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CHINA-BIOTICS, INC 10-K 2009 Documents found in this filing:UNITED
STATES
SECURITIES
AND EXCHANGE COMMISSION
Washington,
D.C. 20549
FORM
10-K/A
AMENDMENT
NO. 1
x
ANNUAL REPORT PURSUANT TO
SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For
the fiscal year ended March 31, 2008
For
the Transition Period from _______ to _________
333-110733
(Commission
File Number)
CHINA-BIOTICS,
INC.
(Exact
name of registrant as specified in its charter)
No.
999 Ningqiao Road
Jinqiao
Export Processing Zone
Pudong,
Shanghai 201206
People's
Republic of China
(Address of principal
executive offices)
Telephone
number: (86 21) 5834 9748
(Registrant’s
telephone number, including area code)
Securities
registered pursuant to Section 12(b) of the Act: Common stock, par
value $0.0001 per share (registered pursuant to Form 8-A effective October 22,
2008).
Securities
registered pursuant to Section 12(g) of the Act: None.
Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act. Yes ¨ No þ
Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act. Yes ¨ No þ
Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days. Yes þ No ¨
Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not
be contained, to the best of registrant’s knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K. ¨
Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
the definitions of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act.
Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act). Yes ¨ No þ
The
aggregate market value of voting and non-voting common equity held by
non-affiliates computed by reference to the price at which the common equity was
last sold was $78,103,400 as of the last business day of the registrant’s most
recently completed second fiscal quarter.
Explanatory
Note:
China-Biotics,
Inc. (the “Company”) filed its Annual Report on Form 10-KSB for the fiscal year
ended March 31, 2008 on July 10, 2008. Prior to the implementation of
the SEC’s Smaller Reporting Company Regulatory Relief and Simplification rules,
the Company was a “small business issuer”. For the fiscal year ended
March 31, 2008, the Company was permitted either to continue to use Form 10-KSB
or to file Form 10-K using the scaled reporting requirements applicable to
smaller reporting companies. Form 10-KSB expired on March 15,
2009. Therefore, the Company has filed this amendment on Form 10-K
using the scaled reporting requirements applicable to smaller reporting
companies. TABLE
OF CONTENTS
PART
I
The
information in this document contains forward-looking statements which involve
risks and uncertainties, including statements regarding our capital needs,
business strategy and expectations. Any statements contained herein that are not
statements of historical fact may be deemed to be forward-looking statements. In
some cases, you can identify forward-looking statements by terminology such as
“may,” “should,” “will,” “expect,” “plan,” “intend,” “anticipate,” “believe,”
“estimate,” “predict,” “potential,” “forecast,” “project,” or “continue,” the
negative of such terms or other comparable terminology. You should not rely on
forward-looking statements as predictions of future events or results. Any or
all of our forward-looking statements may turn out to be wrong. They can be
affected by inaccurate assumptions, risks and uncertainties and other factors
which could cause actual events or results to be materially different from those
expressed or implied in the forward-looking statements.
In
evaluating these statements, you should consider various factors, including the
risks described in the discussion beginning on page 17 of this
prospectus under the caption “Risks Related to Our Business” and elsewhere.
These factors may cause our actual results to differ materially from any
forward-looking statement. In addition, new factors emerge from time to time and
it is not possible for us to predict all factors that may cause actual results
to differ materially from those contained in any forward-looking statements. We
disclaim any obligation to publicly update any forward-looking statements to
reflect events or circumstances after the date of this document, except as
required by applicable law.
ITEMS
1 AND 2.
DESCRIPTION OF BUSINESS AND PROPERTIES
In this
document, references to the “company,” “we,” “us” and “our” refer to
China-Biotics, Inc. and our predecessors and subsidiaries, unless the context
otherwise requires.
History
We were
incorporated under the name Otish Resources, Inc. in Delaware in
February 2003. Prior to March 2006 we were a mineral exploration
stage company specializing in acquiring and consolidating mineral properties
with potential for commercial ore bodies. Although we conducted some preliminary
exploration work with respect to our mineral properties, we never achieved full
operations with respect to our mineral properties. We had never generated any
revenue from our mineral exploration operations.
On
March 22, 2006, we entered into and completed a securities exchange
agreement with Sinosmart Group Inc., or SGI, and the SGI shareholders pursuant
to which the SGI shareholders transferred all of the equity securities of SGI to
us in exchange for the issuance of shares of our common stock. We refer to
this transaction in this document as the share exchange. At the closing of the
share exchange, we issued to the SGI shareholders an aggregate of
15,980,000 shares of our common stock in exchange for their shares of
SGI, and SGI became our wholly-owned subsidiary. SGI owns all of the equity
securities of Shanghai Shining Biotechnology Co. Ltd., or Shining. As a result
of the share exchange, we are no longer a mineral exploration stage company, and
SGI’s business operations become our primary operations. We are currently
engaged in the research, development, production, marketing and distribution of
probiotics products. These products contain live microbial food supplements
which beneficially affect the host by improving its intestinal microbial
balance. In connection with the share exchange, the following also
occurred:
At the
closing of the share exchange, we entered into the following agreements with
certain of our stockholders:
-2-
In
addition, we granted these investors a right of first offer with respect to
any shares of capital stock we sell at a per share price below the then
current market price. The agreement will terminate upon the earlier of:
(a) the date these investors as a group hold less than 25% of our
outstanding shares of common stock, (b) two years from the date of the
agreement, and (c) the date the put right set forth in the Put Agreement
described below is exercised.
Immediately
prior to the completion of the share exchange, Stan Ford, our then-current
director, President, Secretary and Treasurer, beneficially owned 94.8% of our
common stock. Upon the completion of the share exchange, private placement and
Stan Ford Transaction, the former SGI shareholders and their designees
collectively owned 98.7% of our common stock, Song Jinan, our then then-sole
director and President, owned 29.8% of our common stock and members of his
family owned an additional 20.3% of our common stock.
In
February 2006, in anticipation of a potential business combination
transaction, we purchased 1 million shares of our common stock from one of
our directors, Fred Cooper, for $750.
SGI was
incorporated in the British Virgin Islands on February 13, 2004. SGI’s original
shareholders were Mr. Song Jinan, Ms. Yan Li, Mr. Huang Weida and Ms. Yan Yihong
(the “Original SGI Shareholders”). Ms. Kwok Kin Kwok became the sole shareholder
of SGI on March 11, 2005 when she purchased 1000 shares of SGI (100% of the
outstanding shares of SGI) from the Original SGI Shareholders. The SGI shares
were sold to Ms. Kwok in order to comply with Chinese government regulation and
to facilitate the future listing of China-Biotics stock outside of China. The
temporary transfer of stock to a third party in this manner is a common practice
in China.
Until
August 2005, the Original SGI Shareholders owned 99.5% of the outstanding stock
of Shanghai Shining Biotechnology Co. Ltd. (“Shining”), with Shanghai Shengyuan
Property Co., Ltd. (“Shengyuan”) owning the remaining 0.5% of the Shining
equity. Shengyuan became a shareholder of Shining in 2002 when Shining became a
joint stock limited company in order to comply with a Chinese law requiring that
joint stock limited companies have a minimum of five
shareholders. -3-
On August
11, 2005, SGI entered into an agreement to acquire 100% of the outstanding
Shining shares from the Original SGI Shareholders and Shengyuan in exchange for
a total cash consideration of $2.27 million (RMB 18.35 million). Under the terms
of this agreement, SGI agreed to make full payment of the consideration within
three months after the transaction was approved by the relevant government
authorities in the People’s Republic of China. On August 19, 2005, the
transaction was approved by the Economic and Trade Bureau of the Pudong New
District, Shanghai, People’s Republic of China and in October 2005, SGI made
full payment of $2.27 million to the Original SGI Shareholders. In December
2005, SGI’s acquisition of Shining was consummated when a revised business
license was issued to Shining as a Wholly Owned Foreign Corporation, signifying
the formal recognition of SGI as Shining’s sole shareholder by the Chinese
government authorities.
Also on
August 11, 2005, SGI and the Original SGI Shareholders entered into a
supplemental agreement granting the Original SGI Shareholders the option to
purchase an aggregate of 9,000 share of SGI for $1.00 per share. No
consideration was paid by the Original SGI Shareholders in exchange for the
option. On October 25, 2005, the Original SGI Shareholders exercised the option
and purchased 9,000 shares of SGI for an aggregate of $9,000. After exercise of
the option, the Original SGI Shareholders owned 9,000 shares of SGI (90% of the
outstanding SGI equity) and Ms. Kwok owned 1,000 shares of SGI (10% of the
outstanding SGI equity).
In the
share exchange, the Original SGI Shareholders exchanged their 9,000 SGI shares
for 10,067,400 shares of Company common stock, which represented 63% of the
total of 15,980,000 shares received by all SGI shareholders in this transaction.
Ms. Kwok’s shares of SGI stock were exchanged for 1,118,600 shares of Company
common stock issued in the name of Bright Treasure Group Ltd., an entity that is
beneficially-owned by Ms. Kwok.
On
December 9, 2005, SGI incorporated a wholly-owned subsidiary, Growing State
Limited, in accordance with the laws of the British Virgin Islands. On September
22, 2006, Growing State Limited established a wholly-foreign owned enterprise,
Growing Bioengineering (Shanghai) Company Limited, in China.
On
December 11, 2007, we sold a 4% Senior Convertible Promissory Note in the amount
of $25,000,000 (the “Note”) with a maturity date of December 11, 2010 to Pope
Investments II LLC, an affiliate of Pope Investments, LLC, in a private
placement. In connection with the sale, we entered into an Investment Agreement
and a Registration Rights Agreement. In addition, Mr. Song Jinan, the company’s
Chief Executive Officer, Chairman, and largest shareholder, entered into a
Guaranty Agreement and a Pledge Agreement, pursuant to which Mr. Song agreed to
guaranty the company’s obligations under the Note and to secure such guaranty
with a pledge of 4,000,000 shares of China-Biotics common stock owned by Mr.
Song. The principal amount of the Note is convertible into shares of our common
stock at an exercise price of $12.00 per share at any time until the maturity
date subject to adjustment for subdivision or combination of our common stock
and similar events. If the Note is not converted at maturity, we will
redeem the Note to provide Pope with a total yield of 10% per annum inclusive of
the annual interest. The Note also provides for mandatory conversion into common
stock if we achieve a net income of $60 million in fiscal year 2010. Pope
Investments II LLC may declare the outstanding principal amount and any accrued
but unpaid interest, calculated at a rate of 10% per annum, to be immediately
due and payable upon an event of default, including non-payment of obligations
under the Note, bankruptcy or insolvency, or failure to perform any covenant set
forth in the Note or Investment Agreement. Pursuant to the Investment Agreement
we have secured payment of our obligations under the Note with a pledge of
100% of the stock of our subsidiary, SGI, to Pope Investments II
LLC.
Net
proceeds of the Note are expected to be used to fund the construction of a
proposed 150-metric-ton-per-year manufacturing facility and for other capital
expenditures.
Current
Operations
Overview
We are
engaged in the research, development, production, marketing and distribution of
probiotics products, which are products that contain live microbial food
supplements which beneficially affect the host by improving its intestinal
microbial balance. -4-
Our first
product, Shining Essence, was approved by the Chinese Ministry of Health for
production and to market as a health product in August 2000. We launched Shining
Essence in Shanghai in April 2001, and it is currently our best-selling product,
representing approximately 61% of our total sales for the year ended
March 31, 2007 and 48% for the year ended March 31, 2008. The Health Food
Association of China named Shining Essence as the best selling liver health
product in 2001.
From
October to December 2001, we obtained three patents for our production process,
packaging design and packing equipment design. We applied those technologies in
manufacturing process of all products under the “Shining” brand. In June 2004,
we submitted an application for registration of a patent regarding the
production of one of our products to the Intellectual Property Bureau of China.
We have obtained approval for this patent, but have not yet been issued a formal
certificate by the authorities.
In
February 2002, we obtained the certifications below from TÜV
Rheinland/Berlin-Brandenburg Group of Companies. Management believes that our
Shanghai production plant was the first and the only production plant in China
for probiotics that obtained all four certifications.
HACCP> . We obtained HACCP DS
3027 E:1997 certification from TÜV Anlagentechnik GmbH in respect of our
production process for our Shining Essence product, which expires in July 2009.
The term “HACCP” stands for Hazard Analysis Critical Control Point. The HACCP DS
3027 E:1997 standard was developed to ensure food safety among food
manufacturers and their suppliers in Denmark.
Products
We
manufacture and sell several health supplements under the “Shining” brand in the
Shanghai area as set forth below. All of these products have been approved by
the Ministry of Health in China and their content has been tested by the
Shanghai Preventative Medicine Research Institute, which found that our products
contain the quantities of bacteria specified by us. While management believes
these products to be effective, their effectiveness has not been conclusively
established.
Our four
major products are:
-5-
In
addition, in March, 2006, we opened our first retail store in Shanghai and
launched the following products in the market:
We intend
to continue to develop new products to strengthen our product pipeline so that
we may offer an array of products for sale in the market.
Business
prospects
Leveraging
on what our management believes are our technical competence, cost efficiencies
and highly recognized brand, our management expects to achieve significant
growth through:
-6-
Industry
overview and market condition
Probiotics
We
manufacture and sell probiotics. Most probiotics are bacteria based and
naturally exist in the human body in the lower intestinal tract. The
introduction of “helpful” bacteria and other organisms may aid in preventative
fights against infection and improve digestion, especially with respect to dairy
products.
Probiotics
generally have a very short life-span. Water, acid and oxygen are harmful to
probiotics and most die or cease to function after a short period of time after
extraction from the source. A reduction of these naturally-occurring organisms
due to poor eating habits, stress, or the use of antibiotic drugs or other
factors may disrupt the natural equilibrium of the body and could lead to a
variety of abdominal ailments and an overall decrease in the function of the
immune system. Based on information available
on the website www.usprobiotics.org
, a non-profit research and education website sponsored by the California Dairy Research
Foundation and Dairy & Food Culture Technologies, researchers are
also studying potential links between low probiotics microbial levels and
hypertension, certain types of cancer, high cholesterol, and allergies (to
access this information, click on the Section "Probiotics Basics," and then
click on the Section "Health Effects of Probiotics." Subsections of "Health
Effects of Probiotics" include "hypertension," "cancer," "elevated blood
cholesterol" and "allergy.")
China
market
-7-
Demand for dairy product additives is
expected to increase significantly.> The demand for functional foods and
foods that use probiotic supplements is growing at a significant rate. According
to AC Nielsen (article available at
http://cn.en.acnielsen.com/news/20050916.shtml), yogurt and yogurt drinks are
the fastest growing products in the food products segment in China, with sales
increasing by 38% in 2004 alone. Sales of infant formula grew 23% in the same
year. Moreover, according to statements made by the Nutrition Development Centre
of National Development and Reform Commission in China, effective April 1, 2007,
probiotics will be added to baby milk powders produced in China. These factors
translate into significant growth in demands in China for live bacteria as food
addictives.
Business
strategies
Leveraging
on what our management believes are our technical competence, cost efficiencies
and highly recognized brand, our management expects to achieve significant
growth through:
Bulk
market
Most
probiotics used for the manufacture of yogurt, milk powder products and food
preservatives are currently imported. However, we believe imported probiotics
are significantly more expensive and are of lower quality as most bacteria die
during transport. In addition, according to statements made by the
Nutrition Development Centre of National Development and Reform Commission in
China, on April 1, 2007, probiotics must be added to baby milk powders and
other products produced in China. The relevant regulations will be implemented
at a later date. We believe we are poised to achieve first-mover advantage
into the bulk additive business for functional foods through the completion of
our 150-ton capacity plant, which is scheduled to commence production in
the fourth quarter of 2008. Management estimates that Phase 1 of
the project, which involves constructing a facility capable of producing 150
tons of probiotics per year, will cost $27.50 million, $25 million of which is
expected to be paid by the fourth quarter of calendar year
2008 and the balance by the end of third quarter of calendar year 2009.
Phase 2 of this project will only commence when demand for probiotics has
exceeded the production capacity of the Phase 1 facility. Phase 2 of
this project is expected to cost $18 million. The construction cost of
Phase 1 of the plant will be funded by cash received from the sale of
convertible promissory notes to Pope Investments II LLC on December 11, 2007 as
disclosed in “Business-History”. Management believes that there are currently no
manufacturers capable of providing probiotics to be used as additives in China.
Management believes that when completed, this new production plant may be the
only probiotics plant in China that will be able to meet the demands for the
domestic bulk additive market.
Geographic
expansion and direct sales
We sell
our products mainly in Greater Shanghai through distributors. Over the past five
years, we believe we have firmly established ourselves in Shanghai as the
leading supplier and manufacturer of probiotics products. We are now expanding
the sale of our products to the other metropolitan cities in China through a
combination of the traditional distribution channels and dedicated Shining
stores.
We opened
the first Shining retail store in Shanghai in March 2006. Over the following 12
months, we have opened a number of pilot stores in Shanghai to test run the
retail sales operations and to build up our retail experience and expertise. We
have also repackaged our products for sale in our stores, and have introduced
several new products which are sold exclusively in our stores. As at March 31,
2008, we had a total of 60 Shining retail stores. 46 of these stores are located
in Shanghai and the rest are located in 5 cities in China including Changchun
and Jilin. -8-
In
preparation for the opening of additional retail stores, we have also been
actively recruiting and training retail sales staff since the beginning of 2006.
We have already successfully recruited a number of very experienced sales
professionals and have trained a pool of sales staff. We have also designed and
implemented control systems to manage this new business.
We plan
to open over 300 stores by the end of fiscal year 2009 in Shanghai and other
major cities in China. Currently, we have a network of 60 stores in China. Among
the 60 retail centers, we have six in Changchun, two in Longyan, two in Jiaxing,
two in Zhengzhou, two in Jilin and 46 in Shanghai. In addition, we have surveyed
the other cities in China to assess and select suitable locations for new
stores.
As part
of our strategy, we will also consider licensing franchisees to operate retail
stores in due course. We intend to finance the costs of our business expansion
by our internal working capital.
Introduction
of new products
In
connection with the opening of our first Shining store, we launched several new
products under the Shining brand. We currently have regulatory approval to
produce fourteen
products that can be marketed under the Shining brand. We plan to develop new
products to strengthen our product pipeline so that we may offer an array of
products for sale in the Shining stores.
Our
Business Prospects
Growth
potential from geographic expansion leveraging on the Shining
brand.
We have
experienced rapid sales growth. Our products are sold through retail outlets
mainly in the Greater Shanghai area under our “Shining” brand. Management
believes that the “Shining” brand is one of the most recognized health
supplement brands in Shanghai. We are expanding the sales of our retail products
to the other major metropolitan cities in China such as Changchun and Jilin.
Given our high gross margin and low overhead structure, management anticipates
that distribution in these areas would be profitable, assuming there is
sufficient demand. Expansion of retail sales is also a key component of the
marketing of our food additives. We intend to co-brand with food producers
allowing consumers to identify food products that use our additives as high
quality and beneficial. We require our “Shining” logo to be incorporated in the
packaging of products manufactured by food producers which contain probiotics
additives supplied by us. We have already entered into agreements with 3 food
producers for use of our products as food additives. These customers include
Bright Dairy, the third largest dairy company in China and Holiland Group, a
large bakery supplier with nationwide retail coverage.
Significant
potential from the new bulk business (yogurt).
Live
bacteria are essential to the formulation of yogurt and yogurt -based drinks.
Yogurt and yogurt drinks were the fastest growing food product segments in China
in 2004 according to AC Nielsen. Our management believes that there are
currently no manufacturing facilities in China that are capable of producing
high quality probiotics food additives for yogurt and yogurt drinks. As a
result, yogurt producers in China currently import most of their probiotics
additives. We believe that importation of probiotics is costly and a portion of
the effective ingredient (bacteria) dies during transportation. Our new plant is
intended for bulk manufacturing of probiotics for use as food additives for
foods such as yogurt and yogurt drinks. Management believes that, when
completed, this plant may be the only probiotics plant in China that will be
able to meet the demands and standards for the bulk additive
market.
Significant
potential from the new bulk business (milk powder).
Manufacturers
have begun to add probiotics to infant formula and milk powders to facilitate
and improve digestion and absorption as well as strengthen the immune system of
infants. Currently, infant formula made in China by some multinational companies
such as Nestle and Mead Johnson already use imported probiotics produced by
Institut Rosell and Chr. Hansen and other producers in their products. According
to statements made by the Nutrition Development Centre of National Development
and Reform Commission in China, effective April 1, 2007, probiotics are added to
baby milk powders produced in China. Relevant regulations are expected to be
announced at a later date. Currently, management believes there is no
manufacturing facility in China that can meet the demand for probiotics if this
requirement was imposed. Once our new plant is operating, we believe we will be
well positioned to capture this significant new demand for
probiotics. -9-
Advanced
technology provides product quality advantages.
We
believe our proprietary production technology gives us a significant advantage
over our competitors in three respects:
Strong
revenue and profit growth.
Our
probiotics products have generated strong sales and profit growth during the
past two years, and have generated sufficient cash flow to finance our
operations. Sales of our probiotics products increased 38% to $42.3 million in
fiscal year 2008 from $30.6 million in fiscal year 2007. Similarly, income
before taxes increased from $15.1 million in fiscal year 2007 to $22.5 million
in fiscal year 2008. Excluding the $3.4 million gain arising from the
revaluation of the conversion option embedded in the convertible notes issued in
December 2007 included in other income, income before taxes increased by 26.6%
from 2007 to 2008.
Production
We use
micro-ecology technologies to produce the live bacteria which are the active
ingredients of our probiotics. We use a multi-stage fermentation process under a
strictly controlled environment using our proprietary technology. Solid bacteria
are then extracted and stored using controlled freeze drying methods. Prior to
sale to our customers, we transform the solid bacteria into capsule form and
place it in sealed double aluminum packaging using our patented
equipment.
We have
registered the following patents in China:
In June
2004, we submitted an application for registration of a patent regarding the
production of one of our products to the Intellectual Property Bureau of
China. We have obtained approval for this patent, but have not yet been
issued a formal certificate by the authorities.
Our
management believes that we enjoy the following competitive advantages in
utilizing such microecologics technology in our production process:
-10-
Distribution
We sell
our products mainly in the greater Shanghai area, mainly to large distributors
who then sell them through their networks to supermarkets, hypermarkets, such as
Wal-Mart, Carrefour and Lotus, and drug stores. As of March 31, 2008, we had 14
distributors located in Shanghai, Jiangxu, Zhejiang and Hong Kong. At
March 2008, we had 60 Shining branded stores in Shanghai and 5 other major
cities in China. We intend to open over 300 stores by the end of fiscal year
2009. We have been hiring senior executives with strong retail and direct
selling experience to implement our direct retail sale strategy. We are creating
a “Community Network” through which we continuously provide training and
seminars to educate the public about becoming more health conscious and about
the benefits of probiotics and the Shining products. We believe that this
approach has many advantages:
Customers
We have
two different types of customers, consumers and food product manufacturers. Food
product manufacturers include suppliers of dairy producers, bakery and other non
dairy products; and animal feed manufacturers. Consumers are primarily
individuals in major metropolitan areas who are middle aged or above having
middle to higher income levels. We believe that these individuals are becoming
increasingly health-conscious and as their income levels increase, they spend
more on health related products such as probiotic products. We have historically
reached consumers by selling our products to large distributors, who then sell
them through their networks to supermarkets, hypermarkets, such as Wal-Mart,
Carrefour and Lotus, and drug stores, where they are purchased by consumers. At
March 2008, we had 60 Shining branded stores in Shanghai and 5 other major
cities in China where we sell our products directly to the end users. We intend
to have over 300 stores by the end of fiscal year 2009. We believe owning our
own distribution channel and having direct access to the end users will become a
significant entry barrier in the future. For the year ended March 31, 2008,
there are two customers that accounted for 15.5% and 10.5% of our sales revenue.
For the year ended March 31, 2007, no single customer accounted for 10% of our
total sales. -11-
Marketing
and Advertising
We
promote our products through the media by placing advertisements in newspapers
and magazines and on television in China. From time to time, we also sponsor
charitable events to increase public awareness of the benefits of our health
products.
Competition
The
dietary supplement market in China is highly fragmented, with many competitors.
Many manufacturers are local or regional. Management believes that although
there are currently over ten microecologics product producers in China, most of
them lack substantial product development skills and research capability. We
believe that we produce superior products, and that the probiotics contents in
our competitors’ products are not clearly stated on the product labels and
contain an uncertain quantity of active probiotics bacterium.
In
connection with our manufacturing operations, we extract probiotics bacterium
from organisms cultured from human sources to reduce the risk that the active
ingredients will be rejected by the human body. Our proprietary technology
protects the active ingredients in probiotics (live bacteria) and allows a
survival rate of bacteria of 70% two years after manufacture. Management
believes this longevity rate is the highest among all manufacturers of
probiotics products in China. In addition, the concentration of active
ingredients we produce is over 100 times that of the minimum governmental
standards in China.
The table
below contains a comparison of our microbial technology with that of two of our
most comparable competitors in the PRC and one comparable competitor in Japan.
Microbial technology relates to (1) the mass production and use of beneficial
microorganisms and its metabolites and (2) the development of methods which
prevent damages to industrial products caused by harmful microorganisms.
Research in the field of microbial technology generally relates to the study of
microorganisms involved in the fermentation, molding and rotting of industrial
products, focusing on biological characteristics of the microorganisms and the
fermentation process and aimed at maximizing the benefits and minimizing the
negative effects. Traditional researches focuses on food production, industrial
fermentation and preservatives for industrial products. This technology has
developed to a new phase which focuses on fermentation engineering with
microorganisms as the main body.
The
metric “Quantity of active probiotics (cfu/g) that can be maintained” is a
standard commonly used to measure the effectiveness of probiotics. It refers to
the concentration of live bacteria that are maintained over a specified time
period—products with a higher quantity of the active probiotics that can be
maintained are generally recognized as higher quality products. The
international standard is CFU10 6 /g
within 3 months.
The table
below compares the vitality and active rate of our probiotics supplements with
that of our comparable sample competitors. The vitality and active
rate is the most important factor in determining the nutritional value of lactic
acid bacteria contained in our products, which The Institute of Microbiology,
Chinese Academy of Sciences has confirmed is beneficial to humans. The vitality
rate is a ratio of live probiotics contained in a product—the higher the content
of live probiotics in a product, the higher the vitality rate and the higher the
nutritional value of the product. -12-
Set out
below is a comparison of some of the features of our products and similar
products:
(1)
According to a notice issued by the Chinese Ministry of Health on March
23, 2001 (reference number: Wei Fa Jian Fa (2001) No. 84) regarding live
bacteria products in China, which took effect in 2001, these types of products
should maintain concentrations of live bacteria at a level of 10 6 /cfu/ml
(g) within their stated effective period. The Chinese Ministry of Health
notice also clearly expressed that the liquid form of products to carry bacteria
was not recommended and listed a set of recommended bacteria types. The labels
that we have attached to the products indicated as “ Recommended”, “Not
recommended” or “Below standard” in this table indicate whether the form of
products, bacteria type or concentration levels of live bacteria below this
amount met the standards set by the Chinese Ministry of Health
notice.
The
information regarding our competitors’ products in each of the three tables
above was obtained from the labels of their products. No governmental or other
authority specifically considered or rated the specific products in these
tables.
The
competition for bulk additives comes mainly from large overseas producers and
food importers that produce their own supplements. Our management believes that
we have a significant advantage over these competitors in terms of both cost and
quality of product. We are directing efforts toward encouraging customers to
switch from imported bacteria to our products as additives for the production of
yogurt, sour milk and other food products.
Research
and Development
We have a
strong research and development team supported by a technical advisory board of
experts. At March 31, 2008, we have 30 staff members with Masters degrees or
PhDs. In addition to having advanced technology in bacteria culturing and
protection, we also conduct research and development into complimentary
technology, including genetically engineered drugs, drug delivery solutions and
Chinese medicine, in an effort to formulate solutions to address specific health
problems and expand our product line. We incurred research and development costs
of approximately $497,817 and $2,194,474 for the year ended March 31, 2007 and
2008 respectively. Such research and development costs are mainly comprised
of raw material costs, laboratory expenses and staff salaries in the research
and development division, which were included as part of the production costs
in our financial statements for such periods.
Government
Regulation
Food
Business
Laws and
regulations governing our business include the following: the Law on the Food
Conditions of the PRC promulgated and enforced on October 30, 1995, the
Administrative Rules for Healthy Food promulgated by the Ministry of Health, or
MOH, on March 15, 1996 and enforced on June 1, 1996, the Notice of
Circulating the Appraisal Standard of Fungal and Good-Live-Bacterial Healthy
Food and its appendixes-Appraisal Standard of Fungal and
Good-Live-Bacterial Healthy Food, and List of Good-Live-Bacteria Applicable for
Healthy Food, which are promulgated by the MOH and enforced on March 23,
2001, and the Administration Rules for the Registration of Healthy Food
(experimental) promulgated by the State Food and Drug Administration, or SFDA,
on April 30, 2005 and enforced on July 1, 2005. -13-
The
previous governing authority of healthy food was the MOH. Since the General
Office of the State Council of the PRC promulgated the Regulations on the
Internal Organizations and Staff Schedule of the State Food and Drug
Administration on April 25, 2003, the responsibility of approving healthy food
of MOH has been assigned to the SFDA. The SFDA is a direct subordinate authority
under the State Council and its responsibilities are generally supervising the
safety control of food, healthy food and cosmetics, and supervising
drugs.
Pursuant
to the Law on the Food Conditions of the PRC, a food manufacturing or other
food-related enterprise may not engage in any food manufacturing or other
food-related business until it obtains a Health License issued by the competent
health administration. While using a new resource in manufacturing food, before
the formal production, the company must apply for an approval in accordance with
applicable standard food condition application procedures, and obtain a New Food
and Food-used Products Health Approval.
Pursuant
to the Administrative Rules for Healthy Food, the MOH applied an approval system
for healthy food. Any food claiming to have health care functions was required
to be inspected and confirmed by the MOH, which would issue a Certificate of
Healthy Food upon a successful inspection. After the Administration Rules for
the Registration of Healthy Food were enacted, SFDA will make an integral
appraisal and inspection of the safety, effectiveness, quality control and the
label and introduction of the healthy food. If permitted, the SFDA will issue an
Approval Certificate of Native Healthy Food, which is valid for five
years.
Pursuant
to the Appraisal Standard of Fungal and Good-Live-Bacterial Healthy Food, an
enterprise using good-live-bacteria in manufacturing healthy food must satisfy
the following requirements: form a Good Manufacturing Practice (GMP) and a
step-by-step Hazard Analysis Critical Control Point (HACCP) quality control
system; possess a pilot scale experiment manufacturing scale (at least 500 cubic
liters), and submit its pilot scale experiment products for approval; have
special plants or workshop, specific manufacturing equipment and devices, a
good-live-bacteria lab, special staffs looking after the bacteria under the
supervision of experts with at least middle level expert title, and specific
technical rules and procedures. In addition, these Rules require that
good-live-bacterial healthy food must maintain its active bacteria population at
more than 10 6 cfu/ml
during its storage term.
Pursuant
to the List of Good-Live-Bacteria Applicable for Healthy Food, nine
good-live-bacteria can be used in healthy food, including Bifidobacterium
bifidum, B.infantis, B.longum, B.breve, B.adolescentis,
Lactobacillus.bulgaricus, L.acidophilus, L.Casei subsp.casei, and Streptococcus
thermophilus.
Intellectual
Property
The
tables below set forth the trademarks and patents that we have registered in
China. The trademarks were granted by the Trademark Office of State
Administration of Industry and Commerce of the People’s Republic of China and
the patents were granted by the State Intellectual Property Administration
Office of the People’s Republic of China. Each of these trademarks and patents
is enforceable only within China.
Trademarks
-14-
Patents
Pursuant
to the Patent Law of the PRC and its implementation rules amended on August 25,
2000, Chinese laws protect the following three kinds of patents: patent for
invention, patent for utility model and patent for design. The State Bureau of
Intellectual Property is responsible for the management of patents in China,
accepting and reviewing patent applications and granting patents pursuant to
laws and regulations. Any invention or utility model for which patent right may
be granted must possess novelty, inventiveness and practical applicability. Any
design for which patent right may be granted must neither be identical with or
similar to any design which, before the date of filing, has been publicly
disclosed in publications in the country or abroad or has been publicly used in
the country, nor conflict with legal rights of any third party obtained before.
The protection period of patent for invention is 20 years and the protection
period of patent for utility model or design is 10 years, both calculating from
the application date.
Under the
Patent Law of the PRC, we may enforce our rights attached to the registered
patents against the infringer by applying to the relevant governing authorities
for an injunction. We may also apply to the People’s Court for an order of
specific performance which prohibits any third parties from using the registered
patents. The relevant governing authorities may also impose a fine up to three
times the profits made by the infringer from the unauthorized use of the
registered patents or a fixed fine up to RMB50,000 for cases which the infringer
has not earned any profits from such unauthorized uses.
Pursuant
to the Trademark Law of PRC and its implementation rules amended on October 27,
2001, a registered capital may refer to a trademark registered with the
Trademark Bureau, including products, service trademark and collective
trademark, attest trademark; the trademark owner shall have exclusive rights of
using the trademark, under the protection of laws. The exclusive rights of using
the trademark is limited within the registered trademark and the registered
products on which the trademark can be used. The Trademark Bureau of the State
Administration for Industry and Commerce is responsible for managing the
trademark registration and administration throughout the PRC. The protection
period of registered trademark is ten years from the registration
date.
Taxation
and Local Governmental Support
Income
tax of a foreign-invested enterprise in China is principally governed by the Law
on the Income Tax of Foreign-invested Enterprises and Foreign Enterprises of the
PRC and its implementation rules promulgated and enforced on July 1, 1991.
Pursuant to those law and regulations, the corporate income tax rate of a
foreign-invested enterprise is 30%, and the local income tax rate is 3%.
However, foreign-invested enterprises which are located in certain areas or
satisfy certain qualifications are entitled to a corporate income tax exemption
or deduction. For instance, a manufacturing foreign-invested enterprise
established in Pudong District, Shanghai, is entitled to pay its corporate
income tax at a reduced tax rate of 15%. In addition, a manufacturing
foreign-invested enterprise, with a business term in excess of 10 years, is
entitled to a two-year corporate income tax exemption calculating from its first
profitable year, and for the following three years, such foreign-invested
enterprise is entitled to a half deduction of its applicable corporate income
tax rate. From January 1, 2008, the income tax rate is expected to gradually
increase to the standard rate of 25% over a five-year transition period.
However, the New Corporate Tax Law has not set out the details as to how the
existing preferential tax rate will gradually increase to the standard rate of
25%.
Foreign
Exchange
Foreign
exchange in China is principally governed by the PRC Foreign Exchange Control
Regulations promulgated by the State Council and enforced on April 1, 1996, and
the Regulations on the Administration of Foreign Exchange Settlement, Sale and
Payment promulgated by the State Council and enforced on July 1, 1996. Under
these regulations, upon payment of the applicable taxes, foreign-invested
enterprises may convert the dividends they received in Renminbi into foreign
currencies and remit such amounts outside China through their foreign exchange
bank accounts. -15-
If a
foreign-invested enterprise needs foreign exchange transaction services in
relation to the current account item, it may make such payment through its
foreign exchange account or make an exchange and payment at one of the
designated foreign exchange banks by providing applicable receipts and
certificates, and with an approval from the State Administration of Foreign
Exchange, or SAFE. If a foreign-invested enterprise distributes dividends to its
shareholders, it will be deemed as foreign exchange transaction services in
relation to the current account item, therefore, as long as it provides the
board resolutions and other documents authorizing the distribution of dividends,
it may make such payment through its foreign exchange account or make an
exchange and payment at one of the designated foreign exchange
banks.
Notwithstanding
the above, foreign exchange conversion matters under the capital account item
are still subject to regulatory restrictions, and a prior approval from SAFE or
its relevant branches is required before conversion between Renminbi and other
foreign currencies.
Facilities
We do not
own any real estate. We conduct our operations from a leased facility in Pudong,
Shanghai. Pursuant to our lease for this facility, which expires on October 19,
2008, we pay annual rent of RMB507,532, payable in monthly installments of
RMB42,294. This facility, which includes a level 100,000 clean room and a level
10,000 clean room, houses our office space manufacturing facilities and
warehouse. The maximum current production capacity at this location is
approximately 3.5 million capsules per month. We have received ISO 9001,
ISO 14001, OHSAS 18001 and HACCP certifications for this facility. See “Business—Current
Operations—Overview” for further information with respect to these
certifications.
We have
completed laying foundation and placed orders for the equipment for the
construction of a bulk manufacturing facility that will have an initial capacity
of 150 tons per year of bulk product with room for expansion to 300 tons per
year based on market demand. Management estimates that Phase 1 of the project,
which involves constructing a facility capable of producing 150 ton probiotics
per annum, will cost $27.50 million, $25 million of which is expected to be
paid by the fourth quarter of calendar year 2008 and the
balance by the end of third quarter of calendar year 2009. Phase 2 of this
project will only commence when demand for probiotics has exceeded the
production capacity of the Phase 1 facility. Phase 2 of this project is
expected to cost $18 million. The construction cost of Phase 1 of the plant
will be funded by cash received from the sale of convertible promissory
notes to Pope Investments II LLC on December 11, 2007 as disclosed in
“Business-History”. On March 21, 2006, Growing State, our subsidiary, entered
into an agreement with Shanghai Qingpu Industrial Park District Development
(Group) Company Limited for the lease of 73,157 square meters of land in the
Shanghai Qingpu Industrial Park District on which we will construct this plant.
The agreement provides for the payment of leasing fees of approximately $2.1
million, 10% of which we paid on April 11, 2006 as a deposit, to be refunded
upon payment in full of the aggregate lease amount. The Qingpu People’s Republic
Government issued its formal confirmation of the land use right necessary
for the plant construction on November 30, 2007 and confirmed the leasing fee of
$1.78 million (reduced from $2.1 million because the size of the leased
land was reduced to 36,075 square meters) and a refundable land
deposit of $210,083. We have since paid the leasing fee and land deposit
and are waiting for the formal land use right certificate to be issued. The land
deposit is to be refunded when both the land use right is fully paid and
the approval documents are released by the Shanghai Qingpu local government
authorities. There are no future lease payments under this land
lease.
Employees
As at
March 31, 2008, we had 307 staff and employees. The following table
summarizes the functional distribution of our employees:
All of
these employees were full-time. We do not have any payment obligations for any
retirees and are not currently retaining any contractors. -16-
According
to Article 10, Trade Union Law of the People’s Republic of China an enterprise,
public institution or government organ with 25 or more members must establish a
basic-level trade union committee. However, a union is established only if it is
voluntarily formed by the employees. We currently do not have a trade
union.
Risks
Related to Our Business
We
depend on the services of our directors and key employees, the loss of which
could harm our business.
We
believe our success relies on the strategies, vision, efforts and technical
expertise of our directors and key management personnel, including Mr. Song
Jinan, and Dr. Huang Weida. The resignation or departure of any of these key
people could have a material adverse impact on our operations and future
prospects. In addition, if any of these key people join a competitor or form a
competing company, we could lose customers and incur additional expenses to
recruit replacements and train personnel. We have entered into standard form
confidentiality agreements with our technical employees with the exception of
our directors and our key executives which contain non-competition clauses. We
do not maintain key-man life insurance for any of our key
executives.
Failure
to attract and retain qualified employees may adversely affect our
business.
Our
continued success depends largely on our ability to attract and retain highly
skilled executive, managerial and technical employees. We may face difficulties
in recruiting skilled personnel in our industry due to its specialized nature.
If we are unable to attract and retain a sufficient number of suitably skilled
and qualified personnel, our business would be materially and adversely
affected. We may also have to pay substantial wages to attract sufficient
numbers of skilled employees and professionals, which may adversely affect our
operating margins.
We
are not insured against potential losses and could be seriously harmed by
natural disasters, catastrophes or acts of war.
Our
facilities and inventories could be materially damaged by hurricanes, floods and
other natural disasters, catastrophes, acts of war or other catastrophic
circumstances. We do not maintain insurance covering such events. If any of
these events occur, we could incur material losses and liabilities, which could
negatively affect our operating results.
We
may incur material product liability claims, which could increase our costs and
adversely affect our reputation, revenues and operating income.
As a
manufacturer of products designed for human consumption, we are subject to
product liability claims that the use of our products has resulted in injury.
Our products contain three types of live bacteria, lactobacillus acidophilus,
bifidobacterium bifidum and bifidobacterium adolescentis, which fall within the
nine types of “good” live bacteria that are approved for direct sale to the
public in China as health food. We obtain our bacteria from human sources.
Although we believe this reduces the risk that it will be rejected by the human
body, there can be no assurance that consumption of such bacteria could not
result in adverse health effects. We do not maintain any product liability
insurance. A product liability claim against us could result in costly
litigation and could adversely affect our reputation with our customers, which
in turn could adversely affect our revenues and operating income.
Our
revenues primarily depend on sales of one product and a decline in sales of this
product could cause our revenues to decrease.
We have
derived the majority of our revenue from the sale of our Shining Essence
product. Sales of this product represented approximately 61% and 48% of our
total sales for the year ended March 31, 2007 and 2008 respectively. We
expect that Shining Essence will continue to account for a large portion of our
revenues for the foreseeable future. Any factors adversely affecting the pricing
of, demand for or market acceptance of Shining Essence, including increased
competition, could cause our revenues to decline and our business and future
operating results to suffer.
We
are subject to concentrations of credit risk that could adversely affect our
operations.
Our
principal operations are in China and all of our sales during fiscal years 2007
and 2008 arose in China. A significant number of our financial instruments,
principally cash and accounts receivable, are located in China. These financial
instruments include:
The
concentration of these financial instruments in China subjects us to
concentrations of credit risk that could adversely affect our operating
results. -17-
If
our products fail to keep pace with advances in the industry, they may be
displaced by competitors’ newly developed products.
Other
companies in our industry may gain significant competitive advantages by
introducing new products to the market, delivering constant innovation in
products and techniques and offering competitive prices. Our future growth
partially depends on our ability to develop products that are more effective in
meeting consumer needs. In addition, we must be able to manufacture and
effectively market those products. The sales of our existing products may
decline if a competing product is introduced by other companies.
We
may have difficulty competing with larger and better financed companies in our
industry, which could require us, among other things, to lower our prices and
could result in the loss of our customers.
Some of
our existing and future competitors may have greater technical and financial
resources than we do and may use these resources to pursue a competitive
position that threatens our products. Our products could be rendered obsolete or
uneconomical by the development of new products to treat conditions addressed by
our products, as a result of technological advances affecting the cost of
production, or as a result of marketing or pricing action by one or more of our
competitors.
Additionally,
with China’s accession to the World Trade Organization, the Chinese government
has undertaken to open up the Chinese market to foreign companies. China reduced
its average import tariff rate overall to 11.50% in 2003 and has further reduced
it to 9.90% in 2005. As a result, foreign competitors may form alliances with or
acquire companies in our industry in China. Intensified competition from these
foreign competitors may lead to lower profit margins due to price competition,
loss of customers and slower than anticipated growth.
Unfavorable
publicity or research reports casting a negative light on our industry or our
products could change consumer perceptions and have an adverse affect on our
ability to market and sell our products.
We
believe that our industry is affected by media attention. Future research
reports or publicity about the quality of products in our industry generally, or
our products in particular, could have a material adverse effect on our
business. Scientific research to date is preliminary and there can be no
assurance that future scientific research or publicity will be favorable to our
industry or any particular product or consistent with earlier favorable research
or publicity. Adverse publicity could arise even if the adverse effects
associated with such products resulted from consumers’ failure to consume such
products appropriately. Given our dependence upon consumer perceptions, adverse
publicity, whether or not accurate, associated with illness or other adverse
effects resulting from the consumption of our products or any similar products
distributed by other companies could have a material adverse effect on our
business.
Our
planned expansion into the bulk additive business may not generate sufficient
revenues and the construction of our new facility to accommodate this business
may result in increased costs and losses.
We intend
to expand our operations into the bulk additive business through the supply of
high quality probiotics to be used as additives in dairy products to
manufacturers in China. We plan to construct a new production plant with a
150-ton capacity which can accommodate our new bulk additive business. This will
expose us to many risks, including the following:
-18-
Our
plans to geographically expand our marketing and sales efforts and directly sell
our products directly to retail consumers may fail.
To date,
we have sold our products in the greater Shanghai area, Changchun, Longyan,
Jiaxing, Zhengzhou, Jilin and Hong Kong. We currently intend to expand our
marketing and sales efforts to the rest of China. There is no assurance that we
will receive the same level of public demand for our products in other parts of
China.
In
addition, we have been selling through distributors since 2001. We opened our
first retail store in March 2006. We intend to expand our operations by opening
additional new retail stores to facilitate direct sales of our products to
customers. There is no assurance that we can successfully implement our direct
selling model.
As we
increase the geographic area of our selling efforts and implement a direct
selling model, there is a risk that our current systems may not be able to
accommodate the increased volume or the complexity of the future business. Our
short term operating results may be adversely affected as additional capital
investments will have to be made for system upgrades, replacements or
improvements.
We
face potential tax exposure.
Our
principal operations are in China. Business enterprises established in China are
subject to income taxes and value added taxes under Chinese tax laws and
regulations unless they have exemptions. In January 2006, we made tax
payments to the Chinese tax authorities for 2005 and have made regular tax
payments to the Chinese tax authorities for subsequent periods. Our management
believes that our operations in China were exempted from income taxes and value
added taxes for all prior years because we had been recognized by the local
government as an advanced technology enterprise. However, we have never received
a written confirmation from the appropriate tax authorities for the tax
exemption status of our operations in China. As a result, there is no way to
ascertain the position which may be taken by the relevant Chinese tax
authorities in the future. Accordingly, our financial statements contain
full provisions for all applicable tax liabilities (other than potential tax
penalties), plus surcharge, for all prior calendar years for such taxes. Such
provisions for tax liabilities and surcharge will be reversed out of the
financial statements at the appropriate point in the future.
According
to PRC tax regulations, overdue tax liabilities in the PRC for the calendar
years prior to 2005 may be subject to potential penalties for the late payment
of taxes which is calculated on the basis of 0.5 times to five times the amount
of taxes payable, which amounts to $4.9 million (if calculated based on 0.5
times of taxes payable) to $49 million (if calculated based on five times of the
amount of taxes payable) as of March 31, 2007 and 2008. The Group has
reserved for the payment of taxes that may be owed for calendar years prior to
2005 and any associated interest surcharges (which are calculated at 0.05% per
day on the accrued tax liabilities) in its financial statements until the
matter is fully resolved. Following
the adoption of FIN48, the Group has reserved for the surcharges payable for
fiscal year 2008. We consider it more likely than not that the associated
penalty will not need to be paid.
In
addition, in connection with dividends paid to the Shining shareholders between
April 2003 to June 2005, Shining did not deduct a withholding tax at the rate of
20% as required by applicable Chinese laws and regulations. No provision for the
potential tax penalties with respect to this matter has been made in our
financial statements as our management believes that the possibility of having
to pay the penalties is unlikely. The Group has reserved for associated
surcharges for the fiscal year 2008.
We
may not be able to protect our intellectual property against claims by other
parties or enforce our rights with respect to our intellectual
property.
We have
not purchased or applied for any patents other than three registered Chinese
patents in respect of the packaging processes and technologies we use in our
production process and a pending registration of a patent regarding the
production of one of our products, as we are of the view that it would not
be cost-effective to do so at this time. Without patents, we may have no legal
recourse in the event that our processes and technologies are replicated by
other parties. If our competitors are able to replicate our processes,
technologies and systems at lower costs, we may lose our competitive advantage
and our profitability will be adversely affected.
In
addition, we believe that over the last five years our “Shining” brand has
become a highly recognizable brand in our industry in Shanghai. To protect this
brand, which we consider important to our continued success, we have registered
four trademarks in China. If our competitors introduce products of inferior
qualities to the market using trademarks that are confusingly similar to the
“Shining” trademarks, our reputation and operating results will be adversely
affected. -19-
From time
to time, we may have to resort to litigation to enforce our rights with respect
to our intellectual property. This type of litigation could result in
substantial costs and diversion of our resources, which would adversely affect
our results of operations.
Management
by a small team of officers may create conflicts of interests and impede the
successful implementation of our growth plans.
Mr.
Song and Mr. Li, our only executive officers, are responsible for all
managerial functions of our company. We have been hiring additional employees to
complete our management team, but we cannot assure you that we can assemble a
management team that can tackle the expansion plans that we have. The
concentration of management could be disadvantageous to stockholders with
interests different from those of Mr. Song or Mr. Li.
Risks
Related to Government Regulations
We
are subject to government regulation in China, and changes in Chinese
regulations may substantially increase the cost of manufacturing and selling our
products.
The
manufacturing and marketing of our products are subject to various governmental
regulations in China. Government regulation includes inspection of and controls
over manufacturing, safety and environmental controls, efficacy, labeling and
the sale and distribution of wellness products.
As a
company which produces probiotics supplements, we are subject to the Law on the
Food Conditions of the PRC which became effective on October 30, 1995, the
Administrative Rules for Healthy Food promulgated by the Ministry of Health on
March 15, 1996 which became effective on June 1, 1996, the Notice of Circulating
the Appraisal Standard of Fungal and Good-Live-Bacterial Healthy Food and its
appendixes-Appraisal Standard of Fungal and Good-Live-Bacterial Healthy Food,
and List of Good-Live-Bacteria Applicable for Healthy Food, promulgated by the
Ministry of Health which became effective on March 23, 2001, the Administration
Rules for the Registration of Healthy Food (experimental) promulgated by the
State Food and Drug Administration on April 30, 2005 which became effective on
July 1, 2005, and other relevant rules and regulations issued by the Ministry of
Health and the State Food and Drug Administration. In addition, Shining is a
Chinese corporation and therefore is subject to the Company Law of China and
more specifically to the Foreign Company provisions of the Company Law and the
Law on Foreign Capital Enterprises of China.
Our
industry is relatively new in China, and the manner and extent to which it is
regulated is evolving. Changes in existing laws or new interpretations of such
laws may have a significant impact on our methods and costs of doing business.
For example, new legislative proposals that affect our product pricing,
reimbursement levels, approval criteria and manufacturing requirements may be
proposed and adopted.
The costs
of compliance with current or future legislation or regulatory requirements may
be significant, and could force us to curtail our operations or otherwise have a
material adverse effect on our financial condition, results of operations or
cash flows. For example, we have obtained three licenses and permits which are
required for us to operate our business in China. If the regulations regarding
these licenses and permits is changed, it may be materially burdensome for us to
obtain or renew these licenses and permits or they may be otherwise
unavailable.
Government
regulation of our retail prices and advertising methods may adversely affect our
results of operations.
We are
subject to government regulations with respect to the prices we charge, the
rebates we may offer to customers and our marketing methods. In addition, we are
required to obtain approval from Chinese government authorities regarding the
contents of advertisements related to our products before they can be published.
If the Chinese government requires that we set our retail prices at
undesirable prices or significantly limits our ability to advertise our
products, it could have a material adverse effect on our results of
operations. -20-
We
may not be able to obtain regulatory approvals for our products or reimbursement
from the sale of our products.
The
manufacture and sale of our products in China is highly regulated by a number of
state, regional and local authorities. These regulations significantly increase
the difficulty and costs involved in obtaining and maintaining regulatory
approval for marketing new and existing products. In addition, our future growth
and profitability are, to a significant extent, dependent upon our ability to
obtain timely regulatory approvals from the relevant authorities.
Risks
Related to Doing Business in China
Adverse
changes in China’s economic, political and social conditions and government
policies could have a material adverse effect on the overall economic growth of
China, which could adversely affect our results of operations and financial
condition.
We
currently conduct our business solely in China. Changes in the economic and
political situation in China and the economic, financial, fiscal and other
policies adopted by the Chinese government may affect our operations,
performance and profitability. The economy of China differs from the economies
of most developed countries in many respects, including:
China’s
economy has traditionally been subject to central planning, with a series of
economic plans promulgated and implemented by the Chinese government. Over the
past 25 years, the Chinese government has been reforming the economic and
political systems in China in an attempt to achieve economic and social
advancements. Many of these reforms were unprecedented and are expected to
continue while political, economic and social factors may also lead to further
adjustments to China’s reform measures. These reforms and adjustments may not
always have a positive effect on our operations. Accordingly, we cannot assure
you that our performance and profitability will not be adversely affected from
these measures. In addition, there is no assurance that the Chinese government
will continue to pursue economic liberalization and other reforms.
Macroeconomic
measures taken by the Chinese government may cause the Chinese economy to slow
down.
In
response to concerns relating to China’s high rate of growth in industrial
production, bank credit, fixed investment and money supply and growing
inflationary pressures, the Chinese government has taken measures to slow
economic growth to a more manageable level. Among the measures that the Chinese
government has taken are restrictions on bank loans in certain sectors and the
increase of interest rates. We cannot assure you that those measures will not
result in a slowdown in economic growth and hence a reduction in demand for
consumer products in China. These measures and any additional measures could
contribute to a slowdown in the Chinese economy and could potentially cause the
economy to enter a recession, which could have an adverse impact on demand for a
wide range of products in China, including our products.
There
are uncertainties regarding interpretation and enforcement of Chinese laws and
regulations.
China’s
legal system is a civil law system based on statutory law. Prior legal decisions
and judgments have little precedential value. China is still in the process of
developing a comprehensive statutory framework and its legal system is still
considered to be underdeveloped in comparison with the legal systems in some
western countries. Since 1979, the Chinese government has formulated and enacted
a large number of laws and regulations governing economic matters, securities
activities and foreign investments. -21-
Despite
significant development in its legal system, China does not have a comprehensive
system of laws. The interpretation of Chinese law by courts and tribunals may be
inconsistent and influenced by government policies and other considerations. In
addition, the enforcement of existing laws and regulations can be uncertain and
unpredictable. Judgments and arbitration rulings may be unenforceable. The
promulgation of new laws, changes to existing laws and inconsistent
interpretation of laws could have a negative impact on our
business.
All
of our officers and directors, and substantially all of our assets, are located
in China, thus it may be extremely difficult to acquire jurisdiction and enforce
liabilities against our officers, directors and assets.
Because
our executive officers and directors are Chinese citizens it may be
difficult, if not impossible, to acquire jurisdiction over them in the
event a lawsuit is initiated against us or our officers or directors by a
stockholder or group of stockholders in the United States. We anticipate that
our future officers and directors will also be Chinese citizens. Because the
majority of our assets are located in China, it would also be extremely
difficult to access those assets to satisfy an award entered against us in U.S.
court.
Restrictions
on currency exchange may limit our ability to receive and use our revenues
effectively.
Since
almost all of our future revenues may be in the form of Renminbi, any future
restrictions on currency exchanges may limit our ability to use revenue
generated in Renminbi to fund any future business activities outside China or to
make dividend or other payments in U.S. dollars. There are significant
restrictions on convertibility of the Renminbi for current account
transactions, including primarily the restriction that foreign invested
enterprises may only buy, sell or remit foreign currencies, after providing
valid commercial documents, at those banks authorized to conduct foreign
exchange business. In addition, conversion of Renminbi for capital account
items, including direct investment and loans, is subject to governmental
approval in China, and companies are required to open and maintain separate
foreign exchange accounts for capital account items. We cannot be certain that
the Chinese regulatory authorities will not impose more stringent restrictions
on the convertibility of the Renminbi, especially with respect to foreign
exchange transactions.
Risks
Related to our Common Stock
Shares
of our common stock which are eligible for immediate sale by our stockholders
may decrease the market price of our common stock.
We had
17,080,000 shares outstanding as of March 31, 2008, including
approximately 6,542,210 shares which are free trading and may be sold
immediately by our stockholders. An additional 2,083,333 shares, subject to
adjustment for subdivision or combination of our stock and similar events, may
be issued upon conversion of a 4% convertible promissory note issued to
Pope Investments II LLC in the amount of $25 million, as further described
in “Business-History”. If our stockholders sell substantial amounts of our
common stock, or there is a perception in the market that such sales may occur,
then the market price of our common stock could decrease.
Concentration
of our ownership by our President and Chief Executive Officer
and a director and his family may dissuade new investors from
purchasing our securities which could result in a lower trading price for our
securities than if our ownership was less concentrated.
As of
March 31, 2008, Mr. Song, our President and Chief Executive Officer
and a director, owned, directly and indirectly through his family,
47.2% of our outstanding common stock. As a result, Mr. Song has the
ability to exert substantial influence or absolute control over all matters
requiring approval by our stockholders, including the election and removal of
directors, any proposed merger, consolidation or sale of all or substantially
all of our assets and other corporate transactions. This concentration of
control could be disadvantageous to other stockholders with interests different
from those of Mr. Song. For example, Mr. Song could delay or prevent
an acquisition or merger even if the transaction would benefit other
stockholders. In addition, this concentration of share ownership may adversely
affect the trading price for our common stock because investors often perceive
disadvantages in owning stock in companies with a significant concentration of
ownership among a limited number of stockholders. -22-
Our
common stock price has been volatile, and you may not be able to sell
your shares at or above the price that you pay for
the shares.
Our
common stock is currently quoted on the OTC Bulletin Board. Securities quoted on
the OTC Bulletin Board tend to be highly illiquid, in part because there is no
national quotation system by which potential investors can track the market
price of shares except through information received or generated by a
limited number of broker-dealers that make markets in particular stocks. There
is a greater chance of market volatility for securities that trade on the OTC
Bulletin Board as opposed to a national exchange or quotation system. This
volatility may be caused by a variety of factors including:
The price
of our common stock has historically been volatile and our investors experience
wide fluctuations in the market price of our securities. These fluctuations may
have an extremely negative effect on the market price of our securities and may
prevent you from obtaining a market price equal to your purchase price when you
attempt to sell our securities in the open market. In these situations, you may
be required to either sell our securities at a market price which is lower than
your purchase price, or to hold our securities for a longer period of time than
you planned.
Volatility
in the price of our common stock may cause it to be classified as penny stock
which will result in limits on trading and our stock price could
decline.
Because
our common stock is volatile, it may in the future fall under the SEC definition
of “penny stock”, if our common stock is classified as “penny stock” we expect
trading in our common stock, if any, to be limited because broker-dealers are
required to provide their customers with disclosure documents prior to allowing
them to participate in transactions involving our common stock. These disclosure
requirements are burdensome to broker-dealers and may discourage them from
allowing their customers to participate in transactions involving our common
stock.
Rules
promulgated by the SEC under Section 15(g) of the U.S. Securities Exchange
Act of 1934, or Exchange Act, require broker-dealers engaging in transactions in
penny stocks, to first provide to their customers a series of disclosures and
documents, including:
In
addition, these rules require that a broker-dealer obtain financial and other
information from a customer, determine that transactions in penny stocks are
suitable for such customer and deliver a written statement to such customer
setting forth the basis for this determination. -23-
Our
preferred stock may make a third-party acquisition of our company more difficult
which in turn would make a purchase of our shares less desirable, thereby
potentially reducing our stock price or the liquidity of
our shares.
Our
certificate of incorporation authorizes our board of directors to issue up to
10,000,000 shares of preferred stock having such rights as may be
designated by our board of directors, without stockholder approval. However,
pursuant to the terms of the Investors’ Rights Agreement we entered into in
connection with the share exchange, we are restricted from issuing preferred
stock for a period of two years from the date of such agreement without first
obtaining the approval of the holders of at least 75% of our
outstanding shares of common stock. The issuance of preferred stock could
inhibit a change in our control by making it more difficult to acquire the
majority of our voting stock and thereby making the purchase of our shares
by new investors less likely. A lesser interest in the purchase of
our shares could reduce our market price or make it more difficult for
stockholders to sell their shares. No shares of preferred stock are
currently outstanding.
We
do not anticipate paying dividends.
We do not
anticipate paying dividends in the foreseeable future. Also, pursuant to the
terms of the Investors’ Rights Agreement we entered into in connection with the
share exchange, we are restricted from authorizing the payment of dividends for
a period of two years from the date of such agreement without the approval of
the holders of at least 75% of our outstanding shares of common stock. Any
dividends which we may pay in the future will be at the discretion of our board
of directors and will depend on our future earnings, any applicable regulatory
considerations, our financial requirements and other similarly unpredictable
factors. For the foreseeable future, we anticipate that we will retain any
earnings which we may generate from our operations to finance and develop our
growth.
ITEM
3. LEGAL PROCEEDINGS
We have
not been involved in any material litigation or claims arising from our ordinary
course of business. We are not aware of any material potential litigation or
claims against us which would have a material adverse effect upon our results of
operations or financial condition.
ITEM
4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None. -24-
PART
II
ITEM
5. MARKET FOR COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER
PURCHASES OF EQUITY SECURITIES
Market
Information
Our
common stock has been quoted on the OTC Bulletin Board since August 11, 2005. It
is currently quoted under the symbol “CHBT” and, prior to April 4, 2006, was
quoted under the symbol “OTRS.” Quotations for our common stock reflect
inter-dealer prices without retail mark-up, mark-down or commission and may not
necessarily represent actual transactions. We have generally had very low
trading volume for our common stock. Set forth below is information with respect
to the high and low sales prices of our common stock for the periods indicated.
There were no reported sales of our common stock on the OTC Bulletin Board prior
to November 29, 2005.
Security
Holders
At March
31, 2008 there were 17,080,000 shares our common stock outstanding held by
approximately 42 stockholders of record.
Dividend
Policy
We have
not historically paid any cash dividends and do not intend to pay any dividends
in the foreseeable future. We plan to use retained earnings, if any, to finance
our growth. Also, pursuant to the terms of the Investors’ Rights Agreement we
entered into in connection with the share exchange, we are restricted from
authorizing the payment of any dividends for a period of two years from the date
of such agreement without the approval of the holders of at least 75% of our
outstanding shares of common stock. The declaration and payment of
dividends in the future will be determined by our board of directors in light of
conditions then existing, including our financial condition, capital
requirements and restrictions in our financing agreements.
Equity
Compensation Plans
We do not
have any equity compensation plans. We have not granted any stock options or
other equity awards since our inception.
ITEM
7. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
The
following discussion should be read in conjunction with the financial statements
and the notes thereto appearing elsewhere in this Form 10-K. The following
discussion contains forward-looking statements reflecting our plans, estimates
and beliefs. Our actual results could differ materially from those discussed in
the forward-looking statements. You are also urged to carefully review and
consider our discussions regarding the various factors which affect our
business, including the information provided in the discussion beginning on page
17 of this prospectus under the caption “Risks Related to Our Business”. See the
cautionary note regarding forward-looking statements at the beginning of Part I
of this Form 10-K. -25-
General
We were
incorporated under the name Otish Resources, Inc. in Delaware in
February 2003. Until March 2006 we were a mineral exploration stage company
specializing in acquiring and consolidating mineral properties with potential
for commercial ore bodies. Although we conducted some preliminary exploration
work with respect to our mineral properties, we never achieved full operations
with respect to our mineral properties. We had never generated any revenue from
our mineral exploration operations. We incurred a total of expenses of $257,914
from inception to February 28, 2006.
On March
22, 2006, we entered into and completed a securities exchange transaction with
SGI and the shareholders of SGI, pursuant to which the SGI shareholders
transferred all of the equity securities of SGI to us in exchange for an
aggregate of 15,980,000 shares of our common stock. At the closing of the
share exchange, SGI became our wholly-owned subsidiary. Immediately after the
share exchange and related transactions described elsewhere in this document,
the former SGI shareholders and their designees collectively owned 98.7% of our
common stock. As a result of the share exchange, we are no longer a mineral
exploration stage company, and SGI’s business operations become our primary
operations. We are currently engaged in the research, development, production,
marketing and distribution of probiotics products. These products contain live
microbial food supplements which beneficially affect the host by improving its
intestinal microbial balance. See “Business - History”.
We
accounted for the share exchange as a recapitalization whereby the historical
financial statements and operations of the SGI become our historical financial
statements, with no adjustment to the carrying value of the assets and
liabilities. Our issued and outstanding common stock immediate prior to the
share exchange is accounted for at the net book value at the time of the
transaction.
Upon
consummation of the share exchange, we changed our fiscal year end from August
31 to March 31 to conform to the year end date of SGI. We filed a quarterly
report on Form 10-QSB on April 14, 2006 for quarter ended February 28,
2006. This quarterly report was our last filing under our previous fiscal year
end date of August 31, and as a mineral exploration stage company. In our
future filings with the SEC, we will report our business activities as a
manufacturer and distributor of probiotics products based on our new fiscal year
end date of March 31. SGI’s historical financial statements will become our
historical financial statements.
The
results of operations related to Otish Resources, Inc., as a mineral exploration
stage company, are not material and are therefore not included in the discussion
below. Unless otherwise noted, all references to the “company,” “we,” “us” and
“our” hereafter in this section refer to the current business of China-Biotics,
Inc. or the historical business of SGI and its subsidiaries, as
applicable.
In this
document, we use the “Current rate method” to translate the financial statements
of SGI from HKD into U.S. Dollars, and to translate the financial statements of
Shining from RMB into U.S. Dollars, as required under the Statement of Financial
Accounting Standard No. 52, “Foreign Currency Translation” issued by the
Financial Accounting Standard Board. The assets and liabilities of SGI and
Shining, except for the paid-up capital, are translated into U.S. Dollars using
the rate of exchange prevailing at the balance sheet date. The paid-up capital
is translated at the historical rate. Adjustments resulting from the translation
of SGI’s and Shining’s balance sheets from HKD and RMB into U.S. Dollars are
recorded in shareholders’ equity as part of accumulated comprehensive income.
The statement of operations is translated at average rates during the reporting
period. Gains or losses resulting from transactions in currencies other than the
functional currencies are reflected in the statement of operations for the
reporting periods. The statement of cash flows is translated at average rates
during the reporting period, with the exception of issue of share and payment of
dividends which are translated at the historical rates. Due to the use of
different rates for translation, the figures in the statement of changes in cash
flows may not agree with the differences between the year end balances as shown
in the balance sheets. -26-
Overview
We
manufacture and sell probiotics products. Probiotics comprise mainly live
bacteria, which we produce using advanced proprietary fermentation technology.
Currently, our products are sold mainly in the Greater Shanghai
region.
The
products are mainly sold to distributors, which then distribute them to various
retail outlets such as drug stores and supermarkets. During the year ended March
31, 2008, over 90% of our sales revenue comprised amounts receivable from the
distributors for the sale of these products. Typically, 60 to 90 days’ credits
are given to the distributors.
Our first
product, Shining Essence, which was launched in April 2001, remains our
best-selling product. Sales of Shining Essence represented approximately 61% and
48% of our total sales for the years ended March 31, 2007 and 2008,
respectively. In addition to Shining Essence, we have successfully created other
new products, such as Shining Signal. As we release new products in the future,
we expect the percentage contribution of Shining Essence to our total sales will
continue to decrease.
As our
products comprise mainly live bacteria, which are reproduced by fermentation, we
have historically had a low cost of production of which packaging costs
represent the largest cost item. During the last quarter of fiscal year 2008,
packaging costs have significantly increased as a result of increases in pulp
and paper costs. As a result, our gross margin has reduced from 73.3% in the
previous quarter to 66.4% in the fourth quarter. Management is taking action to
negotiate with the suppliers of packaging materials to bring down the packaging
costs going forward.
Our
management believes that the following trends in China will have an important
impact on, and present significant opportunities for, our business:
Our
management expects to capitalize on the opportunities created by these trends to
achieve significant growth through:
-27-
Our
operation is generally not labor-intensive. We employed 307 people as of March
31, 2008. The construction of our new plant and the creation of the new direct
sales network will result in significant increases in our number of employees as
we expect our staff and employees number will increase to 1,000 over the next
two years. We have been recruiting senior executives to strengthen our
management team. However, as wages in China are relatively inexpensive, labor
costs have remained insignificant.
Results
of Operations for Fiscal Year Ended March 31, 2007 Compared with the Fiscal Year
Ended March 31, 2008
Our net
income was $17.5 million for the fiscal year ended March 31, 2008. This included
$3.4 million surplus arising from the revaluation of the conversion feature
embedded in the convertible notes issued in December 2007 as required by FAS133.
Excluding this revaluation surplus, our net income was $14.1 million, which was
29.9% above our net income of $10.9 million for the fiscal year ended March 31,
2007. Our growth in net income primarily resulted from growth in our sales
volume of our products. Shining Essence continued to be our best selling
product. We have enjoyed strong growth in demands for many products such as
Shining Golden Shield and Shining Energy which outpaced that of Shining Essence.
In addition, new product sales now account for 13.6% of our sales revenue during
the year ended March 31, 2008 (1.9% in the year ended March 31, 2007). As a
result, the percentage of sales revenue attributable to Shining Essence has been
diluted to only 48% of our total sales revenue in the year ended March 31, 2008
(61% in the year ended March 31, 2007). -28-
Our
results for 2007 and 2008 are summarized below:
Net
sales
Net sales
in our financial statements are stated at invoiced value less sales discount and
sales tax. Our net sales for the past two fiscal years comprised of the
following:
Net sales
of $42,321,111 for the fiscal year ended March 31, 2008 were 38.3% above the net
sales of $30,609,941 for the fiscal year ended March 31, 2007. The increase was
mainly attributable to increased sales volume and increases in average selling
prices due to changes in sales mix.
The
contributions of each product as a percentage of invoiced value on sales for the
year ended March 31, 2007 and 2008 respectively are summarized below. New
product sales (including Energy, Stomach Protection and others) now account for
13.6% of our sales revenue for the year ended March 31, 2008. While the sales
revenues of Essence and Signal capsules have remained stable, their percentage
contributions to our sales revenue have been diluted by increases in new product
sales.
Unit
volume and unit prices comparatives (on the invoiced value of sales) for 2007
and 2008 are summarized below. The increase in selling prices of Golden Shield
and Energy capsules primarily reflect a combination of price increase and
changes in sales mix with more sales of packages with higher selling
prices. -29-
Cost
of sales
Cost of
sales for the year ended March 31, 2008 was $12,310,092 compared with $8,910,633
for the year ended March 31, 2007. The increase in cost of sales was primarily
caused by increased sales volume.
Unit
volume and unit costs comparatives for the year ended March 31, 2007 and 2008
are summarized below. The increase in unit costs of Golden Shield and Energy
capsules primarily reflect changes in sales mix with more sales of packages with
higher unit costs.
Gross
profit
Gross
profit increased by $8,311,711 from $21,699,308 for the 2007 fiscal year to
$30,011,019 for the 2008 fiscal year. This represents a 38.3% increase, which
reflects primarily increases in sales volume. Our gross profit margin remained
the same as last year at 70.9%. In the fourth quarter of fiscal year 2008, the
cost of packaging increased significantly due to increases in pulp and paper
costs which reduced our gross profit margin for the fourth quarter to 66.6% from
73.3% in the third quarter. Management is taking action to bring down the
packaging costs going forward.
Selling
expenses
Selling
expenses were $6,869,109 or 16.2% of net sales for the fiscal year ended March
31, 2008 compared with $4,502,687 or 14.7% of net sales for the fiscal year
ended March 31, 2007. The operating costs of the retail stores are included as
selling expenses. This increase in selling expenses was primarily caused by the
roll out of retail stores. As of March 31, 2008, we had a total of 60 retail
stores in operation (as of March 31, 2007, we had 9 retail stores).
General
and administrative expenses
General
and administrative expenses were $4,826,473 or 11.4% of net sales for the year
ended March 31, 2008 compared with 2,265,220 or 7.4% of net sales for the year
ended March 31, 2007. The increase in general and administrative expenses was
due to additional research costs of $1,696,657 related to the development and
launching of new products, and staff and administrative costs incurred in
connection with the construction of the new plant. -30-
Other
Income
Other
income comprised the $3.37 million revaluation of the convertible note and
interest income of $0.7 million. At the date of issuance, the estimated fair
value of embedded derivative portion of the convertible note was $9.1 million.
As a result of a decrease in our share price and share trading volatility, the
fair value of such portion as at March 31, 2008 decreased to $5.7 million. The
$3.37 million decrease in the fair value of the convertible note has been
recorded as other income.
Provision
for income taxes
Provision
for income taxes was $4.94 million and $4.19 million for the fiscal years ended
March 31, 2008 and 2007, respectively. Excluding the $3.37 million surplus on
revaluation of the convertible note, income before taxes was $22.5 million for
fiscal year 2008 compared with $15.1 million for 2007. The increase in income
tax payable is attributable to an increase in operating profit.
Segment
reporting
We have
adopted the “products and services” approach for segment reporting. For fiscal
years 2007 and 2008, we had only one reporting segment—the probiotic products as
health supplement. We manufactured and sold the probiotic products solely in
China and delivered all shipments to destinations within China, and all of our
long-lived assets were physically located in China. We made all sales to
external customers.
Liquidity
and Capital Resources
We had
cash of $64.31 million and working capital of $53.08 million as of March 31,
2008, and cash of $26.99 million and working capital of $21.23 million as of
March 31, 2007. Cash generated from operations was $19.36 million for the fiscal
year ended March 31, 2008 and $10.01 million for the fiscal year ended March 31,
2007.
Our
business is not capital or labor intensive. Typically, 60% of our sales take
place in the second half of the fiscal year. Since our customers have
historically been large distributors with which we have done business for a
number of years, our cash flows from our existing business have been, and we
expect them to continue to be, fairly reliable.
We had
capital expenditures totaling $10.30 million for the year ended March 31, 2008,
primarily on improvements to production and research facilities. We spent
$1.49 million on fixed assets in fiscal year 2007.
Our
current facility commenced operations in 2000. With the increases in sales
volume in the last couple of years, we are reaching our production capacity. We
have started to construct a new plant with an overall project size of $45.5
million. Phase 1 of the project involves constructing a facility capable of
producing 150 tons of probiotics per annum and is estimated to cost $27.50
million, $25 million of which is expected to be paid in the fourth quarter of
calendar year 2008 and the balance by the end of second quarter of calendar year
2009. Subsequent phases of this project will only commence when demands for
probiotics have exceeded the production capacity of the Phase 1
facility.
We are
expanding our sales to other cities in China through a combination of
distributors and our own stores. In this regard, we have opened 60 stores in
Shanghai and 5 other cities in China at March 31, 2008 and intend to have over
300 stores by the end of 2009 fiscal year at an anticipated cost of
approximately $11 million. In preparation for the opening of our retail stores,
we have repackaged a number of our existing products for sale in our stores, and
have introduced several new products which are available exclusively in our
stores. The costs of repackaging the existing products and releasing the new
products are minimal and have been included in our cost of sales and selling and
administrative expenses. We will continue to develop new products to strengthen
our product pipeline and add to our retail store offerings. As our development
costs mainly comprise staff costs, we do not expect that such costs will be
significant. -31-
We had
net cash of $25 million generated from financing activities in fiscal year 2008.
We had $2.28 million of cash flows used in financing activities for
the year ended March 31, 2007. Details on our financing
activities for the two fiscal years are as follows:
On
December 11, 2007, we issued a 4% Senior Convertible Promissory Note in the
amount of $25,000,000 (the “Note”) with a maturity date of December 11, 2010.
The principal amount of the Note is convertible into shares of our common stock
at an exercise price of $12.00 per share at any time until the maturity date. If
the Note is not converted at maturity, we will redeem the Note at a price that
gives a total yield of 10% per annum inclusive of the annual interest. The Note
also provides for mandatory conversion into common stock if the Group
achieve a net income of $60 million in fiscal year 2010. Net proceeds of the
Note are expected to be used to fund the construction of a proposed
150-metric-ton-per-year manufacturing facility and for other capital
expenditures.
Taking
into account our current cash position and our anticipated cash flows from
operations, we expect we will be able to meet all our funding needs in the next
twelve months, including payments required to settle our contractual obligations
and for our construction of our new plant. No assurance, however, can be given
that our business plan will succeed. In the event that our business plan does
not materialize as predicted, we may need to seek for external financing to fund
our expansion plan. There can be no assurance that we will be able to raise
needed capital on favorable terms, if at all. In addition, there is no assurance
that our estimate of our liquidity needs is accurate or that new business
development or other unforeseen events will not occur, resulting in the need to
raise additional funds.
Inflation
We
believe that inflation has not had a material impact on our results of
operations for the fiscal years ended March 31, 2007 and 2008.
Seasonality
Typically,
60% of our sales take place in the second half of the fiscal year because many
of our customers purchase our products to give as gifts during the Chinese
festivals that occur during this time of the year. While it is still too early
to tell, we expect that our bulk additive sales will not be seasonal
in nature because the bulk products are purchased by food manufacturers
consistently over the year.
Off-Balance
Sheet Arrangements
We do not
have any off-balance sheet arrangements.
Critical
Accounting Policies
This
MD&A discusses our consolidated financial statements for the fiscal years
ended March 31, 2007 and 2008. These financial statements have been
prepared in accordance with generally accepted accounting principles in the
United States. In preparing these financial statements, we are required to make
estimates and assumptions affecting the reported amounts of assets and
liabilities and the disclosure of contingent assets and liabilities at the date
of the financial statements and the reported amounts of revenues and expenses
during the reporting period. On an ongoing basis, we evaluate our estimates and
judgments. We base our estimates and judgments on historical experience and on
various other factors we believe are reasonable under the circumstances, the
results of which form the basis for making judgments about the carrying values
of assets and liabilities not readily apparent from other sources. Actual
results may differ from these estimates under different assumptions or
conditions. -32-
We
consider accounting policies related to (a) allowance for doubtful accounts and
(b) use of estimates as applied to potential penalties for the late payment of
taxes, to be critical accounting policies due to the estimation process involved
in each.
Allowance
for doubtful accounts
We
maintain an allowance for doubtful accounts for estimated losses that may result
from the inability of our customers to make required payments. Such allowances
are based upon several factors including, but not limited to, historical
experience and the current and projected financial condition of specific
customers. Since our inception of business, we have never experienced any
unrecoverable receivables. We also have never situations causing us to caste
doubt on the ability of our customers to make required payments. The balance of
our allowance for doubtful account has always been zero. We had trade
receivables totaling $13,214,531 as of March 31, 2008 and $14,309,818 as of
March 31, 2007, and a zero balance for allowance for doubtful accounts. We have
considered all relevant factors, including the financial conditions, affecting
the payment abilities of customers comprising these receivables up to the date
of this 10K and we believe these customers are able to make required payments.
We, however, cannot give assurance that these factors, including the financial
conditions of these customers, will not change adversely in the future. We will
continue to evaluate the ability of all our customers to make required payments.
Were the financial condition of a customer to deteriorate, resulting in an
impairment of its ability to make payments, allowances may be
required.
Use
of estimates as applied to potential penalties for the late payment of
taxes
Our
principal operations are in China. Business enterprises established in China are
subject to income taxes and value added taxes under Chinese tax laws and
regulations unless they have exemptions. We have made tax payments to the
Chinese tax authorities since 2005. We believe that our operations in China were
exempted from income taxes and value added taxes for all prior years because we
had been recognized by the local government as an advanced technology
enterprise. However, we have never received a written confirmation from the
appropriate tax authorities for the tax exemption status of our operations in
China. As a result, there is no way to ascertain the position which may be taken
by the relevant Chinese tax authorities in the future. Accordingly, our
financial statements contain full provisions for all applicable tax liabilities
for all prior calendar years. Such provisions for tax liabilities will be
reversed out of the financial statements at the appropriate point in the
future.
According
to PRC tax regulations, our overdue tax liabilities in the PRC for the
calendar years prior to 2005 may be subject to potential penalties for the late
payment of taxes which is calculated on the basis of 0.5 times to five times the
amount of taxes payable, which amounts to $4.9 million (if calculated based on
0.5 times of taxes payable) to $49 million (if calculated based on five times of
the amount of taxes payable) as of March 31, 2007 and 2008. The Group
has reserved for the payment of taxes that may be owed for calendar years prior
to 2005 and any associated interest surcharges (which are calculated at 0.05%
per day on the accrued tax liabilities) in its financial statements until the
matter is fully resolved. Following the adoption of FIN48, the Group has
reserved for the surcharges payable for the fiscal year 2008. We consider it
more likely than not that the associated penalty will not need to be
paid.
Recent
Accounting Pronouncements
In May
2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted
Accounting Principles.” SFAS No. 162 is intended to improve financial reporting
by identifying a consistent framework, or hierarchy, for selecting accounting
principles to be used in preparing financial statements that are presented in
conformity with U.S. generally accepted accounting principles (“GAAP”) for
nongovernmental entities. SFAS No. 162 is effective 60 days following the SEC's
approval of the Public Company Accounting Oversight Board Auditing amendments to
AU Section 411, The Meaning of Present Fairly in Conformity with Generally
Accepted Accounting Principles. Management does not anticipate that the
provisions of SFAS No. 162 will have an impact on the Company’s consolidated
results of operations or consolidated financial position.
In March
2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments
and Hedging Activities – an amendment of FASB Statement No. 133.” SFAS No. 161
requires enhanced disclosures about an entity’s derivative and hedging
activities to improve the transparency of financial reporting. SFAS No. 161 is
effective for financial statements issued for periods beginning after November
15, 2008. SFAS No. 161 is effective for the Company’s fiscal quarter that begins
on January 1, 2009. Management is currently evaluating the potential impact, if
any, on the Company’s disclosures in its consolidated financial
statements. -33-
In
December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in
Consolidated Financial Statements, an Amendment of ARB No. 51.” SFAS No. 160
amends ARB No. 51 to establish accounting and reporting standards for
noncontrolling interests in subsidiaries and for the deconsolidation of
subsidiaries. It clarifies that a noncontrolling interest in a subsidiary is an
ownership interest that should be reported as equity in the consolidated
financial statements. The provisions of SFAS No. 160 are effective for fiscal
years beginning on or after December 15, 2008, and interim periods within those
fiscal years on a prospective basis except for the presentation and disclosure
requirements which apply retrospectively. Earlier application of SFAS No. 160 is
prohibited. SFAS No. 160 is effective for the Company’s fiscal year that begins
on April 1, 2009. Management is currently evaluating the potential impact, if
any, on the Company’s consolidated financial statements.
In
December 2007, the FASB amended SFAS No. 141 (revised 2007), “Business
Combinations.” SFAS No. 141R, establishes principles and requirements for how an
acquirer recognizes and measures in its financial statements the identifiable
assets acquired, the liabilities assumed, and any noncontrolling interest in the
acquiree. SFAS No. 141R applies prospectively to business combinations for which
the acquisition date is on or after the beginning of the first reporting period
for fiscal years beginning on or after December 15, 2008. Earlier application of
SFAS 141R is prohibited. SFAS No. 141R is effective for the Company’s fiscal
year that begins on April 1, 2009 and will be applied to future
acquisitions.
In June
2007, the FASB ratified the consensus reached by the Emerging Issues Task Force
(“EITF”) in EITF Issue No. 06-11, “Accounting for Income Tax Benefits of
Dividends on Share-Based Payment Awards.” Under the provisions of EITF 06-11, a
realized income tax benefit from dividends or dividend equivalents that are
charged to retained earnings and are paid to employees for equity classified
nonvested equity shares, nonvested equity share units, and outstanding equity
share options should be recognized as an increase to additional paid-in capital.
The amount recognized in additional paid-in capital for the realized income tax
benefit from dividends on those awards should be included in the pool of excess
tax benefits available to absorb tax deficiencies on share-based payment awards.
EITF 06-11 should be applied prospectively to the income tax benefits that
result from dividends on equity-classified employee share-based payment awards
that are declared in fiscal years beginning after December 15, 2007, and interim
periods within those fiscal years. EITF 06-11 is effective for the Company’s
fiscal year that begins on April 1, 2008. Management is currently evaluating the
potential impact of EITF 06-11, if any, on the Company’s consolidated financial
statements.
On
February 15, 2007 the FASB issued SFAS No. 159, “The Fair Value Option for
Financial Assets and Financial Liabilities: Including an amendment of FASB
Statement No. 115” (“SFAS 159”). SFAS 159 permits all entities to elect to
measure many financial instruments and certain other items at fair value with
changes in fair value reported in earnings. SFAS 159 is effective as of the
beginning of the first fiscal year that begins after November 15, 2007, with
earlier adoption permitted. The Company does not anticipate that the adoption of
this statement will have a material effect on the Company’s financial condition
and result of operations. The Company does not believe that any of the other
recently issued and adopted, but yet effective, accounting standards would have
a material effect on the accompanying financial statements.
In
September 2006, the FASB issued FAS 157, Fair Value Measurements (FAS 157). FAS
157 defines fair value, establishes a framework for measuring fair value in
accordance with generally accepted accounting principles, and expands
disclosures about fair value measurements. The provisions of FAS 157 are
effective for the fiscal year beginning after November 15, 2007. FAS 157 is
effective for the Company’s fiscal year that begins on April 1, 2008. We are
currently evaluating the impact of the provisions of FAS 157. -34-
ITEM
8. FINANCIAL STATEMENTS
CHINA-BIOTICS,
INC. AND SUBSIDIARIES
CONSOLIDATED
FINANCIAL STATEMENTS
YEARS
ENDED MARCH 31, 2007 AND 2008
TABLE OF
CONTENTS
-35-
Report
of Independent Registered Public Accounting Firm
To the
Board of Directors and shareholders of
China-Biotics,
Inc.
We have
audited the accompanying balance sheets of China-Biotics, Inc. as of March 31,
2007 and 2008 and the related statements of operations, stockholders’ equity and
cash flows for the years ended March 31, 2007 and 2008. These financial
statements are the responsibility of the Company’s management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We
conducted our audits in accordance with standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. The Company is not required to
have, nor were we engaged to perform, an audit of its internal control over
financial reporting. Our audits included consideration of internal control
over financial reporting as a basis for designing audit procedures that are
appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Company’s internal control over financial
reporting. Accordingly, we express no such opinion. An audit includes examining,
on a test basis, evidence supporting the amounts and disclosures in the
financial statements, assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our
opinion, the financial statements referred to above present fairly, in all
material respects, the financial position of China-Biotics, Inc. as of March 31,
2007 and 2008 and the results of its operations and cash flows for the years
ended March 31, 2007 and 2008, in conformity with accounting principles
generally accepted in the United States of America.
BDO
McCabe Lo Limited
Hong
Kong, July 10, 2008 -36-
CHINA-BIOTICS,
INC. AND SUBSIDIARIES
CONSOLIDATED
BALANCE SHEETS
(Amounts
expressed in US Dollars)
The
accompanying notes are an integral part of these financial
statements.
-37-
CHINA-BIOTICS,
INC. AND SUBSIDIARIES
CONSOLIDATED
STATEMENTS OF OPERATIONS
(Amounts
expressed in US Dollars)
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