In addition to the projects set forth in the table above, we commenced clinical trials or efficacy, acute and long-term toxicity testing on several other projects.  We expect to complete testing and/or trials for these projects between 2012 and 2014 at an estimated cost of $600,000 to $1,000,000 per project.

 

Total research and development expenses in fiscal 2009 were $14,960,000.  The above listed projects comprise 75.6% of our total research and development expenses in fiscal 2009.  The other projects and miscellaneous materials make up the remaining 24.2% of total research and development expenses for the year.

 

Cord Blood Stem Cell Bank

 

In 2006, we began implementing a plan to establish a cord blood stem cell bank in the PRC, for the treatment of various diseases such as leukemia, lymphoma and rebirth anemia.  On October 16, 2006, the Health Department of Heilongjiang Province granted us, through Tian Qing, the exclusive right and license to become engaged in tissue and stem cell bank activities in Heilongjiang Province, PRC, through December 2010.  Since the development of this project will require substantial managerial, technical and financial resources, and a number of significant risks, management is still evaluating the proper timing and strategy in launching this project.

 

Sales Approach

 

Over the past several years, we have continuously expanded our distribution channels for our products.   As a result, we have established a sales network covering 24 provinces of mainland China, and have positioned sales managers and representatives in each of these markets.

 

In fiscal 2007, our sales model was focused on the creation of our own distribution channels.  Therefore, we sold products directly to many small distributors and retail store locations.  Commencing in fiscal 2008, we changed our business model and entered into distribution agreements with larger regional sales agents, who resell to smaller distributors and retail store locations.  In addition, we entered into contracts with nationwide chain pharmacies.  These changes to our product distribution channels resulted in our direct customer base decreasing from 943 customers at December 31, 2007 to 212 customers at December 31, 2009.  Our change in sales strategy is further described in “Customers and Distribution” below.

 

We also managed to establish a marketing network through independent agents to develop an international market for our products.  At present, our primary initial growth focus remains in the PRC.  However, part of our sales strategy is to expand our sales outside of the PRC.  Overseas sales accounted for approximately 7.8%, 8.2% and 25.2% of sales revenue for the fiscal years ended December 31, 2009, 2008 and 2007, respectively.

 

Materials and Suppliers

 

We employ purchasing staff with extensive knowledge of our products, who work with our marketing, product development, and formulations and quality control personnel to source raw materials for our products and other items.  Raw materials are sourced principally in the PRC, and are generally available from a variety of suppliers.  Harbin Zhong Jia Medicine Company and Heilongjiang Kangda Medicine Company accounted for approximately 16% and 42% of our total inventory purchases for the year ended December 31, 2009, respectively.  Heilongjiang Kangda Medicine Company accounted for approximately 33% of our total inventory purchases for the year ended December 31, 2008.  Harbin Yong Heng accounted for 23% of our total inventory purchases for the year ended December 31, 2007.  No other suppliers accounted for 10% or more of our total inventory purchases in 2009, 2008, and 2007.

 

We seek to mitigate the risk of a shortage of raw materials, through identification of alternative suppliers for the same or similar raw materials, where available.  We believe raw materials are available through alternative suppliers in the market place, if necessary.  We manufacture bulk branded products to allow more extensive vertical integration and to improve the quality and consistency of raw materials.

 

Historically, we have signed agreements with suppliers that allowed us to hold extra raw materials at the cost of the suppliers.  As a result, we could minimize our own inventory carrying costs, and improve our cash management, by keeping the inventory at the minimum level required to support our short-term sales.  However, due to price increases for raw materials, and the related overhead costs for storing such raw materials, we started to increase our inventory levels toward the second half of 2009.  In anticipation of continued price increases, management may further increase our inventory levels in fiscal 2010.

 

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Customers and Distribution

 

In fiscal 2007, our sales model was focused on the creation of our own distribution channels. Therefore, we sold products directly to many small distributors and retail store locations.  In fiscal 2008, we changed our business model and entered into distribution agreements with larger regional sales agents, who resell to smaller distributors and retail store locations.  In addition, we entered into contracts with nationwide chain pharmacies. Through the extensive sales networks, of these nationwide chains, we were able to reach all major metropolitan areas throughout the PRC. These changes to our product distribution channels resulted in our direct customer base decreasing from 943 customers at December 31, 2007 to 233 customers (not including branches of retail and drug supply chains) at December 31, 2008.  As of December 31, 2009, we had 212 customers, not including branches of retail and drug supply chains.

 

The change in our sales strategy, which began in fiscal 2008, was initiated to improve product channel efficiencies, and to give us access to an increased number of ultimate purchasers.  We believe that these changes will continue to lead to increased revenue by extending the reach of our distribution network.  By reducing the number of customers we sell to directly, we have streamlined our accounts receivable management and collection and reduced channel distribution costs.  These favorable cost variances have been partially offset by product price incentives we grant to the larger agents with which we have contracted.

 

For the year ended December 31, 2009, sales to Harbin Shiji Baolong Medicine Company and Shanxi Xintai Medicine Company accounted for approximately 16% and 11% of total revenues, respectively.  Harbin Bao Da Medicine Company and Harbin Shiji Baolong Medicine Company accounted for approximately 16% and 14% of our accounts receivable in 2009, respectively.  For the year ended December 31, 2008, sales to Shanxi Xintai and Harbin Shiji Baolong accounted for 15% and 12% of our total revenues, respectively.  Harbin Shiji Baolong and Shanxi Xintai accounted for approximately 29% and 11% of our accounts receivable in 2008, respectively.  For the year ended December 31, 2007, sales to Ning BoYue Hua Trading Company and Guang Zhou Xing He Trading Company accounted for approximately 14% and 11% of our total revenues, respectively.  Hua Li Jiu Zhou Company accounted for approximately 11% of our accounts receivable in 2007.  No other customers accounted for 10% or more of our total revenues or accounts receivable in 2009, 2008, and 2007.

 

In 2009, we implemented various initiatives toward promoting and marketing our products.  Our advertising costs for the fiscal years ended December 31, 2009, 2008, and 2007 were approximately are $14,527,000, $7,299,000 and $4,385,000, respectively.

 

We will continue efforts to expand our markets into other provinces and larger cities in the PRC, and to other markets worldwide.  Currently, our products are sold primarily in the PRC.  In 2009, 2008 and 2007, approximately 92.2%, 91.8% and 74.8% of our revenues were from the sale of products in China, respectively. Part of our sales strategy is to expand our worldwide sales.  As a means of accelerating our distribution into other countries, we will seek to enter into strategic marketing arrangements with qualified firms that have distribution channels, brand name recognition, or other unique marketing strengths.

 

Competition

 

Competition in the TCM, pharmaceutical, and over-the-counter nutraceutical business is intense in China, and throughout the world.  We compete with various firms, many of which produce and market products similar to our products, and many of which have greater resources than us in terms of manufacturing and marketing capabilities, management expertise and breadth, and financial wherewithal.  Some of these competitors are far larger, have more resources then us and have stronger sales and distribution networks.

 

Our direct competitors are other domestic firms engaged in developing, manufacturing and marketing TCM and nutraceutical products.  There are many of these companies in the PRC, in Heilongjiang Province, and even in the city of Harbin.

 

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We expect that the competition for medicinal products in the PRC and other world markets will become more intense over the next few years, both from existing competitors, and new market entrants.  We will also face competition from foreign companies who may have established products, a strong proprietary pipeline and strong financial resources.  Our management believes that we have certain competitive advantages in introducing new products to market due to key focus areas for development, our existing distribution channels, research and development capabilities and our relationship with certain universities and other research institutions.  However, there can be no assurance that we will be able to compete and continue to grow in this highly competitive environment.  Additional information relating to competition in the PRC can be found in the “Risk Factors” section below.

 

Government Regulation

 

Regulatory Environment

 

Our principal sales market is in the PRC.  We are subject to the Pharmaceutical Administrative Law of the PRC, which governs the licensing, manufacturing, marketing and distribution of pharmaceutical products in the PRC, and sets penalties for violations.  Our business is subject to various regulations and permit systems of the government of the PRC.  Additionally, we are subject to government licensing rights and regulations, which relate to our stem cell R&D license.  Permits we attain for TCM products are granted on a non-exclusive basis and are subject to periodical review for renewal.

 

The governmental approval process in the PRC for a newly developed health product can be lengthy and difficult.  A product sample is first sent to a clinical testing agent designated by the Ministry of Health, which conducts extensive clinical testing and examination of the product to verify if it has the specified functions as stated by the company producing the product.  A report will then be prepared and issued by the clinical testing agent confirming or negating such functions.  After submittal to the agency, it generally takes six months to one year for a report to be issued by the testing agent.  The report must then be submitted to a provincial Health Management Commission for approval.  Following this submittal, a letter of approval issued by such commission will be submitted to the Ministry of Health for the issuance of a certificate that authorizes sale and marketing of the product in the PRC.

 

This entire process will generally take between eighteen months and two years.  The approval process will depend to a certain extent on whether a specified product is a plant based pharmaceutical (“PBP”), or a plant based nutraceutical (“PBN”).  PBPs are products composed of herbs, roots and plants that do not use synthetic chemicals, with certain medicinal functions for treatment of one or more illnesses.  PBPs are generally prescription-based but in some cases may be sold over-the-counter.   PBNs, also frequently known as “dietary supplements” or “nutritional supplements,” are also composed of herbs, roots and plants, but are essentially prophylactic or preventive in nature.  All PBNs are available over-the-counter without a prescription.  In the PRC, PBPs require the approval of the SFDA, while PBNs only require the approval of state and local governments prior to manufacturing and sale.  Obtaining the approval from the SFDA is generally more complex and lengthy.

 

Because we and our subsidiaries are wholly-owned enterprises, we are subject to the law of foreign investment enterprises in the PRC, and the foreign company provisions of the Company Law of China, which governs the conduct of our wholly-owned subsidiaries and their officers and directors, and also limits our ability to pay dividends.

 

Compliance with Environmental Law

 

We comply with the Environmental Protection Law of the PRC, as well as applicable local regulations.  In addition to compliance with the PRC law and local regulations, we consistently undertake active efforts to ensure the environmental sustainability of our operations.  Because the manufacturing of herb and plant-based products does not generally cause significant damage or pollution to the environment, the cost of complying with applicable environmental laws is not material.  In the event we fail to comply with applicable laws, we may be subject to penalties.

 

Intellectual Property

 

We own certain SFDA licenses for drug batch numbers and other proprietary technologies.   Historically, we included our proprietary technologies and SFDA licenses for drug batch numbers within the category of patents.  We now believe it is more accurate to categorize such intellectual property as SFDA licenses for drug batch numbers and other proprietary technologies.

 

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As of December 31, 2009, our intellectual property breakdown by SFDA licenses for drug batch numbers and other proprietary technologies is as follows:

IPs  (Intangible Assets)		Year Acquired		Acquisition Cost $ in thousands				Reflected under Intangible Assets				Proprietary Technologies				Drug Batch Numbers
Endostatin		2006		$	1,727				Yes				Yes				-
SFDA licenses for drug batch numbers		2008		$	6,848				Yes				-				Yes
Monoclonal Antibody		2008		$	5,106				Yes				Yes				-
Breast Cancer Technology		2008		$	1,459				Yes				Yes				-
Antroquinonol		2009		$	5,119				Yes				Yes				-
Small RNAs Technology		2009		$	5,850				Yes				Yes				-

We purchased the rights to the patents for Endostatin and Antroquinonol, which are registered under the names of Harbin Medical University and Taiwan Golden Biotechnology Corporation, respectively.

 

We have acquired certain additional proprietary technologies from non-related third parties.  The fair value of these proprietary technologies recorded in our financial statements are appraised periodically and amortized during its useful life.

 

As of the date of this filing, we own two registered patents for product packaging.  As of December 31, 2009, these patents have nominal carrying values.

 

Under the PRC’s State Protection Law, certain herbal medicine products, which have received approval from the SFDA, have automatic protection.  SFDA licenses for drug batch numbers we acquired in connection with our acquisitions of Tianlong and Peng Lai in fiscal 2008 have been recorded as part of our intangible assets.  We did not appraise or assign any value to the SFDA licenses for drug batch numbers developed internally by TDR or First.

 

We have registered “Kang Xi” as our trademark, which is used for all of our TCM products.   The “Kang Xi” trademark was developed internally and registered by TDR before we became a public company.  Our cost basis in the trademark is nominal.

 

Employees

 

The number of our employees has increased due to growth, increased research and development activities and expanded marketing and distribution efforts for our products.  Our employees generally fall into the following categories:

 

By subsidiary company:

 

		Number of Employees
Company		2009				2008
TDR			1,315				1,515
Tian Qing			0				0
First			107				97
Tianlong			207				97
Haina			399				24
Peng Lai			126				71
TOTAL:			2,154				1,804

 

 

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By nature of job:

 

		Number of Employees
Type of Job		2009				2008
Executives and managers			201				146
Production and clerical			424				359
Sales and marketing			1,491				1,261
Research and development, technology			38				38
TOTAL:			2,154				1,804

 

As of December 31, 2008, we had 1,804 full-time employees.  Our 2,154 employees, as of December 31, 2009, includes both 305 full time employees and 1,849 individuals hired on a contract basis through agencies.  In 2009, we began hiring certain employees on a contract basis, in order to take advantage of cost efficiencies.

 

We do not have any employment agreements in place with our executive officers.  None of the employees are covered by a collective bargaining agreement, however, we believe our relationship with employees is good.

 

Available Information

 

We file various reports with the SEC, including Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on From 8-K, which are available though the SEC’s electronic data gathering, analysis and retrieval system by accessing the SEC’s home page (http://www.sec.gov). The documents are also available to be read or copied at the SEC’s Public Reference Room located at 100 F Street, NE, Washington, D.C., 20549. Information on the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330.

 

We also make available free of charge through our website (www.cski.com.cn) our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and, if applicable, amendments to those reports filed or furnished pursuant to the Exchange Act as soon as reasonably practicable after we electronically file such material with, or furnishes it to, the SEC.

 

 

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Item 1A.  Risk Factors.

 

We are subject to certain risks and uncertainties as described below.  These risks and uncertainties may not be the only ones we face.  There may be additional risks that we do not presently know of, or that we currently consider immaterial.  All of these risks could adversely affect our business, financial condition, results of operations and cash flows.  Our business and operations may be adversely affected if any of such risks are realized.  All investors should consider the following risk factors before deciding to purchase or sell our securities.

 

Risks Related to Our Business

 

Adverse economic conditions may harm our business.

 

In 2008, general worldwide economic conditions declined due to sequential effects of the sub prime lending crisis, general credit market crisis, collateral effects on the finance and banking industries, concerns about inflation, slower economic activity, decreased consumer confidence, reduced corporate profits and capital spending, adverse business conditions and liquidity concerns.  This global economic downturn poses a risk as consumers and businesses may postpone spending, or seek new ways to eliminate spending, in response to these uncertain and challenging economic conditions.  In addition, there could be a number of follow-on effects including foreign currency exchange rate fluctuations, insolvency of key suppliers and customer insolvencies.  We cannot predict the timing or duration of any economic slowdown or recession or the timing or strength of a subsequent recovery, worldwide, or in the specific markets we serve.  If the markets for our products significantly deteriorate due to these economic effects, our business, financial condition and results of operations may be materially and adversely affected.

 

Certain officers and directors have significant control over our company.

 

Liu Yan-qing and Han Xiao-yan, who are officers and directors of ours, also serve as officers and directors of ACPG, TDR and its subsidiaries.  As of the date hereof, Dr. Liu and Ms. Han own, in the aggregate, approximately 36.5% of the issued and outstanding shares of our common stock.  As a result, these shareholders are effectively able to control certain corporate governance matters requiring shareholders’ approval.  Such matters may include transactions in which they have an interest other than as a shareholder of ours, the approval of significant corporate transactions such as increasing the authorized number of our shares to complete acquisitions or raise capital, if necessary, and any other transactions requiring a majority vote without seeking other shareholders’ approval.  These persons also have the ability to control other matters requiring shareholder approval including our election of directors which could result in the entrenchment of management.

 

We depend on our key management personnel and the loss of their services could adversely affect our business.

 

We place substantial reliance upon the efforts and abilities of our executive officers, Liu Yan-qing, President, Chief Executive Officer and Chairman of the Board, Han Xiao-yan, Vice Chairman, and Stanley Hao, Chief Financial Officer and Secretary.  We do not have employment agreements with these members of management.  Accordingly, if any of these persons should leave the company, we would have no remedy or protections in place and would not be able to prevent them from competing with us or working for competitors.  The loss of the services of any of these executive officers could have a material adverse effect on our business, operations, revenues or prospects.  In addition, we do not maintain key man life insurance on the lives of these individuals.

 

Our expansion plan may not be successful.

 

Part of our strategy is to continue our growth through increasing the distribution and sales of our products by penetrating existing markets in the PRC, and entering new geographic markets in the PRC as well as Asia, the United States and other countries. However, many obstacles to entering such new markets exist, including, but not limited to, international trade and tariff barriers, regulatory constraints, product liability concerns, shipping and delivery costs, costs associated with marketing efforts abroad and maintaining attractive foreign exchange ratios.  Moreover, our expansion strategy may be based on incorrect assumptions and may be flawed, and may even damage our performance, competitive position in the market and, ultimately, even our ability to survive in the marketplace.  We cannot, therefore, assure shareholders that we will be able to successfully overcome such obstacles and establish our products in any additional markets.  Our inability to implement this growth strategy successfully may have a negative impact on our growth, future financial condition, results of operations or cash flows.

 

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There are many safety risks involved in our products and services that could expose us to liability or inhibit our ability to secure insurance.

 

Our products and services involve direct or indirect impact on human health and life.  The products we manufacture and sell may be flawed and cause dangerous side effects, and even fatality in certain cases, leading to major business losses and legal and other liabilities and damages to our company.  In the event that any of our products are alleged to have adverse side effects, we could be subject to product liability claims.  In addition to the threat of liability, there may be insurance costs if we enter into certain markets or may not be able to obtain insurance for certain products in some countries.  Some distributors may refuse to sell our products in certain countries if they perceive such products to have a high risk or to be uninsurable.

 

We do not maintain any insurance and are exposed to all risks of loss, including resulting from product liability, property loss or damages, or other harm that we may cause to customers, vendors, suppliers and other third parties, or securities law claims.

 

We do not maintain liability or property insurance coverage or director and officer insurance coverage and, therefore, we are self-insured for all risks of loss.  Although we seek to reduce potential liability through measures such as contractual indemnification provisions with distributors and suppliers, we cannot assure you that such measures will be enforced or effective.  Our policy is to record losses associated with our lack of insurance coverage at such time as realized loss is incurred. Historically, we have not had any material losses in connection with our lack of insurance coverage and are not party to any material pending legal proceedings as of the date of this report.  Management’s intention is to use our working capital to fund any such losses incurred due to our exposure to inadequate insurance coverage.  Our operating results could be materially and adversely affected if we were to pay significant damages or incur significant defense costs in connection with a claim.

 

We are highly dependent upon the public perception and quality of our products.  Additionally, anti-corruption measures taken by the government to correct corruptive practices in the pharmaceutical industry could adversely affect our sales and reputation.

 

We are highly dependent upon consumers’ perception of the safety and quality of our products as well as similar products distributed by other companies.  Thus, the mere publication of reports asserting that such products may be harmful could have a material adverse effect on our business, regardless of whether these reports are scientifically supported.

 

The PRC government has recently taken anti-corruption measures to correct corrupt practices.  In the pharmaceutical industry, such practices include, among other things, acceptance of kickbacks, bribery or other illegal gains or benefits by the hospitals and medical practitioners from pharmaceutical distributors in connection with the prescription of a certain drug.  Substantially all of our sales to our ultimate customers are conducted through third-party distributors.  We have no control over our third-party distributors, who may engage in corrupt practices to promote our products.  While we maintain strict anti-corruption policies applicable to our internal sales force and third-party distributors, these policies may not be effective.  If any of our third-party distributors engage in such practices and the government takes enforcement action, our products may be seized and our own practices, and involvement in the distributors’ practices may be investigated.  If this occurs, our sales and reputation may be materially and adversely affected.

 

Our success will depend on our research and the ability to develop new products.

 

Our growth depends on our ability to consistently discover, develop and commercialize new products, and find new and improve on existing technologies, platforms and products.  As such, if we fail to make sufficient investments in research, to be attentive to consumer needs, or fail to focus on the most advanced technologies, our current and future products could be surpassed by more effective or advanced products of other companies.

 

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We currently rely on third parties to supply the key raw materials we use to produce our products.

 

Our business depends upon the availability of key raw materials.  We rely on only external suppliers for these raw materials.  In fiscal year 2009, Harbin Zhong Jia Medicine Company and Heilongjiang Kangda Medicine Company accounted for approximately 16% and 42% of our total inventory purchases, respectively.  Heilongjiang Kangda Medicine Company accounted for approximately 33% of our total inventory purchases for the year ended December 31, 2008.  For the 2010 fiscal year, we expect that our raw material suppliers will be substantially similar to last year and the amount of raw materials will increase commensurate with the increase in the demand of our products.  If any of our major suppliers were to default or become unable to deliver the raw materials in sufficient quantities, we may be unable to purchase these raw materials from alternative sources on the same or similar terms, which could result in a significant decrease in our operating costs.  In addition, any disruption in the supply of our raw materials could cause delay in the delivery of our products which would be harmful to our sales reputation and business.  If supply is disrupted the increased amount we have to pay for raw materials could negatively impact our margins, cause us to cease production if an alternate supplier cannot be found.  If we are unable to procure replacement supplies, our ability to meet the production demands of our customers could cause the loss of costumers and/or market share.  Our financial results could be negatively impacted by the lost sales or decreased margins.

 

We are dependent on a limited number of customers for a significant portion of our revenues and accounts receivable and this dependence is likely to continue.

 

We have been dependent on a limited number of customers for a significant portion of our revenue.  For the year ended December 31, 2009, sales to Harbin Shiji Baolong Medicine Company and Shanxi Xintai Medicine Company accounted for approximately 16% and 11% of total revenues, respectively.  For the year ended December 31, 2008, sales to Shanxi Xintai and Harbin Shiji Baolong accounted for 15% and 12% of our total revenues, respectively.  For the year ended December 31, 2007, sales to Ning BoYue Hua Trading Company and Guang Zhou Xing He Trading Company accounted for approximately 14% and 11% of our total revenues, respectively.  Dependence on a few customers could make it difficult to negotiate attractive prices for our products and could expose us to the risk of substantial losses if any such customer stops purchasing our products.  We expect that a limited number of customers will continue to contribute to a significant portion of our sales in the near future. Our ability to maintain close relationships with these top customers is essential to the growth and profitability of our business.  If we fail to sell our products to one or more of these top customers in any particular period, or if a large customer purchases fewer of our products, defers orders or fails to place additional orders with us, or if we fail to develop additional major customers, our revenue would likely decline and our results of operations would be adversely affected.

 

In addition, our accounts receivable are concentrated among a small number of our customers.  Harbin Bao Da Medicine Company and Harbin Shiji Baolong Medicine Company accounted for approximately 16% and 14% of our accounts receivable in 2009, respectively.  Harbin Shiji Baolong and Shanxi Xintai accounted for approximately 29% and 11% of our accounts receivable in 2008, respectively.  Hua Li Jiu Zhou Company accounted for approximately 11% of our accounts receivable in 2007. If any our customers fail to pay us on a timely basis, or do not pay us at all, our business, cash flow, financial condition and results of operations may be materially and adversely affected.

 

Significant competition from existing and new entities could adversely affect revenues and profitability.

 

We compete with other companies, many of which are developing and/or offering, or can be expected to develop and offer, products similar to ours.  Our market is a large market with many competitors.  Many of our competitors are more established than we are, and have significantly greater financial, technical, marketing and other resources than us.  Some of our competitors have greater name recognition and a larger customer base.  These competitors may be able to respond more quickly to new or changing opportunities and customer requirements and may be able to undertake more extensive promotional activities, offer more attractive terms to customers, and adopt more aggressive pricing policies.  We cannot assure investors that we will be able to compete effectively with current or future competitors or that the competitive pressures we face will not harm our business.

 

We are subject to market and channel risks.

 

In fiscal year 2009, over 92% of our sales were made in the PRC, where we primarily sell our products through drug chain stores.  Because of this, we are dependent to a large degree upon the success of our PRC-based distribution channel, as well as the success of specific retailers in the distribution channel.  We rely on these distribution channels to purchase, market, and sell our products.  Our success is dependent, to a large degree, on the growth and success of the drug stores, which may be outside our control.  There can be no assurance that the drug store distribution channels will be able to grow or prosper as they faces price and service pressure from other channels, including the mass market.  There can be no assurance that retailers in the drug store distribution channel, in the aggregate, will respond or continue to respond to our marketing commitment in these channels.

 

 

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We may have difficulty in defending intellectual property rights from infringement.

 

Our TCM products are generally not protected by patents but by trade secrets.  Certain TCM license agreements are made on a non-exclusive basis.  Our success depends, in large part, on our ability to protect current and future technologies and products and to defend our intellectual property rights.  If we fail to protect our intellectual property adequately, competitors may manufacture and market similar products.  We have filed patent applications seeking to protect newly developed and/or technologies.  Some patent applications in the PRC are maintained in secrecy until the patent is issued.  Because the publication of discoveries tends to follow their actual discovery by many months, we may not be the first to invent, or file patent applications on any of its discoveries.  Patents may not be issued with respect to any of our patent applications and existing or future patents issued to or licensed by us may not provide competitive advantages for its products.  Patents that are issued may be challenged, invalidated or circumvented by competitors.  Furthermore, our patent rights may not prevent our competitors from developing, using or commercializing products that are similar or functionally equivalent to our products.

 

To the extent that we market products in other countries, we may have to take additional action to protect our intellectual property.  The measures we take to protect our proprietary rights may be inadequate, and we cannot provide any assurance that our competitors will not independently develop formulations and processes that are substantially equivalent or superior to our products or copy our products.

 

We also rely on trade secrets, non-patented proprietary expertise and continuing technological innovation that we seek to protect, in part, by entering into confidentiality agreements with licensees, suppliers, employees and consultants.  These agreements may be breached and there may not be adequate remedies in the event of a breach.  Disputes may arise concerning the ownership of intellectual property or the applicability of confidentiality agreements.  Moreover, trade secrets and proprietary technologies may otherwise become known or be independently developed by competitors.  If patents are not issued with respect to products arising from research, we may not be able to maintain the confidentiality of information relating to these products.

 

We will be subject to risks relating to third parties that may claim that we infringe on their proprietary rights and may prevent us from manufacturing and selling certain of our products.

 

There has been substantial litigation in the pharmaceutical and nutraceutical industries with respect to the manufacturing, use and sale of new products.  These lawsuits relate to the validity and infringement of patents or proprietary rights of third parties.  We may be required to commence or defend against charges relating to the infringement of patent or proprietary rights.  Any such litigation could involve or result in:

 

·

the incurrence of substantial expense, even if we are successful in the litigation;

 

·

a diversion of significant time and effort of technical and management personnel;

 

·

the loss of our rights to develop or make certain products; and

 

·

the payment of substantial monetary damages or royalties in order to license proprietary rights from third parties.

 

Although patent and intellectual property disputes within these industries have often been settled through licensing or similar arrangements, costs associated with these arrangements may be substantial and could include the long-term payment of royalties.  These arrangements may be investigated by regulatory agencies and, if improper, may be invalidated.  Also, the required licenses may not be made available to us on acceptable terms.  Accordingly, an adverse determination in a judicial or administrative proceeding or a failure to obtain necessary licenses could prevent our company from manufacturing and selling some of our products or increase costs to market these products.

 

In addition, when seeking regulatory approval for some of our products, we are required to certify to regulatory authorities, including the SFDA that such products do not infringe upon third party patent rights.  Filing a certification against a patent gives the patent holder the right to bring a patent infringement lawsuit against us.  Any lawsuit would delay regulatory approval by the SFDA.  A claim of infringement and the resulting delay could result in substantial expenses and even prevent us from manufacturing and selling certain of our products.

 

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The launch of a product prior to a final court decision or the expiration of a patent held by a third party may result in substantial damages to us.  Depending upon the circumstances, a court may award the patent holder damages equal to three times their loss of income.  If we are found to infringe a patent held by a third party and become subject to such treble damages, these damages could have a material adverse effect on our results of operations and financial condition.

 

Our failure to comply with accounting policies and regulations in making reasonable estimates and judgments could negatively impact our financial position and results of operation.

 

We are subject to critical accounting policies and actual results may vary from estimates.  We have followed, and will continue to follow, generally accepted accounting principles for the United States in preparing financial statements.  As part of this work, we must make many estimates and judgments concerning future events.  These affect the value of the assets and liabilities, contingent assets and liabilities, and revenue and expenses reported in such financial statements.   We believe that these estimates and judgments are reasonable, and we have made them in accordance with accounting policies based on information available at the time.  However, actual results could differ from estimates, and this could require us to record adjustments to expenses or revenues that could be material to our financial position and results of operations in the future.

 

Our business is subject to many governmental regulatory and policy risks.

 

Our business must be conducted in compliance with various government regulations and in particular, the SFDA’s regulations.  Government regulations may have material impact on our operations, increase costs and could prevent or delay the manufacturing and selling of our products.  Research, development, testing, manufacturing and marketing activities are subject to various governmental regulations in China, including health and drug regulations.  Government regulations, among other things, cover the inspection of and controls over testing, manufacturing, safety and environmental considerations, efficacy, labeling, advertising, promotion, record keeping and sale and distribution of pharmaceutical products.  We will not be able to license, manufacture, sell and distribute the vast majority of our products without a proper approval from government agencies and in particular the SFDA.  This approval process is lengthy, with approvals for TCM products typically occurring 18-24 months after the application is initially filed.  There is no assurance that we will obtain such approvals on a timely basis, or at all.  Delays in obtaining approvals will delay our ability to market products and denial of approval for a specific product will result in our inability to market the product and recoup the expenses incurred in that products development and testing.

 

In addition, delays or rejections may be encountered based upon additional government regulation from future legislation, administrative action or changes in governmental policy and interpretation during the period of product development and product assessment.   Although we have, so far, obtained the rights to sell our products in the PRC, we may not continue to receive and maintain regulatory approvals for the sales of these products.  Our marketing activities are also subject to government regulations with respect to the prices that it intends to charge or any other marketing and promotional related activities.  Government regulations may substantially increase the costs for developing, licensing, manufacturing and selling products, impacting negatively our operations, revenue, income and cash flow.

 

There could be changes in government regulations towards the pharmaceutical and nutraceutical industries that may adversely affect our business.

 

The manufacture and sale of pharmaceutical and nutraceutical products in the PRC is heavily regulated by many state, provincial and local authorities.  These regulations significantly increased the difficulty and costs involved in obtaining and maintaining regulatory approvals for marketing new and existing products.  Our future growth and profitability depends to a large extent on our ability to obtain regulatory approvals.

 

The SFDA has implemented new guidelines for licensing of pharmaceutical products.  All existing manufacturers with licenses, which are currently valid under the previous guidelines, were required to apply for the GMP certifications by June 30, 2004, and to receive approvals by December 31, 2004.  We received certifications for our current products.  However, should we fail to maintain the GMP certifications under the new guidelines in the future, or for new products, our businesses would be materially and adversely affected.

 

Moreover, the laws and regulations regarding acquisitions of the pharmaceutical and nutraceutical industries in the PRC may also change and may significantly impact our ability to grow through acquisitions.

 

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We need to manage growth in operations to maximize our potential growth and achieve our expected revenues.

 

Our success depends on our ability to achieve continued growth.  In order to maximize potential growth in current and potential markets, we believe that we must expand our manufacturing and marketing operations.  This expansion will place a significant strain on management and operational, accounting and information systems and will require substantial additional capital.  We will need to continue to improve financial controls, operating procedures, and management information systems if and as we grow.  We will also need to effectively train, motivate, and manage our employees.  A failure to manage our growth could disrupt operations and ultimately prevent us from generating the revenues we expect.

 

International operations require our company to comply with a number of U.S. and international regulations.

 

We are required to comply with a number of international regulations in countries outside of the United States.  In addition, we must comply with the Foreign Corrupt Practices Act, or FCPA, which prohibits U.S. companies or their agents and employees from providing anything of value to a foreign official for the purposes of influencing any act or decision of these individuals in their official capacity to help obtain or retain business, direct business to any person or corporate entity or obtain any unfair advantage.  Any failure to adopt appropriate compliance procedures and ensure that our employees and agents comply with the FCPA and applicable laws and regulations in foreign jurisdictions could result in substantial penalties and/or restrictions in our ability to conduct business in certain foreign jurisdictions.  The U.S. Department of The Treasury’s Office of Foreign Asset Control, or OFAC, administers and enforces economic and trade sanctions against targeted foreign countries, entities and individuals based on U.S. foreign policy and national security goals.  As a result, we are restricted from entering into transactions with certain targeted foreign countries, entities and individuals except as permitted by OFAC which may reduce our future growth.

 

We may incur significant costs to ensure compliance with U.S. corporate governance and accounting requirements.

 

We are a public reporting company, and, as such, we will incur significant costs associated with public company reporting requirements, costs associated with newly applicable corporate governance requirements, including requirements under the Sarbanes-Oxley Act of 2002 and other rules implemented by the U.S. Securities and Exchange Commission (“SEC”). All of these applicable rules and regulations can be expected to increase legal and financial compliance costs and to make some activities more time consuming and costly.  Management also expects that these applicable rules and regulations may make it more difficult and more expensive to obtain director and officer liability insurance and we may be required to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage.  As a result, it may be more difficult for us to attract and retain qualified individuals to serve on our board of directors or as executive officers.

 

We may have difficulty raising necessary capital to fund operations as a result of market price volatility for our shares of common stock.

 

In recent years, the securities markets in the U.S. have experienced a high level of price and volume volatility, and the market price of securities of many companies have experienced wide fluctuations that have not necessarily been related to the operations, performances, underlying asset values or prospects of such companies.  For these reasons, our shares of common stock can also be expected to be subject to volatility resulting from purely market forces over which we will have no control.  If our business development plans are successful, we may require additional financing to continue to develop and exploit existing and new technologies and to expand into new markets.  The exploitation of existing and new technologies may, therefore, be dependent upon our ability to obtain financing through debt and equity or other means.

 

We are obligated to indemnify our officers and directors for certain losses they suffer.

 

To the fullest extent permitted by Chapter 78 of the Nevada Revised Statues, we may, if and to the extent authorized by our board of directors, indemnify our officers and any other persons who we have power to indemnify against liability, reasonable expense or other matter whatsoever.  If we are required to indemnify any persons under this policy, we may have to pay indemnity in a substantial amount which we may be unable to recover at all.

 

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Risks Related to Doing Business in China

 

Our business will be affected by the government regulation and Chinese economic environment because most of our sales will be in the China market.

 

In 2009, 2008, and 2007, approximately 92%, 92% and 75% of our total revenues, respectively, were from sales in the PRC.  The manufacture and sale of pharmaceutical products in China is heavily regulated by many state, provincial and local authorities.  The SFDA requires pharmaceutical manufacturers to obtain GMP certifications.  We currently have the certifications needed for our current operations.  However, should we fail to receive or maintain the GMP certifications in the future, we would no longer be able to manufacture pharmaceuticals in China, and our businesses would be materially and adversely affected.  These regulations significantly increase the difficulty and costs involved in obtaining and maintaining regulatory approvals for marketing new and existing products.  Our future growth and profitability depend to a large extent on our ability to obtain regulatory approvals.  Additionally, the law could change so as to prohibit the use of certain pharmaceuticals.  If one of our products becomes prohibited, this change would cease the productivity of that product.  The China National Development and Reform Commission (“CNDRC”), has recently implemented price adjustments on many marketed pharmaceutical products.  We have no control over such governmental policies, which may impact the pricing and profitability of our products.

 

Although we have started exporting products to other countries, most of our sales are in the PRC.  It is anticipated that our products in the PRC will continue to represent a significant portion of sales in the near future.  As a result of our reliance on the PRC markets, our operating results and financial performance could be affected by any adverse changes in economic, political and social conditions in the PRC.

 

The modernization of regulations for the pharmaceutical industry is relatively new in the PRC, and the manner and extent to which it is regulated will continue to evolve.  As a pharmaceutical company, we are subject to the Pharmaceutical Administrative Law, which governs the licensing, manufacture, marketing and distribution of pharmaceutical products in the PRC, and sets penalty provisions for violations of provisions of the Pharmaceutical Administrative Law.  In addition as a  “Foreign Owned Enterprise,” we will be subject to the Foreign Company provisions of the Company Law of the PRC.  Changes in these laws or new interpretations of existing laws may have a significant impact on our methods and our cost of doing business.  For example, if legislative proposals for pharmaceutical product pricing, reimbursement levels, approval criteria or manufacturing requirements should be proposed and adopted, such new legislation or regulatory requirements may have a material adverse effect on our financial condition, results of operations or cash flows.  In addition, we are subject to varying degrees of regulation and licensing by governmental agencies in China. At this time, we are unaware of any China legislative proposals that could adversely affect our business. There can be no assurance that future regulatory, judicial and legislative changes will not have a material adverse effect on our operations, that regulators or third parties will not raise material issues with regard to compliance or non-compliance with applicable laws or regulations, or that any changes in applicable laws or regulations will not have a material adverse effect on our business.

 

Certain political and economic considerations relating to China could adversely affect us.

 

China is transitioning from a planned economy to a market economy.  While the PRC government has pursued economic reforms since its adoption of the open-door policy in 1978, a large portion of the Chinese economy is still operating under five-year plans and annual state plans.  Through these plans and other economic measures, such as control on foreign exchange, taxation and restrictions on foreign participation in the domestic market of various industries, the PRC government exerts considerable direct and indirect influence on the economy.  Many of the economic reforms carried out by the PRC government are unprecedented or experimental, and are expected to be refined and improved.  Other political, economic and social factors can also lead to further readjustment of such reforms.  This refining and readjustment process may not necessarily have a positive effect on our operations or future business development.  Our operating results may be adversely affected by changes in China’s economic and social conditions as well as by changes in the policies of the PRC government, such as changes in laws and regulations, or the official interpretation thereof, which may be introduced to control inflation, changes in the interest rate or method of taxation, and the imposition of additional restrictions on currency conversion.

 

Accordingly, government actions in the future, including any decision not to continue to support recent economic reforms and to return to a more centrally planned economy or regional or local variations in the implementation of economic policies, could have a significant effect on economic conditions in China or particular regions thereof, and could require us to divest ourselves of any interest we then hold in Chinese properties or joint ventures.

 

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There are risks inherent in doing business in China.

 

The PRC is a developing country with a young market economic system overshadowed by the state under heavy regulation and scrutiny.  Its political and economic systems are very different from the more developed countries.  China also faces many social, economic and political challenges that may produce major shocks and instabilities and even crises, in both its domestic arena and in its relationship with other countries, including but not limited to the United States.  Such shocks, instabilities and crises may in turn significantly and adversely affect our performance.

 

The recent nature and uncertain application of many PRC laws applicable to our company create an uncertain environment for business operations and they could have a negative effect on our business and operations.

 

The PRC legal system is a civil law system.  Unlike the common law system, the civil law system is based on written statutes in which decided legal cases have little value as precedents.  In 1979, the PRC began to promulgate a comprehensive system of laws and has since introduced many laws and regulations to provide general guidance on economic and business practices in the PRC and to regulate foreign investment.  Progress has been made in the promulgation of laws and regulations dealing with economic matters such as corporate organization and governance, foreign investment, commerce, taxation and trade.  However, there are substantial uncertainties regarding the interpretation and application of PRC laws and regulations, including, but not limited to, the laws and regulations governing our business. In addition, the effectiveness of newly-enacted laws, regulations or amendments may be delayed, resulting in detrimental reliance by investors.  New laws and regulations that affect existing and proposed future businesses may also be applied retroactively. The promulgation of new laws, changes of existing laws and the abrogation of local regulations by national laws could have a negative impact on our business, business prospects and operations.  In addition, as these laws, regulations and legal requirements are relatively recent, their interpretation and enforcement involve significant uncertainty.

 

Our business may be affected by unexpected changes in regulatory requirements in the jurisdictions in which we operate.

 

Our company, and its subsidiaries, are subject to many general regulations governing business entities and their behavior in China and in other jurisdictions in which we and our subsidiaries have, or plan to have, operations and market products.   In particular, we are subject to laws and regulations covering food, dietary supplements and pharmaceutical products.   Such regulations typically deal with licensing, approvals and permits.  Any change in product licensing may make our products more or less available on the market.  Such changes may have a positive or negative impact on the sale of our products and may directly impact the associated costs in compliance and our operational and financial viability.  Such regulatory environment also covers any existing or potential trade barriers in the form of import tariff and taxes that may make it difficult for us to import our products to certain countries and regions, such as Hong Kong, which would limit its international expansion.

 

A slowdown or other adverse developments in the PRC economy may materially and adversely affect our customers, demand for our services and our business.

 

All of our operations are conducted in the PRC and almost all of our revenues are generated from sales in the PRC. Although the PRC economy has grown significantly in recent years, we cannot assure you that such growth will continue.  According to the PRC National Bureau of Statistics, the PRC’s economy expended 6.8% from a year earlier in the fourth quarter of 2008, which means that a full-year growth for 2008 was 9.0%.  It is the first time since 2002 that the PRC has expanded by less than 10% annually.  A number of factors have contributed to this slow-down, including appreciation of the RMB, which has adversely affected the PRC’s exports. In addition, the slow-down has been exacerbated by the recent global crisis in the financial services and credit markets, which has resulted in significant volatility and dislocation in the global capital markets. It is uncertain how long the global crisis in the financial services and credit markets will continue and how much adverse impact it will have on the global economy in general or the PRC economy in particular.  We do not know how sensitive we are to a slowdown in economic growth or other adverse changes in the PRC economy which may affect demand for our products.  A slowdown in overall economic growth, an economic downturn or recession or other adverse economic developments in the PRC may materially reduce the demand for our products and materially and adversely affect our business.

 

 

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Inflation in the PRC could negatively affect our profitability and growth.

 

While the PRC economy has experienced rapid growth, it has been uneven among various sectors of the economy and in different geographical areas of the country. Rapid economic growth can lead to growth in the money supply and rising inflation. If prices for our products do not rise at a rate that is sufficient to fully absorb inflation-driven increases in our costs of supplies, our profitability can be adversely affected.

 

During the past ten years, the rate of inflation in the PRC has been as high as 20.7% and as low as 2.2%. These factors have led to the adoption by the Chinese government, from time to time, of various corrective measures designed to restrict the availability of credit or regulate growth and contain inflation. In order to control inflation in the past, the PRC government has imposed controls on bank credits, limits on loans for fixed assets and restrictions on state bank lending. The implementation of these and other similar policies can impede economic growth and thereby harm the market for our products.

 

Substantially all of our assets are located in the PRC and all of our revenues are derived from our operations in the PRC.  Accordingly, our results of operations and prospects are subject, to a significant extent, to the economic, political and legal developments in the PRC.

 

Substantially all of our assets are located in the PRC and all of our revenues are derived from our operations in the PRC.  Accordingly, our results of operations and prospects are subject, to a significant extent, on the economic, political and legal developments in the PRC.  The PRC economy differs from the economies of most developed countries in many respects.

 

Since 1978, the PRC has been one of the world’s fastest-growing economies in terms of gross domestic product, or GDP growth. We cannot assure you, however, that such growth will be sustained in the future. If, in the future, the PRC’s economy experiences a downturn or grows at a slower rate than expected, there may be less demand for spending in certain industries.

 

Our ability to implement our business plan is based on the assumption that the Chinese economy will continue to grow. The PRC’s economic growth has been uneven, both geographically and among various sectors of the economy. The PRC government has implemented various measures to encourage economic growth and guide the allocation of resources. Some of these measures benefit the overall PRC economy, but may also have a negative effect on us.

 

The PRC economy has been transitioning from a planned economy to a more market-oriented economy. Although in recent years the PRC government has implemented measures emphasizing the use of market forces for economic reform, the reduction of state ownership of productive assets and the establishment of sound corporate governance in business enterprises, a substantial portion of productive assets in the PRC is still owned by the PRC government. In addition, the PRC government continues to play a significant role in regulating industry development by imposing industrial policies. It also exercises significant control over PRC economic growth through the allocation of resources, controlling payment of foreign currency-denominated obligations, setting monetary policy and providing preferential treatment to particular industries or companies. We cannot assure you that changes in the PRC’s economic, political or legal systems will not detrimentally affect our business, prospects, financial conditions and results of operations.

 

We may have difficulty attracting talent in foreign countries.

 

Currently, over 92% of our sales are in the PRC.  We are in the process of attempting to establish marketing and sales presence in the U.S. and other countries.  We expect to establish an office in the U.S. for investor relations.  In the future, we may explore expanding its operations in other countries throughout the world.  Upon effecting any such expansion, we may not be able to identify and retain qualified personnel due to its lack of understanding of different cultures and lack of local contacts.  This may impede international expansion.

 

Currency conversion and exchange rate volatility could adversely affect our financial condition, by making acquisitions in China or of Chinese products more expensive.

 

The PRC government imposes control over the conversion of Renminbi (“RMB”), the currency of China, into foreign currencies.  Under the current unified floating exchange rate system, the People’s Bank of China publishes an exchange rate, referred to as the PBOC exchange rate, based on the previous day’s dealings in the inter-bank foreign exchange market.  Financial institutions authorized to deal in foreign currency may enter into foreign exchange transactions at exchange rates within an authorized range above or below the PBOC exchange rate according to market conditions.

 

 

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Pursuant to the Foreign Exchange Control Regulations of the PRC issued by the State Council which came into effect on April 1, 1996, and the Regulations on the Administration of Foreign Exchange Settlement, Sale and Payment of the PRC which came into effect on July 1, 1996, regarding foreign exchange control, conversion of RMB into foreign exchange by Foreign Investment Enterprises (“FIEs”), for use on current account items, including the distribution of dividends and profits to foreign investors, is permissible.  FIEs are permitted to convert their after-tax dividends and profits to foreign exchange and remit such foreign exchange to their foreign exchange bank accounts in the PRC.

 

Conversion of RMB into foreign currencies for capital account items, including direct investment, loans, and security investment, is still subject to certain restrictions.  On January 14, 1997, the State Council amended the Foreign Exchange Control Regulations and added, among other things, an important provision, which provides that the PRC government shall not impose restrictions on recurring international payments and transfers under current account items.  These rules are subject to change.

 

Enterprises in the PRC (including FIEs) which require foreign exchange for transactions relating to current account items, may, without approval of the State Administration of Foreign Exchange (“SAFE”) effect payment from their foreign exchange account or convert and pay at the designated foreign exchange banks by providing valid receipts and proofs.

 

Convertibility of foreign exchange in respect of capital account items, such as direct investment and capital contribution, is still subject to certain restrictions, and prior approval from the SAFE or its relevant branches must be sought.

 

Our company is a FIE to which the Foreign Exchange Control Regulations are applicable.  There can be no assurance that we will be able to obtain sufficient foreign exchange to pay dividends or satisfy other foreign exchange requirements in the future.

 

Since 1994, the exchange rate for RMB against the U.S. dollar has remained relatively stable, most of the time in the region of approximately RMB 8.00 to U.S.$1.00.  However, in 2005, the Chinese government announced that would begin pegging the exchange rate of the Chinese RMB against a number of currencies, rather than just the U.S. dollar.  Currently, exchange rates are approximately RMB 6.84 to U.S.$1.00 resulting in the increase in price of Chinese products to U.S. purchasers.   As our operations are primarily in China, any significant revaluation of the Chinese RMB may materially and adversely affect cash flows, revenues and financial condition.  For example, to the extent that we need to convert United States dollars into Chinese RMB for operations, appreciation of this currency against the U.S. dollar could have a material adverse effect on our business, financial condition and results of operations.  Conversely, if we decide to convert Chinese RMB into U.S. dollars for other business purposes and the U.S. dollar appreciates against this currency, the U.S. dollar equivalent of the Chinese RMB that we convert would be reduced.

 

Restrictions on currency exchange may limit our ability to utilize our revenues effectively and the ability of the PRC entities to obtain financing.

 

Substantially all of our revenues and operating expenses are denominated in Renminbi. Restrictions on currency exchange imposed by the PRC government may limit our ability to utilize revenues generated in Renminbi to fund our business activities outside the PRC, if any, or expenditures denominated in foreign currencies. Under current PRC regulations, Renminbi may be freely converted into foreign currency for payments relating to “current account transactions,” which include among other things dividend payments and payments for the import of goods and services, by complying with certain procedural requirements. The PRC entities may also retain foreign exchange in their respective current account bank accounts, subject to a cap set by the State Administration for Foreign Exchange, or SAFE, or its local counterpart, for use in payment of international current account transactions. However, conversion of Renminbi into foreign currencies, and of foreign currencies into Renminbi, for payments relating to “capital account transactions,” which principally includes investments and loans, generally requires the approval of SAFE and other relevant PRC governmental authorities. Restrictions on the convertibility of the Renminbi for capital account transactions could affect the ability of the PRC entities to make investments overseas or to obtain foreign exchange through debt or equity financing, including by means of loans or capital contributions from the parent entity.

 

 

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Any existing and future restrictions on currency exchange may affect the ability of the PRC entities or an affiliated entity to obtain foreign currencies, limit our ability to utilize revenues generated in Renminbi to fund any business activities outside the PRC that are denominated in foreign currencies, or otherwise materially and adversely affect our business.

 

We are required to be in compliance with the registered capital requirements of the PRC.

 

Under the Company Law of the PRC, we are required to contribute a certain amount of  “registered capital” to our wholly owned subsidiary.  By law, our subsidiaries are required to contribute at least 10% of after tax net income (as determined in accordance with Chinese GAAP) into a statutory surplus reserve until the reserve is equal to 50% of our and our subsidiaries’ registered capital, and between 5% and 10% of its after tax net income, as determined by our board of directors, into a public welfare fund.  These reserve funds are recorded as part of shareholders’ equity but are not available for distribution to shareholders other than in the case of liquidation.  As a result of this requirement, the amount of net income available for distribution to shareholders will be limited.

 

Dividends we receive from our subsidiaries located in the PRC may be subject to PRC withholding tax.

 

The PRC’s Enterprise Income Tax Law (“EIT Law”) provides that an income tax rate of 10% may be applicable to dividends payable to non-PRC investors that are “non-resident enterprises.” Non-resident enterprises refer to enterprises which do not have an establishment or place of business in the PRC, or which have such establishment or place of business in the PRC but the relevant income is not effectively connected with the establishment or place of business, to the extent such dividends are derived from sources within the PRC. The income tax for the non-resident enterprises shall be subject to withholding at income source with the payer acting as the obligatory withholder under the EIT Law, and therefore, such income tax is generally called “withholding tax” in practice.  It is currently unclear in what circumstances a source will be considered as located within the PRC.  As a U.S. holding company and substantially all of our income will be derived from dividends we receive from our PRC operating subsidiaries. Thus, if we are considered as a “non-resident enterprise” under the EIT Law and the dividends paid to us by our PRC operating subsidiaries are considered income sourced within the PRC, such dividends may be subject to a 10% withholding tax.  No dividends were paid to us by our PRC operating subsidiaries in 2007, 2008 or 2009.

 

Deterioration of the PRC’s political relations with the U.S., Europe, or other nations could make Chinese businesses less attractive to Western investors.

 

The relationship between the U.S. and the PRC is subject to sudden fluctuation and periodic tension. Changes in political conditions in the PRC and changes in the state of Sino-foreign relations are difficult to predict and could materially adversely affect our operations or cause potential target businesses or services to become less attractive. This could lead to a decline in our profitability. Any weakening of relations between the U.S., Europe, or other nations and the PRC could have a material adverse effect on our operations or our ability to raise additional capital.

 

The discontinuation of any of the preferential tax treatments currently available to the PRC entities could materially increase our tax liabilities.

 

The rate of income tax on companies in China may vary depending on the availability of preferential tax treatment or subsidies based on their industry or location. The current maximum corporate income tax rate is 33%. The new Enterprise Income Tax Law became effective as of January 1, 2008, pursuant to which, an enterprise income tax of 25% applies to any enterprise. Although we were approved by the local tax authority to be exempted from the enterprise income tax for a five-year period commencing in 2007 and ending in 2012, we do not know whether such new law will change the preferential treatment that was granted to us. Any loss or substantial reduction of the tax benefits enjoyed by us would reduce our net profit.

 

 

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Because PRC law governs almost all of our operating subsidiaries’ material agreements, we may not be able to enforce our rights within the PRC or elsewhere, which could result in a significant loss of business, business opportunities or capital.

 

PRC law governs almost all of the material agreements of our subsidiaries. We cannot assure you that we will be able to enforce any of our material agreements or that remedies will be available outside of the PRC.  The Chinese legal system is similar to a civil law system based on written statutes. Unlike common law systems, it is a system in which decided legal cases have little precedential value.  In 1979, the PRC government began to promulgate a comprehensive system of laws and regulations governing economic matters in general.  The overall effect of legislation since then has been to significantly enhance the protections afforded to various forms of foreign investment in the PRC.  Certain of our subsidiaries are wholly foreign-owned enterprises, and are subject to laws and regulations applicable to foreign investment in the PRC in general and laws and regulations applicable to wholly foreign-owned enterprises in particular.  Relevant PRC laws, regulations and legal requirements may change frequently, and their interpretation and enforcement involve uncertainties.  For example, we may have to resort to administrative and court proceedings to enforce the legal protection that we enjoy either by law or contract. However, since PRC administrative and court authorities have significant discretion in interpreting and implementing statutory and contractual terms, it may be more difficult to evaluate the outcome of administrative and court proceedings and the level of legal protection we enjoy than under more developed legal systems.  Such uncertainties, including the inability to enforce our contracts, could materially and adversely affect our business and operations.  In addition, confidentiality protections in the PRC may not be as effective as in the U.S. or other countries.  Accordingly, we cannot predict the effect of future developments in the PRC legal system, particularly with respect to financing sectors, including the promulgation of new laws, changes to existing laws or the interpretation or enforcement thereof, or the preemption of local regulations by national laws.  These uncertainties could limit the legal protections available to us and other foreign investors.

 

Our PRC subsidiaries are obligated to withhold and pay PRC individual income tax on behalf of our employees who are subject to PRC individual income tax. If we fail to withhold or pay such individual income tax in accordance with applicable PRC regulations, we may be subject to certain sanctions and other penalties and may become subject to liability under PRC laws.

 

Under PRC laws, our PRC subsidiaries are obligated to withhold and pay individual income tax on behalf of our employees who are subject to PRC individual income tax. If we fail to withhold and/or pay such individual income tax in accordance with PRC laws, we may be subject to certain sanctions and other penalties and may become subject to liability under PRC laws.

 

In addition, the State Administration of Taxation has issued several circulars concerning employee stock options. Under these circulars, our employees working in the PRC (which could include both PRC employees and expatriate employees subject to PRC individual income tax) who exercise stock options will be subject to PRC individual income tax. Our PRC subsidiaries have obligations to file documents related to employee stock options with relevant tax authorities and withhold and pay individual income taxes for those employees who exercise their stock options. While tax authorities may advise us that our policy is compliant, they may change their policy, and we could be subject to sanctions.

 

Failure to comply with the U.S. Foreign Corrupt Practices Act could subject us to penalties and other adverse consequences.

 

We are required to comply with the U.S. Foreign Corrupt Practices Act, which generally prohibits U.S. companies from engaging in bribery or other prohibited payments to foreign officials for the purpose of obtaining or retaining business. Foreign companies, including some that may compete with us, are not subject to these prohibitions, and therefore may have a competitive advantage over us. Corruption, extortion, bribery, pay-offs, theft and other fraudulent practices may occur in the PRC.  If our competitors engage in these practices they may receive preferential treatment, giving our competitors an advantage in securing business, which would put us at a disadvantage. We can make no assurance that our employees or other agents will not engage in such conduct for which we might be held responsible. If our employees or other agents are found to have engaged in such practices, we could suffer severe penalties and other consequences that may have a material adverse effect on our business, financial condition and results of operations.

 

We face risks related to health epidemics and outbreak of contagious disease.

 

Our business could be materially and adversely affected by the effects of H1N1 Flu, Avian Flu, Severe Acute Respiratory Syndrome (“SARS”) or other epidemics or outbreaks.  In April 2009, an outbreak of H1N1 Flu first occurred in Mexico and quickly spread to other countries, including the U.S. and the PRC.  In the last decade, the PRC has suffered health epidemics related to the outbreak of Avian Flu and SARS.  Any prolonged occurrence or recurrence of H1N1 Flu , Avian Flu, SARS or other adverse public health developments in the PRC may have a material adverse effect on our business and operations.  These health epidemics could result in severe travel restrictions and closures that would restrict our ability to ship our products.  Potential outbreaks could also lead to temporary closure of our manufacturing facilities, our suppliers’ facilities and/or our end-user customers’ facilities, leading to reduced production, delayed or cancelled orders, and decrease in demand for our products. Any future health epidemic or outbreaks that could disrupt our operations and/or restrict our shipping abilities may have a material adverse effect on our business and results of operations.

 

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Risks Relating to the Market for Our Common Stock and our Capital Structure

 

Application of guidance related to the Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock has negatively impacted our  statement of operations for the year ended December 31, 2009 (restated) and could continue to negatively impact our statement of operations.

 

For the year ended December 31, 2009 (restated), we reported an unrealized loss on derivatives in the consolidated statements of operations of $4,807,000 as a result of the issuance of warrants to purchase up to an aggregate of 750,000 shares of common stock in our January 2008 private placement.  Our comprehensive income will continue to fluctuate as a result of the impact of such warrants and will be adversely effected in each reporting period in which the fair value of the warrants that remain outstanding continue to increase.

Our stock price is likely to be highly volatile.

 

The trading price of our common stock has been highly volatile.  Failure to meet market expectations in our financial results could cause our stock price to decline.  Moreover, factors that are not related to our operating performance could cause our stock price to decline.  The stock market has recently experienced significant price and volume fluctuations that have affected the market prices for securities of technology and communications companies.  Consequently, you may experience a decrease in the market value of your common stock, regardless of our operating performance or prospects.

 

We do not plan to declare or pay any dividends to our shareholders in the near future and would need regulatory approval to do so.

 

We have not declared any dividends in the past, and we do not intend to distribute dividends in the near future.  The declaration, payment and amount of any future dividends will be made at the discretion of the board of directors and subject to PRC law, and will depend upon, among other things, the results of operations, cash flows and financial condition, operating and capital requirements, and other factors as the board of directors considers relevant.  There is no assurance that future dividends will be paid, and if dividends are paid, there is no assurance with respect to the amount of any such dividend.

 

We have the right to issue up to 5,000,000  shares of "blank check" preferred stock, which may adversely affect the voting power of the holders of other of our securities and may deter hostile takeovers or delay changes in management control.

 

Our articles of incorporation provides that we may issue up to 5,000,000 shares of preferred stock from time to time in one or more series, and with such rights, preferences and designations as our board of directors may determinate from time to time.  Our board of directors, without further approval of our common stockholders, is authorized to fix the dividend rights and terms, conversion rights, voting rights, redemption rights, liquidation preferences and other rights and restrictions relating to any series of our preferred stock. Issuances of shares of preferred stock could, among other things, adversely affect the voting power of the holders of other of our securities and may, under certain circumstances, have the effect of deterring hostile takeovers or delaying changes in management control.  Such an issuance would dilute existing stockholders, and the securities issued could have rights, preferences and designations superior to our common stock.

 

Sales of our common stock may have an adverse effect on the market price of our common stock.  Additionally, we may issue shares upon exercise of outstanding warrants that are exercisable at prices that are below current market prices which will be dilutive to the common stock.

 

As of March 15, 2010, we had 16,790,851 shares of common stock outstanding, many of which are freely transferable under Rule 144.  The sale of these shares may have an adverse effect on the market price for our common stock.

 

In addition, as of March 15, 2010, we had issued and outstanding warrants to purchase an aggregate of 593,800 shares of our common stock, which are exercisable at a price of $12.50 per share.  Our issuance of additional shares of common stock upon exercise of our outstanding warrants will reduce the percentage equity ownership of holders of shares of our common stock. Further, the exercise of a significant number of warrants, and subsequent sale of shares of common stock received upon such exercise, could cause a sharp decline in the market price of our common stock.

 

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FORWARD-LOOKING STATEMENTS

 

Some of the statements contained in this report are not statements of historical or current fact.  As such, they are "forward-looking statements" based on our current expectations, which are subject to known and unknown risks, uncertainties and assumptions.  They include statements relating to:

 

·

future sales and financings;

 

·

the future development of our business;

 

·

our ability to execute our business strategy;

 

·

projected expenditures; and

 

·

the market for our products.

 

You can identify forward-looking statements by terminology such as "may," "will," "should," "could," "expects," "intends," "plans," "anticipates," "believes," "estimates," "predicts," "potential" or "continue" or the negative of these terms or other comparable terminology.  These statements are not predictions.  Actual events or results may differ materially from those suggested by these forward-looking statements.  In evaluating these statements and our prospects generally, you should carefully consider the factors set forth below.  All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these cautionary factors and to others contained throughout this prospectus.  We are under no duty to update any of the forward-looking statements after the date of this prospectus or to conform these statements to actual results.

 

Although it is not possible to create a comprehensive list of all factors that may cause actual results to differ from the results expressed or implied by our forward-looking statements or that may affect our future results, some of these factors are set forth under "Risk Factors" in this report.

 

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Item. 1B.  Unresolved Staff Comments.

 

None.

 

Item 2.  Properties.

 

Under Chinese law, the government owns all of the land in the PRC and companies and individuals are authorized to use the land only through land use rights granted by the PRC government.

 

Our manufacturing facilities are located in the cities of Harbin and Peng Lai in the PRC.  These facilities are operated in accordance with GMP.  We own these facilities and are not subject to costs associated under rental or lease obligations.

 

In January 2010, we completed the construction of two office buildings and TDR and Haina moved into these new facilities, located in Song Bei District of Harbin City, Heilongjiang Province, PRC.  It is anticipated that residual work, including road construction,  fire control equipment, amenity improvement, and final acceptance, will be completed on these facilities in the third quarter of 2010, at an additional cost of approximately $3.0 million. We own these facilities and are not subject to costs associated under rental or lease obligations.

 

A breakdown of our facilities by subsidiary is as follows:

 

		Subsidiaries Facilities as of March 15, 2010, in Square Meters
		TDR				First				Tianlong				Peng Lai
Land Area			35,000				40,000				15,000				40,000
Expiration Year		2058				2054				2051				2056
Production, Warehouse, and Office			14,000				10,000				9,000				12,000

 

At this time, our subsidiaries Haina and Tian Qing use an insignificant portion of our facilities.

 

Item 3.  Legal Proceedings.

 

We are not a party to any material pending legal proceedings.

 

Item 4.  Reserved.

 

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PART II

 

Item 5.  Market for Common Equity, Related Stockholder Matters and Small Business Issuer Purchases of Equity Securities.

 

Market Information

 

Until May 28, 2008, our common stock was traded on FINRA’s Over-the-Counter Bulletin Board under the trading symbol “CSKI.”  On May 28, 2008, our common stock commenced trading on the American Stock Exchange under the trading symbol “CSY.”  As of September 14, 2008, we terminated our listing on the American Stock Exchange and became listed on the Nasdaq Global Market under the trading symbol “CSKI.”  Effective as of January 4, 2010, we qualified to be listed on Nasdaq Global Select Market.  The high and low sales prices for our common stock in the fiscal years of 2009 and 2008 are as follows:

 

		Year Ended December 31, 2009								Year Ended December 31, 2008
		High				Low				High				Low
1st Quarter		$	19.11			$	10.03			$	14.00			$	9.40
2nd Quarter		$	17.80			$	10.21			$	17.10			$	9.50
3rd Quarter		$	16.80			$	12.00			$	14.99			$	9.00
4th Quarter		$	25.45			$	11.02			$	16.28			$	6.29

 

On March 15, 2010, the closing price for our common stock was $17.24.

 

Dividends

 

Since inception, no dividends have been paid on our common stock.  We intend to retain any earnings for use in our business, so it is not expected that any dividends on the common stock will be declared and paid in the foreseeable future.  We do not currently have any restrictions that would limit our ability to pay dividends, and we are not currently aware of any restrictions that are likely to limit our ability to pay dividends in the future.

 

Holders

 

At March 15, 2010, there were 381 holders of record of our common stock, with 16,790,851 shares issued and outstanding.  Such number of record owners was determined from our shareholder records and does not include beneficial owners whose shares are held in nominee accounts with brokers, dealers, banks and clearing agencies.

 

Securities Authorized For Issuance Under Equity Compensation Plan

 

As of December 31, 2009, we had only one stock option, bonus, profit sharing, pension or similar plan in place, which is our 2006 Stock Incentive Plan (the “Plan”).  The Plan reserves an aggregate of 1,500,000 shares of our common stock for awards of stock options, stock appreciation rights, restricted stock, performance stock and bonus stock granted thereunder.  The following table provides information as of December 31, 2009 with respect to the shares of our common stock that may be issuable under our existing equity compensation plans:

 

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Equity Compensation Plan Information

 

		(a)				(b)				(c)
Plan Category		Number of securities to be issued upon  exercise of outstanding options, warrants and rights				Weighted- average exercise price of  outstanding options, warrants and  rights				Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a))
Equity compensation plans approved by security holders (1)			0			$	-				1,273,593	(3)
Equity compensation plans not approved by security holders (2)			0				N/A				0
Total			0			$	-				1,273,593

(1)

Our board of directors adopted the 2006 Stock Incentive Plan (the “Plan”), to be effective on July 31, 2006.  The Plan was approved by the shareholders on July 31, 2006.

 

(2)

We do not have any equity compensation plans not approved by the security holders.

 

(3)

The Plan reserves an aggregate of 1,500,000 shares of our common stock for awards of stock options, stock appreciation rights, restricted stock, performance stock and bonus stock granted thereunder.  We have issued the following securities under the Plan:

 

(a)  In October 2006, we granted stock options to purchase an aggregate of 113,500 shares of common stock to a total of 36 participants under the Plan.  In May 2009, an aggregate of 101,000 of these stock options were exercised on a “cashless” basis by 36 participants, resulting in our issuance of an aggregate of 75,888 shares.  In August 2009, the remaining 12,500 of these stock options were exercised  on a “cashless” basis by 9 participants, resulting in our issuance of an aggregate of 9,407 shares.

 

(b)  In April 2007, we issued an aggregate of 30,000 shares of restricted stock to a total of 200 individuals under the Plan.

 

(c)  In July 2008, we issued an aggregate of 30,063 shares of restricted stock to a total of 27 individuals under the Plan.

 

(d)  In December 2009, we issued an aggregate of 52,844 shares of restricted stock to a total of 11 individuals under the Plan.

 

Recent Sales of Unregistered Securities

 

The following is a list of certain securities we sold or issued during fiscal 2008.   There were no underwriting discounts or commissions paid in connection with the sale of these securities, except as otherwise noted.   Certain information previously included in prior Exchange Act reports we filed has not been furnished in this report.

 

As of December 26, 2009, we issued 52,844 “restricted” shares of our common stock to certain employees, executive officers and directors of ours as consideration for services pursuant to our 2006 Stock Incentive Plan.

 

We believe the issuance of these shares was exempt from registration under the Securities Act of 1933, as amended, pursuant to Section 4(2) and/or Regulation D promulgated thereunder, as a transaction by an issuer not involving a public offering.

 

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Item 6.  Selected Financial Data.

 

Restatement of 2009 Financial Statements

 

As discussed in Note 2 to the Financial Statements, the Company restated its financial statements for the year ended December 31, 2009.  On May 7, 2010, the Company determined that ASC 815-40, which was effective January 1, 2009, should have been applied to warrants issued in the Company’s 2008 private placement, resulting in a reclassification of the warrants as a derivative liability, measured at fair value, with changes in fair value recognized as part of other income or expense for each reporting period thereafter.  In addition, the Company previously recorded a liability in connection with certain registration rights provided to investors in the private placement.  On May 7, 2010, the Company determined that because the obligations do not recognize cash settlement and the warrants can be settled in unregistered shares, paragraphs 14 – 18 of EITF 00-19 do not apply to the registration rights obligation.  As a result, no liability is required to be recorded with respect to this obligation and the Company has recharacterized this previously recorded liability.

 

Key financial data from the fiscal years ended December 2005 to 2009 is set forth in the following table.

 

		For the Years Ended December 31,  ($ in thousands, except per share data)
		2009 (restated)				2008				2007				2006 (restated)				2005
Operating Data:
Revenues		$	130,092			$	91,816			$	49,318			$	19,882			$	7,712
Cost of Goods Sold			31,671				22,403				10,940				5,063				2,214
Gross Profit			98,421				69,413				38,379				14,819				5,498
Selling expense			30,763				22,968				14,784				9,894				2,540
General and administrative expense			4,191				2,514				1,380				844				735
Research and development			14,960				7,413				3,158				2,027				64
Income from Operations			46,251				35,659				18,614				1,932				2,462
Other Income (Expense)			(4,768	)			814				38				(228	)			(18	)
Provision for income taxes			10,503				7,616				3,319				1,080				356
Net Income			30,980				28,857				15,333				624				2,089
Basic Earnings Per Share			1.87				1.91				1.27				0.05				0.19
Diluted Earnings Per Share			1.86				1.87				1.15				0.05				0.19
Balance Sheet Data:
Total Assets		$	140,363			$	101,259			$	37,285			$	16,681			$	8,992
Total Current Liabilities			19,494				6,326				5,040				2,370				1,641
Working Capital			56,895				49,509				15,447				7,798				2,858
Stockholder's Equity			120,869				94,933				32,245				14,311				7,351
Other Data:
Net cash provided by operating activities		$	33,449			$	27,538			$	11,601			$	5,183			$	1,090
Net Cash used in investing activities			(21,154	)			(23,115	)			(10,261	)			(4,597	)			(776	)
Net Cash provided by (used in) financing activities			29				25,355				(33	)			(2,931	)			591

 

 

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Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of Operation.

 

The financial and business analysis in this Annual Report on Form 10-K (the “Report”) provides information we believe is relevant to an assessment and understanding of our financial condition and results of operations. The following discussion should be read in conjunction with our consolidated financial statements and related notes included in Part II, Item 8 of this Report.

 

FORWARD LOOKING STATEMENTS

 

The following discussion should be read in conjunction with the information contained in our consolidated financial statements and the notes thereto appearing elsewhere herein and in the risk factors and “Forward Looking Statements” summary set forth in the forepart of this Annual Report as well as the “Risk Factors” section above and are afforded the safe harbor provisions of Section 27A of the Securities Act and Section 21E of the Securities Exchange Act of 1934, as amended. Readers should carefully review the risk factors disclosed in this Annual Report and other documents filed by us with the SEC.

 

DISCUSSION

 

We are engaged, through our China-based indirect subsidiaries described below, in the development, manufacture, marketing and sale of over-the-counter, branded nutritional supplements and over-the-counter plant and herb-based pharmaceutical and medicinal products.  Our principal products are external use TCMs.  We have evolved into an integrated manufacturer, marketer and distributor of external-use TCM products sold primarily in the PRC and through Chinese domestic pharmaceutical chains.  Recently, we have been expanding our worldwide sales effort as well.  Prior to 2009, we sold both our own manufactured products, as well as medicinal and pharmaceutical products manufactured by others on a contract basis, categorized by us as Contract Sales.  Commencing in 2009, we discontinued all of our Contract Sales as part of our revised strategic plan.

 

In 2009, we achieved continued growth on the sale of our own product line through our sustained efforts to expand our distribution channels and promote our products.  For the year ended December 31, 2009, total revenues were $130,092,000, compared to $91,816,000 and $49,318,000 for the years ended December 31, 2008 and 2007, respectively. Net income was $30,980,000, or $1.86 per share, in 2009, compared to net income of $28,857,000, or $1.87 per share, in 2008, and net income of $15,333,000, or $1.15 per share, in 2007, as calculated on a diluted basis for all periods presented.

 

All of our business is conducted through our wholly-owned subsidiary, ACPG which, in turn, wholly owns Harbin TDR, and TDR’s subsidiaries.

 

Recent Developments

 

On April 3, 2008, TDR completed its acquisition of Tianlong, a company that had a variety of medicines approved by the SFDA and new medicine applications, and which was in the business of manufacturing external-use pharmaceuticals.  TDR previously acquired the Beijing sales office of Tianlong in mid-2006.  In connection with this transaction, TDR acquired 100% of the issued and outstanding capital stock of Tianlong from its sole stockholder, in consideration for an aggregate purchase price of approximately $8,300,000, consisting of $8,000,000 in cash, and 23,850 shares of our common stock (valued at $12.00 per share).

 

On April 18, 2008, TDR consummated its acquisition of Haina, licensed as a wholesaler of TCM, bio-products, medicinal devices, antibiotics and chemical medicines.  Haina did not have an established sales network and was acquired for its primary asset, a GSP license issued by the Heilongjiang Province office of the SFDA.  The SFDA only issues such licenses to pharmaceutical resellers that maintain certain quality control standards.  The GSP license was issued as of December 21, 2006 and will expire on January 29, 2012.  This GSP license has enabled us to expand our sales of medicinal products without having to go through a lengthy license application process.  In connection with this transaction, TDR acquired 100% of the issued and outstanding capital stock of Haina from its three stockholders in consideration for payment of approximately $437,000.

 

 

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On September 5, 2008, TDR acquired Peng Lai, from Peng Lai Jin Chuang Group Corporation.  Peng Lai, which has received Good Manufacturing Practice (“GMP”) certification from the SFDA, was organized to develop, manufacture and distribute pharmaceutical, medicinal and diagnostic products in the PRC.  In connection with this transaction, TDR acquired all of Peng Lai’s assets, including, without limitation, franchise, production and operating rights to a portfolio of twenty (20) medicines approved by the SFDA, for an aggregate purchase price of approximately $7,000,000 million, consisting of approximately $2,500,000 million in cash, and 381,606 shares of our common stock (valued at $12.00 per share).

 

Trends and Uncertainties

 

In 2008, general worldwide economic conditions declined due to sequential effects of the sub prime lending crisis, general credit market crisis, collateral effects on the finance and banking industries, concerns about inflation, slower economic activity, decreased consumer confidence, reduced corporate profits and capital spending, adverse business conditions and liquidity concerns.  However, since all of our business operations, and most of our sales, are currently conducted in the PRC, we have not been greatly affected by the economic downtown.

 

We have benefited from the overall economic development in the PRC in recent years and the increase in the number of elderly people in China, which together have resulted in increased expenditures on medicine in the PRC, including TCMs.

 

In fiscal 2007, our sales model was focused on the creation of our own distribution channels.  Therefore, we sold products directly to many smaller distributors and retail store locations.  In fiscal 2008, we changed our business model and entered into distribution agreements with larger regional sales agents, who resell to smaller distributors and retail store locations.  In addition, we entered into contracts with nationwide chain pharmacies, such as Nepstar, Tong Ren Tang, Jin Xiang, and Ren Min Tong Tai.  Through the extensive sales networks of these nationwide chains, we are able to reach all major metropolitan areas throughout the PRC.  These changes to our product distribution channels resulted in our direct customer base decreasing from 943 customers at December 31, 2007 to 212 customers at December 31, 2009.

 

Our change of sales strategy in fiscal 2008 was initiated to improve product channel efficiencies, and to give us access to an increased number of ultimate purchasers.  We believe that these changes will lead to further increased revenue by extending the reach of its distribution network.  We also believe that, by reducing the number of customers we sell to directly, we will be able to streamline our accounts receivable management and collection, and reduce channel distribution costs.  These favorable cost variances are expected to be partially offset by product price incentives we grant to the larger agents with which we have contracted.

 

In fiscal 2007, 26.4% of our total revenues, or $12,998,000, was attributable to sales of other manufacturers’ products through Contract Sales.  One of the main manufacturers for which we resold products was Tianlong.  On April 3, 2008, we acquired Tianlong and were able to fully integrated Tianlong’s products, which we had been previously selling on a contract basis, into our marketing and distribution channels.  Following the acquisition of Tianlong we continued to phase out our Contract Sales and, as of the end of fiscal 2008, we no longer sell other company’s products on a contract basis.

 

Historically, we signed agreements with suppliers that allowed us to hold extra raw materials at the cost of the suppliers.  As a result, we were able to minimize our own inventory carrying costs, and improve our cash management, by keeping the inventory at the minimum level required to support the short-term sales.  However, due to the forecasts for certain cost increases of raw materials in fiscal 2010, we began to increase our inventory levels toward the second half of 2009.

 

 

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Results of Operations

 

Restatement of Financial Statements

 

As discussed in Note 2 to the Financial Statements, the Company restated its financial statements for the year ended December 31, 2009.  On May 7, 2010, the Company determined that ASC 815-40, which was effective January 1, 2009, should have been applied to warrants issued in the Company’s 2008 private placement, resulting in a reclassification of the warrants as a derivative liability, measured at fair value, with changes in fair value recognized as part of other income or expense for each reporting period thereafter.  In addition, the Company previously recorded a liability in connection with certain registration rights provided to investors in the private placement.  On May 7, 2010, the Company determined that because the obligations do not recognize cash settlement and the warrants can be settled in unregistered shares, paragraphs 14 – 18 of EITF 00-19 do not apply to the registration rights obligation.  As a result, no liability is required to be recorded with respect to this obligation and the Company has recharacterized this previously recorded liability.

 

For the years ended December 31, 2009, 2008 and 2007

 

Revenue, Cost of Goods Sold Gross Profit and Gross Profit Margin

 

The following table sets forth our revenues, cost of goods sold,  gross profit and gross profit margin during the fiscal years ended December 31, 2009, 2008, and 2007:

 

		For the Years Ended December 31,  ($ in thousands)
		2009				Variance				2008				Variance				2007
Revenues
Product Sales (net of sales allowance)		$	130,092				51	%		$	86,161				137	%		$	36,320
Contract Sales			0				-				5,655				(57	)%			12,998
Total Revenues		$	130,092				42	%		$	91,816				86	%		$	49,318
Cost of Goods Sold
Cost of goods sold			31,671				41	%			22,403				105	%			10,940
Gross Profit		$	98,422				42	%		$	69,413				81	%		$	38,378
Gross Profit Margin			75.7	%							75.6	%							77.8	%

 

Year over year – 2009 to 2008

 

Total revenues increased by approximately $38,276,000, or 42%, from approximately $91,816,000 in the fiscal year ended December 31, 2008, to approximately $130,092,000 for the fiscal year ended December 31, 2009.  The increase in our revenues is primarily attributable to increase in our product sales related to:

 

·

strong performances from our sales distribution channels, obtained by our hiring of additional direct territory managers and sales agents;

 

·

our efforts to locate and cooperate with more reputable distributors for certain of our products;

 

·

the increase in marketing and advertising expenditures of approximately $7,228,000, or 99%, from approximately $7,299,000 in fiscal 2008 to approximately $14,527,000 in fiscal 2009; and

 

·

the full-year effect of sales of products of Tianlong, which generated approximately $43,138,000 and approximately $13,803,000 in 2009 and 2008, respectively, and Peng Lai, which generated approximately $11,188,000 and approximately $2,164,000 in 2009 and 2008, respectively, two of the businesses we acquired in fiscal 2008.

 

 

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The increase in our product sales were partially offset by our discontinuance of all Contract Sales in fiscal 2009, which we began to phase out in fiscal 2008.

 

Cost of goods sold increased by approximately $9,268,000, or 41%, to approximately $31,671,000 in fiscal 2009 compared to the prior year.  This increase was directly related to an increase in sales.

 

Gross profit increased by 42%, from approximately $69,413,000 in 2008 to approximately $98,422,000 in 2009.  Our gross margin remained constant at approximately 76%.

 

Year over year – 2008 to 2007

 Total revenues increased by approximately $42,498,000, or 86%, from approximately $49,318,000 in the fiscal year ended December 31, 2007, to approximately $91,816,000 for the fiscal year ended December 31, 2008.  The increase in revenue is primarily attributable to strong performances from our sales distribution channels, and our sales of products of Tianlong and Peng Lai, which we acquired in fiscal 2008.

 

Product sales increased by 137% in the year ended December 31, 2008, to approximately $86,161,000 from approximately $36,320,000 in 2007.  This growth in sales is attributable to volume and our efforts to continue to develop our distribution channels by hiring additional direct territory managers and sales agents to assure that our products and their associated benefits are seen by those making or influencing the purchasing decisions, and our sales of products of Tianlong and Peng Lai, which we acquired in fiscal 2008.

 

Contract sales of non-manufactured products amounted to approximately $5,655,000 in the year ended December 31, 2008, or a significant decrease of approximately $7,343,000 from sales of approximately $12,998,000 in 2007.

 

In 2007, our sales model was focused on the creation of our own distribution channels.  Therefore, we sold products directly to many smaller distributors and retail store locations.  In 2008, we changed our business model and entered into distribution agreements with larger regional sales agents, which resell to smaller distributors and retail store locations.  In addition, we began entering into contracts with nationwide chain pharmacies.  In 2008, TDR began to discontinue contract sales as part of its strategic goals.

 

Our change of sales strategy in fiscal 2008 was initiated to improve product channel efficiencies, and to give us access to an increased number of ultimate purchasers.  We believe that these changes will lead to further increased revenue by extending the reach of our distribution network.  We also believe that, by reducing the number of customers we sell to directly, we will be able to streamline our accounts receivable management and collection, and reduce channel distribution costs.  These favorable cost variances are expected be partially offset by product price incentives we grant to the larger agents with which we have contracted.

 

Cost of goods sold increased by approximately $11,464,000, or 105%, from approximately $10,940,000 in the year ended December 31, 2007, to approximately $22,403,000 for the year ended December 31, 2008, as a direct result of increased sales activities, partially offset by a higher gross margin on our sales of Tianlong products following the acquisition in April 2008. Overall, our product gross margins decreased slightly to 76% for the year ended December 31, 2008 from 78% for the year ended December 31, 2007. From January 1, 2008 thought April 2, 2008, revenues from Tianlong contract sales were approximately $1,477,000, and gross profit from these sales were approximately $1,173,000. The gross margin from these sales were approximately 79.4%, After our acquisition of Tianlong, revenues from sales of Tianlong products were approximately $13,803,000, and gross profit from these sales were approximately $12,298,000. The gross margin from these sales was approximately 89.1%. This increase in gross margin from sales of Tianlong’s products following the acquisition was offset by the decrease in gross margins related to sales of certain TDR’s products due to our reduction in the sales prices of certain of our products to be competitive in the PRC market.

 

 

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Sales by Product Line

 

We believe that the most meaningful presentation of our products is by categories of method of delivery. The following table sets forth our principal product categories based on application type, and the approximate amount and percentage of revenue from each of such product categories, during each of the fiscal years ended December 31, 2009, 2008, and 2007:

 

		For the Years Ended December 31 ($ in thousands)
		2009								2008								2007
Product Category		Sales				% of Sales				Sales				% of Sales				Sales				% of Sales
Patches		$	40,770				31.3	%		$	35,484				38.6	%		$	19,609				39.9	%
Ointments			28,862				22.2	%			23,068				25.1	%			3,270				12.6	%
Sprays			18,499				14.2	%			10,613				11.6	%			8,742				18.7	%
Diagnostic Kits			10,239				7.9	%			8,781				9.6	%			2,994				6.1	%
Contract Sales			0				0.0	%			5,655				6.2	%			12,998				16.6	%
Others			31,722				24.4	%			8,215				8.9	%			1,705				6.2	%
Total		$	130,092				100.0	%		$	91,816				100.0	%		$	49,318				100.0	%

 

Year over year – 2009 to 2008

 

During the fiscal year ended December 31, 2008, we acquired Tianlong  (April 2008), Haina (April 2008) and Peng Lai (September 2008).  Our revenues increased in 2009 compared to 2008, primarily due to our cooperation with more reputable sales agents and distributors, which have been able to put our products in more extensive sales networks, and the full-year effect of sales of products of Tianlong and Peng Lai, two of the businesses we acquired in fiscal 2008.  As a result of signing agreements with these distributors, the sales revenues for products in the patches, sprays, and diagnostic kits categories increased 14.9%, 74.3%, and 16.6% year over year.  The revenue increase of approximately $5,794,000 in the ointment category, and the revenue  increase of approximately $23,507,000 in other products category, are primarily due to our increased spending in marketing and advertising for certain products in these categories.  Tianlong’s products generated approximately $43,138,000 and $13,803,000 in 2009 and 2008, respectively.  Revenue generated by Tianlong’s products are included in the ointment, spray and other product categories.  Peng Lai’s products generated approximately $11,188,000 and $2,164,000 in 2009 and 2008, respectively.  Revenue generated by Peng Lai’s products are included in the other product category.  These increases were partially offset by a decrease in our contract sales of approximately $5,655,000, due to our discontinuance of all contract sales as of January 1, 2009.

 

Out of the 91 products we commercialized in fiscal year 2009, 10 products accounted for approximately 68% of the total revenue.  Out of the 97 products we commercialized in fiscal year 2008, 10 products accounted for approximately 72% of total revenue.

 

Year over year – 2008 to 2007

 

Our increase in revenues in 2008 as compared to 2007 was due to a combination of our sale of products of Tianlong and Peng Lai, two of the businesses we acquired in fiscal 2008, as well as our internal growth driven by increases in the revenues of TDR and First.

 

Our internal growth was driven by increases in the revenues of TDR, which increased from $33,326,000 in 2007 to $60,078,000 in 2008 and First, which increased from approximately $2,994,000 in 2007 to approximately $8,781,000 in 2008.  These increases were partially offset by a decrease in our contract sales of approximately $7,358,000, or 57% from approximately $12,998,000 in fiscal 2007 to approximately $5,640,000 in fiscal 2008, due primarily to our discontinuance of contract sales of Tianlong products following the acquisition of Tianlong as of April 3, 2008.

 

 

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In 2008, before TDR acquired Tianlong, the majority of our contracts sales consisted of products purchased from Tianlong. In 2008, TDR began to discontinue contract sales, and in 2009, TDR discontinued contract sales as part of its strategic goals and, in 2009 TDR discontinued contact sales. Revenues derived from the sale of Tianlong products of approximately $4,805,000 and approximately $1,477,000 for 2007 and 2008 respectively, have been reallocated to each of the appropriate product categories to present a more appropriate measure of our revenues by product line.

 

Following the Tianlong acquisition, we were able to fully integrate Tianlong’s products into our marketing and distribution channels and increase overall sales.  As a result, we derived an aggregate of approximately $13,803,000 from the sale of Tianlong’s products for the remainder of 2008, in addition to approximately $1,447,000 of contract sales of Tianlong’s products from January 1, 2008 through the Tianlong acquisition.

 

Prior to our acquisition of Peng Lai, as of September 5, 2008, Peng Lai had nominal production and operations.  Following the acquisition, Peng Lai contributed revenue of approximately $2,164,000 to our total revenue in 2008.

 

Haina did not have an established sales network and was acquired only for its GSP license.

 

Operating Expenses

 

The following table summarizes the changes in our operating expenses for the years ended December 31, 2009, 2008 and 2007:

 

		For the Years ended December 31, ($ in thousands)
		2009				Variance				2008				Variance				2007
Operating Expenses
Selling expense		$	30,763				34	%		$	22,969				55	%		$	14,784
General and administrative expense			4,191				67	%			2,514				82	%			1,380
Depreciation and amortization			2,255				163	%			858				94	%			443
Research and development			14,960				102	%			7,413				135	%			3,158
Total operating expenses		$	52,170				55	%		$	33,754				71	%		$	19,765
Percentage of operating expenses to revenue			40.1	%							36.8	%							40.1	%

Year over year – 2009 to 2008

 

Total operating expenses increased by approximately $18,416,000, or 55%, from approximately $33,754,000 in the fiscal year ended December 31, 2008, to approximately $52,170,000 for the fiscal year ended December 31, 2009.

 

Selling expenses increased by approximately $7,794,000 in 2009 compared with 2008. This increase was primarily related to increased costs of advertising from approximately $7,299,000 in 2008 to approximately $14,527,000 in 2009, resulting from our increased marketing and sales efforts.

 

 General and administrative expenses for the year ended December 31, 2009 increased approximately $1,677,000, or 67%, compared with 2008.  This increase was primarily due to an expense for share-based compensation, of approximately $1,242,000, for common shares we issued in December 2009 ($316,000 in 2008).

 

Depreciation and amortization expenses in 2009 increased by approximately $1,397,000, or 163%, compared with 2008.  This increase was primarily due to:

 

·

the amortization of certain proprietary technologies we acquired in the fourth quarter of fiscal 2008, in the amount of approximately $6.6 million, which are amortized over a period of 10 years; and

 

·

the full year effect of depreciation and amortization of tangible and intangible assets we acquired in the business acquisitions we consummated in fiscal 2008, in the amount of approximately $15.7 million.

 

 

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Research and development expenses were approximately $14,960,000 in the year ended December 31, 2009, compared to approximately $7,413,000 for 2008.  The increased R&D expenses in 2009 were primarily due to our research and development of certain proprietary technologies.

 

Set forth below is certain information regarding our major research and development projects in 2009.  The additional costs and expected completion dates set forth in the table below are subject to change, which may be material, based on various factors, many of which are out of our control:

 

 

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