax exemption on all pre-tax income generated by the Company above its pre-tax income generated in the year 2006. This tax exemption was superseded as a result of the Joint Venture having been awarded the "High-Tech Enterprise" certificate by the Chinese government. The High-Tech Enterprise certificate is valid for three years and provides for a reduced tax rate for years 2009 through 2011. The Company used a tax rate of 25% for the first three quarters of 2012. In December 2012, the Joint Venture passed the re-assessment of the High-Tech Enterprise certificate by the government, according to the relevant PRC income tax laws. Accordingly, it continues to be taxed at a 15% rate in 2012 through 2014. Income tax expense was $1,164,445 for the six months ended June 30, 2014, as compared to $708,188 for the six months ended June 30, 2013. The increase was mainly due to increased pre-tax income.



Net Income Attributable to Non-Controlling Interest in Subsidiaries

Non-controlling interest in subsidiaries represents a 10% non-controlling interest in Ruian and 40% non-controlling interest in SIH. Each of the non-controlling interest is held by our Joint Venture partners. Net income attributable to non-controlling interest in subsidiaries amounted to $740,818 and $652,438 for the six months ended June 30, 2014 and 2013, respectively.

25



Net Income Attributable to Stockholders

The net income attributable to stockholders for the six months ended June 30, 2014, increased by $1,634,606, to $6,902,777 from $5,268,171 for the six months ended June 30, 2013 due to increased net income, which was caused by increased sales. The main factors contributing to our sales increase in the six months ended June 30, 2014 include expansion of our portfolio of products and our adoption of product promotion strategy. Earnings per share ("EPS"), both basic and diluted, for the six months ended June 30, 2014 and 2013, were $0.36 and $0.27, respectively. FINANCIAL CONDITION



Liquidity and Capital Resources

As of June 30, 2014, the Company had cash and cash equivalents of $27,020,085, as compared to cash and cash equivalents of $28,241,983 as of December 31, 2013. The Company had working capital of $155,521,961 at June 30, 2014, as compared to working capital of $144,658,883 at December 31, 2013, reflecting current ratios of 3.79:1 and 4.13:1, respectively. OPERATING - Net cash used in operating activities was $4,379,173 for six months ended June 30, 2014 a decrease of $5,378,556, as compared with $999,383 of net cash provided by operating activities in the same period in 2013. Such decrease was primarily due to the increased cash outflow resulted by changes in accounts receivable.

INVESTING - During the six months ended June 30, 2014, the Company expended net cash of $2,008,225 in investing activities mainly for acquisition of new equipment to support the growth of the business. For the six months ended June 30, 2013, the Company expended net cash of $2,219,689 in investing activities. FINANCING - During the six month period ended June 30, 2014, the cash provided by financing activities was $4,540,724. Cash used in financing activities was $2,749,989 for the six months ended June 30, 2013. The Company has taken a number of steps to improve the management of its cash flow. We place more emphasis on collection of accounts receivable from our customers. We maintain good relationships with local banks. We believe that our current cash and cash equivalents and anticipated cash flow generated from operations and our bank lines of credit will be sufficient to finance our working capital requirements for the foreseeable future.



OFF-BALANCE SHEET ARRANGEMENTS

As of June 30, 2014, we did not have any material commitments for capital expenditures or have any transactions, obligations or relationships that could be considered off-balance sheet arrangements.

According to the laws of China, the government owns all the land in China. Companies and individuals are authorized to possess and use the land only through land use rights granted by the Chinese government. The Company purchased the land use rights from the Ruili Group, a related party. The Company also purchased a building on the land in the same transaction. The purchase price of land use right and building amounted to approximately $20 million. The Company has been negotiating with the government for a reduction in or exemption from the tax being sought by the government in connection with the transfer of the land use rights. Because of the change in personnel of the local government, there is no new development of negotiations regarding taxes related to the land use rights. Due to the lack of resolution of that issue, the land use right certificate and the property ownership certificate have not been issued to the Company. There is no assurance that we can conclude the negotiations with the government and obtain a favorable result. We plan to conclude negotiations with the government and to obtain the land use rights certificate as soon as practicable. 26



Even if the Company is unable to timely resolve obtain the land use right certificate for the land and related building, there will be no potential adverse implication on the Company for the following reasons.

1. The Company acquired the land use rights in a transaction between the Company and Ruili Group, a related party. Ruili Group, as the original land use right owner, has granted the land use right to the Company by contract which is supported by valid consideration. 2. No third party would oppose the Company's use of the land, because no third party has any interest in the land use right or property ownership right, other than the Ruili Group and the government.



a) The Ruili Group promised that the Company has the right to use the land and related building, even before the land use certificate is transferred.

b) According to the laws of China, the government owns all the land and the buildings attached to the land in China. Once the land use right is granted to Ruili Group, Ruili Group has the right to assign its land use rights to any third parties, including the Company, without interference from the government. Therefore, it is unlikely for the government to oppose the Company's right to use the land and related building. c) The Company has made tax payments in full to the local government as if no reduction or exemption of tax is approved. Therefore, even if the reduction in tax request is rejected, the Company would not be liable for a substantial amount of taxes to the local government.


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