Annual Reports

 
Other

China Medical Technologies 20-F 2007
Form 20-F
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 


FORM 20-F

 


(Mark One)

¨ REGISTRATION STATEMENT PURSUANT TO SECTION 12(b) OR (g) OF THE SECURITIES EXCHANGE ACT OF 1934

OR

 

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended March 31, 2007

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

OR

 

¨ SHELL COMPANY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission file number: 000-51440

 


CHINA MEDICAL TECHNOLOGIES, INC.

(Exact name of Registrant as specified in its charter)

 


N/A

(Translation of Registrant’s name into English)

Cayman Islands

(Jurisdiction of incorporation or organization)

No. 24 Yong Chang North Road

Beijing Economic-Technological Development Area

Beijing 100176

People’s Republic of China

(Address of principal executive offices)

 


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

American Depositary Shares, each representing ten ordinary shares, par value $0.10 per share,

Nasdaq Global Select Market

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

Name of each exchange and Title of each class on which registered:

None

(Title of Class)

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

None

(Title of Class)

 


Indicate the number of outstanding shares of each of the issuer’s classes of capital or common stock as of the close of the period covered by the annual report. 273,600,001

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    ¨  Yes    x  No

If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.    ¨  Yes    x  No

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    x  Yes    ¨  No

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

¨  Large accelerated filer                    x  Accelerated filer                    ¨  Non-accelerated filer

Indicate by check mark which financial statement item the registrant has elected to follow:    ¨  Item 17    x  Item 18

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

 



Table of Contents

TABLE OF CONTENTS

 

INTRODUCTION    1

PART I

      3

    Item 1.

  

Identity of Directors, Senior Management and Advisers

   3

    Item 2.

  

Offer Statistics and Expected Timetable

  

3

    Item 3.

  

Key Information

  

3

    Item 4.

  

Information on the Company

  

30

    Item 5.

  

Operating and Financial Review and Prospects

  

51

    Item 6.

  

Directors, Senior Management and Employees

  

70

    Item 7.

  

Major Shareholders and Related Party Transactions

  

77

    Item 8.

  

Financial Information

  

80

    Item 9.

  

The Offer and Listing

  

80

    Item 10.

  

Additional Information

  

82

    Item 11.

  

Quantitative and Qualitative Disclosures About Market Risk

  

89

    Item 12.

  

Description of Securities Other than Equity Securities

  

89

PART II

     

90

    Item 13.

  

Defaults, Dividend Arrearages and Delinquencies

  

90

    Item 14.

  

Material Modifications to the Rights of Security Holders and Use of Proceeds

  

90

    Item 15.

  

Controls and Procedures

  

90

    Item 16A.

  

Audit Committee Financial Expert

  

91

    Item 16B.

  

Code of Ethics

  

91

    Item 16C.

  

Principal Accountant Fees and Services

  

92

    Item 16D.

  

Exemptions from the Listing Standards for Audit Committees

  

92

    Item 16E.

  

Purchases of Equity Securities by the Issuer and Affiliated Purchasers

  

92

PART III

     

93

    Item 17.

  

Financial Statements

  

93

    Item 18.

  

Financial Statements

  

93

    Item 19.

  

Exhibits

  

93


Table of Contents

INTRODUCTION

Unless otherwise indicated, references in this annual report on Form 20-F to:

 

   

“ADRs” are to the American depositary receipts, which, if issued, evidence our ADSs;

 

   

“ADSs” are to our American depositary shares, each of which represents ten ordinary shares;

 

   

“Articles of association” are to our memorandum and articles of association, as amended and restated from time to time;

 

   

“China” and the “PRC” are to the People’s Republic of China, excluding, for the purposes of this annual report on Form 20-F only, Taiwan and the special administrative regions of Hong Kong and Macau;

 

   

“RMB” and “Renminbi” are to the legal currency of China;

 

   

“shares” and “ordinary shares” are to our ordinary shares, par value US$0.10 per share; and

 

   

“US$” and “U.S. dollars” are to the legal currency of the United States.

Unless the context indicates otherwise, “we,” “us,” “our company,” “our,” “China Medical” and “CMED” refer to China Medical Technologies, Inc. and its predecessor and wholly owned subsidiary, YDME Beijing.

In addition, unless otherwise indicated, references in this annual report on Form 20-F to:

 

   

“Asset Managers” are to Asset Managers (China) Fund Co., Ltd.;

 

   

“Beijing Chengxuan” are to Beijing Chengxuan Economic and Trade Co., Ltd.;

 

   

“Beijing GP” are to Beijing GP Medical Technologies, Ltd., one of our wholly owned subsidiaries in China;

 

   

“Beijing Weixiao” are to Beijing Weixiao Biological Technology Development Co., Ltd.;

 

   

“Chengxuan” are to Chengxuan International Ltd.;

 

   

“GE” are to General Electric Company or to one or more of its wholly owned subsidiaries, as the case may be and where applicable, to its relevant subsidiaries and its related companies;

 

   

“Golden Meditech” are to Golden Meditech (BVI) Company Ltd.;

 

   

“Green Wall” are to Green Wall Development Ltd.;

 

   

“Neon Liberty” are to certain investment funds managed by Neon Liberty Capital Management LLC;

 

   

“PUPH” are to Peking University People’s Hospital; and

 

   

“YDME Beijing” are to Beijing Yuande Bio-Medical Engineering Co., Ltd., our predecessor and wholly owned subsidiary in China.

The following technical and industry specific terms used in this annual report on Form 20-F have the meanings set forth below:

 

   

“Ablation” means elimination or removal;

 

   

“CCD camera” means charge-couple-device camera equipped with a chip to control the brightness and brilliance of colors of the recorded images;

 

   

“DNA” means deoxyribonucleic acid, a nucleic acid molecule that contains the genetic instructions for the development and functioning of all known living organisms;

 

   

“ECLIA analyzer” means an IVD instrument capable of detecting minute levels of light triggered by combining reagents with body fluid samples to produce quantitative diagnostic results;

 

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“ECLIA system” means an integrated luminescence immunoassay IVD system comprised of an analyzer and reagents for detecting and quantifying a specific antigen or antibody in a blood or body fluid sample using an immunological reaction;

 

   

“Enhanced chemiluminescence immunoassay technology,” or “ECLIA technology,” means an advanced light-based technology that improves chemical reactions and enables reagents to be more sensitive, accurate and stable;

 

   

“FISH imaging analysis system” means an integrated system comprised of a fluorescent microscope, CCD camera and FISH imaging analysis software that enable medical practitioners to visualize and locate DNA sequences in human cells for identifying chromosomal abnormalities using fluorescent in situ hybridization technology;

 

   

“FISH probes,” or “DNA probes” means a synthetic piece of DNA is coupled with a fluorescent indicator, or tag, so that the chromosomes or genes that it binds to can be directly visualized under a fluorescent microscope;

 

   

“Fluorescent in situ hybridization technology,” or “FISH technology,” means a molecular diagnostic technology that uses a fluorescent-labeled probe to detect and localize the presence or absence of specific DNA sequences on chromosome;

 

   

“HIFU tumor therapy system,” or “HIFU therapy system,” means an ultrasound-guided ablation system that is used for the non-invasive treatment of solid tumors.

 

   

“HIV” means human immunodeficiency virus, a retrovirus that can lead to acquired immunodeficiency syndrome, a condition in humans in which the immune system begins to fail, leading to life-threatening opportunistic infections;

 

   

“In-vitro diagnostics,” or “IVD,” means the detection and monitoring of diseases through laboratory evaluation and the analysis of bodily fluids and tissues from patients;

 

   

“IVD systems” consists of the ECLIA analyzer, ECLIA reagents, FISH imaging analysis system and probes;

 

   

“Luminescence immunoassay IVD system” means an advanced, light-based IVD system commonly used in the United States and Western Europe;

 

   

“Probes” means a piece of labeled DNA used to detect the presence of a complementary DNA sequence by molecular hybridization;

 

   

“Reagent” means a substance used in a chemical reaction to detect, measure and produce other substances; and

 

   

“Reagent kits” means commercially prepared reagent sets, with accessory devices, containing all major components necessary to perform IVD tests.

This annual report on Form 20-F includes our audited consolidated financial statements for the years ended March 31, 2005, 2006 and 2007 and as of March 31, 2006 and 2007.

We and certain selling shareholders of our company completed the initial public offering of 7,360,000 ADSs, each representing ten ordinary shares in August 2005. On August 10, 2005, we listed our ADSs on the Nasdaq National Market under the symbol “CMED.” On March 27, 2006, we completed a follow-on offering of 5,750,000 ADSs, which were sold by certain of our existing shareholders.

 

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PART I

ITEM 1.    IDENTITY OF DIRECTORS, SENIOR MANAGEMENT AND ADVISERS

Not Applicable.

ITEM 2.    OFFER STATISTICS AND EXPECTED TIMETABLE

Not Applicable.

ITEM 3.    KEY INFORMATION

A.    Selected Financial Data

The following selected consolidated statement of income data for the years ended March 31, 2003, 2004, 2005, 2006 and 2007 and the consolidated balance sheet data as of March 31, 2003, 2004, 2005, 2006 and 2007 have been derived from our consolidated financial statements, which have been audited by KPMG, an independent registered public accounting firm. Our consolidated financial statements as of March 31, 2006 and 2007 and for each of the years in the three-year period ended March 31, 2007 and the report of KPMG thereto, are included elsewhere in this annual report on Form 20-F. Our selected consolidated statement of income data for the fiscal years ended March 31, 2003 and 2004 and our consolidated balance sheet data as of March 31, 2003, 2004 and 2005 have been derived from our audited consolidated financial statements, which are not included in this annual report on Form 20-F. You should read the selected consolidated financial data in conjunction with the consolidated financial statements for the year ended March 31, 2007, the related notes, KPMG’s report, which refers to a change in method of accounting for share-based compensation, and “Item 5. Operating and Financial Review and Prospects” included elsewhere in this annual report on Form 20-F. Our consolidated financial statements are prepared and presented in accordance with U.S. Generally Accepted Accounting Principles (“U.S. GAAP”). Our historical results do not necessarily indicate our results expected for any future periods.

 

    Year ended March 31,  
    2003     2004     2005     2006     2007     2007  
    RMB     RMB     RMB     RMB     RMB     US$  
    (in thousands, except for number of shares, per share and per ADS data)  

Statement of Selected Income Data:

           

Revenues, net(1)

  63,716     110,750     217,547     371,767     546,970     70,822  

Gross profit

  43,089     76,767     152,968     261,273     395,356     51,191  

Research and development

  (1,246 )   (2,036 )   (2,815 )   (14,374 )   (31,469 )   (4,075 )

Sales and marketing

  (1,963 )   (2,632 )   (4,960 )   (15,327 )   (18,264 )   (2,365 )

General and administrative

  (7,235 )   (5,619 )   (16,644 )   (38,309 )   (55,352 )   (7,167 )

Operating income

  32,645     66,480     128,549     193,263     290,271     37,584  

Net interest (expense)/income and other income(2)

  (1,803 )   14     1,748     23,838     29,541     3,825  

Income before tax

  30,842     66,494     130,297     217,101     319,812     41,409  

Income tax expense

  (3,286 )   (4,933 )   (11,854 )   (18,088 )   (30,094 )   (3,896 )

Net income(3)

  27,556     61,561     118,443     199,013     289,718     37,513  

Earnings per share(3)

           

Basic

  0.23     0.31     0.59     0.81     1.08     0.14  

Diluted

  0.23     0.31     0.59     0.81     1.07     0.14  

Earnings per ADS (unaudited)(4)

           

Basic

  2.30     3.10     5.90     8.10     10.80     1.40  

Diluted

  2.30     3.10     5.90     8.10     10.70     1.40  

Weighted average number of shares outstanding

           

Basic

  122,411,000     200,000,001     200,000,001     246,878,001     269,232,171     269,232,171  

Diluted

  122,411,000     200,018,001     200,018,001     247,163,001     286,979,793     286,979,793  

 

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(1) Revenues, net, include revenue from sales of our products, net of value-added tax, or VAT and sales return, but include VAT refunds on the sales of self-developed software embedded in our products. VAT refunds for the five fiscal years ended March 31, 2003, 2004, 2005, 2006, and 2007 were RMB3.6 million, RMB7.1 million, RMB14.7 million, RMB23.0 million and RMB29.6 million (US $3.8 million), respectively.
(2) Net interest (expense)/income and other income include “interest expense,” “interest income” and “other income” from our consolidated financial statements included elsewhere in this annual report on Form 20-F.
(3) If YDME Beijing had not had a reduced EIT rate of 7.5% for the three calendar years ended December 31, 2002, 2003 and 2004 and 10% for the three calendar years ended December 31, 2005, 2006 and 2007 YDME Beijing would have had an EIT rate of 15%. With an EIT rate of 15%, our net income and basic and diluted earnings per share for the following periods would have been reduced as follows:

 

     Year ended March 31,
   2003    2004    2005    2006    2007    2007
   RMB    RMB    RMB    RMB    RMB    US$
   (in thousands, except for per share and per ADS data)

Net income

   2,880    4,538    5,749    13,000    15,570    2,016

Earnings per share:

                 

Basic

   0.03    0.02    0.03    0.05    0.06    0.01

Diluted

   0.03    0.02    0.03    0.05    0.05    0.01

 

(4) Each ADS represents 10 ordinary shares.

 

     As of March 31,
      2003    2004    2005     2006    2007    2007
     RMB    RMB    RMB     RMB    RMB    US$
     (in thousands)

Balance Sheet Data:

                

Cash and cash equivalents

   27,371    24,114    14,646     843,791    1,173,640    151,963

Working capital(1)

   98,442    52,238    (66,707 )   906,875    764,090    98,935

Intangible assets

   —      —      239,662     224,744    1,565,362    202,683

Total assets

   179,810    192,161    457,768     1,375,841    3,192,228    413,330

Amounts due to related parties (current and non-current)

   520    4,807    102,714     —      —      —  

Convertible notes

   —      —      —       —      1,158,480    150,000

Payables to Sellers and deferred credit related to acquisition

   —      —      —       —      530,598    68,702

Total liabilities

   38,498    56,651    203,815     129,307    1,906,489    246,852

Total shareholders’ equity

   141,312    135,510    253,953     1,246,534    1,285,739    166,478

(1) Working capital is current assets less current liabilities.

 

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Exchange Rate Information

This annual report on Form 20-F contains translations of certain RMB amounts into U.S. dollar amounts at specified rates. All translations from RMB to U.S. dollars were made at the noon buying rate in The City of New York for cable transfers of RMB as certified for customs purposes by the Federal Reserve Bank of New York, or the noon buying rate. Unless otherwise stated, the translations of RMB into U.S. dollars have been made at the noon buying rate in effect on Friday, March 30, 2007, which was RMB7.7232 to US$1.00. We make no representation that the RMB or U.S. dollar amounts referred to in this annual report on Form 20-F could have been or could be converted into U.S. dollars or RMB, as the case may be, at any particular rate or at all. See “Item 3. Key Information—D. Risk Factors—Risks Related to Doing Business in China—Fluctuations in the value of the Renminbi may have a material adverse effect on your investment” and “—Restrictions on currency exchange may limit our ability to receive and use our revenues effectively” for discussions of the effects of fluctuating exchange rates and currency control on the value of our ADSs. On September 27, 2007 the noon buying rate was RMB7.5540 to US$1.00.

The following table sets forth information concerning exchange rates between the RMB and the U.S. dollar for the periods indicated. These rates are provided solely for your convenience and are not necessarily the exchange rates that we used in this annual report or will use in the preparation of our periodic reports or any other information to be provided to you. The source of these rates is the Federal Reserve Bank of New York.

 

Period

   Noon Buying Rate
   Period
End
   Average(1)    Low    High
     (RMB per $1.00)

2002

   8.2800    8.2770    8.2800    8.2669

2003

   8.2767    8.2772    8.2800    8.2765

2004

   8.2765    8.2768    8.2771    8.2765

2005

   8.0702    8.1826    8.2765    8.0702

2006

   7.8041    7.9579    8.0702    7.8041

2007

           

March

   7.7232    7.7369    7.7454    7.7232

April

   7.7090    7.7247    7.7345    7.7090

May

   7.6516    7.6773    7.7065    7.6463

June

   7.6120    7.6333    7.6680    7.6120

July

   7.5720    7.5757    7.6055    7.5580

August

   7.5462    7.5734    7.6181    7.5420

September (through September 27)

   7.5135    7.5211    7.5540    7.5000

(1) Annual averages are calculated from month-end rates. Monthly averages are calculated using the average of the daily rates during the relevant period.

B.    Capitalization and Indebtedness

Not Applicable.

C.    Reasons for the Offer and Use of Proceeds

Not Applicable.

 

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D.    Risk Factors

Risks Related to Our Company

We generate a substantial portion of our revenues from our core product, the HIFU therapy system. A reduction in revenues of our HIFU therapy system would cause our revenues to decline and could materially harm our business.

We derive a substantial percentage of our revenues from sales of our HIFU therapy system. Our HIFU therapy system accounted for 81%, 66% and 61% of our total net revenues for the fiscal years ended March 31, 2005, 2006 and 2007, respectively. Prior to September 2004, we generated all of our revenues from sales of our HIFU therapy system. Although we began marketing and selling our ECLIA system in September 2004 and launched our FISH imaging analysis system and probes in June 2007, we expect that sales of our HIFU therapy system will continue to comprise a substantial portion of our net revenues for the foreseeable future. The segment income derived from HIFU therapy system was RMB110.1 million, RMB141.7 million and RMB185.7 million (US$24.0 million) for the fiscal years ended March 31, 2005, 2006 and 2007, respectively. Going forward, continued market acceptance of our HIFU therapy system will remain critical to our success, and a reduction in revenues from sales of our HIFU therapy system will have a direct negative impact on our business, financial condition and results of operations.

If we fail to increase awareness and acceptance of our HIFU therapy system in the medical community and among patients, we will not be able to grow or even sustain our business.

Our HIFU therapy system uses a relatively new, high intensity focused ultrasound technology that is very different from conventional treatments for tumors, such as surgery, radiotherapy and chemotherapy. As of March 31, 2007, we have sold over 300 units of our HIFU therapy system. To achieve greater penetration of the potential market in China, we must increase market awareness and use of our HIFU therapy system, which depends on, among other things, the following:

 

   

the general levels of awareness and acceptance in the medical community and among patients of HIFU technology and our HIFU therapy system;

 

   

the effectiveness of our HIFU therapy system, which we intend to further investigate through long-term studies;

 

   

the relative costs and benefits of treatment using our HIFU therapy system as compared to other treatments;

 

   

the financial or other benefits gained by hospitals that use our HIFU therapy system;

 

   

the amount of resources we have available to increase product awareness and to educate potential purchasers and users of our HIFU therapy system;

 

   

our ability to continue to develop and enhance our HIFU therapy system;

 

   

our ability to provide good technical support and customer service; and

 

   

our ability to keep up with technological changes and remain competitive.

We may not have the financial and operational resources required to promote awareness and acceptance of our HIFU therapy system as widely or rapidly as is necessary to grow or sustain our business. Even if we were to devote a substantial portion of our resources to promoting our product, we may not succeed in raising the levels of awareness and acceptance of our HIFU therapy system as quickly as is necessary to grow or sustain our business, if at all. If we fail to increase awareness and acceptance of our HIFU therapy system in the medical community and among patients, we will not be able to grow, or even sustain, our business as planned and our financial condition and results of operations will be harmed.

 

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The long-term effectiveness of HIFU medical devices for tumor treatment has not been proven.

HIFU therapy for tumors is a relatively new type of tumor therapy. We sold our first HIFU therapy system in November 1999. Although current studies on the use of HIFU medical devices for tumor treatment, including our HIFU therapy system, have shown a reduction in short-term side effects compared to radiotherapy and chemotherapy and suggest an improvement in long-term results, there are presently very few long-term studies of over five years on the effectiveness of using HIFU technology for the treatment of tumors. We plan to continue our participation in future long-term studies of the effectiveness of our HIFU therapy system. These long-term studies include a large scale clinical study in collaboration with the Ministry of Health of the People’s Republic of China (MOH) and a clinical trial conducted in the United States on pancreatic cancer based on the conditional approval received for our Investigational Device Exemption (IDE) application. If any of these studies fail to confirm the effectiveness of our HIFU therapy system or other HIFU medical devices, our sales could decline. In addition, some of the data produced in currently available studies were not randomized and/or included small patient sample sizes. Consequently, the results of these studies may not be representative of the results that may be achieved in studies involving larger patient sample sizes. Moreover, there may be other clinical studies published on our HIFU therapy system of which we are not aware and which contain different conclusions with respect to the safety, effectiveness or other aspects of our technologies. Our customers and users of our products may conclude that our HIFU therapy system is not an acceptable treatment regimen, that the technologies underlying our system are ineffective or unsafe, or that our system is less effective or safe than other therapies. This could result in a decrease in our sales, which would have a material adverse effect on our business, results of operations and financial condition.

We may not succeed in sustaining a market for our ECLIA system.

We began marketing and selling our ECLIA system in September 2004. Our ECLIA system is referred to as a “closed system” since our ECLIA analyzer can only use reagent kits manufactured by us and our reagent kits can only be used with our ECLIA analyzer. The segment income derived from ECLIA system was RMB21.4 million, RMB74.9 million and RMB 137.2 million (US$17.8 million) for the fiscal years ended March 31, 2005, 2006 and 2007, respectively. Going forward, the long-term success of our ECLIA system depends on several factors, including our ability to:

 

   

successfully promote product awareness of our ECLIA system in China;

 

   

competitively price our ECLIA system, including the ECLIA analyzer and reagent kits;

 

   

develop new reagent kits to expand the applications of our ECLIA system and to respond to new forms of diseases and disorders;

 

   

select effective distributors; and

 

   

comply with new or changing regulatory requirements and obtain additional regulatory approvals or clearances for new reagent kits in a timely manner.

Luminescence immunoassay technology is a well established method of clinical diagnosis. As a result, our ECLIA system is competing in a market in which there are already many established industry players. We cannot assure you that we will be able to successfully market or sell our ECLIA system in the future. We also cannot assure you that our ECLIA system, or any future enhancements to our ECLIA system, will generate adequate revenue to offset our investments and costs in acquiring, developing or marketing our ECLIA system. If there is insufficient demand for our ECLIA system, our business, financial condition and results of operations may be harmed. In addition, any announcement of new products, services or enhancements by us or our competitors may cause our customers to cancel or postpone purchasing decisions for our existing products in anticipation of these new products, services or enhancements.

We may not succeed in developing a market for our FISH imaging analysis system and probes.

We only introduced our FISH imaging analysis system and probes to the market in June 2007. We develop and manufacture the FISH probes internally. The fluorescent microscope, CCD camera and imaging analysis

 

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software that we sourced from component suppliers are integrated into our FISH imaging analysis system. Our imaging analysis system can be used with FISH probes manufactured by other manufacturers. Our FISH probes can be used with a fluorescent microscope offered by other manufacturers. The success of our FISH imaging analysis system and probes depends on several factors, including our ability to:

 

   

successfully promote product awareness of our FISH imaging analysis system and probes in China;

 

   

competitively price our FISH imaging analysis system and probes;

 

   

develop new probes to expand the applications of our FISH operation for diagnosis of new diseases and disorders;

 

   

build and strengthen our direct sales force; and

 

   

comply with new or changing regulatory requirements and obtain additional regulatory approvals or clearances for new probes in a timely manner.

FISH technology is an established method of clinical diagnosis in prenatal and postnatal and cancer applications in Western countries. As a result, our FISH imaging analysis system and probes are competing in a market in which there are international players with extensive experience. Although the adoption rate of FISH imaging analysis system and probes in China is low due to a lack of affordable products, we cannot assure you that we will be able to successfully market or sell our FISH imaging analysis system and probes with our cost advantage together with our distribution experience in China. We also cannot assure you that our FISH imaging analysis system and probes, or any future enhancements to our FISH imaging analysis system and probes, will generate adequate revenue to offset our investments and costs in acquiring, developing or marketing our FISH imaging analysis system and probes. If there is insufficient demand for our FISH imaging analysis system and probes, our business, financial condition and results of operations may be adversely affected. In addition, any announcement of price change, new products, services or enhancements by our competitors may cause our customers to cancel or postpone purchasing decisions for our products.

If we fail to protect our intellectual property rights, our competitors may take advantage of our proprietary technology and know-how and compete directly against us.

Our success depends, in part, on our ability to protect our proprietary technologies. In China, we own seven invention patents and two utility patents directed towards various aspects of our HIFU therapy system and one invention patent and five utility patents relating to our ECLIA system. We also have nine invention patent applications and one utility patent application pending in China, which are directed towards our HIFU therapy system and ECLIA system. Invention patents are granted for invention or discovery of any new and useful process or article of manufacture, or any new and useful improvement thereof. Utility patents are granted for invention of a new and practical structure or form, or a combination of both, for an article of manufacture.

In addition, we have made applications for eight patents directed toward our HIFU technology in countries outside China, including the United States, the United Kingdom, Germany, Japan, South Korea and India. As of June 30, 2007, we had been granted all four of the patents we applied for in the United Kingdom and two out of the four patents we applied for in India. These overseas patents will be valid until March 2022. We also have filed a patent application directed towards our FISH methodology in the United States.

Due to the different regulatory bodies and varying requirements in these countries, we cannot assure you that we will be able to obtain patent protection for all or any aspects of our HIFU technology, ECLIA and FISH technologies in all or any of these countries. The process of seeking patent protection can be lengthy and expensive, and we cannot assure you that our patent applications will result in patents being issued or that our existing or future issued patents will be sufficient to provide us with meaningful protection or commercial advantage. Our patents and patent applications may be challenged, invalidated or circumvented in the future. We cannot assure you that our current or potential competitors, many of which have substantial resources and have made substantial investments in competing technologies, do not have, and will not develop, products that compete directly with our products despite our intellectual property rights.

 

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We also rely on trade secrets, proprietary know-how and other non-patentable technology, which we seek to protect through non-disclosure agreements with employees. We cannot assure you that these non-disclosure agreements will not be breached, that we will have adequate remedies for any breach, or that our trade secrets, proprietary know-how and other non-patentable technology will not otherwise become known to, or be independently developed by, our competitors.

Implementation and enforcement of PRC intellectual property-related laws has historically been deficient and ineffective, and is hampered by corruption and local protectionism. Accordingly, intellectual property rights and confidentiality protections in China may not be as effective as in the United States or other countries. Policing unauthorized use of proprietary technology is difficult and expensive, and we might need to resort to litigation to enforce or defend patents issued to us or to determine the enforceability, scope and validity of our proprietary rights or those of others. The experience and capabilities of PRC courts in handling intellectual property litigation varies, and outcomes are unpredictable. Further, such litigation may require significant expenditure of cash and management efforts and could adversely affect our business, financial condition and results of operations. An adverse determination in any such litigation will impair our intellectual property rights and may adversely affect our business, prospects and reputation.

We may be exposed to intellectual property infringement and other claims by third parties, which, if successful, could cause us to pay significant damage awards and incur other costs.

Our success also depends in large part on our ability to use and develop our technology and know-how without infringing the intellectual property rights of third parties. As litigation becomes more common in China in resolving commercial disputes, we face a higher risk of being the subject of intellectual property infringement claims. The validity and scope of claims relating to medical device technology patents involve complex scientific, legal and factual questions and analysis and, therefore, may be highly uncertain. The defense and prosecution of intellectual property suits, patent opposition proceedings and related legal and administrative proceedings can be costly and time consuming, with unpredictable outcomes, and may significantly divert the efforts and resources of our technical and management personnel. Courts in some jurisdictions in China are inexperienced in these types of cases, and may be influenced by local protectionism. An adverse determination in any such litigation or proceedings to which we may become a party could subject us to significant liability, including damage awards, to third parties, require us to seek licenses from third parties, to pay ongoing royalties, or to redesign our products or subject us to injunctions preventing the manufacture and sale of our products. Protracted litigation could also result in our customers or potential customers deferring or limiting their purchase or use of our products until resolution of such litigation.

Unauthorized use of our brand name by third parties, and the expenses incurred in developing and preserving the value of our brand name, may adversely affect our business.

Our brand name is critical to our success. Unauthorized use of our brand name by third parties may adversely affect our business and reputation, including the perceived quality and reliability of our products. We rely on trademark law, company brand name protection policies, and agreements with our employees, customers, business partners and others to protect the value of our brand name. Despite our precautions, we cannot assure you that those procedures provide effective prevention for unauthorized third-party use of our brand name. Enforceability, scope and validity of protection of trademarks in the PRC are uncertain and still evolving, and we may not be successful in prosecuting unauthorized third-party use. Future litigation could also result in substantial costs and diversion of our resources, and could adversely affect our business, financial condition and results of operations.

We are dependent on a relatively small group of distributors for a significant portion of our revenues, and this dependence is likely to continue in the future.

We depend on distributors for a significant portion of our revenues. These customers are distributors of medical devices and supplies. We do not have long-term contracts with our distributors, but rather typically sell

 

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to them on a unit-by-unit basis. We expect that a substantial portion of our revenue will continue to be generated by a relatively small group of distributors that may change from year to year. Because our core product, the HIFU therapy system, is sold at a relatively high unit price, the size and timing of individual orders can have a significant effect on our quarterly results. We cannot assure you that any distributor will continue to purchase our products at the same levels as in prior years or that such relationships will continue. We expect that in any given period a relatively small, and changing, number of distributors will continue to account for a significant portion of our revenues. If we are unable to manage our distributor network, our reputation among end users of our products and our revenues may be adversely affected.

Our business strategy to grow through acquisitions of new products or technologies may result in integration costs, failures and dilution to existing stockholders.

An important business strategy of ours is to acquire medical technologies with significant market potential and bring them to the market. We continue to seek suitable opportunities both inside and outside China to acquire new products or technologies, particularly those that could assist us in advancing our current products, technologies and market penetration, or in expanding our product offerings or technologies. If we decide to acquire another company or its assets in order to obtain its products or technologies, we would face a number of risks including consummating the acquisition on unfavorable terms and not obtaining adequate financing, which may adversely affect our ability to develop new products and services and to compete in our rapidly changing marketplace. These acquisitions could also require that our management develop expertise in new areas, manage new business relationships and trade models, and attract new customers. Successful management and integration of acquisitions are subject to a number of risks, including difficulties in assimilating acquired operations and managing remote operations, potential loss of key employees, diversion of management’s attention from existing business operations, assumption of contingent liabilities and incurrence of potentially significant write-offs, which may adversely affect our business or results of operations. In addition, if we consummate such an acquisition through an exchange of our securities, our existing stockholders could suffer dilution.

Rapid growth and a rapidly changing operating environment may strain our limited resources.

Our growth strategy includes our efforts to build our brand, develop new products, increase market penetration of our HIFU therapy system in large-and-medium sized hospitals in China, grow our ECLIA system sales by targeting small-and medium-sized hospitals and accelerate market acceptance of our FISH imaging analysis system and probes in large hospitals. This growth strategy requires significant capital resources, and we may not generate an adequate return on our investment. Our growth may involve the acquisition of new technologies, businesses, products or services or the creation of strategic alliances in areas in which we do not currently operate. This could require our management to develop expertise in new areas, manage new business relationships and attract new types of customers. We may also experience difficulties integrating these acquired businesses, products or services into our existing business and operations. The success of our growth strategy also depends in part on our ability to utilize our financial, operational and management resources and to attract, train, motivate and manage an increasing number of employees. The success of our growth strategy depends on a number of internal and external factors, such as:

 

   

the growth of the market for medical devices and supplies in China;

 

   

increase customer awareness and acceptance of our products;

 

   

continued enhancement of our research and development capabilities;

 

   

competition from other manufacturers of HIFU tumor therapy devices and alternative methods of tumor therapy; and

 

   

competition from other companies that offer IVD products in China,

many of which are beyond our control. We may not be able to implement our growth strategy successfully or manage our expansion effectively.

 

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Our limited operating history makes evaluating our business and prospects difficult.

We commenced operations in July 1999, and delivered the first commercial unit of our HIFU therapy system in November 1999. We started to market and sell our second product, the ECLIA system, in September 2004. Aiming to expand and diversify our IVD portfolio, we consummated on a major acquisition of FISH operation in March 2007. We began to ship FISH imaging analysis system in June 2007. Our limited operating history may not provide a meaningful basis for you to evaluate our business, financial performance and prospects. We may not have sufficient experience to address the risks frequently encountered by early-stage companies, and as a result we may not be able to:

 

   

maintain profitability;

 

   

preserve our leading position in the market of HIFU tumor therapy devices;

 

   

diversify our revenue sources by successfully marketing and selling our IVD products;

 

   

commercialize our new FISH imaging analysis system and probes effectively;

 

   

acquire and retain customers;

 

   

attract, train, motivate and retain qualified personnel;

 

   

keep up with evolving industry standards and market developments;

 

   

increase the market awareness of our products;

 

   

respond to competitive market conditions;

 

   

maintain adequate control of our expenses;

 

   

manage our relationships with our suppliers, distributors and direct-selling hospitals; or

 

   

protect our proprietary technologies.

If we are unsuccessful in addressing any of these risks, our business may be materially and adversely affected.

We are controlled by a major shareholder and its affiliated entities, and their interests may not be aligned with the interests of our other shareholders.

Currently, Chengxuan and its affiliated entities beneficially own approximately 26% of our outstanding ordinary shares. Chengxuan could exert substantial influence over matters such as electing directors and approving material mergers, acquisitions or other business combination transactions.

The interests of Chengxuan may differ from the interests of our other shareholders. We, Chengxuan, Golden Meditech and GE entered into a shareholders’ agreement in June 2005. The rights and obligations contained in the shareholders’ agreement may be terminated by written agreement among Chengxuan, Golden Meditech and GE. If any of Chengxuan’s, Golden Meditech’s or GE’s ownership interest in our company falls below 5% of our outstanding shares, calculated on a fully diluted basis, such shareholder will cease to be a party pursuant to the June 2005 shareholders’ agreement and will no longer have any rights or obligations under that shareholder’s agreement. On June 21, 2006, GE’s ownership interest in our company fell below 5% of our outstanding shares and ceased to be a party to the shareholders’ agreement. On October 4, 2006, Golden Meditech’s interest in our company fell below 5% of our outstanding shares and ceased to be a party to the shareholders’ agreement. As of September 28, 2007, GE and Golden Meditech no longer hold any of our ordinary shares.

In addition, the concentration of ownership in Chengxuan, may discourage, delay or prevent a change in control of our company, which could deprive our shareholders of an opportunity to receive a premium for their shares as part of a sale of our company and might reduce the price of our ADSs. These actions may be taken even if they are opposed by our other shareholders. In cases where the interests of our significant shareholders are aligned and they vote together, these shareholders will also have the power to prevent or cause a change in control. In addition, Chengxuan could divert business opportunities from us to themselves or others.

 

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We are highly dependent on senior management and key research and development personnel.

We are highly dependent on our senior management to manage our business and operations and our key research and development personnel for the development of new technologies and applications and the enhancement of our existing products. In particular, we rely substantially on our chairman and chief executive officer, Mr. Xiaodong Wu, to manage our operations. We also depend on our key research personnel. In addition, we also rely on customer service personnel for the installation and support of our products and on marketing and sales personnel, engineers and other personnel with technical and industry knowledge to market, sell, install and service our products. We do not maintain key man life insurance on any of our senior management or key personnel. The loss of any of our senior management or key personnel could have a material adverse effect on our business and operations. Competition for senior management and research and development personnel is intense, and the pool of suitable candidates is limited. We may be unable to locate a suitable replacement for any senior management or key research and development personnel that we lose. In addition, if any member of our senior management or key research and development personnel joins a competitor or forms a competing company, they may compete with us for customers, business partners and other key professionals and staff members of our company. Although each of our senior management and key research and development personnel has signed a confidentiality and non-competition agreement in connection with his employment with us, we cannot assure you that we will be able to successfully enforce these provisions in the event of a dispute between us and any member of our senior management or key research and development personnel.

We compete for qualified personnel with other medical technology companies, medical device and supplies manufacturers, universities and research institutions. Intense competition for these personnel could cause our compensation costs to increase significantly, which could have a material adverse effect on our results of operations. Our future success and ability to grow our business will depend in part on the continued service of these individuals and our ability to identify, hire and retain additional qualified personnel. If we are unable to attract and retain qualified employees, we may be unable to meet our business and financial goals.

We rely on single-source suppliers to provide materials and major components. A significant interruption in supply could prevent or limit our ability to accept and fulfill orders for our products.

We purchase all our materials and major components from third-party suppliers and assemble our products in-house. We currently rely on single-source suppliers to provide a majority of our materials and major components. Currently, we do not have any long-term supply contracts with our suppliers however we have not experienced any significant interruption of supplies in the past. Our purchases are made on a purchase order basis. If the supply of certain materials, components or services were interrupted, our own manufacturing process would be delayed. We may be unable to secure alternative sources of supply in a timely and cost-effective manner. We purchase the components of our three devices, HIFU therapy system, ECLIA analyzer and FISH imaging analysis system from various domestic and international suppliers, some of which are our sole supplier for certain components. The raw materials for our ECLIA reagents and FISH probes are also supplied by various domestic and international vendors. The failure of any of these suppliers to provide materials to us, particularly if we are unable to obtain these materials from alternative sources on a timely basis or on commercially reasonable terms, could impair our ability to manufacture our products or increase our costs. We also plan to further increase the production and sales of our products in the future. If we are unable to obtain required materials and components that meet our production standards in sufficient quantities or at acceptable cost, we will be unable to increase our production and sales as planned. Failure to obtain adequate supplies of materials, components or services in a timely and cost-effective manner could delay our delivery to our customers. This could harm our reputation, cause us to lose sales, and force us to use more expensive sources of supply, which could significantly increase our production costs and harm our operating results. Any of these occurrences could have a material adverse effect on our business, financial condition and results of operations.

 

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We need to expand our existing sales force and distribution network to maintain and grow our business and revenues. If we fail to expand and maintain an effective sales force or successfully develop our relationship with distributors, our business, prospects and brand may be materially and adversely affected.

We currently market and sell our HIFU therapy system and ECLIA systems to third-party distributors, while our FISH imaging analysis system and probes are promoted and marketed solely through our own direct sales force. As part of our growth plan, we intend to increase the number of distributors we utilize to distribute our HIFU therapy system and ECLIA system. Our plan also includes strengthening and growing our direct sales force for distribution of our new FISH imaging analysis system and probes. We have limited experience in managing a large sales force and distributor network. We cannot assure you that we will be able to maintain an effective sales force or successfully develop our relationships with third-party distributors. If we fail to do any one of those, our sales could fail to grow or could even decline, and our ability to grow our business could be adversely affected. The expansion of our sales force and distribution network is also likely to require a significant investment of financial resources and management efforts, and the benefits, if any, which we gain from such expansion may not be sufficient to generate an adequate return on our investment.

If we fail to effectively manage our distribution network, our business, prospects and brand may be materially and affected by actions taken by our distributors.

We have a limited ability to manage the activities of our third-party distributors, who are independent from us. Our distributors could take one or more of the following actions, any of which could have a material adverse effect on our business, prospects and brand:

 

   

sell products that compete with our products in breach of their non-competition agreements with us;

 

   

fail to adequately promote our products;

 

   

fail to provide proper service to our end-users; or

 

   

violate the anti-corruption laws of China.

Failure to adequately manage our distribution network or the non-compliance of our distributors with their obligations under distribution agreements with us could harm our corporate image among end users of our products and disrupt our sales, resulting in a failure to meet our sales goals. The PRC government has increased its anti-bribery efforts in the healthcare sector to reduce improper payments received by hospital administrators and doctors in connection with the purchase of pharmaceutical products and medical devices. To our knowledge, none of our distributors engages in corrupt practices. However, our distributors may violate these laws or otherwise engage in illegal practices with respect to their sales or marketing of our products.

International expansion may be costly, time consuming and difficult. If we do not successfully expand internationally, our profitability and prospects would be materially and adversely affected.

Our long-term success also depends upon our ability to enter into international markets. In expanding our business internationally, we intend to enter markets in which we have no experience and in which our brand has low or no recognition. This expansion requires capital and management resources to promote our brand and generate demand for our products in targeted oversea markets. We may be unable to successfully execute our expansion plan. In new markets we may fail to anticipate competitive conditions that are different from those in China. These competitive conditions may make it difficult or impossible for us to effectively sell and distribute our products in these markets. If our expansion efforts in new markets are unsuccessful, our profitability and prospects would be materially and adversely affected.

We are exposed to other risks associated with international operations, including:

 

   

economic instability and recessions;

 

   

changes in tariffs;

 

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difficulties of administering foreign operations;

 

   

financial condition, expertise and performance of our international distributors; or

 

   

potentially adverse tax consequences.

Our costs could substantially increase if we experience a significant number of warranty claims.

We provide 12-month product warranties against technical defects of our HIFU therapy system, ECLIA analyzer and FISH imaging analysis system. Our product warranty requires us to repair defects arising from product design and production process and if necessary, replace defective components. Historically, we have received a limited number of warranty claims for our HIFU therapy system and ECLIA analyzer. The costs associated with our warranty claims have historically been relatively low. Thus, we generally do not accrue any liability for potential warranty claims at the time of sales, but rather at the time claims are actually made. As we only began selling our FISH imaging analysis system in June 2007, we currently only have a short period of historical data on the warranty claims for our FISH system. The fluorescent microscope, CCD camera and imaging analysis software that are integrated into our FISH imaging analysis system are warranted by our component suppliers.

If we experience an increase in warranty claims or if our repair and replacement costs associated with warranty claims increase significantly, we will begin to incur liabilities for potential warranty claims at the time of sale of our products. An increase in the frequency of warranty claims or amount of warranty costs may harm our reputation and could have a material adverse effect on our financial condition and results of operations.

Our operations might be interrupted by the occurrence of a natural disaster or other catastrophic events.

Almost all of our manufacturing and research and development facilities are located in a single location in Beijing, China. We do not maintain back-up facilities, so we depend on our manufacturing and other facilities for the continued operation of our business. Natural disasters or other catastrophic events, including power interruptions, water shortages, storms, fires, earthquakes, terrorist attacks and wars could disrupt our operations. We might suffer losses as a result of business interruptions and our operations and financial results might be materially and adversely affected. Moreover, any such event could delay our research and development programs.

If we are unable to successfully operate and manage our manufacturing operations, we may experience a decrease in revenues.

As we ramp up our manufacturing operations to accommodate our planned growth, we may encounter difficulties associated with increasing production scale, including shortages of qualified personnel to operate our equipment, assemble our products or manage manufacturing operations, as well as shortages of key raw materials or components for our products. In addition, we may also experience difficulties in producing sufficient quantities of products or in achieving desired product quality. If we are unable to successfully operate and manage our manufacturing operations to meet our needs, we may not be able to provide our customers with the quantity or quality of products they require in a timely manner. This could cause us to lose customers and result in reduced revenues.

Our business may suffer if we are unable to collect payments from our customers on a timely basis.

Our distributors and other customers must make a significant commitment of capital to purchase our products. Any downturn in the businesses of our distributors and other customers could reduce their willingness or ability to pay us. We have historically been able to collect substantially all of our receivable balances. Consequently, we have not found it necessary to provide an allowance for doubtful accounts historically. The failure of any of our distributors to make timely payments could require us to recognize an allowance for doubtful accounts, which could have a material adverse effect on our results of operations and financial condition.

 

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Fluctuations in our quarterly operating results could cause our ADS price to decline.

Our revenues and operating results have fluctuated in the past and may continue to fluctuate significantly from quarter to quarter depending upon numerous factors. Our third and fourth fiscal quarters, ending December 31 and March 31, respectively, have historically been our strongest. We believe that the relatively stronger performance of our third and fourth fiscal quarters has been largely due to the budget cycles of hospitals in China. Hospitals in China typically make their capital expenditure decisions, such as decisions on whether to purchase our HIFU therapy system, between June and December. Based on orders during that period, our HIFU therapy systems are usually shipped to customers between September and March, which are our third and fourth fiscal quarters. Other factors that may affect the fluctuation of our quarterly operating results include changes in pricing policies by us or our competitors, the length of our sales cycle, the timing and market acceptance of new product introductions and product enhancements by us or our competitors, customer order deferrals in anticipation of new or enhanced products offered by us or our competitors, the loss of key sales personnel or distributors, changes in government policies or regulations and a downturn in general economic conditions in China. Furthermore, because we have historically sold a relatively small number of our main product, the HIFU therapy system, at a relatively high unit price, the size and timing of each individual order have a particularly significant effect on our results of operations in any given quarter. Many of these factors are beyond our control, and you should not rely on our results of operations for prior quarters as an indication of our results in any future period. As our revenues vary significantly from quarter to quarter, our business is difficult to predict and manage, and our quarterly results could fall below investor expectations, which could cause our ADS price to decline.

We are subject to product liability exposure and have limited insurance coverage.

As our main product, the HIFU therapy system, is a medical device for the treatment of patients, we are exposed to potential product liability claims in the event that the use of our products causes or is alleged to have caused personal injuries or other adverse effects. A successful product liability claim against us could require us to pay substantial damages. Product liability claims against us, whether or not successful, are costly and time-consuming to defend. Also, in the event that our products prove to be defective, we may be required to recall or redesign such products. We have a product liability insurance policy with an annual aggregate insured amount of RMB4.0 million (US$0.5 million) to cover potential product liability arising from the use of our HIFU therapy system. However, as the insurance industry in China is still in an early stage of development, product liability insurance available in China offers limited coverage compared to coverage offered in many other countries. As a result, future liability claims could be excluded from our policies or exceed the coverage limits of our policies. We also cannot assure you that product liability insurance will continue to be available on commercially reasonable terms, if at all. To date, we have not been subject to any product liability claim, but we cannot assure you that such claim will not be brought against us in the future. A product liability claim, with or without merit, could result in significant adverse publicity against us, and could have a material adverse effect on the marketability of our products and our reputation, which in turn, could have a material adverse effect on our business, financial condition and results of operations. In addition, we do not have any business interruption insurance coverage for our operations. Any business disruption or natural disaster could result in substantial costs and diversion of resources.

Our future capital needs are uncertain and we may need to raise additional funds in the future.

We may require additional cash resources in the future due to:

 

   

changed business conditions or other future developments;

 

   

the receipt of, and the time and expenses required to obtain and maintain, regulatory clearances and approvals;

 

   

the resources we devote to developing, marketing and producing our products;

 

   

our ability to identify and our desire or need to pursue acquisitions or other investments; and

 

   

the extent to which our products generate market acceptance and demand.

 

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We cannot assure you that our revenues will be sufficient to meet our operational needs and capital requirements in the future. In addition, we cannot assure you that financing will be available in amounts or on terms acceptable to us, if at all. Our future capital needs and other business reasons could require us to sell additional equity or debt securities or obtain a credit facility. The sale of additional equity or equity-linked securities could result in additional dilution to our shareholders. The incurrence of indebtedness would result in increased debt service obligations and could result in operating and financing covenants that would restrict our operations or our ability to pay dividends to our shareholders. In the past, we have not encountered difficulties in obtaining financing.

If a poll is not demanded at our shareholder meeting, voting will be by show of hands and shares will not be proportionately represented. Shareholder resolutions may be passed without the presence of the majority of our shareholders in person or by proxy.

Voting at any of our shareholder meetings is by show of hands unless a poll is demanded. A poll may be demanded by the chairman of our board of directors or by any shareholder present in person or by proxy. If a poll is demanded, each shareholder present in person or by proxy will have one vote for each ordinary share registered in his name. If a poll is not demanded, voting will be by show of hands and each shareholder present in person or by proxy will have one vote regardless of the number of shares registered in his name. In the absence of a poll, shares will therefore not be proportionately represented. In addition, the quorum required for our shareholder meetings consists of shareholders who hold at least one-third of our ordinary shares being present at a meeting in person or by proxy. Therefore, subject to the requisite majorities, shareholder resolutions may be passed at our shareholder meetings without the presence of the majority of our shareholders in person or by proxy.

If we fail to achieve and maintain effective internal control over financial reporting in accordance with the Sarbanes-Oxley Act, we may suffer a loss of investor confidence which may have a material adverse effect on the trading price of our ADSs.

We are subject to reporting obligations under the U.S. securities laws. SEC, as required by Section 404 of the Sarbanes-Oxley Act of 2002, or the Sarbanes-Oxley Act, adopted rules requiring every public company to include a management report on such company’s internal control over financial reporting in its annual report, which must also contain management’s assessment of the effectiveness of our internal control over financial reporting. As a foreign accelerated filer, our management assessment must commence for the fiscal year ended on or after July 15, 2006. Therefore, we are applying this requirement to our annual report on Form 20-F the first time for the fiscal year ended March 31, 2007. An independent registered public accounting firm is required to report on the effectiveness of our internal control over financial reporting for the fiscal year ending on or after July 15, 2007. Therefore, this auditor reporting requirement will first apply to our annual report on Form 20-F for the fiscal year ending March 31, 2008.

We cannot assure you that our management will be able to conclude that our internal control over financial reporting is effective when the requirements of Section 404 become applicable to us. Moreover, even if our management concludes that our internal control over financial reporting is effective, our independent registered public accounting firm may still conclude that our internal control is not effective. Furthermore, during the course of evaluation, documentation and attestation, we may identify weaknesses and deficiencies that we may not be able to remedy in time to meet the deadline imposed by the Sarbanes-Oxley Act for compliance with the requirements of Section 404. If we fail to achieve and maintain effective internal control over financial reporting in accordance with the Sarbanes-Oxley Act, we could suffer a loss of investor confidence in the reliability of our financial statements, which in turn could negatively impact the trading price of our ADSs, result in lawsuits being filed against us by our shareholders or otherwise harm our reputation. Furthermore, we have incurred and anticipate that we will continue to incur considerable costs and use significant management time and other resources in an effort to comply with Section 404 and other requirements of the Sarbanes-Oxley Act.

 

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Our reported earnings could decline if we recognize impairment losses on intangible assets relating to our acquisition of the ECLIA technology and FISH operation.

As a result of our acquisition of the ECLIA technology and FISH operation in August 2004 and March 2007, respectively, we have recorded certain intangible assets which are amortized over their respective estimated useful lives and are tested for impairment by us annually or more frequently if an event occurs or a circumstance develops that would likely result in impairment. Examples of such events or circumstances include, but are not limited to, a significant adverse change in legal or business climate, an adverse regulatory action or unanticipated competition. See “Item 5. Operating and Financial Review and Prospects—Critical Accounting Policies.” In the future, we could recognize impairment losses on intangible assets and that impairment could result in a charge to our reported results of operations, which would cause our reported earnings to decline.

Changes in accounting standards regarding our 2005 stock option plan may have a material adverse effect on our reported earnings, may harm our ability to attract and retain employees, and may also negatively impact our results of operations.

Statement of Financial Accounting Standards No. 123 (Revised 2004), “Share-Based Payment,” or SFAS 123R, which we adopted on April 1, 2006, requires all companies to recognize as an expense the fair value of stock options granted to employees. Prior to February 2005, we did not have any stock option plan, so we did not incur any share-based compensation charges. On February 2, 2005, we adopted our 2005 stock option plan and have, to date, granted options to acquire 800,000 of our ordinary shares. Prior to April 1, 2006, we accounted for these options in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” or APB 25, and its related interpretations, which require us to recognize compensation expense for stock options we grant where the exercise price is less than the fair value of our ordinary shares on the date of the grant and we are not required to record share-based compensation charges if the stock option exercise price equals or exceeds the fair value of our ordinary shares at the date of grant. However, beginning on April 1, 2006, we started to account for the compensation costs for stock options using a fair-value based method and recognize expenses in our consolidated statements of income in accordance with SFAS 123R. On June 11, 2007, share options and restricted shares to acquire 2,550,000 of our ordinary shares were granted to four directors, certain officers and management personnel. While the adoption of SFAS 123R did not have a material effect on our consolidated financial statements, the use of the fair-value based approach, as opposed to an intrinsic value approach, in determining the compensation costs for our share-based awards could have a material and adverse effect on our future earnings.

Risks Related to Our Industry

New product development in the medical device and supply industry is both costly and labor-intensive and has a very low rate of successful commercialization.

Our success will depend in part on our ability to enhance our existing products and technologies and to develop and acquire new products or technologies. The development process for medical technology is complex and uncertain, as well as time-consuming and costly. Product development requires the accurate assessment of technological and market trends as well as precise technological execution. We cannot assure you that:

 

   

our product or technology development will be successfully completed;

 

   

necessary regulatory clearances or approvals will be granted by the State Food and Drug Administration of China (SFDA) or other regulatory bodies as required on a timely basis, or at all; or

 

   

any product or technology we develop can be commercialized or will achieve market acceptance.

Also, we may be unable to locate suitable products or technologies to acquire or acquire such products or technologies on commercially reasonable terms. Failure to develop or acquire, obtain necessary regulatory clearances or approvals for, or successfully commercialize or market potential new products or technologies could have a material adverse effect on our financial condition and results of operations.

 

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In order to manufacture and market our products, we are required to obtain various authorizations from governmental regulatory authorities in China. If we fail to obtain clearances or approvals in a timely fashion, our business may be significantly affected.

The sale and marketing of our medical device products are subject to regulation in China and other countries where we plan to expand our product distribution. We are required to obtain registrations with the SFDA and the regulators administrating the approval in countries where we plan to export. The process for obtaining regulatory clearances or approvals can be lengthy and expensive, and the results are unpredictable. In addition, the relevant regulatory authorities may introduce additional requirements or procedures that have the effect of delaying or prolonging the regulatory clearance or approval for our existing or new products. If we are unable to obtain clearances or approvals needed to market existing or new products, or obtain such clearances or approvals in a timely fashion, our business could be significantly disrupted, and sales and profitability could be materially and adversely affected.

We are required to obtain a registration certificate from the SFDA in order to sell our HIFU therapy system. The registration certificate for our second generation HIFU therapy system expired in January 2007. Due to stricter regulations recently imposed by SFDA, we were granted an extension and are required to obtain a renewal for our third generation HIFU therapy system by December 2007. Renewing our registration certificate entails submission of various information and the review of that submission by the applicable regulatory authorities. We do not foresee any significant difficulties in obtaining such renewal. But if we fail to obtain such renewal in a timely fashion, our business may be adversely affected.

In April 2007, SFDA announced a new regulation to be effective on June 1, 2007. Reagents used for IVD testings are divided into three different categories, Class I, Class II and Class III, depending on the degree of risk associated with each reagent. Our reagents are classified as Class III reagents and they therefore are subject to all regulatory control governing Class III reagents. We are required to obtain a registration certificate for each IVD reagent prior to selling that reagent for clinical use. However, a regent that is used for research purpose only is exempt from registration and/or approval. A reagent kit intended for research use only must comply with the labeling requirements that present the statement: “For research use only. Not for use in diagnostic procedures” on the package. Of the 62 ECLIA reagents that we market as of June 30, 2007, 36 are covered by registration certificates. Of the 26 reagents we currently sell for research use only, we have submitted registration applications for 11 of them. We intend to apply for registration certificates for all of our reagents, but we may not succeed in obtaining registration certificates for all these ECLIA reagents or for any reagents that we develop in the future. Before receiving the necessary registration certificate, these ECLIA reagents can be sold for research only. Thus, this may delay the surge of sales in these reagents.

Competition in the markets in which we operate is expected to increase in the future.

Our HIFU therapy system competes with both existing and emerging alternative treatment methods for tumors, including other tumor therapy devices that use similar technologies. Competition in the markets in which we operate is expected to increase in the future. For our HIFU therapy system, we believe that competition comes from new and existing manufacturers of HIFU tumor therapy devices, as well as traditional cancer treatment methods such as surgery, radiotherapy and chemotherapy. In addition, we also compete with other minimally invasive treatments, including radio frequency ablation, microwave thermo-coagulation and cryosurgery, and targeted therapeutics. We believe that other companies offer HIFU technology for the treatment of tumors including EDAP TMS S.A., or EDAP, Focus Surgery, Inc., or Focus Surgery, and InSightec. According to Focus Surgery’s website, its HIFU product is being used in China; and although no other overseas-based company currently offers or sells its products in China, they may choose to enter the China market in the future, either independently or in cooperation with our existing competitors in China. In China, competitors for our HIFU therapy system include Chongqing Haifu Technology Co., Ltd., or Chongqing Haifu, and Shanghai A&S Science Technology Development Co., Ltd., or Shanghai A&S.

Our ECLIA system competes with IVD systems and reagents offered in the China market by many established international companies, including Abbott Diagnostics, Bayer AG, Beckman Coulter, Diagnostic

 

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Products Corporation, PerkinElmer, Inc., Johnson & Johnson and Roche Group. There are also a number of China-based manufacturers who also offer luminescence immunoassay systems but their market shares are relatively small.

Our FISH probes compete with probes offered by Abbott Diagnostics, Ventana, Cancer Genetics and Cytocell. We are not aware of any China-based manufacturers who offer a FISH imaging analysis system and probes in China.

See “Item 4. Information on the Company—B. Business Overview—Competition.”

Certain of our existing and potential competitors have significantly greater financial, research and development, sales and marketing, personnel resources and other resources than we do. Competition will intensify as other companies enter our markets. Competing companies may succeed in developing products that are more effective or less costly than those that we may offer, and these companies may also be more successful in marketing their products. Competing companies may also introduce competitive pricing measures that adversely affect our sales levels and margins. If we do not adequately address our competitive challenges, we could lose sales and market share and fail to grow our business as planned, which would have a material adverse effect on our financial condition, results of operations and future growth.

In addition, we believe that corrupt practices in the healthcare industry in China still occur. In order to increase sales, certain manufacturers or distributors of medical devices may pay kickbacks to hospital personnel who make procurement decisions. We prohibit our employees from engaging in such practices and, to our knowledge, none of our distributors engages in such practices. However, as competition intensifies in the medical device and supplies industry in China, we may lose sales, customers or contracts to competitors to the extent we or our distributors refuse to engage in such practices.

The tumor therapy and IVD industries are characterized by constant technological change, and if we fail to respond effectively to technological changes, we could lose our competitive advantage.

The tumor therapy and IVD industries in which we currently compete are characterized by:

 

   

changing technologies;

 

   

frequent new product introductions and enhancements;

 

   

changing customer needs; and

 

   

product obsolescence.

To develop new products and designs, we must develop, gain access to and use leading technologies in a cost-effective and timely manner and continue to expand our technical and design expertise. Failure to do so could cause us to lose our competitive position and may a material adverse effect on our revenues in the future.

The price and sales of our HIFU therapy system may be adversely affected by reductions in treatment fees by the Chinese government.

Treatment fees for HIFU tumor therapy, like many other medical treatments, are subject to prices set by provincial governments in China, and these prices can be adjusted downward or upward from time to time. If the treatment fees for HIFU tumor therapy are reduced by the government, some hospitals and distributors may be discouraged from buying our HIFU therapy system, which would reduce our sales. We may need to decrease the price of our HIFU therapy system to provide hospitals acceptable returns on their purchases. We cannot assure you that our business or results of operations will not be adversely affected by a reduction in treatment fees for HIFU tumor therapy in the future.

 

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Governmental and private health insurers may not provide sufficient, or any, coverage for the use of our HIFU therapy system.

Our ability to market and sell our HIFU therapy system to hospitals will depend in part on the availability of governmental and private health insurance in China for treatments using our HIFU therapy system. The insurance coverage for treatments using new medical devices, such as our HIFU therapy system, is subject to significant uncertainty and varies from region to region, as local government approvals for such coverage must be obtained in each geographic region in China. In addition, provincial governments may change, reduce or eliminate the government insurance coverage currently available for HIFU tumor therapy. We cannot assure you that adequate third-party insurance coverage will be generally available for patients who elect to use our HIFU therapy system for the treatment of tumors. In the absence of sufficient medical insurance coverage for the use of our HIFU therapy system, patients may choose alternative treatment methods that are covered by insurance, and hospitals may use their limited funds to buy products for these alternative treatments, which would reduce demand for our products and, consequently, our sales. If this occurs, our business, results of operations and financial condition could be materially and adversely affected.

Any product recall could have a material adverse effect on our business, results of operations and financial condition.

Complex medical devices, such as our HIFU therapy system, can experience performance problems that require review and possible corrective action by the manufacturer. From time to time, we receive reports from users of our products relating to performance problems they have encountered. Those problems arose in the past were rectified in a timely fashion and related spending was insignificant. We expect that we will continue to receive customer reports from time to time regarding performance problems they encounter through the use of our products. Furthermore, component failures, manufacturing errors or design defects that could result in an unsafe condition or injury to the patient might occur. Any serious failures or defects could cause us to withdraw or recall products, which could result in significant costs such as repair and product replacement costs. We cannot assure you that market withdrawals or product recalls will not occur in the future, which could have a material adverse effect on our business, financial condition and results of operations.

Risks Related to Doing Business in China

Adverse changes in political, economic and other policies of the Chinese government could have a material adverse effect on the overall economic growth of China, which could reduce the demand for our products and materially and adversely affect our competitive position.

All of our business operations are conducted in China, and all of our sales are made in China. Accordingly, our business, financial condition, results of operations and prospects are affected significantly by economic, political and legal developments in China. The Chinese economy differs from the economies of most developed countries in many respects, including:

 

   

the extent of government involvement;

 

   

the level of development;

 

   

the growth rate;

 

   

the control of foreign exchange;

 

   

the allocation of resources;

 

   

an evolving regulatory system; and

 

   

lack of sufficient transparency in the regulatory process.

While the Chinese economy has experienced significant growth in the past 20 years, growth has been uneven, both geographically and among various sectors of the economy. The Chinese government has

 

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implemented various measures to encourage economic growth and guide the allocation of resources. Some of these measures benefit the overall Chinese economy, but may also have a negative effect on us. For example, our financial condition and results of operations may be adversely affected by government control over capital investments or changes in tax regulations that are applicable to us.

The Chinese economy has been transitioning from a planned economy to a more market-oriented economy. Although in recent years the Chinese government has implemented measures emphasizing the utilization of market forces for economic reform, the reduction of state ownership of productive assets and the establishment of sound corporate governance in business enterprises, a substantial portion of the productive assets in China is still owned by the Chinese government. The continued control of these assets and other aspects of the national economy by the Chinese government could materially and adversely affect our business. The Chinese government also exercises significant control over Chinese economic growth through the allocation of resources, controlling payment of foreign currency-denominated obligations, setting monetary policy and providing preferential treatment to particular industries or companies. Efforts by the Chinese government to slow the pace of growth of the Chinese economy could result in decreased capital expenditure by hospitals, which in turn could reduce demand for our products.

Moreover, the political relationship between the United States, Europe, or other Asian nations and China is subject to sudden fluctuation and periodic tension. Changes in political conditions in China and changes in the state of foreign relations are difficult to predict and could adversely affect our operations or cause our services to become less attractive. This could lead to a decline in our profitability.

Any adverse change in the economic conditions or government policies in China could have a material adverse effect on overall economic growth and the level of healthcare investments and expenditures in China, which in turn could lead to a reduction in demand for our products and consequently have a material adverse effect on our businesses.

Future changes in laws, regulations or enforcement policies in China could adversely affect our business.

Laws, regulations or enforcement policies in China, including those regulating medical devices and supplies, are evolving and subject to future change. For example, under a regulation enacted by the SFDA in September 2002 and was renewed in April 2007, reagents are required to be registered with the SFDA and are subject to regulatory controls. As of June 30, 2007, we have obtained SFDA registrations and/or approvals for 36 of the 62 ECLIA reagents we sell and are in the process of obtaining the required registrations and/or approvals for the 26 reagents that are currently sold with research labels. Moreover, in October 2004, the SFDA imposed certain good manufacturing practice, or GMP, requirements for ECLIA reagents. As a result, all manufacturers of ECLIA reagents were obligated to meet GMP standards by January 1, 2006. We obtained GMP certification for the production of our ECLIA reagents in November 2005 and are currently in compliance with GMP requirements. This GMP certification is valid until October 2010. We have also submitted an application for the new GMP that we added recently to enlarge our production capacity of our ECLIA reagents.

Future changes in laws, regulations or administrative interpretations, or stricter enforcement policies by the Chinese government, could impose more stringent requirements on us, including fines or other penalties. Changes in applicable laws and regulations may also increase our operating costs. Compliance with such requirements could impose substantial additional costs or otherwise have a material adverse effect on our business, financial condition and results of operations. These changes may relax some requirements, which could be beneficial to our competitors or could lower market entry barriers and increase competition. Further, regulatory agencies in China may periodically, and sometimes abruptly, change their enforcement practice. Therefore, prior enforcement activity, or lack of enforcement activity, is not necessarily predictive of future actions. Any enforcement actions against us could have a material and adverse effect on us and the market price of our ADSs. In addition, any litigation or governmental investigation or enforcement proceedings in China may be protracted and may result in substantial cost and diversion of resources and management attention, negative publicity, damage to our reputation and decline in the price of our ADSs.

 

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We rely on dividends paid by our subsidiary for our cash needs.

We are a holding company, and we rely on dividends paid by our wholly owned operating subsidiaries, YDME Beijing and Beijing GP, for our cash needs, including the funds necessary to pay dividends and other cash distributions to our shareholders, service any debt we may incur and pay our operating expenses. The payment of dividends in China is subject to limitations. Regulations in the PRC currently permit payment of dividends only out of accumulated profits as determined in accordance with accounting standards and regulations in China. Both YDME Beijing and Beijing GP are also required to set aside at least 10% of its after-tax profit based on PRC accounting standards each year to its general reserves until the reserves reach 50% of the subsidiaries’ own registered capital. These reserves are not distributable as cash dividends. In addition, if these two PRC operating subsidiaries incur debt on their own behalf in the future, the instruments governing the debt may restrict their ability to pay dividends or make other distributions to us.

Restrictions on currency exchange may limit our ability to receive and use our revenues effectively.

We receive all of our revenues in Renminbi, which currently is not a freely convertible currency. A portion of our revenues may be converted into other currencies to meet our foreign currency obligations, including, among others, payment of dividends declared, if any, in respect of our ordinary shares. Under China’s existing foreign exchange regulations, both YDME Beijing and Beijing GP are able to pay dividends in foreign currencies without prior approval from the State Administration of Foreign Exchange, or the SAFE, by complying with certain procedural requirements. However, we cannot assure you that the PRC government will not take future measures to restrict access to foreign currencies for current account transactions.

All our PRC subsidiaries’ ability to obtain foreign exchange is subject to significant foreign exchange controls and, in the case of amounts under the capital account, requires the approval of and/or registration with PRC government authorities, including the SAFE. In particular, if any of these subsidiaries borrow foreign currency loans from us or other foreign lenders, they must do so within approved limits that satisfy their approval documentation and PRC debt to equity ratio requirements. Further, such loans must be registered with the SAFE. If we finance any of these subsidiaries by means of additional capital contributions, the amount of these capital contributions must first be approved by the relevant government approval authority. These limitations could affect the ability of these subsidiaries to obtain foreign exchange through debt or equity financing.

Fluctuation in the value of the Renminbi may have a material adverse effect on your investment.

The value of the Renminbi against the U.S. dollar and other currencies may fluctuate and is affected by, among other things, changes in China’s political and economic conditions. The conversion of Renminbi into foreign currencies, including U.S. dollars, has historically been set by the People’s Bank of China. On July 21, 2005, the PRC government changed its policy of pegging the value of the Renminbi to the U.S. dollar. Under the new policy, the Renminbi is permitted to fluctuate within a band against a basket of certain foreign currencies, determined by the Bank of China, against which it can rise or fall by as much as 0.3% each day. This change in policy resulted initially in an approximately 4.1% appreciation in the value of the Renminbi against the U.S. dollar. Since the adoption of this new policy, the value of Renminbi against the U.S. dollar has fluctuated on a daily basis within narrow ranges, but overall has further strengthened against the U.S. dollar. There remains significant international pressure on the PRC government to further liberalize its currency policy, which could result in a further and more significant appreciation in the value of the Renminbi against the U.S. dollar. As we import certain materials and supplies for reagent kits from the United States, Finland and Sweden, fluctuations in the value of the Renminbi against the currencies of those countries may increase the cost of our reagent kits. In addition, as we rely entirely on dividends paid to us by our wholly owned subsidiaries, any significant revaluation of the Renminbi may have a material adverse effect on our revenues and financial condition, and the value of, and any dividends payable on, our ADSs in foreign currency terms. For example, to the extent that we need to convert U.S. dollars we receive from our initial public offering into Renminbi for our operations, appreciation of the Renminbi against the U.S. dollar would have an adverse effect on the Renminbi amount we receive from the conversion. Conversely, if we decide to convert our Renminbi into U.S. dollars for the purpose

 

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of making payments for dividends on our ordinary shares or ADSs or for other business purposes, appreciation of the U.S. dollar against the Renminbi would have a negative effect on the U.S. dollar amount available to us. In addition, appreciation or depreciation in the value of the Renminbi relative to the U.S. dollar would affect our financial results reported in U.S. dollar terms without giving effect to any underlying change in our business or results of operations.

Our business benefits from certain government incentives. Expiration of, or changes to, these incentives could have a material adverse effect on our operating results.

The PRC government has provided various incentives to high technology companies, including YDME Beijing, in order to encourage development of the high technology industry. Such incentives include reduced tax rates and other measures. For example, as a high technology company operating in an approved economic-technological development area, YDME Beijing is entitled to an Enterprise Income Tax (EIT) rate of 15%, compared to an EIT rate of 33% applicable to most PRC companies. This classification also qualified YDME Beijing to a 50% reduction in EIT rate to 7.5% during the three calendar years ended December 31, 2002, 2003 and 2004. In addition, as a “foreign-invested advanced technology enterprise” certified by the Beijing Commerce Bureau, YDME Beijing is entitled to a reduced EIT rate of 10% for the three calendar years ending December 31, 2007. The reduced EIT rate will expire on December 31, 2007, after which the EIT rate of YDME Beijing will return to 15%. For the three fiscal years ended March 31, 2005, 2006 and 2007, YDME Beijing incurred income tax expense of RMB11.9 million, RMB18.1 million, and RMB30.1 million (US$3.9 million), respectively. If YDME Beijing had not had a reduced EIT rate of 7.5% for the two calendar years ended December 31, 2003 and 2004 and 10% for the calendar years ended December 31, 2005 and 2006 it would have had an EIT rate of 15%, and our income tax expense for the three fiscal years ended March 31, 2005, 2006 and 2007 would have been increased by RMB5.7 million, RMB13.0 million and RMB15.6 million (USD2.0 million), respectively.

As a foreign owned enterprise and high technology enterprise with operations in an economic-technological development area in the PRC, Beijing GP is eligible for a tax holiday, an exemption from income tax for the two years starting from the first profitable year of operations and thereafter a 50% relief from income tax for the following three years. Beijing GP is currently in the process of applying for approval from the tax authority for the grant of a tax holiday.

Additionally, any adverse changes to the PRC’s Corporate Income Tax Law may adversely affect the taxation of YDME Beijing and Beijing GP or remittances by these two operating subsidiaries to us. To date, the detailed implementation rules have yet to be made public by the PRC government. However, it is believed that among the possible changes are elimination of tax holidays and other incentives, increases in tax rates and imposition of a dividend withholding tax. Historically, we have benefited from tax holidays and incentives. The extent and timing of any such changes in the PRC’s tax laws is uncertain and it is not known whether any transitional or other relief will be granted to companies such as YDME Beijing that have already established operations in China. If adopted, these changes could significantly increase our tax expense.

YDME Beijing is also entitled to a refund of VAT on the sales of self-developed software embedded in our HIFU therapy system and ECLIA analyzers, which we recognize as part of our net revenues under U.S. GAAP. In the fiscal year ended March 31, 2007, VAT refunds accounted for 5.4% of our total revenues from these two segments.

In March 2007, China passed the China Unified Corporate Income Tax Law, or New CIT Law, which will become effective on January 1, 2008. The New CIT Law establishes a unified 25% income tax rate for most companies, with some preferential income tax rates for qualified hi-tech enterprises. The related detailed implementation rules and regulations for the New CIT Law, which will define various terms and interpret the New CIT Law’s application of and its provisions, are expected to be promulgated by the State Council in 2007. We believe that the New CIT Law, as drafted, does not affect our qualification as a hi-tech enterprise. As such, we believe that the current tax rate of 15% will continue to apply to our operating subsidiaries. If the

 

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implementation rules and regulations result in a change that causes us to no longer qualify as a hi-tech enterprise, we will be required to adjust certain deferred income tax liabilities which will result in additional tax expense in the period during which the change takes effect.

The enactment of the New CIT Law, could adversely affect our financial condition and results of operations. Moreover, our historical operating results may not be indicative of our operating results for future periods as a result of the expiration of the tax holidays and value-added tax refunds we enjoy. In addition, under the New CIT Law, dividends we receive from our PRC subsidiaries will be subject to a withholding tax at a rate of 20%. The withholding tax on dividends may be exempted or reduced by the State Council of the PRC. Furthermore, the ultimate tax rate will be determined by treaty between the PRC and the tax residence of the holder of the PRC subsidiary. We are actively monitoring the proposed withholding tax and are evaluating appropriate organizational changes to minimize the corresponding tax impact.

Dividends payable by us to our foreign investors may become subject to withholding taxes under PRC tax laws.

Under the New CIT Law, dividends payable to foreign investors which are “derived from sources within the PRC” may be subject to income tax at the rate of 20% by way of withholding. Since we are a holding company and substantially all of our income will come from dividends that we receive from our PRC subsidiaries, dividends that we declare from such income may be deemed “derived from sources within the PRC” for purposes of the New CIT Law and therefore subject to a 20% withholding tax. While the New CIT Law stipulates that such taxes may be exempted or reduced, since no rules or guidance concerning the new tax law have been issued yet, it is unclear under what circumstances, and to what extent, such tax would be exempted or reduced. One example of a limitation on the 20% withholding tax is the way in which, pursuant to a treaty for the avoidance of double taxation, income tax levied by the PRC authorities on U.S. investors may not exceed 10% of the gross amount of the dividends, provided that we are deemed to be a PRC resident enterprise under the New CIT Law. If we are required under the New CIT Law to withhold PRC income tax on our dividends payable to our foreign shareholders and ADS holders, the value of your investment in our ADSs may be materially and adversely affected.

Gains on the sales of our shares or ADSs may become subject to PRC income taxes.

Under the New CIT Law, our foreign corporate shareholders and corporate ADS holders may be subject to a 20% income tax upon any gains they realize from the transfer of their shares or ADSs, if such income is regarded as income from “sources within the PRC.” What will constitute “sources within the PRC” and whether or not there will be any exemption or reduction in taxation for our foreign corporate investors, however, are unclear since no rules or guidance concerning the new tax law has been issued yet. If our foreign shareholders and ADS holders are required to pay PRC income tax on the transfers of their shares or ADSs, the value of your investment in our ADSs may be materially and adversely affected.

We face risks related to health epidemics and outbreaks of contagious diseases, including avian influenza and Severe Acute Respiratory Syndrome, or SARS.

Our business could be adversely affected by the effects of avian influenza, SARS or other epidemics or outbreaks of contagious diseases. There have been recent reports of outbreaks of a highly pathogenic avian influenza, or avian flu, caused by the H5N1 virus in certain regions of Asia and Europe. In 2005 and 2006, there have been reports on the occurrences of avian flu in various parts of China, including a few confirmed human cases. An outbreak of avian flu in the human population could result in a widespread health crisis that could adversely affect the economies and financial markets of many countries, particularly in Asia. Additionally, a recurrence of SARS, a highly contagious form of atypical pneumonia, similar to the occurrence in 2003 which affected China, Hong Kong, Taiwan, Singapore, Vietnam and certain other countries, would also have similar adverse effects. The 2003 SARS outbreak significantly and adversely affected our revenues and, consequently, our profitability. Since all of our operations and substantially all of our customers and suppliers are based in Asia, an outbreak of avian flu,

 

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SARS or other contagious diseases in China, other places in Asia or elsewhere, or the perception that such outbreak could occur, and the measures taken by the governments of countries affected, would adversely affect our business, financial condition or results of operations. We have not adopted any written preventive measures or contingency plans to combat any future outbreaks of avian flu, SARS or any other epidemics.

Risks Related to Our Ordinary Shares and ADSs

The market price for our ADSs may be volatile.

The market price for our ADSs has been and may continue to be subject to significant fluctuations. Since August 10, 2005, the intraday sales prices of our ADSs have ranged from US$14.95 to US$44.93 per ADS, and the last reported sale price on September 27, 2007 was US$42.24 per ADS. The price of our ADSs may fluctuate in response to factors including the following:

 

   

announcements of technological or competitive developments;

 

   

announcements regarding patent litigation or the issuance of patents to us or our competitors;

 

   

governmental developments in China, such as changes in fiscal policies or developments relating to the regulatory or health care reimbursement environment, affecting us or our competitors;

 

   

announcements of studies and reports relating to the effectiveness or safety of our products or those of our competitors;

 

   

actual or anticipated fluctuations in our quarterly operating results and changes or revisions of our expected results;

 

   

changes in financial estimates by securities research analysts;

 

   

changes in the economic performance or market valuations of other medical technology companies;

 

   

addition or departure of our senior management and key research and development personnel;

 

   

any litigation, governmental investigation or enforcement proceedings brought against us by authorities and industry regulators in China or elsewhere;

 

   

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

 

   

sales of additional ordinary shares or ADSs, or the perception that such sales might occur.

In addition, the securities market has from time to time experienced significant price and volume fluctuations that are not related to the operating performance of particular companies. These market fluctuations may also have a material adverse effect on the market price of our ADSs.

Our articles of association contain anti-takeover provisions that could adversely affect the rights of holders of our ordinary shares and ADSs.

Our articles of association contain provisions that could limit the ability of others to acquire control of our company or cause us to engage in change-of-control transactions. These provisions could have the effect of depriving our shareholders of an opportunity to sell their shares at a premium over prevailing market prices by discouraging third parties from seeking to obtain control of our company in a tender offer or similar transaction. For example, our board of directors has the authority, without further action by our shareholders, to issue preferred shares in one or more series and to fix their designations, powers, preferences, privileges, and relative participating, optional or special rights and the qualifications, limitations or restrictions, including dividend rights, conversion rights, voting rights, terms of redemption and liquidation preferences, any or all of which may be greater than the rights associated with our ordinary shares, in the form of ADS or otherwise. Preferred shares could be issued quickly with terms calculated to delay or prevent a change in control of our company or make removal of management more difficult. If our board of directors issues preferred shares, the price of our ADSs may fall and the voting and other rights of the holders of our ordinary shares and ADSs may be adversely affected.

 

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Holders of ADSs have fewer rights than shareholders and must act through the depositary to exercise those rights.

Holders of ADSs do not have the same rights as holders of our ordinary shares and may only exercise the voting rights with respect to the underlying ordinary shares in accordance with the provisions of the deposit agreement. Under the deposit agreement, if the vote is by show of hands, the depositary will vote the deposited securities in accordance with the voting instructions received from a majority of holders of ADSs that provided timely voting instructions. If the vote is by poll, the depositary will vote the deposited securities in accordance with the voting instructions it timely receives from ADS holders. In the event of poll voting, deposited securities for which no instructions are received will not be voted. Under our articles of association, the minimum notice period required to convene a general meeting is seven days. When a general meeting is convened, you may not receive sufficient notice of a shareholders’ meeting to permit you to withdraw your ordinary shares to allow you to cast your vote with respect to any specific matter. In addition, the depositary and its agents may not be able to send voting instructions to you or carry out your voting instructions in a timely manner. We will make all reasonable efforts to cause the depositary to extend voting rights to you in a timely manner, but we cannot assure you that you will receive the voting materials in time to ensure that you can instruct the depositary to vote your shares. Furthermore, the depositary and its agents will not be responsible for any failure to carry out any instructions to vote, for the manner in which any vote is cast or for the effect of any such vote. As a result, you may not be able to exercise your right to vote and you may lack recourse if your ordinary shares are not voted as you requested. In addition, in your capacity as an ADS holder, you will not be able to call a shareholder meeting.

You may be subject to limitations on transfers of your ADSs.

Your ADSs are transferable on the books of the depositary. However, the depositary may close its transfer books at any time or from time to time when it deems expedient in connection with the performance of its duties. In addition, the depositary may refuse to deliver, transfer or register transfers of ADSs generally when our books or the books of the depositary are closed, or at any time if we or the depositary deem it advisable to do so because of any requirement of law or of any government or governmental body, or under any provision of the deposit agreement, or for any other reason.

Your right to participate in any future rights offerings may be limited, which may cause dilution to your holdings, and you may not receive cash dividends if it is impractical to make them available to you.

We may from time to time distribute rights to our shareholders, including rights to acquire our securities. However, we cannot make rights available to you in the United States unless we register the rights and the securities to which the rights relate under the Securities Act or an exemption from the registration requirements is available. Also, under the deposit agreement, the depositary will not make rights available to you unless the distribution to ADS holders of both the rights and any related securities are either registered under the Securities Act, or exempted from registration under the Securities Act. We are under no obligation to file a registration statement with respect to any such rights or securities or to endeavor to cause such a registration statement to be declared effective. Moreover, we may not be able to establish an exemption from registration under the Securities Act. Accordingly, you may be unable to participate in our rights offerings and may experience dilution in your holdings.

In addition, the depositary of our ADSs has agreed to pay to you the cash dividends or other distributions it or the custodian receives on our ordinary shares or other deposited securities after deducting its fees and expenses. You will receive these distributions in proportion to the number of ordinary shares your ADSs represent. However, the depositary may, at its discretion, decide that it is inequitable or impractical to make a distribution available to any holders of ADSs. For example, the depositary may determine that it is not practicable to distribute certain property through the mail, or that the value of certain distributions may be less than the cost of mailing them. In these cases, the depositary may decide not to distribute such property, in which event you would not receive such distribution.

 

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We are a Cayman Islands company, and because the rights of shareholders under Cayman Islands law differ from those under U.S. law, you may have difficulty protecting your shareholder rights.

We are an exempted company with limited liability incorporated under Cayman Islands law, and substantially all of our assets are located outside the United States. In addition, a majority of our directors and executive officers reside outside the United States, and a substantial portion of their assets is located outside of the United States. As a result, it may be difficult for you to effect service of process within the United States upon our directors or executive officers, or enforce judgments obtained in the United States courts against our directors or executive officers.

Our corporate affairs are governed by our articles of association, the Companies Law (2004 Revision) and the common law of the Cayman Islands. The rights of shareholders to take legal action against our directors and us, actions by minority shareholders and the fiduciary responsibilities of our directors to us under Cayman Islands law are to a large extent governed by the common law of the Cayman Islands. The common law of the Cayman Islands is derived in part from comparatively limited judicial precedent in the Cayman Islands as well as from English common law, which has persuasive, but not binding, authority on a court in the Cayman Islands. The rights of our shareholders and the fiduciary responsibilities of our directors under Cayman Islands law are not as clearly established as they would be under statutes or judicial precedents in the United States. In particular, the Cayman Islands has a less developed body of securities laws as compared to the United States and some states, such as Delaware, have more fully developed and judicially interpreted bodies of corporate law. In addition, shareholders in Cayman Islands companies may not have standing to initiate a shareholder derivative action before the federal courts of the United States and will have no general right under Cayman Islands law to inspect or obtain copies of our list of shareholders or our corporate records.

There is uncertainty regarding whether Cayman Islands courts would:

 

   

recognize or enforce against us judgments of courts of the United States based on certain civil liability provisions of U.S. securities laws; and

 

   

impose liability against us, in original actions brought in the Cayman Islands, based on certain civil liability provisions of U.S. securities laws.

There is no statutory recognition in the Cayman Islands of judgments obtained in the United States, although the courts of the Cayman Islands will generally recognize and enforce a non-penal judgment of a foreign court of competent jurisdiction of a fixed sum that is not contrary to natural justice or the public policy of the Cayman Islands without retrial on the merit.

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

We may be considered a passive foreign investment company, which could result in adverse U.S. federal income tax consequences for U.S. investors.

We do not believe that we are, for United States federal income tax purposes, a passive foreign investment company (a “PFIC”), and we expect to operate in such a manner so as not to become a PFIC. We must make a separate determination each year as to whether we are a PFIC. As a result, our PFIC status may change. In particular, our PFIC status may be determined in large part based on the market price of our ADSs and the underlying ordinary shares, which is likely to fluctuate (and may fluctuate considerably given that market prices of technology companies have been especially volatile). Accordingly, fluctuations in the market price of the ADSs and the underlying ordinary shares may result in our being a PFIC for any year. Thus, there can be no assurance that we will not be considered a PFIC for our current taxable year or any future taxable year. If we are or become a PFIC, U.S. investors could be subject to additional U.S. federal income taxes on gain recognized with respect to the ADSs or ordinary shares and on certain distributions, plus an interest charge on certain taxes

 

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treated as having been deferred under the PFIC rules. Non-corporate U.S. investors will not be eligible for reduced rates of taxation on any dividends received from us prior to January 1, 2011, if we are a PFIC in the taxable year in which such dividends are paid or in the preceding taxable year. See “Taxation—United States Federal Income Taxation—Passive Foreign Investment Company.”

Risks Related to Our Convertible Notes

The notes are subordinated to our existing and future senior indebtedness.

The notes are unsecured and contractually subordinated in right of payment to our existing and future senior indebtedness. In the event of bankruptcy, liquidation or reorganization or upon acceleration of the notes due to an event of default and in specific other events, our assets will be available to pay obligations on the notes only after all senior indebtedness has been paid in full in cash or other payment satisfactory to the holders of senior indebtedness has been made. There may not be sufficient assets remaining to pay amounts due on any or all of the notes then outstanding. As a result of these payments, our general creditors may recover less, ratably, than the holders of our senior indebtedness and such general creditors may recover more, ratably, than the holders of our notes or our other subordinated indebtedness. The indenture does not limit the creation of additional senior indebtedness (or any other indebtedness). Any significant additional senior indebtedness incurred may also materially adversely impact our ability to service our debt, including the notes. In addition, the holders of our senior indebtedness may, under certain circumstances, restrict or prohibit us from making payments on the notes. As of September 28, 2007, we had no senior indebtedness outstanding. We anticipate that from time to time we may incur additional indebtedness, including senior indebtedness.

The notes are effectively subordinated to the liabilities of our existing subsidiaries and any of our future subsidiaries.

The notes are not guaranteed by our existing subsidiaries or any future subsidiaries and, accordingly, the notes are effectively subordinated to the existing and future indebtedness and other liabilities of our subsidiaries, including those of YDME Beijing and Beijing GP, through which we conduct substantially all of our operations. These liabilities may include indebtedness, trade payables, guarantees, lease obligations and letter of credit obligations. Therefore, our rights and the rights of our creditors, including the holders of the notes, to participate in the assets of any subsidiary upon that subsidiary’s liquidation or reorganization will be subject to the prior claims of the subsidiary’s creditors, except to the extent that we may ourselves be a creditor with recognized claims against the subsidiaries. However, even if we are a creditor of one of our subsidiaries, our claims would still be effectively subordinated to any security interests in, or mortgages or other liens on, the assets of that subsidiary and would be subordinate to any indebtedness of the subsidiary senior to that held by us. As of September 28, 2007, our subsidiaries had no indebtedness outstanding (excluding inter-company liabilities and contingent liabilities).

There are no restrictive covenants in the indenture for the notes relating to our ability to incur future indebtedness or complete other transactions.

The indenture governing the notes does not contain any financial or operating covenants that would protect you from several kinds of transactions that may adversely affect you. In particular, the indenture does not contain restrictions on the payment of dividends, the incurrence of indebtedness, transactions with affiliates, incurrence of liens or the issuance or repurchase of securities by us or any of our subsidiaries. We therefore may incur additional debt, including secured indebtedness or indebtedness at the subsidiary level to which the notes would be structurally subordinated. We may not be able to generate sufficient cash flow to pay the interest on our debt, including the notes offered hereby and indebtedness that is senior in right of payment to the notes offered hereby, or that future working capital, borrowings or equity financing will be available to pay or refinance any such debt.

 

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Fluctuations in the price of our ADSs may impact the price of the notes and make them more difficult to resell.

Because the notes are convertible into our ADSs, volatility or depressed prices for our ADSs could have a negative effect on the trading price of the notes. Holders who receive ADSs upon conversion of the notes will also be subject to the risk of volatility and depressed prices of our ADSs.

The make whole premium that may be payable upon conversion in connection with a fundamental change may not adequately compensate you for the lost option time value of your notes as a result of such fundamental change.

If you convert notes in connection with a fundamental change, we may be required to pay a make whole premium by increasing the conversion rate. The make whole payment is described in our registration statement on Form F-3 (File No. 333-139777), as amended, initially filed with the Commission on January 3, 2007, under the section titled “Description of the Notes—Make Whole Premium Upon a Fundamental Change.” While the make whole premium is designed to compensate you for the lost option time value of your notes as a result of a fundamental change, the make whole amount is only an approximation of such lost value and may not adequately compensate you for such loss.

Because your right to require repurchase of the notes is limited, the market price of the notes may decline if we enter into a transaction that is not a fundamental change under the Indenture.

The term “fundamental change” is limited and may not include every event that might cause the market price of the notes to decline or result in a downgrade of the credit rating of the notes. The term “fundamental change” does not apply to transactions in which 100% of the consideration paid for our ordinary shares in a merger or similar transaction is publicly traded ordinary shares. Our obligation to repurchase the notes upon a fundamental change may not preserve the value of the notes in the event of a highly leveraged transaction, reorganization, merger or similar transaction. See the section titled “Description of the Notes—Fundamental Change Permits Purchase of Notes By Us at the Option of the Holder” in our registration statement on Form F-3 (File No. 333-139777), as amended, initially filed with the Commission on January 3, 2007.

If you hold notes, you are not entitled to any rights with respect to our ADSs, but you are subject to all changes made with respect to our ADSs.

If you hold notes, you are not entitled to any rights with respect to our ADSs (including, without limitation, voting rights and rights to receive any dividends or other distributions on our ADSs), but you are subject to all changes affecting the ADSs. You will only be entitled to rights on the ADSs if and when we deliver ADSs to you in exchange for your notes. For example, in the event that an amendment is proposed to our certificate of incorporation or articles of association requiring shareholder approval and the record date for determining the shareholders of record entitled to vote on the amendment occurs prior to delivery of the ADSs, you will not be entitled to vote on the amendment, although you will nevertheless be subject to any changes in the powers, preferences or special rights of our ADSs.

Provisions of the notes could discourage an acquisition of us by a third party.

Certain provisions of the notes could make it more difficult or more expensive for a third party to acquire us. Upon the occurrence of certain transactions constituting a fundamental change, holders of the notes will have the right, at their option, to require us to repurchase all of their notes or any portion of the principal amount of such notes in integral multiples of $1,000. We may also be required to issue additional shares upon conversion or provide for conversion into the acquirer’s capital stock in the event of certain fundamental changes.

 

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ITEM 4.    INFORMATION ON THE COMPANY

A.    History and Development of the Company

Our predecessor company, Beijing Yuande Bio-Medical Engineering Co. Ltd., or YDME Beijing, was incorporated in China and commenced business operations in July 1999. In anticipation of our initial public offering, we incorporated China Medical Technologies Inc., or China Medical, in the Cayman Islands as a listing vehicle in July 2004. China Medical is an exempted company with limited liability incorporated under Cayman Islands law. China Medical became our ultimate holding company when it issued shares to the existing shareholders of YDME Beijing in January 2005 in exchange for all of the shares that these shareholders held in YDME Beijing. Prior to our acquisition of the FISH operation in March 2007, we conducted substantially all of our operations through YDME Beijing. In June 2007, we completed the full integration of the FISH operation and launched our FISH imaging analysis system and probes to the market through Beijing GP. We currently conduct substantially all of our operations through YDME Beijing and Beijing GP. For additional information on our organizational structure, see Item 4.C, “Organizational Structure.”

Our principal executive offices are located at No. 24 Yong Chang North Road, Beijing Economic-Technological Development Area, Beijing 100176, People’s Republic of China. Our telephone number at this address is (8610) 6787-1166 and our fax number is (8610) 6788-9588.

Investor inquiries should be directed to us at the address and telephone number of our principal executive offices set forth above. Our website is http://www.chinameditech.com. The information contained on our website is not part of this annual report on Form 20-F. Our agent for service of process in the United States is Corporation Service Company located at 1133 Avenue of the Americas, Suite 3100, New York, New York 10036.

B.    Business Overview

Overview

We are a leading China-based medical device company that develops, manufactures and markets advanced IVD products using ECLIA and FISH technology, to detect and monitor various diseases and disorders through laboratory evaluation and analysis of blood, urine or other body fluids, and system using HIFU for the treatment of solid cancers and benign tumors.

Our ECLIA system is a luminescence immunoassay IVD system based on the ECLIA technology that we acquired in August 2004. Luminescence immunoassay IVD systems are advanced types of IVD systems commonly used in the United States and Western Europe, but are relatively new in China. We began marketing and selling our ECLIA system in September 2004 and had sold over 2,500 units of our ECLIA analyzer as of March 31, 2007. We currently offer 62 types of reagent kits for use with our ECLIA analyzer. These reagents are used to detect various thyroid disorders, diabetes, hepatitis, Down syndrome, liver fibrosis, disorders related to reproduction and growth and various types of tumors, as well as to assess the effect of digoxin, a widely used drug for the treatment of heart failure. In addition, we were one of the first companies to obtain SFDA approval in China for an ECLIA reagent kit for the early detection of SARS.

Our FISH product offering consists of our FISH imaging analysis system and probes. FISH technology is a molecular diagnostic technology that we acquired in March 2007. Although widely used in hospitals in the United States and Western Europe, FISH technology is relatively new to the market in China. The technology is commonly used for prenatal and postnatal diagnosis, and early detection and prognosis of various cancers. When used together with the FISH probes, our FISH imaging analysis system enables medical practitioners to visualize and locate DNA sequences in human cells for identifying chromosomal abnormalities. In June, we successfully integrated the FISH operation in our existing businesses. The FISH probes we currently offer are used to detect various genetic syndromes and cancers including breast cancer, bladder cancer, cervical cancer, leukemia and multiple myeloma.

Our HIFU therapy system is an ultrasound-guided ablation system that is used for the non-invasive treatment of solid tumors. Our system is designed to destroy tumors by using HIFU waves to instantly raise the

 

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temperature of the targeted tumor tissue to between 60° C and 70° C (140° F and 158° F). Our proprietary designs enable our system to treat a wide range of tumors, many of which cannot be treated with other HIFU tumor therapy devices currently available in the market. Our HIFU therapy system is SFDA-approved to treat liver, breast and kidney tumors, solid tumors in the pelvic cavity or on bone and tumors in the four limbs or superficial tissues. Treatments using our system are performed without anesthesia and do not cause significant discomfort, skin-burn or hemorrhage. We acquired our HIFU technology in November 1999 and as of March 31, 2007, have sold over 300 units of our HIFU therapy system to date. Sales of our HIFU tumor therapy system constituted 61% of our total revenue in the fiscal year ended March 31, 2007.

Historically, we have benefited from a strong relationship with PUPH, a leading medical research institution and hospital in China affiliated with Peking University. PUPH was the initial developer of our HIFU and ECLIA technologies. We believe that our acquisition of the HIFU and ECLIA technologies and the development and marketing of products using such technologies demonstrate our ability to successfully identify and commercialize medical technologies with significant market potential.

We sell our HIFU therapy systems primarily to distributors with a small percentage of additional sales made directly to hospitals. We sell our ECLIA systems solely to distributors. Our FISH imaging analysis system and probes are distributed solely by our own sales force to hospitals.

Our Competitive Strengths

We believe that our principal competitive strengths include the following:

Innovative ECLIA system and FISH imaging analysis system and probes for in-vitro diagnostics

We believe that we were the first China-based company to offer an integrated luminescence immunoassay IVD system that does not require devices or reagents provided by outside sources. Our ECLIA system is a simple-to-use IVD platform and is sensitive, accurate and safe. Our ECLIA analyzer incorporates proprietary technologies that give our system several advantages over radioimmunoassay and enzymatic immunoassay IVD systems, the two most widely used IVD systems in China. Additionally, compared with the imported automatic luminescence immunoassay systems available in China, our ECLIA system, including our reagent kits, are priced significantly lower, but can achieve test results with comparable accuracy. Our reagent menu is growing rapidly and our broad range of reagents puts us in a competitive position in the ECLIA sector. We believe we have a significant market opportunity to market our ECLIA system to small- and medium-sized hospitals in China. Many of these hospitals currently use less advanced IVD systems because they lack sufficient financial means to purchase the more expensive automatic and imported luminescence immunoassay systems or do not have sufficient patient volume. Our fully automatic system, which we market to large hospitals, is undergoing the approval process with the SFDA. We intend to introduce the full automatic model at a lower price than our overseas-based competitors can achieve.

We believe that we are the first China-based company to offer the FISH imaging analysis system and probes. Compared to some of the other more traditional methodologies such as karyotyping for prenatal diagnosis, our FISH imaging analysis system and probes are easier to use, easier to train people to use and provides a much faster turnaround. It also delivers high sensitivity and specificity of results required for definitive diagnosis. Our FISH imaging analysis system and probes are priced considerably lower than the imported products. We believe we have a significant market opportunity to market our FISH imaging analysis system and probes to large hospitals in China. Many of these hospitals currently use less advanced methodologies for prenatal and cancer diagnosis due to a lack of affordable alternatives. The less advanced methodologies are generally labor intensive or invasive, or yield less accurate results.

HIFU technology leader for tumor treatment

We believe that we are a leader in the design and development of HIFU tumor therapy devices in China. Our patented HIFU therapy system is SFDA-approved and has been used to treat more tumor patients in China

 

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than other available HIFU tumor therapy devices. As of March 31, 2007, we have sold over 300 units of our HIFU therapy system. Treatments using our system are performed without anesthesia and do not cause significant discomfort, skin-burn or hemorrhage. Our third generation HIFU therapy system launched in October 2006 features a non-invasive ultrasound technology for measuring the temperature of the tumor tissues being treated. We also intend to sell a non-invasive ultrasound-based heat measuring device separately as a product upgrade for existing users of our HIFU therapy system. We believe that we are the first company to develop this technology.

Strong research and development capability and our commitments to research and development efforts

We have strong research and development capabilities, and we plan to continue to focus our development efforts on new applications for or enhancements to our HIFU and IVD technologies. Many of the key research and development personnel who developed the HIFU and ECLIA technologies at the PUPH are currently employed by us. The key research and development personnel of our FISH operation, which we acquired in March 2007, signed three-to-five year employment contracts.

We believe that we have a strong patent portfolio compared to other medical technology companies based in China. In China, we currently have 15 patents directed towards our HIFU therapy system and ECLIA system, and have 10 patent applications pending in China directed towards our HIFU therapy and ECLIA systems. We have also made applications for eight patents directed towards our HIFU technology in countries outside China, including the United States, the United Kingdom, Germany, Japan, South Korea, Saudi Arabia and India. As of June 30, 2007, we had been granted four patents and two patents in the United Kingdom and India, respectively. We have also made an application in the United States to secure a methodology patent related to the production of FISH probes, which is currently pending approval.

We have developed multiple generations of our HIFU therapy system. The two-transducer design, developed since our second-generation HIFU therapy system, enables the patient to be treated in the supine, side or seated positions so that more locations in the body can be targeted. In addition, our third-generation HIFU therapy system is equipped with our non-invasive ultrasound temperature measuring technology. We have established relationships with a number of major hospitals and universities in China, as many of these hospitals and universities use our HIFU therapy system to treat patients and to conduct research. We believe that these relationships raise our profile, enhance awareness of our products in the medical community and among patients and provide us with valuable clinical data to improve our products and keep us abreast of industry trends and developments.

As one of our major initiatives to increase the visibility of and develop the HIFU market in China, we are collaborating with the MOH on a large-scale, three-year clinical study. This study aims to demonstrate the clinical benefits of HIFU in combination with radiotherapy and chemotherapy through approximately 20 participating large hospitals. We are also collaborating with the Chinese Academy of Sciences Institute of Acoustics on new product development for HIFU applications. In July 2007, the U.S. Food and Drug Administration granted us conditional approval for our IDE application on our HIFU therapy system. This approval allows us to begin a clinical trial in a limited number of patients with pancreatic cancer. The clinical trial will be performed at the University of Washington Medical Center in Seattle after receiving approval from the Institutional Review Board of the University. Our HIFU tumor therapy system is intended in this trial to ablate targeted tumor tissue of the pancreas for the palliation of pain associated with locally advanced or metastatic pancreatic cancer.

Our growing reagent portfolio is an important driver of the growth in our ECLIA business. Our reagent offering increased from 56 to 62 reagents over the last year. We expect to add another 10-20 reagents to our offering by the end of 2007, these include reagents for infertility disorders and infectious diseases.

Low manufacturing and operating costs

We have significant cost advantages that allow us to price our products competitively and to maintain favorable margins. We believe that our facilities in China allow us to maintain our cost of operations at a

 

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competitive level that could potentially deter other overseas-based competitors from entering the China market. This is due primarily to the lower wages and costs of components and raw materials in China relative to other locations. In addition, our sales and distribution costs are low because we market and sell our products primarily to distributors. Our direct sales force, built in association with our distribution of FISH products, will increase our selling and marketing expenses; however, we expect this increase in expenses to be largely offset by the anticipated resulting growth in sales. Also, our research and development effort mainly focuses on developing new applications and improving the product designs of our HIFU therapy system and ECLIA system, as well enhancing the functionality of our ECLIA reagents and FISH probes, which generally requires lower research and development expense than the development of new technologies and products.

Our Products and Services

Our IVD Systems

In-vitro diagnostics

IVD refers to laboratory tests that are performed on samples of blood, urine, saliva or other body fluids for the diagnosis and analysis of various diseases and disorders. Our IVD systems include ECLIA analyzers, ECLIA reagents, FISH imaging analysis system and FISH probes.

The ECLIA system

Our ECLIA system consists of an ECLIA analyzer, reagent kits and a data analysis system.

The ECLIA analyzer is a sensitive, accurate, low cost and simple-to-use IVD device capable of detecting minute levels of light triggered by combining reagents with body fluid samples to produce diagnostic results. The key component of our ECLIA analyzer is the photon counter. We have developed several technologies that make our photon counter more sensitive and accurate. Reagents are chemically active substances that are formulated to create different reactions with blood or other body fluid samples depending on the extent to which a disease or condition is present or absent. The data analysis system uses our proprietary integrated circuit card, or IC Card, input technology to analyze and organize the information produced. The IC Card contains encryption codes that prevent users from conducting tests with reagents produced by other manufacturers.

To use our ECLIA system, our reagents are mixed with a sample of body fluid from the patient in a microplate provided in our reagent kit. The mixture reacts and emits light, which is measured by the ECLIA analyzer. The light signal is analyzed by the data analysis system. The result is compared with the reference ranges for the relevant disease in order to reach a diagnosis.

Our ECLIA reagent kits

We currently offer 62 types of reagent kits for detecting and monitoring various types of diseases and disorders, including thyroid disorders, diabetes, hepatitis, and disorders related to reproduction and growth, SARS, Down syndrome, liver fibrosis and various types of tumors. We are also developing reagents for other applications such as infertility disorders, HIV, hepatitis C and cardiac diseases.

 

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The following table sets out the major clinical applications of our reagent kits:

 

Types of test

  

Numbers of
reagent kits

  

Description

Anemia    1    Ferritin is an iron-containing protein complex that functions as the primary form of iron storage in the body. Levels of serum ferritin correlate with the amount of iron stored. Our assay test is used for evaluating levels of serum ferritin in diagnosing iron deficiency anemia.
Cardiac diseases    1    Our assay tests for the effectiveness of digoxin, a widely used drug for treatment of heart failure.
Growth disorder    1    Our assay is a test for the early diagnosis, identification and prognosis evaluation of problems relating to growth and development.
Hepatitis B    10    The ten assays comprise the basic tests hospitals perform to test for hepatitis B.
Infertility    7    Our assays test for the sterility caused by the malfunction of immune system.
Liver fibrosis    4    The four assays comprise the main tests performed by hospitals for evaluating the presence and degree of liver fibrosis.
Metabolic function (including diabetes)    4    Diabetes is also a common endocrine disorder in China. Two of our assays tests for insulin and C-Peptide level, two common indications of diabetes. Our other two assays test for and monitor diabetes where insulin and C-Peptide level may not be a reliable indicator.
Other virus (including TOCHR)    10    TOCHR is the abbreviation of five viruses that could cause the fetal malformation if infected during pregnancy. Our assays test for the infection.
Reproductive endocrinology    8    Four of our assays comprise the main tests performed by hospitals for evaluating the functions of the female reproductive organs, including the diagnosis of hormonal imbalance of postmenopausal women. Two of our assays are for evaluation of the male reproductive function. Two of our assays are used for assessing the Down syndrome.
SARS    1    SARS is an atypical pneumonia of unknown etiology, and was recognized in February 2003 in China, Taiwan, Hong Kong, Singapore and certain other regions in the world.
Thyroid disorders    5    The five assays comprise the basic tests hospitals perform to evaluate the functions of a patient’s thyroid gland. We believe that for many hospitals, thyroid testing is a mainstay of their routine endocrine tests.
Tumors    10    Our assays for “tumor markers” can detect the following types of tumors:
     

•      Breast

•      Colon

•      Intestine

•      Kidney

•      Liver

•      Lung

•      Ovary

•      Pancreas

•      Prostate

•      Stomach

 

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FISH imaging analysis system and probes

Our FISH imaging analysis system is used to analyze human tissue samples attached to microscope slides. The system consists of a fluorescent microscope, CCD camera and imaging analysis software. The key component of our FISH imaging analysis system is the fluorescent microscope. The microscope, CCD camera and imaging analysis software are provided by our component suppliers with internal modifications. Through the use of FISH probes, the imaging analysis system enables medical practitioners to detect and localize the presence or absence of specific DNA sequences in chromosomes.

To use our FISH imaging analysis system, a specific fluorescent labeled DNA probe is mixed with a patient fluid sample or tissue sample placed on a microscope slide. This step allows the DNA probe to hybridize with its complementary target DNA. Once hybridized, the fluorescent fragments on the probes will show precisely where their target DNA lies along a chromosome. Under the fluorescent microscope, the medical practitioners examine the labeled sample and check the quality of the fluorescent signals and record the areas for analysis. The software captures and saves the fluorescent images in the computer.

Three types of probes from our production can be used in clinical FISH studies:

 

   

Satellite repeat-sequence probes, which target the centromeres of specific chromosomes. These are particularly useful in determining chromosome numbers in cases of possible trisomies or sex chromosome aneuploidies, such as for prenatal diagnosis;

 

   

Whole chromosome paint probes, which cover the entire targeted chromosome. Paints are especially helpful in translocation cases and in marker chromosome identification; and

 

   

Unique sequence probes, which target a specific locus or gene on a chromosome. Certain acquired abnormalities such as TERC amplification in cervical cancer and HER-2 amplification in breast cancer can be detected in interphase cells with dual-color unique sequence probes.

Our FISH probes

We currently offer probes used for prenatal and cancer management.

 

Applications

  

Numbers of
probes

  

Description

Bladder cancer    4    An advanced approach for early detection and monitoring the course of bladder cancer.
Breast cancer    2    An effective tool to guide treatment. Mostly used to determine whether a breast cancer patient is suitable for receiving Herceptin therapy.
Cervical cancer    2    An effective tool for early diagnosis of cervical cancer and for prediction of the risk of developing cervical cancer.
Leukemia    15    For diagnosis and prognosis of various leukemias and multiple myeloma.
Prenatal    6    For detecting Trisomy 21, Trisomy 18, Trisomy 13, Turner syndrome, Trisomy X, XYY syndrome, DiGeorge syndrome, triploidy.

Our HIFU Solution

Treatment methods for cancer

The conventional treatment methods for cancer in China and elsewhere are generally surgery, radiotherapy and chemotherapy. High intensity focused ultrasound, radio frequency ablation, microwave thermo-coagulation and cryosurgery are some of the major new cancer treatment methods developed and commercialized in recent years. Biotherapy and gene therapy are currently still in experimental stages and are not currently available to patients generally. The selection of a particular treatment method for a patient depends on various factors,

 

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including the tumor’s receptivity to the treatment method, the location of the tumor, the stage of the tumor and the patient’s state of health. Cancer patients are usually treated by a combination of various treatment methods.

Surgery. Surgery is the most commonly used treatment method for most types of cancers and other tumors. Patients who undergo surgery face risks associated with anesthesia and complications, such as hemorrhages, infections or weakening of organ functions. In addition, the recurrence of cancer tumors is common and repeat surgery can involve high risks and significant complications.

Radiotherapy. Radiotherapy uses radiation or radioactive implants to destroy or inhibit the growth of tumor tissues. Radiotherapy is often used together as a complementary treatment method to surgery. Although radiotherapy is used to treat a wide range of cancer types, different types of tumor tissues have different sensitivities to radiation, and different patients have different levels of tolerance to radiation. Serious side effects, including skin ulceration or hemorrhage can result from excessive doses of radiation.

Chemotherapy. Chemotherapy uses drugs to destroy or inhibit the growth of tumor tissues and is commonly used as a supplemental treatment method together with surgery. Chemotherapy is relatively more effective than other cancer treatment methods for lymph tumors or metastatic tumors. However, chemotherapy destroys not only tumor tissues but also normal healthy tissues, resulting in serious side effects for the patient, including loss of appetite, nausea and vomiting, hair loss, as well as damage to the liver, bone marrow and immune functions.

Other minimally invasive treatments and targeted therapeutics. There are several relatively new treatment methods that have shown some clinical success in treating cancer. For example, radio frequency ablation, microwave thermo-coagulation and cryosurgery are minimally invasive treatments that attempt to destroy the tumor by either heating or freezing the targeted tissue with a needle, laser or cryogenic device that is inserted into the tumor. In addition, there is a new class of cancer therapeutics that have been developed by large pharmaceutical and biotechnology companies, such as Avastin®, Tarceva® and ERBITUX®, that are specifically designed to impede tumor development, while having little to no effect on healthy cells. The clinical applications of these treatments and targeted therapeutics are limited to certain types of cancers, and their long-term effectiveness is still being evaluated.

Therapeutic principles of HIFU

Heat therapy, also known as hyperthermia or thermotherapy, is a well-established method of medical treatment. It is generally accepted by the scientific community that the irreversible destruction of tissues, medically known as coagulation necrosis, occurs when tissues are exposed to temperatures above a certain level for a certain period of time. The maximum temperature under which tumor tissues can survive is 43º C (109.4º F), while normal tissues can tolerate a temperature of up to 45º C (113º F). The higher the temperature, the shorter the time needed to destroy tumor tissues. When the temperature reaches 60º C (140º F) or higher, coagulation necrosis will occur within one second.

In focused ultrasound ablation, a transducer directs ultrasound waves to converge on a small area of tissue inside the body, resulting in very high ultrasound intensity at this point. The effect of this process is similar to that of using a magnifying glass to focus the sun’s energy into a single spot. The ultrasound energy causes the temperature of the tumor tissues at the focal point to increase within a very short period of time to a level high enough to destroy the targeted tumor tissues. An important feature of this technology is that only a limited temperature increase occurs in the body tissue surrounding the focal point.

HIFU therapy can be used in conjunction with other treatment methods such as surgery, radiotherapy and chemotherapy, or as a stand-alone treatment. HIFU treatment increases the sensitivity and receptivity of body tissues to radiotherapy and chemotherapy. We believe that, because it is a relatively new procedure, HIFU therapy to date has typically been used for patients not eligible for one of the conventional therapies or when these other therapies have failed. When used in combination with conventional treatment methods, HIFU treatment often enhances their effectiveness and reduces the required chemical or radiation dosage. As a result, patients generally experience less side effects associated with radiotherapy and chemotherapy.

 

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Our HIFU therapy system is SFDA-approved and has been used for the treatment of a wide range of tumors in China since November 1999. In addition, other companies have also developed HIFU technologies, and a few HIFU medical devices have been approved for the treatment of limited types of tumors, mostly prostate cancer and uterine fibroids, in the European Union, Canada, Russia, South Korea, Japan and the United States, and a larger number of HIFU tumor therapy devices have been approved for clinical studies and trials in these regions and elsewhere. See “—Competition.”

Benefits and limitations of our HIFU solution

Our HIFU therapy system can be used as a supplemental or stand-alone treatment method with surgery, radiotherapy and chemotherapy for the treatment of many types of solid tumors. We believe that the benefits of our HIFU solution include:

Non-invasive procedure. Our HIFU therapy system offers patients a non-invasive treatment alternative. Treatments performed with our HIFU therapy system do not require incisions and transfusions and as a result, minimize the risk and complications associated with invasive procedures. In addition, it is often difficult for patients who receive traditional treatments to later undergo the same treatment in the event of a relapse due to the invasive nature of surgery and the significant side effects associated with chemotherapy and radiotherapy. Patients can undergo repeated treatments for cancer using our system with minimal side effects.

Minimal side effects. Treatments performed with our HIFU therapy system have minimal side effects and a relatively low level of complications. Compared to other HIFU tumor therapy systems that are commercially available in China, our HIFU therapy system produces less intense ultrasound waves at the point of skin penetration, which significantly reduces the likelihood of skin burns and collateral damage to healthy body tissue.

High degree of safety. Treatments using our HIFU therapy system can be performed without anesthesia and do not cause significant discomfort, skin-burn or hemorrhage. However, improper operation and use of our HIFU therapy system could cause skin burn.

Treatment for broad ranges of tumors. Our patented two-transducer system enables our HIFU therapy system to target tumors in more body locations than the other HIFU tumor therapy systems currently commercially available in China. Our HIFU therapy system is approved by the SFDA to treat liver, breast and kidney tumors, solid tumors in the pelvic cavity or on bone and tumors in the four limbs or superficial tissues. Based on published clinical studies conducted by researchers and practitioners of hospitals in China, we believe that hospitals have used our HIFU therapy system to treat many types of tumors, including the following:

 

•      breast tumors

•      kidney tumors

•      liver tumors

•      pancreatic tumors

  

•      solid tumors in the pelvic cavity including:

•      bladder tumors

•      uterine tumors

•      uterine fibroids

•      prostate tumors

•      prostate hypertrophyrectal tumors

  

•      tumors in the four limbs or superficial tissues

•      solid tumors on bone

•      metastasis tumors of the abdominal lymph node

•      rear abdominal tumors

     
     
     
     
     

We believe as our HIFU therapy system gains higher acceptance from the medical community and among patients, it could be used more frequently as a stand-alone treatment due to its low risk profile.

Cost-effective for hospitals. We believe our HIFU therapy system is a more cost-effective option for hospitals for the types of tumors it can treat compared to other currently commercially available cancer treatment methods in China. Chemotherapy requires expensive drugs while surgery requires the use of anesthesia and other medical supplies. Radiotherapy requires the use of significantly more expensive equipment than our HIFU therapy system. In addition, we believe our HIFU system can treat a broader range of tumors than other HIFU tumor therapy systems available in China.

 

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However, the use of our HIFU solution is subject to a number of limitations. The clinical use of our HIFU therapy system has been limited mostly to patients with cancer at advanced stages or who are not eligible for conventional treatment. In addition, HIFU therapy is suitable for the treatment of a single tumor of an identifiable size or a group of tumors that are located in very close proximity. It is not suited for the treatment of a single tumor that is too small or tumors that are widespread. It is also not suitable to treat blood-borne cancers. Furthermore, as ultrasound cannot be transmitted in a straight line through solid bone or air, HIFU therapy is not suited for the treatment of tumors located in the head, neck, lung and tumors behind bones.

Clinical studies of our HIFU therapy system

To our knowledge, clinical studies that have used our HIFU therapy system have been reported in various published international and Chinese national level reports and peer-review journals. Some studies using our HIFU therapy system have been reported in multiple publications or presentations. These published studies have reported over 1,500 cases for the treatment of rectal tumors, bladder tumors, colon tumors, gastric tumors, ampullary tumors, liver tumors, pancreatic tumors, metastasis tumors of the abdominal lymph nodes, prostate tumors, adrenal tumors, kidney tumors, smooth muscle tumors, endometrial tumors, ovarian carcinoma, rear abdominal tumors, lymphoma tumors, cervical tumors, breast tumors, hepatocellular tumors, non-Hodgkin’s lymphoma, neurofibroma, osteolytic sarcoma and skin squamous tissue cancers. Currently, our HIFU therapy system has been used in over 40,000 clinical cases.

These clinical studies have been conducted by both physicians affiliated with us as consultants and other physicians in hospitals and universities in China, such as PUPH, Fudan University Zhongshan Hospital, Beijing University Medical School, the Second-Affiliated Hospitals of Sun Yat-Sen University, the First Hospital of Jilin University, Taian Central Hospitals, Qilu Hospital of Shandong University, the Central Railway Hospital of Liuzhou, and the First Hospital of Jiangxi Medical University. Our collaboration with MOH in a large scale study aims to demonstrate the clinical benefits of HIFU in combination with radiotherapy and chemotherapy. In the United States, we plan to begin our clinical trial on limited patients with advanced pancreatic cancer. These research initiatives conducted domestically and internationally are intended to study the effectiveness of our HIFU therapy system on various types of tumors.

The HIFU therapy system

We currently offer our third-generation two-transducer HIFU therapy system. This model, which we launched in October 2006, is equipped with our newly-developed non-invasive ultrasound temperature measuring technology. We have applied for patents directed toward this technology in China and in other countries, also see “Item 4 Business Overview—Intellectual Property”.

Our HIFU therapy system consists of the following main components:

Integrated transducers. The integrated transducer consists of HIFU transmitting sources and drives circuits and can move in six directions with millimeter precision. Our HIFU transmitting sources are patented, and the patent for the HIFU transmitting sources expires in March 2019. The HIFU transmitting sources generate high-frequency ultrasound waves, which converge from a wide angle to focus on a designated focal point inside the body. We have obtained a patent for the wide convergence angle design in China, and the patent for this design expires in November 2021. Our third-generation HIFU therapy system is equipped with two transducers, which enable the patient to be treated in the supine, side or seated positions so that more locations in the body can be targeted and more tumors can be treated. This patented two-transducer design also increases the patient’s comfort level during treatment, and the patent for this design expires in November 2021. We have also applied for patents in other countries for these technologies.

Ultrasound imaging system. The ultrasound imaging system is an ultrasonic system that creates a computer image of the tumor that guides the physician in monitoring and targeting the ultrasound waves. The probe that captures the image of the tumor can monitor the patient from many angles and can be controlled automatically by a computer or manually by the physician.

 

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Patient treatment table and seat. The table and seat frames are adjustable and can be rotated to facilitate treatment of tumors located in different parts of the body. The middle section of the patient treatment table can be removed to install a treatment seat so that the patient can sit while undergoing treatment for tumors in the pelvic cavity. The patient’s position depends on the location of the tumor. We have obtained a patent for the design of the table and seat frames in China, and this patent expires in November 2021. We have also applied for patents in other countries for the treatment seat design. As of June 30, 2007, the United Kingdom and India had granted us such patents.

Control station. The control station consists of our proprietary software program, which controls the targeting and duration of the treatment, a computer, a monitor and peripheral equipment. The control station allows the operator to select automatic or manual treatment, as well as the duration of each ultrasound emission and other treatment parameters. If the operator inputs an unsafe ultrasound shot duration or treatment parameter, a built-in safety mechanism causes the HIFU therapy system to cease its operation immediately.

Conduct structure. Ultrasound energy does not transmit in a straight line through air. To introduce linear ultrasound waves into a patient’s body from the upper transducer, our HIFU therapy system contains a conduct structure, which consists of a semi-sphere container filled with degassed water. We have also developed a proprietary vacuum degassing device that converts large volumes of tap water into degassed water. We have obtained a patent for this device in China, and this patent expires in November 2011. We have also applied for patents for the semi-sphere container and the degassing device in other countries. As of June 30, 2007, we had been granted such patents in the United Kingdom.

The treatment procedure

A physician and an ultrasound technician first locate the tumor tissues and define the area to be treated by using the ultrasound imaging system. The computer uses the physician’s input to plan the best way to target and ablate the tumor. Each individual high-energy focused ultrasonic shot ablates an oval-shaped targeted zone measuring up to ten millimeters in height by five millimeters in diameter. During the treatment, the transducer and the ultrasound imaging system automatically moves and ablates the targeted zone until the entire defined area has been treated. The shooting times can be selected between 0.1 and one second. The intervals between shots can also be selected from 0.1 to two seconds, depending on the depth of the tumor. Intervals between shots reduce the ultrasound volume passing through the skin over a period of time to avoid skin-burn. The individual targeted zone produces almost instantaneous coagulative necrosis of tissues due to an increase in temperature to between 60º C and 70º C (140º F and 158º F).

The treatment duration and the number of treatment sessions vary according to the size of the tumor. For example, for a single four centimeter tumor, four to five sessions are usually performed on different days, with each treatment session lasting approximately half an hour.

Manufacturing

Our manufacturing strategy combines our internal design expertise and proprietary technology with strategic sourcing. We produce our reagent kits and conduct the final product assembly, testing and packaging of our HIFU therapy system, ECLIA analyzer and FISH imaging analysis system and probes at our facility in Beijing, China. We source the production of a majority of our components to, and purchase raw materials from, third-party suppliers.

We design or configure many key components of our products and outsource their production to qualified manufacturers. Our suppliers undergo quality certification in accordance with the standards developed by us, and we conduct frequent quality audits of each of our suppliers’ manufacturing facilities. We believe we maintain components and raw materials at an adequate level to ensure a stable supply.

The major components of our HIFU therapy system are integrated ultrasound transducers, an ultrasound imaging system, a treatment table/seat, a control station and a conduct structure. The ultrasound imaging system

 

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and the treatment bed, two of the major components of our HIFU therapy system, are manufactured by GE and a local supplier, Beijing Tianyuan Kehui, respectively, and we purchase other components from other local suppliers. The major components of our ECLIA analyzer are the photon-multiplier, motor drive and various types of other electrical and plastic parts that are generally readily available in sufficient quantities from our local suppliers. The raw materials of our reagent kits are antibodies and antigens for the production of coated microplate and conjugator, chemicals for the production of reagents, and plastics and packaging such as vacant microplate and bottles. We purchase a portion of our supplies of antibodies and antigens overseas and source the other raw materials from local suppliers. The major component of our FISH imaging analysis system is the fluorescent microscope sourced from international suppliers. The raw materials of our FISH probes are substances from our DNA clone bank.

We generally produce our products based on firm orders from our customers and anticipated orders that we are reasonably confident will be obtained. Lead times for raw materials and components vary and depend on the specific supplier and the availability and demand for the raw materials or components. We currently use one or more suppliers for some of our key components for quality control purposes. We source the ultrasound imaging system, one of the major components of our HIFU therapy system, from GE, which produces the ultrasound imaging system based on our specifications. Even if we are unable to obtain this component from GE, it may not be difficult to find an alternate supplier on a timely basis that can provide a replacement system with comparable quality as we require. We also believe that we will be able to source most of our other key components from other suppliers if necessary. We do not currently have any long-term supply contracts, and our purchases are made on a purchase order basis.

During the fiscal year, we had further streamlined our product assembly process to improve our responsiveness to changes in our business volume by training our employees to assemble multiple components. As our sales fluctuate from month to month, employees with multiple skill sets and multi-tasked teams will allow us to make quicker deliveries while enabling us to more effectively manage our costs.

In November 2005, we obtained a Certificate of Good Manufacturing Practices (GMP) for Pharmaceutical Products, or the GMP certificate, for the production of ECLIA reagents. The GMP certificate was issued by the SFDA and certifies that our ECLIA manufacturing facilities comply with the requirements of good manufacturing practices for pharmaceutical products. The GMP certificate is valid for a term of five years. We are currently in compliance with such GMP requirements and have obtained GMP certification for the production of our ECLIA reagents in November 2005. This GMP certification is valid until October 2010. Recently, we completed the enlargement of our GMP facility to increase our capacity for the production of our ECLIA reagents.

In addition to the product registration certificates described above, we are required to obtain production permits and to renew these permits six months prior to the expiration of the original permit. Our production permit for medical devices, which covers our HIFU system, our ECLIA system and certain of our ECLIA reagents, is valid until July 2010.

Quality Control

We have our own independent quality control system and devote significant attention to quality control for the designing, manufacturing and testing of our products. We have established a quality control system in accordance with SFDA regulations. In May 2006, we obtained ISO9001 and ISO13485:2003 certifications for the production of our HIFU therapy system and ECLIA system, which indicates our compliance with recognized international standards for quality control. We inspect components prior to assembly, and inspect and test internally manufactured products both during and after the manufacturing process.

Our quality control team is also responsible for ensuring that we are in compliance with all applicable regulations, standards and internal policies. Our senior management team is actively involved in setting quality policies and managing internal and external quality performance.

 

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Markets and Customers

We believe that both our HIFU therapy system and our IVD systems have significant market potential in China as there is a strong demand for tumor treatment devices and sensitive and reliable IVD systems. The target market for our HIFU therapy system is large-and medium-sized hospitals in China with oncology departments. According to the MOH, there were approximately 7,700 large-and medium-sized hospitals in China as categorized by number of beds in 2006. As of March 31, 2007, we had sold over 300 units of our HIFU therapy system. The target market for our ECLIA system is small-and medium-sized hospitals in China. According to the MOH, there were approximately 18,100 small-and medium-sized hospitals in China in 2006. We began marketing and selling our ECLIA system in September 2004 and had sold over 2,500 ECLIA analyzers as of March 31, 2007.

In the three fiscal years ended March 31, 2005, 2006 and 2007, 97.0%, 98.9% and 100.0% respectively, of our HIFU therapy system were sold to distributors. Sales of our HIFU therapy system have been, and will continue to be, generated by sales to a relatively small group of distributors that change from year to year. We do not have long-term contracts with any of our distributors. Because our main product, the HIFU therapy system, is sold at a relatively high unit price, the size and timing of individual orders can have a significant effect on our quarterly results. See “Item 3. Key Information—D. Risk factors—Risks Related to Our Company—We are dependent on a small number of distributors for a significant portion of our revenues and this dependence is likely to continue in the future.”

Sales and Marketing

We market and sell our ECLIA system solely to distributors. For sales of our ECLIA analyzer, we require a payment of 20% to 40% of the sale price before delivery or after acceptance and the balance within six months of acceptance. For sales of reagent kits, we do not require down payments, and we collect payments three months after acceptance.

We market and sell our FISH imaging analysis system and probes directly to hospitals. For sales of our FISH imaging analysis system, we require a payment of 30% to 50% of the sale price before delivery or after acceptance and the balance within six months of acceptance. For sales of FISH probes, we do not require down payments, and we collect payments three months after acceptance.

We market and sell our HIFU therapy systems primarily to third-party distributors. We recognize revenues at the time our products are accepted by either our distributors or the hospitals designated by these distributors, which typically occurs within one to two weeks after shipment. We sign binding purchase agreements with our distributors or with our hospital customers each time we make a sale of our products. Under these purchase agreements, our distributors or hospital customers agree to pay a non-refundable, non-adjustable fixed amount of money for our products over a period of time. Our distributors take ownership of our products when either they or the hospitals they designate accept the products, depending on the terms of each contract. The acceptance typically occurs within one or two weeks of shipment, during the period when we help hospitals to install our products. Once the products are accepted, the one-year warranty period commences. For sales of our HIFU therapy system, we require an initial payment of 30% to 40% of the sale price when customers place purchase orders or after the shipment is accepted by either our distributors or the hospitals designated by these distributors. The balance is payable within one year of acceptance. Some of our distributors purchase our products to operate profit-sharing programs with hospitals. Under these profit-sharing programs, these distributors install our HIFU therapy system in hospitals without any up-front charge to hospitals and in return receive a portion of the net profits generated by the system.

We select our third-party distributors based on their reputation, market coverage, sales experience and the size of their sales force. We conduct credit assessments of each of our distributors or hospital customers before we enter into a purchase agreement. Currently, all our products are being marketed and sold in China. However, we are expanding distribution of our products to other countries, including South Korea, Japan and European countries. We have exclusive distribution agreements with AsianStar, Inc., Century Medical, and EDAP for future distribution in South Korea, Japan and the European Union, pending approval from relevant governmental authorities.

 

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As of June 30, 2007, we had a team of 59 marketing and sales personnel who conduct sales of our HIFU therapy system, manage distributors for both our HIFU therapy system and our ECLIA systems and perform other sales related tasks. We intend to further increase the size of our sales force as our business grows.

The hospital’s chief administrator and the head of the department of oncology, in the case of our HIFU therapy system, or the head of the department of diagnostics, in the case of our ECLIA system and FISH imaging analysis system and probes, typically make the purchasing decision for our products. We believe that hospitals make purchase decisions on HIFU tumor therapy devices based on the safety and effectiveness of the device, the types of cancer treatment methods that they already offer, their available budget and the anticipated economic return. We believe that hospitals make purchase decisions on diagnostics equipment based on the performance and the range of reagent kits available, the prices of equipment and reagents, ease of use and the turnaround time of results.

We have established relationships with many hospital administrators at prominent hospitals and other leading medical institutions, many of whom we believe are advocates for our HIFU therapy system. We believe our relationships with these major hospitals and medical institutions raise our profile, enhance awareness of our products in the medical community, medical equipment and supplies industry and among patients, provide us with valuable clinical data to improve our products and keep us abreast of industry trends and developments, all of which in turn helps us market and sell our products. We manage our relationships with ECLIA distributors by pricing our ECLIA system more attractively to distributors than imported alternatives. Our FISH imaging analysis system and probes address large unmet market in China, primarily the prenatal and cancer diagnosis market. Our direct sales force formed in association with FISH distribution help us build a closer relationship with the end-users in these large hospitals. We believe these relationships facilitate cross-selling of our other two products.

Customer Support and Service

We maintain a dedicated team to provide customer support and service for our products. Our customer support and service team is based in Beijing, and it provides on-site and off-site technical and clinical support to hospitals across China upon customer request. As of June 30, 2007, this team consisted of 60 full-time employees, including physicians, biomedical engineers, acoustics engineers, computer science engineers, and service and repair technicians. We plan to build service centers and station service engineers in major cities in China to continue providing good customer support and service as we continue to grow. We believe that our ability to provide good customer support and service is an important part of our business.

We provide training to hospitals that purchase our HIFU therapy system, our ECLIA system and our FISH imaging analysis system and probes. Training sessions are provided directly by us or through larger hospitals that have purchased our product. We offer a two-week training course to hospitals that purchase our HIFU therapy system. Hospital participants typically include a physician, an ultrasound technician, a nurse and a maintenance engineer. In addition, due to the technical nature of our HIFU therapy system, it is usually necessary for members of our customer support and service team to assist with the installation. Our ECLIA system and FISH system training is generally only one to five days long as our IVD systems are relatively easy and simple to operate.

Each of our HIFU therapy systems, ECLIA analyzers and FISH imaging analysis systems are typically sold with a 12-month warranty against technical defects. We have experienced a very limited number of warranty claims in the past for our HIFU therapy systems and ECLIA systems. The costs associated with our warranty claims have historically been relatively low. We do not generally accrue any liability for potential warranty costs at the time of sale. As we only began selling our FISH imaging analysis systems in June 2007, we currently only have a short period of historical data on the warranty claims for our FISH imaging analysis system. See “Item 5. Operating and Financial Review and Prospects—Critical Accounting Policies—Warranty obligations.”

Intellectual Property

We are committed to developing and protecting our intellectual property portfolio. We own and have applied for patents to protect the technologies, inventions and improvements that we believe are significant to our

 

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business. As of September 28, 2007, we have obtained 15 patents in China, including two utility patents and seven patents for inventions, directed toward different aspects of our HIFU therapy system and five utility patents and one invention patent directed to our ECLIA system. The validity period for our seven utility patents and eight invention patents is 10 and 20 years, respectively, from the date the application was filed. See “—Our HIFU solution—the HIFU therapy system” for a detailed description of our most important patents. We also have 10 patent applications pending in China relating to our HIFU and ECLIA systems, including one application for a utility patent and nine applications for inventions. Generally, invention patents are viewed as offering more commercial protection than utility patents. As with patent rights in most other jurisdictions, a patent holder in the PRC enjoys the exclusive right to exclude others from using, licensing and otherwise exploiting the patent within the PRC. To protect some of the most important proprietary technologies internationally, we have applied for eight HIFU technology patents in countries including the United States, the United Kingdom, Germany, Japan, South Korea and India. As of June 30, 2007, we had been granted all four of the patents we applied for in the United Kingdom and two of the four patents we applied for in India. We are in the process of applying for a patent of our FISH methodology in the United States.

We have developed, among others, the following key technologies for our HIFU tumor therapy system, ECLIA system and FISH probes:

 

   

a wide convergence angle range for ultrasound waves—Our HIFU therapy system is capable of producing ultrasound waves from a wide convergence angle range in order to reduce the intensity of ultrasound waves when they penetrate the surface of the skin. This technology significantly reduces the likelihood of skin burns and collateral damage to surrounding body tissues. We have obtained a patent for this technology in China and have applied for patents in other countries.

 

   

non-invasive ultrasound temperature detecting—This technology is designed to collect real time temperature data during treatment by generating “acoustic signals” while the focused ultrasound shots occur. The feedback data from these acoustic signals allow the physician to adjust the parameters of the HIFU therapy system so that the target temperature can be more precisely achieved at each focal point throughout the patient’s treatment, thus giving the physician more control over the treatment process and outcome. We have applied for a patent directed toward this technology in China and in other countries.

 

   

two-transducer design—This design enables the patient to be treated in the supine, side or seated positions so that more locations in the body can be targeted. This patented design also increases the patient’s comfort level during treatment. We have obtained a patent directed toward this technology in China and have applied for patents in other countries.

 

   

enhanced chemiluminescence substrate technology—This technology improves the chemical reaction of reagents with the patient’s body fluid sample to produce a long lasting and linear signal and enables our reagent kits to be more sensitive and accurate. We have a pending patent application directed toward this technology in China.

 

   

substance storage technology—This technology can improve the shelf life of our reagent kits from six months to two years, thus reducing the risk of inventory obsolescence. We have obtained a patent directed toward this technology in China.

 

   

FISH methodology—This methodology discloses an innovative method to deplete repetitive sequences from human DNA. The approach has consistently demonstrated that our present subtraction method is efficient in removing DNA hybridized complexes, thus leading to a significant depletion of repetitive sequences from a source DNA. We have filed a patent application directed toward this methodology in the United States.

We require our employees, consultants and advisors to execute confidentiality agreements in connection with their employment, consulting and advisory relationships with us. We also require our employees, consultants and advisors who are privy to confidential information to agree to disclose and assign to us all

 

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inventions conceived during their terms of employment or contract. Despite any measures we take to protect our intellectual property, unauthorized parties may attempt to copy aspects of our products or our proprietary technology or to obtain and use information that we regard as proprietary.

We, like other medical device manufacturers in China and elsewhere, are subject to a number of uncertainties regarding the commercial value of our patent portfolio. See “Item 3. Key Information—D. Risk Factors—If we fail to protect our intellectual property rights, our competitors may take advantage of our proprietary technology and know-how and compete directly against us.”

Competition

Rapid product development, technological advances, intense competition and a strong emphasis on proprietary products characterize the industry in which we compete. Our products could be rendered obsolete or uneconomical by the introduction and market acceptance of competing products or by technological advances of our current or potential competitors. We face direct competition from a number of publicly traded and privately held companies, including other manufacturers of tumor therapeutic and diagnostic products. Many of our existing and potential competitors have substantially greater financial, research and development, sales and marketing, personnel and other resources than we do and may have more experience in developing, manufacturing, marketing and supporting new products. Competition will intensify as more players enter this field. We believe that an important competitive advantage for a medical technology company is its ability to make continuous investments in research and development and to identify commercially viable technologies and successfully bring the technologies into the market.

Insurance

We maintain insurance coverage from PICC Property and Casualty Company Limited, with an annual aggregate insured amount of RMB4.0 million (US$0.5 million) to cover product liability claims arising from the use of our HIFU therapy system. We also have property insurance coverage from China Pacific Property Insurance Co., Ltd. to cover certain of our fixed assets. Our insurance coverage, however, may not be sufficient to cover any claim for product liability or damage to our fixed assets. See “Item 3. Key Information—D. Risk factors—Risks related to our company—We are subject to product liability exposure and have limited insurance coverage.”

Regulation

Our HIFU therapy system and ECLIA analyzer are medical devices and are subject to regulatory controls governing medical devices. In April 2007, SFDA announced a new regulation on IVD reagents to be effective on June 1, 2007. Pursuant to the SFDA regulation announced on April 19, 2007, reagents used for IVD testings are divided into three different categories depending on the degree of risk associated with the reagent. All reagents are subject to regulatory controls governing IVD reagents. As a manufacturer of medical equipment and supplies we are subject to regulation and oversight by different levels of the SFDA. We are also subject to other government laws and regulations which are applicable to manufacturers in general. SFDA requirements include obtaining production permits, compliance with clinical testing standards, manufacturing practices, quality standards, applicable industry and adverse reporting, and advertising and packing standards.

Classification of medical devices

In China, medical devices are classified into three different categories, Class I, Class II and Class III, depending on the degree of risk associated with each medical device and the extent of control needed to ensure safety and effectiveness. Classification of a medical device is important because the class to which a medical device is assigned determines, among other things, whether a manufacturer needs to obtain a production permit and the level of regulatory authority involved in obtaining such permit. Classification of a device also determines the types of registration required and the level of regulatory authority involved in effecting the registration.

 

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Class I devices are those with low risk to the human body and are subject to “general controls.” Class I devices are regulated by the city level food and drug administration where the manufacturer is located. Class II devices are those with medium risk to the human body and are subject to “special controls.” Class II devices require product certification, usually through a quality system assessment, and are regulated by the provincial level food and drug administration where the manufacturer is located. Class III devices are those with high risk to the human body, such as life-sustaining, life-supporting or implantable devices, and are regulated by the SFDA under the strictest regulatory control.

Our HIFU therapy system is classified as a Class III device, and it therefore is subject to all regulatory controls governing Class III medical devices, as well as special regulations governing HIFU medical devices. Our ECLIA analyzers and FISH imaging analysis system are classified as Class II devices.

Production permit for medical devices

A manufacturer must obtain a production permit from the provincial level food and drug administration before commencing the manufacture of Class II or Class III medical devices. A production permit, once obtained, is valid for five years and is renewable upon expiration. Our production permit for the manufacture of our HIFU therapy system and our ECLIA analyzer will expire on July 3, 2010. We sourced our fluorescent microscope and CCD camera from third-party suppliers whose equipment is SFDA approved. To renew a production permit, a manufacturer needs to submit to the provincial level food and drug administration an application to renew the permit, along with required information six months before the expiration date of the permit. We do not believe it will be difficult for us to renew our production permit.

Registration requirements of medical devices

Before a medical device can be manufactured for commercial distribution, a manufacturer must effect medical device registration by proving the safety and effectiveness of the medical device to the satisfaction of respective levels of the food and drug administration. In order to conduct a clinical trial on a Class II or Class III medical device, the SFDA requires manufacturers to apply for and to obtain in advance a favorable inspection result for the device from a third party inspection center recognized by the SFDA. The application to the inspection center must be supported by appropriate data, such as animal and laboratory testing results. If the inspection center approves the application for clinical trial, and the respective levels of the food and drug administration approve the institutions which will conduct the clinical trials, the manufacturer may begin the clinical trial. A registration application for a Class II or Class III device must provide certain pre-clinical and clinical trial data and information about the device and its components regarding, among other things, device design, manufacturing and labeling. The provincial level food and drug administration, within 60 days of receiving an application for the registration of a Class II device, and the SFDA, within 90 days of receiving an application for the registration of a Class III device, will notify the applicant whether the application for registration is approved. If approved, a registration certificate will be issued within ten days of the notification. If the food and drug administration requires supplemental information, the approval process may take much longer. The registration is valid for four years.

Clinical trials for our HIFU therapy system are also subject to SFDA regulation governing HIFU medical devices. Under these regulations, the minimum clinical trial period for a HIFU medical device is one year, with a minimum of 100 subjects participating and utilizing a minimum of two units of the HIFU medical device. Compliance with SFDA regulations on clinical investigations also includes satisfactory clinical reports from a minimum of two institutions which participated in the clinical trial, proper labeling of the device, obtaining informed consent from each subject, and compliance with monitoring and record-keeping requirements.

The SFDA occasionally changes its policies, adopts additional regulations, revises existing regulations or tightens enforcement, each of which could block or delay the approval process for a medical device. For example, in November 2001, the SFDA adopted regulations requiring additional clinical trials to be conducted if

 

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a manufacturer of HIFU medical devices seeks to increase the types of tumors its device is approved to treat. A 2003 regulation further specifies that a 100-patient clinical trial is required before any medical device can be approved for commercial production.

We received SFDA approval for our first generation HIFU therapy system in September 1999 for the treatment of solid tumors in the pelvic cavity and the abdominal cavity. Solid tumors in the pelvic cavity include bladder, uterine, prostate and rectal tumors, uterine fibroids and prostate hypertrophy. Solid tumors in the abdominal cavity include pancreatic, rear abdominal, liver and kidney tumors and metastasis tumors of the abdominal lymph node. We discontinued the production of our first generation HIFU therapy system in December 2002. Although the September 1999 approval expired on May 24, 2004, it is still valid for all units of our first generation HIFU therapy system that were sold to hospitals before our approval expired. In January 2003, we received a four-year SFDA approval for our second generation HIFU therapy system for the treatment of liver tumors, breast tumors, kidney tumors, solid tumors in the pelvic cavity, tumors in the four limbs or superficial tissues and solid tumors on bone. The registration certificate for our second generation HIFU therapy system expired in January 2007, although we were granted an extension until December 2007. We discontinued the production of our second generation HIFU system in October 2006 when we launched our third generation model. We must obtain a renewal for our third generation HIFU therapy system by December 2007. We do not believe it will be difficult for us to renew this approval.

Beijing Weixiao received SFDA approval for our ECLIA analyzer in February 2004. After our ECLIA acquisition, we applied for the transfer of the SFDA approval to us and substantially completed the transfer in March 2005. The SFDA approval we have obtained will expire in March 2009 and we do not believe it will be difficult for us to renew this approval for the upgraded version of our ECLIA analyzer.

Classification of ECLIA reagents

In April 2007, the SFDA announced a new regulation to be effective on June 1, 2007. Reagents used for IVD testing are divided into three different categories, Class I, Class II and Class III, depending on the degree of risk associated with each reagent. Classification of a reagent is important because the class to which a reagent is assigned determines, among other things, the types of registration required and the level of regulatory authority involved in effecting the registration.

Class I reagents are those with low risk and are subject to “general controls”. Class I reagents are regulated by the city level food and drug administration where the manufacturer is located. Class II reagents are those with medium risk and are subject to “special controls.” Class II reagents are regulated by the provincial level food and drug administration where the manufacturer is located. Class III devices are those with high risk and are regulated by the SFDA under the strictest regulatory control.

Our reagents are classified as Class III reagents, and they therefore are subject to all regulatory controls governing Class III reagents.

Production permit for ECLIA reagents

A manufacturer must obtain a production permit from the food and drug administration at the provincial level. A production permit, once obtained, is valid for five years and is renewable upon expiration. Our production permit for the manufacture of reagents will expire in July 2010. To renew the production permit, a manufacturer needs to submit to the provincial level food and drug administration an application to renew the permit, along with required information six months before the expiration date of the permit. We do not believe it will be difficult for us to renew our production permit. In addition, pharmaceutical manufacturing operations are also subject to periodic re-inspection and must comply with applicable quality regulations.

Registration requirements of ECLIA reagents

Prior to selling an IVD reagent kit, a manufacturer must obtain both SFDA registration of, and SFDA approval for, the product it plans to sell. The registration process starts with submitting a registration dossier to

 

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the SFDA. The registration dossier contains primarily detailed information concerning the effectiveness and quality of the reagent. It also contains details concerning the manufacturing process and the production facilities. The registration process can last a few months and the timing depends on the nature of the pharmaceutical product under review, the quality of the data and the general efficiency of the SFDA. The approval process involves the detailed examination of the testing, effectiveness, labeling, manufacturing and marketing of IVD reagents by the SFDA. The registration is valid for four years.

As of June 30, 2007, we offer a total of 62 ECLIA reagents in China. Of these 62 ECLIA reagents, 36 are covered by registration certificates. Of the 26 reagents we currently sell for research purpose which are exempt from registration certificates, we have submitted registration applications for 11 of them.

Thus, although regulations require that both SFDA registration and approval be obtained before a reagent kit is sold, a reagent kit may be exempt from registration and/or approval if it is used for research purposes only. A reagent kit intended for research use only may not be applied in human clinical diagnostic or prognostic uses. In addition, a reagent kit intended for research use only must comply with the labeling requirements that require the statement: “For research use only. Not for use in diagnostic procedures.” We have sold many of our reagent kits without required registrations and/or approvals. In addition, we believe that many reagent kits sold in China, including some manufactured by our overseas-based competitors, are also sold without required registrations and/or approvals. See “Item 3. Key Information—D. Risk factors—Risks related to our industry—In order to manufacture and market our products, we are required to obtain various authorizations from governmental regulatory authorities in China. In some cases, we have been operating without these authorizations, which could subject us to significant penalties.” and “Item 3. Key Information—D. Risk factors—Risks related to doing business in China—Future changes in laws, regulations or enforcement policies in China could adversely affect our business.”

In October 2004, the SFDA imposed certain good manufacturing practice, or GMP, requirements for ECLIA reagents. As a result, all manufacturers of ECLIA reagents were obligated to meet GMP standards by January 1, 2006. We are currently in compliance with such GMP requirements and obtained GMP certification for our ECLIA reagents in November 2005. The GMP certification is valid until October 2010.

Continuing SFDA regulations

We are subject to continuing regulation by the SFDA. In the event of significant modification to an approved medical device, its labeling or its manufacturing process, a new pre-market approval or pre-market approval supplement may be required. Our HIFU therapy system, our ECLIA analyzer and our FISH imaging analysis system and probes are subject to, among others, the following regulations:

 

   

SFDA’s quality system regulations, which require manufacturers to create, implement and follow certain design, testing, control, documentation and other quality assurance procedures;

 

   

medical device reporting regulations, which require that manufacturers report to the SFDA certain types of adverse reactions and other events involving their products; and

 

   

SFDA’s general prohibition against promoting products for unapproved uses.

Class II and III devices may also be subject to special controls applicable to them, such as supply purchase information, performance standards, quality inspection procedures and product testing, which may not be required for Class I devices. We believe we are in compliance with the applicable SFDA guidelines, but we could be required to change our compliance activities or be subject to other special controls if the SFDA changes or modifies its existing regulations or adopts new requirements.

We are also subject to inspection and market surveillance by the SFDA to determine compliance with regulatory requirements. If the SFDA decides to enforce its regulations and rules, the agency can institute a wide variety of enforcement actions, such as:

 

   

fines, injunctions and civil penalties;

 

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recall or seizure of our products;

 

   

the imposition of operating restrictions, partial suspension or complete shutdown of production; and

 

   

criminal prosecution.

Other national and provincial level laws and regulations

We are subject to changing regulation under many other laws and regulations administered by governmental authorities at the national, provincial and city levels, some of which are, or may be, applicable to our business. Our hospital customers are also subject to a wide variety of laws and regulations that could affect the nature and scope of their relationships with us.

Laws regulating medical device manufacturers and hospitals cover a broad array of subjects. For example, regulations control the confidentiality of patient medical information and the circumstances under which patient medical information may be released for inclusion in our databases, or released by us to third parties. These laws and regulations governing both the disclosure and the use of confidential patient medical information may become more restrictive in the future.

We must also comply with numerous additional state and local laws relating to matters such as safe working conditions, manufacturing practices, environmental protection and fire hazard control. We believe we are currently in compliance with these laws and regulations; however, we may be required to incur significant costs to comply with these laws and regulations in the future. Unanticipated changes in existing regulatory requirements or adoption of new requirements could therefore have a material adverse effect on our business, results of operations and financial condition.

Regulation of foreign currency exchange and dividend distribution

Foreign currency exchange regulation in China is primarily governed by the following rules:

 

   

Foreign Currency Administration Rules (1996), as amended, or the Exchange Rules; and

 

   

Administration Rules of the Settlement, Sale and Payment of Foreign Exchange (1996), or the Administration Rules.

Under the Exchange Rules, the Renminbi is convertible for current account items, including the distribution of dividends, interest payments, trade and service-related foreign exchange transactions. Conversion of Renminbi for capital account items, such as direct investment, loan, security investment and repatriation of investment, however, is still subject to the approval of the SAFE.

Under the Administration Rules, companies in China with foreign investments, such as YDME Beijing, may only buy, sell and/or remit foreign currencies at those banks authorized to conduct foreign exchange business after providing valid commercial documents and, in the case of capital account item transactions, obtaining approval from the SAFE. Capital investments by foreign-invested enterprises outside of China are also subject to limitations, which include approvals by the SAFE and other relevant government authorities.

The principal regulations governing distribution of dividends paid by wholly foreign owned enterprises include:

 

   

Wholly Foreign Owned Enterprise Law (1986), as amended; and

 

   

Wholly Foreign Owned Enterprise Law Implementation Rules (1990), as amended.

Under these regulations, foreign-invested enterprises in China may pay dividends only out of their accumulated profits, if any, determined in accordance with PRC accounting standards and regulations. In addition, foreign-invested enterprises in China are required to set aside certain amounts out of their accumulated profits each year, if any, to fund certain reserve funds. These reserves are not distributable as cash dividends.

 

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Regulation of foreign exchange in certain onshore and offshore transactions.

In January and April 2005, the SAFE issued two rules that require PRC residents to register with and receive approvals from the SAFE in connection with their offshore investment activities. The SAFE has announced that the purpose of these regulations is to achieve the proper balance of foreign exchange and the standardization of the cross-border flow of funds.

On October 21, 2005, the SAFE issued the Notice on Issues Relating to the Administration of Foreign Exchange in Fund-raising and Reverse Investment Activities of Domestic Residents Conducted via Offshore Special Purpose Companies, or Notice 75, which became effective as of November 1, 2005. Notice 75 replaced the two rules issued by the SAFE in January and April 2005 mentioned above.

According to Notice 75:

(i) prior to establishing or assuming control of an offshore company for the purpose of financing that offshore company with assets or equity interests in an onshore enterprise in the PRC, each PRC resident who is an ultimate controller, whether a natural or legal person, must complete the overseas investment foreign exchange registration procedures with the relevant local SAFE branch;

(ii) an amendment to the registration with the local SAFE branch is required to be filed by any PRC resident that directly or indirectly holds interests in that offshore company upon either (a) the injection of equity interests or assets of an onshore enterprise to the offshore company, or (b) the completion of any overseas fund raising by such offshore company; and

(iii) an amendment to the registration with the local SAFE branch is also required to be filed by such PRC resident when there is any material change involving a change in the capital of the offshore company, such as (a) an increase or decrease in its capital, (b) a transfer or swap of shares, (c) a merger or division, (d) a long-term equity or debt investment, or (e) the provision of a guarantee to third parties.

Moreover, Notice 75 applies retroactively and to indirect shareholdings. As a result, PRC residents who have established or acquired direct or indirect control of offshore companies that have made onshore investments in the PRC in the past are required to complete the relevant overseas investment foreign exchange registration procedures by March 31, 2006. Under the relevant rules, failure to comply with the registration procedures set forth in Notice 75 may result in restrictions being imposed on the foreign exchange activities of the relevant onshore company, including the payment of dividends and other distributions to its offshore parent or affiliate and the capital inflow from the offshore entity, and may also subject relevant PRC residents to penalties under PRC foreign exchange administration regulations.

In order to clarify the issues arising from the implementation and application of Notice 75, on May 29, 2007, SAFE promulgated Implementing Procedures of Notice 75, or Notice 106. However, the complex rules and requirements set forth under Notice 106 need even more interpretation and operating guidance. For example, it is not clear under Notice 106 if our establishment of the two entities in the British Virgin Islands would be subject to the registration requirement of Notice 106.

As a result of the lack of implementing rules and other uncertainties relating to the interpretation and implementation of Notice 75 and Notice 106, we cannot predict how these regulations will affect our business operations or strategies. For example, our present or future PRC subsidiaries’ ability to conduct foreign exchange activities, such as remittance of dividends and foreign-currency-denominated borrowings, may be subject to compliance with such SAFE registration requirements by relevant PRC residents, over whom we have no control. In addition, we cannot assure you that any such PRC residents will complete the necessary approval and registration procedures required by the SAFE regulations.

On March 28, 2007, SAFE promulgated the Operating Procedures on Administration of Foreign Exchange regarding PRC Individuals’ Participation in Employee Share Ownership Plans and Employee Share Option Plans of Overseas Listed Companies, or the Share Option Rules. Under the Share Option Rules, PRC citizens who

 

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participate in employment share ownership or share option plans of an overseas listed company are required to appoint a domestic agent to deal with the relevant foreign exchange matters in China. For participants of an employment share ownership plan, an overseas custodian bank should be retained by the domestic agent to hold on trusteeship all overseas assets held by such participants under the employment share ownership plan. In the case of a share option plan, a financial institution with stock brokerage qualification at the place where the overseas listed company is listed or a qualified institution designated by the overseas listed company is required to be retained to handle matters in connection with exercise or sale of stock options for the share option plan participants. For participants who had already participated in an employment share ownership plan or share option plan before the date of the Share Option Rules, the Share Option Rules require their domestic employers or domestic agents to complete the relevant formalities within three months of the date of the Share Option Rules. The failure to comply with the Share Option Rules may subject us as the company offering the plan to penalties under the PRC foreign exchange regime.

Company Law

On October 27, 2005, the Standing Committee of the National People’s Congress adopted amendments to the PRC Company Law, which substantially overhauled the PRC company law system and removed a number of legal restrictions and hurdles on the management and operations of limited liability companies and companies limited by shares. It is expected that the PRC Law of Wholly Foreign-owned Enterprises, or the WFOE Law, and its implementing regulations will be amended accordingly in order to align the WFOE Law with the amendments to the PRC Company Law. YDME Beijing is governed by both the PRC Company Law and the WFOE Law and their implementing regulations, and we believe that YDME Beijing will be able to benefit from a more flexible and business friendly company law regime under the new PRC Company Law. For example, the amended PRC Company Law eliminated a restriction which limited the amount of equity investments a company could make to a maximum of 50% of such company’s net assets. With the removal of this restriction, YDME Beijing may have increased flexibility in making equity investments or planning potential acquisitions. In addition, the amended PRC Company Law now permits the establishment of single-shareholder limited liability companies. As a result, YDME Beijing may acquire 100% of the equity interest in a PRC limited liability company and become the sole shareholder of such limited liability company.

 

C.    Organizational Structure

The following diagram illustrates our company’s organizational structure, and the place of formation, ownership interest and affiliation of each of our subsidiaries as of June 30, 2007.

LOGO


* Yuande (USA) Corp was closed in January 2007.

 

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Our predecessor company, Beijing Yuande Bio-Medical Engineering Co. Ltd., or YDME Beijing, was incorporated in China and commenced business operations in July 1999. In anticipation of our initial public offering, we incorporated China Medical Technologies Inc., or China Medical, in the Cayman Islands as a listing vehicle in July 2004. China Medical became our ultimate holding company when it issued shares to the existing shareholders of YDME Beijing in January 2005 in exchange for all of the shares that these shareholders held in YDME Beijing. As of June 30, 2007, we conduct substantially all of our operations through YDME Beijing and Beijing GP. In January 2007, we closed down a wholly owned subsidiary Yuande (USA) Corp. in California, which was principally engaged in assisting research and development projects and clinical studies on using the HIFU therapy system in the United States. In March 2007, CMED HIFU Development Corporation was set up in Seattle to assume the principal activities of the Yuande (USA) Corp. that we closed down in California. In March 2007, we established a wholly owned subsidiary, CMED Molecular Diagnostics Ltd., for investment holding purposes. CMED (HK) Limited was set up in April 2007 to provide administrative services to our group companies.

 

D. Property, Plant and Equipment

All of our manufacturing facilities are located in the Beijing Economic-Technological Development Area, where we own two buildings with an aggregate of approximately 10,000 square meters of office, research and development and manufacturing spaces. To further enlarge our production capacity, we have leased properties in the Beijing Economic-Technological Development Area for the production of our ECLIA analyzer and FISH imaging analysis system and probes.

In September 2005, we entered into a three-year lease for approximately 494 square meters of office space in a central business district of Beijing, China. We use this office for our management and international sales and marketing purposes.

ITEM 5.    OPERATING AND FINANCIAL REVIEW AND PROSPECTS

You should read the following discussion and analysis of our financial condition and results of operations in conjunction with our consolidated financial statements and the related notes included elsewhere in this annual report on Form 20-F. This discussion may contain forward-looking statements based upon current expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under “Item 3. Key Information—D. Risk Factors” or in other parts of this annual report on Form 20-F.

A.    Operating Results

Overview

We are a China-based medical device company that develops, manufactures and markets in China advanced IVD products using ECLIA technology to detect and monitor various diseases and systems using HIFU for the treatment of solid cancers and benign tumors. As of March 31, 2007, our sales were generated from two products, our HIFU therapy system and ECLIA system. We started reporting our financial results in these two segments along product lines since our acquisition of the ECLIA technology in August 2004. The sales and distribution of our FISH imaging analysis system began in June 2007, thus, no segment sales were recorded for the fiscal year ended March 31, 2007.

Our main product, the HIFU therapy system, is an ultrasound-guided acoustic ablation system that is used for the non-invasive treatment of solid tumors. Our second product, the ECLIA system, is an enhanced chemiluminescence immunoassay IVD system that can be used to diagnose and analyze a variety of diseases and conditions, including various thyroid disorders, diabetes, hepatitis, liver fibrosis, Down syndrome, disorders related to reproduction and growth, various types of tumors and SARS, as well as to assess the effect of digoxin, a widely used drug for the treatment of heart failure.

 

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The HIFU therapy system was our only product until September 2004. PUPH commenced research on HIFU medical devices for the treatment of tumors in the early 1990s with funding provided by Beijing Chengxuan, a company controlled by Mr. Xiaodong Wu. Mr. Wu is the chairman of our board of directors, our chief executive officer and a significant shareholder of our company. Clinical trials of an early version of the HIFU therapy system commenced in 1998. We acquired our HIFU technology at a price of RMB6.0 million from PUPH and Beijing Chengxuan and commenced the commercial production and distribution of our HIFU therapy system in November 1999. This was shortly after YDME Beijing was co-founded by PUPH and Beijing Chengxuan.

We began marketing and selling our ECLIA system in September 2004. PUPH commenced research on ECLIA technology in the early 1990s with funds provided by Beijing Weixiao, a company controlled by Mr. Wu. Beijing Weixiao began participating in ECLIA technology research in August 2001 and subsequently acquired the ECLIA technology from PUPH in July 2003. We acquired the ECLIA technology from Beijing Weixiao in August 2004. Pursuant to the acquisition agreement, we paid Beijing Weixiao a total purchase price of RMB250.0 million (US$31.0 million) for the ECLIA technology, related inventories and a non-compete commitment, which was paid in five installments from September 2004 to September 2005. This acquisition broadens our product offerings and presented us with a significant opportunity to market our ECLIA system to small- and medium-sized hospitals in China. Many of these hospitals currently use less advanced IVD systems because they lack sufficient financial means to purchase other luminescence immunoassay systems available in China, which are mostly automatic and imported. Many of the key research and development personnel who developed the HIFU and ECLIA technologies at PUPH are currently employed by our company.

Pricing

Distributors in China operate primarily on a for-profit basis, and hospitals in China are expected to use a substantial portion of their revenues to fund their operations. Treatment fees for HIFU tumor therapy are set by provincial governments in China, a factor we consider when pricing our HIFU therapy system. To gain market penetration, we price our HIFU therapy system at levels that we believe offer attractive economic returns to distributors and hospitals, taking into account the prices of competing products in the market. We market and sell our products to distributors at a price that is significantly lower than the price that hospitals pay for our products. We believe that our HIFU therapy system is competitively priced compared to other HIFU tumor therapy devices available in China.

We believe that our ECLIA system is competitively priced to offer attractive economic returns to our distributors. The prices of our reagent kits are significantly lower than those of foreign imports.

The provincial governments in China set the treatment fee rates for HIFU tumor therapy, and they may adjust the fee rates from time to time. If they reduce the fee rates, some hospitals and distributors may be discouraged from purchasing our HIFU therapy system, which would reduce our sales. In that event, we may need to decrease the price of our HIFU therapy system to provide our customers acceptable returns on their purchases. We cannot assure you that our business, financial condition and results of operations will not be adversely affected by any reduction in treatment fees for HIFU tumor therapy in the future.

Revenues

As of March 31, 2007, we derived revenues primarily from three sources, which include sales of our HIFU therapy system, ECLIA analyzers and ECLIA reagent kits.

Our net revenues are net of VAT and sales return, but include VAT refunds on the sales of self-developed software embedded in our HIFU therapy system and our ECLIA system. See “—Taxation.”

 

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Revenues from sales represent the invoiced value of goods, net of value added taxes and sales return. We recognize revenues at the time our products are accepted by either our distributors or the hospitals designated by these distributors depending on contractual stipulation, which typically occurs within one to two weeks of shipment.

Our revenues, growth and results of operations depend on several factors, including the level of acceptance of our products among doctors, hospitals and patients and our ability to maintain prices for our products at levels that provide favorable margins. The level of acceptance among doctors, hospitals and patients is influenced by the performance and pricing of our products, our ability to educate distributors and the medical community about our products, our relationships with hospitals and major distributors, government reimbursement levels as well as other factors.

Our revenues have fluctuated significantly from quarter to quarter in the past due to the fluctuation in the sales of our HIFU therapy system. Sales of our HIFU therapy system are seasonal, and our third and fourth fiscal quarters, which are the quarters ending December 31 and March 31, respectively, have historically been our strongest. We believe that the relatively stronger performance in our third and fourth fiscal quarters is largely due to the budget cycles of hospitals in China. Hospitals in China typically make their capital expenditure decisions, such as decisions on whether to purchase our HIFU therapy system, between June and December. Our HIFU therapy system is usually shipped to customers between September to March. As our main product, the HIFU therapy system, is sold at a relatively high unit price, the size and timing of individual orders can have a significant effect on our results of operations in any given quarter. We only began to sell our ECLIA system in September 2004. We expect that sales of our ECLIA system will fluctuate to a lesser extent from quarter to quarter compared to sales of our HIFU therapy system.

Our sales have historically been made on the basis of unit-by-unit purchase orders rather than long-term commitments, and we do not have long-term contracts with any of our customers. We expect that in any given period a relatively small, and changing, number of distributors will continue to account for a significant portion of our revenues. In the earlier stage of our development, a significant percentage of the sales of our HIFU therapy systems was generated through our own direct sales. At present, we rely predominantly on sales to distributors rather than our own direct sales. In the three fiscal years ended March 31, 2005, 2006 and 2007, 97.0%, 98.9% and 100.0%, respectively, of our HIFU therapy systems were sold to distributors. As the target end markets for our HIFU therapy system and our ECLIA system are different, we expect our two products to be sold to different groups of distributors. We cannot assure you that any customer will continue to purchase our products at the same levels as in prior years or that our relationship with any of them will continue.

We expect that a substantial portion of our sales will continue to be generated by a relatively small group of distributors that may change from year to year. Such changes are due primarily to the fragmented nature of the medical equipment distribution industry in China. Distributors of our HIFU therapy systems are typically companies that only have the resources to target a limited number of hospitals at a given time. Once they have won orders from targeted hospitals, it takes some time to develop relationships with new hospitals. In addition, we require our distributors to pay us in full within a year of accepting our products, but our distributors may give their hospital customers longer payment terms under various types of sales arrangements, including profit-sharing programs, in order to facilitate their own sales. For example, under profit-sharing programs, distributors install our HIFU therapy system in hospitals for free and, in return, receive a portion of the net profits generated by the system. Such profit-sharing programs require upfront capital commitments from distributors upon their purchase of the HIFU therapy system from us. As a result, these distributors may need time to recover their financial resources to purchase additional products from us.

For sales of our HIFU therapy system, we generally collect 30% to 40% of the sale price when customers place purchase orders or after the shipment is accepted by either our distributors or the hospitals designated by these distributors, and the balance within one year of acceptance. For sales of ECLIA analyzer, we collect 20% to 40% of the sale price before delivery or after acceptance and the balance within six months of acceptance. For sales of reagent kits, we do not require down payments, and collect payments within three months after product acceptance.

 

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Costs

Cost of revenues. Our cost of revenues primarily consists of material and component costs. It also includes amortization of intangible assets and direct costs incurred in the assembly, installation and service of our products, such as salaries and related personnel expenses and depreciation costs of plant and equipment used for production purposes. Depreciation of property, plant and equipment for the fiscal years ended March 31, 2005, 2006 and 2007 in the amount of RMB1.2 million, RMB1.6 million and RMB2.6 million (US$0.3 million), respectively, were recorded as cost of revenue. Our in-house production manufactures the reagent kits, and conduct the final product assembly, testing and packaging of our HIFU therapy systems and our ECLIA analyzers. We also source a majority of our components from third-party suppliers.

As we source a significant portion of our components and raw materials in China, we currently have a relatively low cost base compared to medical technology companies in more developed countries. We expect the costs of components and raw materials in China will increase in the future as a result of further economic development in China. In addition, our focus on new generations and applications of our products may require higher cost components and raw materials. We plan to offset increases in our cost of raw materials and components through more efficient product designs and product assembly enhancements as well as through savings due to economies of scale.

Operating expenses. Our operating expenses primarily consist of research and development expenses, sales and marketing expenses and general and administrative expenses.

 

   

Research and development. Research and development expenses primarily consist of costs associated with the design, development, testing and enhancement of our existing products. These costs consist of expenditures for purchases of supplies, clinical trials, salaries and related personnel expenses, and other relevant costs. Going forward, we expect to increase our research and development expenses, both on an absolute basis and as a percentage of revenue, to develop new applications and improve the product designs of our HIFU therapy system, ECLIA system and FISH imaging analysis system and probes.

 

   

Sales and marketing. Sales and marketing expenses consist primarily of salaries and related expenses for personnel engaged in sales, marketing and customer support functions and costs associated with advertising and other marketing activities. Similar to most China-based manufacturers of medical equipment and supplies, our sales are made primarily to distributors. As a result, our sales and marketing expenses as a percentage of revenues are significantly lower than manufacturers of medical equipment and supplies that operate their own marketing and distribution networks and sell directly to hospitals. Going forward, we expect to increase our expenditures on sales and marketing, both on an absolute basis and as a percentage of revenue, to promote our products, especially our ECLIA system and FISH products.

 

   

General and administrative. General and administrative expenses consist primarily of salaries and benefits and related costs for our administrative personnel and management, fees and expenses of our outside advisers, including legal, audit and valuation expenses, expenses associated with our administrative offices and the depreciation of equipment used for administrative purposes. We expect that our general and administrative expenses will increase, both on an absolute basis and as a percentage of revenue, as we hire additional personnel and incur costs related to the anticipated growth of our business. Share-based compensation of RMB1.3 million (US$0.2 million) was included in general and administrative expenses for the fiscal year ended March 31, 2007. We adopted our 2005 stock option plan in February 2005. On March 14, 2005, we granted share options to acquire 200,000 of our ordinary shares to each of two of our directors under this stock option plan and on August 8, 2005, we granted share options to acquire 200,000 of our ordinary shares to each of two additional directors under this stock option plan. On June 11, 2007, we granted four directors, certain officers and management personnel restricted shares and share options to purchase an aggregate of 2,550,000 ordinary shares. We account for these restricted shares and share options in accordance with SFAS No. 123(R), and its related interpretations, which require us to record a compensation charge measured at the fair value of

 

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the restricted shares and share options. We recognize the compensation expense over the applicable service period of the grantee, which is usually the vesting period. See “—Critical Accounting Policies—Share-based compensation.”

Income taxes

Under the current laws of the Cayman Islands, we are not subject to tax on our income or capital gains. In addition, no Cayman Islands withholding tax will be imposed on payments of dividends by us to our shareholders.

Under the current PRC laws, YDME Beijing and Beijing GP are subject to EIT and VAT. Beijing GP has been approved as a hi-tech enterprise on June 17, 2007, therefore, management believes that it will be entitled to an EIT rate of 15%, this classification is also expected to exempt Beijing GP from paying the EIT for the two calendar years ending December 31, 2008 and a 50% reduced tax rate for the three calendar years ending December 31, 2011.

YDME Beijing has been classified as a high technology company and currently operates in an approved economic-technological development area. Given this classification, it is entitled to an EIT rate of 15%, compared to a statutory rate of 33% for most companies in China. This classification also exempted YDME Beijing from paying the EIT for the three calendar years ended December 31, 1999, 2000 and 2001 and a 50% reduced YDME Beijing’s EIT rate to 7.5% for the three calendar years ended December 31, 2002, 2003 and 2004. In addition, as a “foreign-invested advanced technology enterprise” certified by the Beijing Commerce Bureau, YDME Beijing is entitled to a further reduced EIT rate of 10% for the three calendar years ending December 31, 2007. YDME Beijing obtained approval from the tax authority in February 2006 regarding this further reduction in EIT rate.

For the three fiscal years ended March 31, 2005, 2006 and 2007, YDME Beijing incurred income tax expense of RMB11.9 million, RMB18.1 million and RMB30.1 million (US$3.9 million), respectively. If YDME Beijing had not had a reduced EIT rate of 10% for the three calendar years ending December 31, 2007, it would have had an EIT rate of 15% for each respective year, and our income tax expense for the three fiscal years ended March 31, 2005, 2006 and 2007 would have increased by RMB5.7 million, RMB13.0 million and RMB15.6 million (US$2.0 million), respectively (see Item 3 Key Information Note 3).

VAT is charged based on the selling price of our products at a general rate of 17%. Our revenues are recorded net of this VAT. However, we are entitled to a refund of VAT in excess of 3% on the sales of self-developed software embedded in our HIFU therapy system and our ECLIA system. We recognize the VAT refund as part of our net revenues under U.S. GAAP. For the fiscal years ended March 31, 2005, 2006 and 2007, VAT refunds amounted to RMB14.7 million, RMB23.0 million and RMB29.6 million (US$3.8 million), respectively which accounted for 6.8%, 6.2% and 5.4% of our revenues for the respective year.

In March 2007, China passed the New CIT Law, which will become effective on January 1, 2008. The New CIT Law establishes a unified 25% income tax rate for most companies, with some preferential income tax rates for qualified hi-tech enterprises. The related detailed implementation rules and regulations for the New CIT Law, which will define various terms and interpret the New CIT Law’s application of and its provisions, are expected to be promulgated by the State Council in late 2007. We believe that the New CIT Law, as drafted, does not affect our qualification as hi-tech enterprises. As such, we believe that the current tax rate of 15% will continue to apply to us. If the implementation rules and regulation result in a change that causes us to no longer qualify as hi-tech enterprises, we will be required to adjust certain long term deferred income tax which will result in a loss in the period the change takes effect.

The enactment of the New CIT Law, could adversely affect our financial condition and results of operations. Moreover, our historical operating results may not be indicative of our operating results for future periods as a result of the expiration of the tax holidays and value-added tax refunds we enjoy. In addition, under the New CIT

 

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Law to be effective on January 2008, dividends from our PRC subsidiaries to us will be subject to a withholding tax at a rate of 20%. The withholding tax on dividends may be exempted or reduced by the State Council of the PRC. Furthermore, the ultimate withholding tax rate will be determined by treaty between the PRC and the tax residence of the holder of the PRC subsidiary. At this point, we are uncertain of the withholding tax arrangement on dividends. Therefore, we are actively monitoring the proposed withholding tax and are evaluating appropriate organizational changes to minimize the corresponding tax impact.

Critical Accounting Policies

We prepare financial statements in accordance with U.S. GAAP, which requires us to make judgments, estimates and assumptions that affect the reported amounts of our assets and liabilities and the disclosure of our contingent assets and liabilities at the end of each fiscal period and the reported amounts of revenues and expenses during each fiscal period. We continually evaluate these judgments and estimates based on our own historical experience, knowledge and assessment of current business and other conditions, our expectations regarding the future considering available information and assumptions that we believe to be reasonable, which together form our basis for making judgments about matters that are not readily apparent from other sources. Since the use of estimates is an integral component of the financial reporting process, our actual results could differ from those estimates. Some of our accounting policies involve a greater use of estimates or require a higher degree of judgment than others in their application.

The selection of critical accounting policies, the judgments and other uncertainties affecting application of those policies and the sensitivity of reported results to changes in conditions and assumptions are factors that should be considered when reviewing our consolidated financial statements. We believe the following accounting policies involve the most significant judgments and estimates used in the preparation of our consolidated financial statements.

Depreciation and amortization of long-lived assets

We depreciate property, plant and equipment and amortize our intangible assets on a straight-line basis over the respective estimated useful lives of these assets, after taking into account their estimated residual values.

The patent we acquired as part of our ECLIA acquisition in August 2004 is amortized over its remaining protected period of 17 years.

In determining the estimated useful lives of our unpatented technology in our ECLIA acquisition, we consider the following pertinent factors:

 

   

the protective period of similarly patented technology;

 

   

the planning horizon of our operations taking into account the medical equipment and supply market in China as a whole; and

 

   

the economic lives and history of other similar diagnostic technologies currently used by hospitals in the world.

As a result, we have estimated the useful life of the unpatented technology we acquired as part of our ECLIA acquisition to be 20 years.

The estimated useful life of the non-compete agreement we acquired in our ECLIA acquisition is based on the period of time during which the non-compete agreement is expected to be of value to us, which we consider to be the estimated time required for Beijing Weixiao to develop a similar technology and the length of the impact if Beijing Weixiao were to develop the technology and to compete with us. As a result, we have estimated the useful life of the non-compete agreement to be 10 years.

 

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The intangible assets we acquired as part of our FISH acquisition in March 2007 are amortized over their respective estimated useful lives. These intangible assets are amortized over the length of time that they are expected to bring economic value to us.

In determining the estimated useful lives of FISH related technology and know-how acquired in March 2007, we consider the following pertinent factors:

 

   

the useful life of similar technology and technical know-how;

 

   

the planning horizon of our operations taking into account the medical equipment and supply market in China as a whole; and

 

   

the economic lives and history of other similar diagnostic technologies currently used by hospitals in the world.

Our estimated useful life for the technical know-how for production for FISH imaging analysis system and FISH probes are 5 years and 20 years, respectively. The period of non-compete agreement is 5 years. The FISH related technology and know-how relates to the production of our FISH imaging analysis system as well as the mass production of probes. The non-compete agreement contains covenants of the sellers not to compete with us.

We review the estimated useful lives and estimated residual values of our assets regularly in order to determine the amount of depreciation and amortization expenses to be recorded during any reporting period. We determine the estimated useful lives for property, plant and equipment based on our historical usage experience with similar assets and taking into account anticipated technological changes.

We adjust the depreciation and amortization expenses for future periods if there are significant changes from previous estimates. For the fiscal years ended March 31, 2005, 2006 and 2007, there were no significant changes in the estimated useful lives or residual values of these long-lived assets.

Valuation of inventories

Our inventories are stated at the lower of cost and market. Cost is determined using first-in, first-out method and consists of the cost of direct material, direct production cost and an allocation of production overheads. We review periodically the carrying amounts of our inventories including raw materials, work-in-progress and finished goods in order to assess whether a write down is needed. We will write down inventories that we identify and consider as obsolete. We manage our inventory level based on our estimates of future demand in reference to received backlogs and forecasted customer orders. This measure helps us to manage our exposure to significant risk of obsolescence. There have been no significant inventory write downs for the fiscal years ended March 31, 2005, 2006 and 2007.

Acquisitions

As of March 31, 2007, our intangible assets consisted of ECLIA-related patented technology, unpatented technology and non-compete agreement as well as FISH-related technical know-how and non-compete agreement. The acquisitions in ECLIA assets and the FISH operation were made during the fiscal years ended March 31, 2005 and March 31, 2007, respectively. We allocate the cost of acquisitions based on the estimated fair value of the net assets acquired on the date of acquisition. This process is commonly referred to as the purchase price allocation. As part of the purchase price allocation, we are required to determine the fair value of any identifiable intangible assets acquired. The determination of the fair value of the intangible assets acquired involves certain judgments and estimates. These judgments can include, but are not limited to, the cash flows that an asset is expected to generate in the future. A change in the amount allocated to identifiable intangible assets would change the amount of amortization expense recognized related to those identifiable intangible assets. When a business combination involves an excess of fair value of the acquired net assets over cost and a contingent consideration agreement that, when resolved, might result in the recognition of an additional element

 

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of cost with respect to the acquired entity, we recognize a liability for the lesser of the maximum amount of contingent consideration or the initial amount of negative goodwill. If an amount of negative goodwill remains after we recognize this liability, we first write down the eligible acquired assets, and recognize any remaining unallocated amount as an extraordinary gain.

The fair values of our identifiable ECLIA-related and FISH-related intangible assets were determined by management with the assistance of independent appraisers using mainly the income approach. For technical know-how of FISH probes and FISH imaging analysis system, the fair values were determined by using the relief-from-royalty method under the income approach. Under the relief-from-royalty method, a hypothetical construct is used to represent what we would be willing to pay to continue to use the intangible asset in business operations if we no longer had legal ownership of the intangible asset. Since ownership of the asset relieves the business from being required to make these payments, financial results are improved to the extent the upfront payment and royalty payments are avoided. The net of tax hypothetical royalties of 25.5% for the first ten years and 20% for the next ten years are discounted at a weighted average cost of capital at 14.75% to present value and to arrive at the indication of the asset’s fair value. Capital Asset Pricing Model was adopted to determine the weighted average cost of capital. For the non-compete agreement in FISH business, we have adopted an income approach that compares the perspective cash flows with and without the subject competition in place.

Recoverability of long-lived assets

Our long-lived assets consisted of property, plant and equipment and intangible assets. We review periodically the carrying amounts of our long-lived assets to be held and used in order to assess whether the recoverable amounts, based on expected undiscounted net cash flows, have declined below the carrying amounts. We test these assets for impairment whenever events or changes in circumstances indicate that their recorded carrying amounts may not be recoverable. When such a decline has occurred, we reduce the carrying amount to the estimated fair value and record the difference as an impairment loss, which is charged against earnings. We determine estimated fair value using expected future cash flows generated by the assets and such future cash flows are discounted to their present value, which requires significant judgment in terms of projection of cash flows for future years and the assumption on the pre-tax discount rate that reflects current market assessments of the time value of money and the risks specific to the asset. For the fiscal years ended March 31, 2005, 2006 and 2007, we did not recognize any impairment losses in our consolidated financial statements.

Collectibility of our accounts receivable

We evaluate the collectibility of our accounts receivable based on the aging of account balances, collection history, credit quality of the customer and current economic conditions that may affect a customer’s ability to pay.

We currently do not recognize an allowance for doubtful accounts in our consolidated financial statements because of our past collection experience. However, we have been dependent on a small number of distributors for a significant portion of our revenues. If a major customer’s financial condition deteriorates, or if our customer default rates become higher than historical levels, our estimates of the recoverability of amounts due to us could change, and an allowance could be required, which could have a material adverse effect on our results of operations.

Warranty obligations

Each of our HIFU therapy systems and ECLIA analyzers are typically sold with a 12-month unlimited warranty against technical defects, the term of which begins upon acceptance of the product by the customer. Our FISH imaging analysis system will offer a similar warranty policy. Based on the limited number of warranty claims in the past for our HIFU therapy system and the relatively low historical repair costs, we do not generally accrue any liability for potential warranty costs at the time of sale. However, if we begin to experience an increase in the frequency of claims or the amount of repair costs to cover our warranty obligations, we will begin to provide for such warranty costs at the time of product sale. If we had incurred a warranty claim rate of 1% of

 

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our net revenues, our estimated warranty costs for the three fiscal years ended March 31, 2005, 2006 and 2007 would have been approximately RMB2.2 million, RMB3.7 million and RMB5.5 million (US$0.7 million), respectively. Our customers do not have a right of return with respect to products purchased from us.

Share-based compensation

Beginning April 1, 2006, we adopted SFAS No. 123(R), “Share-Based Payment”, which requires all share-based compensation to directors, officers and management personnel, including grants of share options and restricted shares, to be recognized as an expense in the financial statements based on their grant date fair values. This statement was adopted using the modified prospective method of application, which requires us to recognize compensation cost on a prospective basis. Therefore, prior year’s financial statements have not been restated. Under this method, we recorded share-based compensation cost for awards granted prior to but not yet vested as of April 1, 2006 using the fair value amounts determined for pro forma disclosure under SFAS No. 123. For purposes of disclosing the pro forma net income, the value of the awards are estimated using the Black-Scholes option-pricing model and recognized over the service period. Under the fair value recognition provisions of SFAS 123R, stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as an expense on a straight-line basis, net of estimated forfeitures, over the requisite service period, which is generally the vesting period.

For share-based awards granted after April 1, 2006, we recognized compensation cost based on estimated grant date fair values using the Black-Scholes option-pricing model. The determination of the fair value of share-based compensation awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of complex and subjective variables, including our expected stock price volatility over the term of the awards, actual and projected share option exercise behaviors, risk-free interest rate and expected dividends. Furthermore, we estimate forfeitures at the time of grant and record share-based compensation expense only for those awards that are expected to vest. If actual forfeitures differ from those estimates, we revise the estimates used in subsequent periods.

If factors change and we employ different assumptions for estimating share-based compensation expense in future periods or if we decide to use a different valuation model, the future expenses may differ significantly from what we have recorded in the current period and could materially affect our operating income, net income and net income per share.

The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable, characteristics not present in our option grants and restricted shares. Existing valuation models, including the Black-Scholes and lattice binomial models, may not provide reliable measures of the fair values of our share-based compensation. Consequently, there is a risk that our estimates of the fair values of our share-based compensation awards on the grant dates may bear little resemblance to the actual values realized upon the exercise, expiration, early termination or forfeiture of those share-based payments in the future. Certain share-based compensation awards, such as share options, may expire resulting in intrinsic value of nil as compared to the fair values originally estimated on the grant date and reported in our financial statements. Alternatively, value may be realized from these instruments that are significantly higher than the fair values originally estimated on the grant date and reported in our consolidated financial statements. There is currently no market-based mechanism or other practical application to verify the reliability and accuracy of the estimates stemming from these valuation models, nor is there a means to compare and adjust the estimates to actual values.

 

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Results of Operations

The following table sets forth a summary, for the periods indicated, our consolidated results of operations and each item expressed as a percentage of our total net revenues. Our historical results presented below are not necessarily indicative of the results that may be expected for any future period.

 

     Year ended March 31,  
     2005     2006     2007  
     RMB (in
thousands)
    % of net
revenues
    RMB (in
thousands)
    % of net
revenues
    RMB (in
thousands)
    % of net
revenues
 

Revenues, net(1)

   217,547     100.0 %   371,767     100.0 %   546,970     100.0 %

Cost of revenues

   (64,579 )   (29.7 )   (110,494 )   (29.7 )   (151,614 )   (27.7 )
                                    

Total gross profit

   152,968     70.3     261,273     70.3     395,356     72.3  

Operating expenses:

            

Research and development

   (2,815 )   (1.3 )   (14,374 )   (3.9 )   (31,469 )   (5.8 )

Sales and marketing

   (4,960 )   (2.3 )   (15,327 )   (4.1 )   (18,264 )   (3.3 )

General and administrative

   (16,644 )   (7.6 )   (38,309 )   (10.3 )   (55,352 )   (10.1 )
                                    

Total operating expenses

   (24,419 )   (11.2 )   (68,010 )   (18.3 )   (105,085 )   (19.2 )

Operating income

   128,549     59.1     193,263     52.0     290,271     53.1  

Net interest income and other income(2)

   1,748     0.8     23,838     6.4     29,541     5.4  
                                    

Income before tax

   130,297     59.9     217,101     58.4     319,812     58.5  

Income tax expense

   (11,854 )   (5.4 )   (18,088 )   (4.9 )   (30,094 )   (5.5 )
                                    

Net income

   118,443     54.5 %   199,013     53.5 %   289,718     53.0 %
                                    

(1) Revenues, net, include revenues from sales of our products, net of VAT and sales return, but include VAT refunds on the sales of self-developed software embedded in our products.
(2) Net interest income and other income includes “interest expense,” “interest income” and “other income” from our consolidated financial statements included elsewhere in this annual report.

Year Ended March 31, 2007 Compared to Year Ended March 31, 2006

Revenues, net. Our revenues were derived from two operating segments—HIFU therapy system sales and ECLIA system sales. HIFU therapy system sales and ECLIA system sales accounted for 60.6% and 39.4% of our sales, respectively, for the fiscal year ended March 31, 2007 and 66.4% and 33.6%, respectively, for the fiscal year ended March 31, 2006. We expect ECLIA sales, principally sales of ECLIA reagent kits, to grow at a higher rate than that of our HIFU therapy system sales. Together with sales generated from our recently launched FISH imaging analysis system and probes, we expect our combined revenue from the IVD platform will account for a significant part of our revenue. See “—Revenues.”

Our revenues increased 47.1% to RMB547.0 million (US$70.8 million) for the fiscal year ended March 31, 2007, from RMB371.8 million for the fiscal year ended March 31, 2006. This increase was due primarily to the increase in sales of both our HIFU therapy system and our ECLIA system. Sales to our largest customer for the fiscal year ended March 31, 2007, Beijing Yi Min Wei Kang Technology Co., Ltd., amounted to RMB34.6 million (US$4.5 million), or 6.3% of our net revenues during that year while sales to another major customer, Beijing Wei Jian Da Medical Technology Co. Ltd. for the fiscal year ended March 31, 2006 amounted to RMB91.8 million, or 24.7% of our net revenues for that fiscal year.

Revenues from sales of our HIFU therapy system increased 34.3% from RMB246.9 million for the fiscal year ended March 31, 2006 to RMB331.4 million (US$42.9 million) for the fiscal year ended March 31, 2007. Sales of our HIFU therapy system increased to 114 units for the fiscal year ended March 31, 2007 from 89 units for the fiscal year ended March 31, 2006. This increase was attributable to the increased market penetration of our HIFU therapy system as it gains acceptance in the medical community and with patients.

 

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Revenues from sales of our ECLIA system increased significantly to RMB215.6 million (US$27.9 million) for the fiscal year ended March 31, 2007 from RMB124.9 million for the fiscal year ended March 31, 2006 as a result of the increasing acceptance of the ECLIA system in the medical community in China and higher recurring revenue from reagent kit sales due to the increased installed base of ECLIA analyzers.

Our revenue increase was also due in part to a significant increase in VAT refunds, which we recognize as part of our net revenues. Our VAT refunds increased to RMB29.6 million (US$3.8 million) for the fiscal year ended March 31, 2007, from RMB23.0 million for the fiscal year ended March 31, 2006, as a result of the increase in the sales of our self-developed software embedded in our HIFU therapy system and ECLIA system.

Cost of revenues and gross margin. Our cost of revenues increased 37.2% to RMB151.6 million (US$19.6 million) for the fiscal year ended March 31, 2007, from RMB110.5 million for the fiscal year ended March 31, 2006. Our overall gross margin increased to 72.3% for the fiscal year ended March 31, 2007 as compared to 70.3% for the fiscal year ended March 31, 2006. Gross margin for our HIFU therapy system increased to 71.7% for the fiscal year ended March 31, 2007 from 70.5% for the fiscal year ended March 31, 2006 due primarily to the price increase for the Company’s HIFU therapy system in October 2006. Gross margin for our ECLIA system increased to 73.2% for the fiscal year ended March 31, 2007 from 69.9% for the fiscal year ended March 31, 2006 due primarily to the higher revenue contribution of ECLIA reagents, which generate higher gross margin than that of ECLIA analyzers.

Operating expenses. Our operating expenses increased significantly to RMB105.1 million (US$13.6 million) for the fiscal year ended March 31, 2007, from RMB68.0 million for the fiscal year ended March 31, 2006. This increase was due primarily to significant increases in our research and development expenses, our sales and marketing expenses and our general and administrative expenses. Our operating expenses as a percentage of revenues increased to 19.2% for the fiscal year ended March 31, 2007 from 18.3% for the fiscal year ended March 31, 2006. Operating expenses for our HIFU therapy system increased 60.5% to RMB51.9 million (US$6.7 million) for the fiscal year ended March 31, 2007 from RMB32.3 million for the fiscal year ended March 31, 2006. Operating expenses for our ECLIA system increased 67.5% to RMB20.6 million (US$2.7 million) for the fiscal year ended March 31, 2007 from RMB12.3 million for the fiscal year ended March 31, 2006. Operating expenses for our FISH system were RMB1.5 million for the fiscal year ended March 31, 2007.

Our research and development expenses increased significantly to RMB31.5 million (US$4.1 million) for the fiscal year ended March 31, 2007, from RMB14.4 million for the fiscal year ended March 31, 2006. The increase was primarily due to our HIFU-related medical study that is being conducted in partnership with the MOH, the pre-clinical trials of our HIFU therapy system that are being conducted in the United States for FDA pre-market approval and our collaboration with the Chinese Academy of Sciences Institute of Acoustics and the Biomed-X Centre of Peking University. Our research and development expenses as a percentage of revenues increased to 5.8% for the fiscal year ended March 31, 2007 from 3.9% for the fiscal year ended March 31, 2006.

Our sales and marketing expenses increased significantly to RMB18.3 million (US$2.4 million) for the fiscal year ended March 31, 2007, from RMB15.3 million for the fiscal year ended March 31, 2006. This increase was primarily due to our increased participation at exhibitions and organization of more promotional events. In addition, we increased expenditure on our sales and marketing efforts during this period to further promote our ECLIA system. Our sales and marketing expenses as a percentage of revenues decreased to 3.3% for the fiscal year ended March 31, 2007 from 4.1% for the fiscal year ended March 31, 2006.

Our general and administrative expenses increased significantly to RMB55.4 million (US$7.2 million) for the fiscal year ended March 31, 2007, from RMB38.3 million for the fiscal year ended March 31, 2006. This increase was due primarily to our increased headcount to meet the expansion of the Company’s operations. Our general and administrative expenses as a percentage of revenues decreased to 10.1% for the fiscal year ended March 31, 2007 from 10.3% for the fiscal year ended March 31, 2006

Net interest income and other income. Our net interest income increased significantly to RMB23.5 million (US$3.0 million) for the fiscal year ended March 31, 2007, from RMB14.0 million for the fiscal year ended March 31, 2006. This increase was due primarily to an increase in interest income generated from the net

 

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proceeds received from our initial public offering in August 2005. We have other income of RMB6.0 million (US$0.8 million) for the fiscal year ended March 31, 2007, which was primarily related to non-refundable government grants.

Included in interest expense is an amortization of convertible notes issuance cost of RMB3.1 million(US$0.4 million) for the fiscal year ended March 31, 2007 was due to the US$150 million convertible notes issued in November 2006. The issuance costs are amortized over a five-year term of the convertible notes.

Income tax expense. Our effective tax rate for the fiscal year ended March 31, 2007 was 9.4%, compared to 8.3% for the fiscal year ended March 31, 2006. The effective tax rate in the fiscal year ended March 31, 2007 increased because the foreign tax rate differential in the fiscal year ended March 31, 2007 was substantially higher than that of fiscal year ended March 31, 2006. The retroactive change in enacted tax rate recorded in the fiscal year ended March 31, 2006 while none was recorded for fiscal year ended March 31, 2007 was also responsible for the change in effective tax rate. In February 2006, we received a further reduction in statutory tax rates from 15% to 10% for the three calendar years ended December 31, 2007. The reduction in tax rate applied retroactively to fiscal year ended March 31, 2005 was taken into effect in the fiscal year ended March 31, 2006. Therefore, the effective tax rate for the fiscal year ended March 31, 2006 was lower than of fiscal year ended March 31, 2007.

Net income. Net income increased significantly to RMB289.7 million (US$37.5 million) for the fiscal year ended March 31, 2007, from RMB199.0 million for the fiscal year ended March 31, 2006, as a result of the cumulative effect of the above factors. The basic earnings per ADS increased to RMB10.8 (US$1.40) for the fiscal year ended March 31, 2007, from RMB8.1 for the fiscal year ended March 31, 2006. The diluted earnings per ADS increased to RMB10.7 (US$1.40) for the fiscal year ended March 31, 2007, from RMB8.1 for the fiscal year ended March 31, 2006. The tax holiday increased the net income by RMB13.0 million and RMB15.6 million (US$2.0 million) for the fiscal years ended March 31, 2006 and March 31, 2007, respectively. The effects of the tax holiday on basic earnings per ADS are RMB0.5 and RMB0.6 (US$0.1) for the fiscal years ended March 31, 2006 and 2007, respectively. The effects of the tax holiday on diluted earnings per ADS are RMB0.5 and RMB0.5 (US$0.1) for the fiscal years ended March 31, 2006 and 2007, respectively.

Year Ended March 31, 2006 Compared to Year Ended March 31, 2005

Revenues, net. Our revenues were derived from two operating segments—HIFU therapy system sales and ECLIA system sales. HIFU therapy system sales and ECLIA system sales accounted for 66.4% and 33.6% of our sales, respectively, for the fiscal year ended March 31, 2006 and 81.5% and 18.5%, respectively, for the fiscal year ended March 31, 2005. We expect ECLIA sales, principally sales of ECLIA reagent kits, to grow at a higher rate than that of our HIFU therapy sales. See “—Revenues.”

Our revenues increased 70.9% to RMB371.8 million for the fiscal year ended March 31, 2006, from RMB217.5 million for the fiscal year ended March 31, 2005. This increase was due primarily to the increase in sales of both our HIFU therapy system and our ECLIA system. Revenues from sales of our HIFU therapy system increased 39.3% from RMB177.3 million for the fiscal year ended March 31, 2005 to RMB246.9 million for the fiscal year ended March 31, 2006. Sales of our HIFU therapy system increased to 89 units for the fiscal year ended March 31, 2006 from 65 units for the fiscal year ended March 31, 2005. This increase was attributable to the increased market penetration of our HIFU therapy system as it gains acceptance in the medical community and with patients. Sales to our largest customer for the fiscal year ended March 31, 2006, Beijing Wei Jian Da Medical Technology Co. Ltd., amounted to RMB91.8 million, or 24.7% of our net revenues during that year while sales to the same largest customer for the fiscal year ended March 31, 2005 amounted to RMB51.3 million, or 23.6% of our net revenues for that fiscal year. Revenues from sales of our ECLIA system increased significantly to RMB124.9 million for the fiscal year ended March 31, 2006 from RMB40.3 million for the fiscal year ended March 31, 2005 as a result of the increasing acceptance of the ECLIA system in the medical community in China and higher recurring revenue from reagent kit sales due to the increased installed base of ECLIA analyzers. Our revenue increase was also due in part to a significant increase in VAT refunds, which we recognize as part of our net revenues. Our VAT refunds increased to RMB23.0 million for the fiscal year ended March 31, 2006, from RMB14.7 million for the fiscal year ended March 31, 2005, as a result of the increase in the sales of our self-developed software embedded in our HIFU therapy system and ECLIA system.

 

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Cost of revenues and gross margin. Our cost of revenues increased 71.1% to RMB110.5 million for the fiscal year ended March 31, 2006, from RMB64.6 million for the fiscal year ended March 31, 2005. Our overall gross margin remained stable at approximately 70.3% for the fiscal years ended March 31, 2005 and 2006. Gross margin for HIFU therapy system decreased to 70.5% for the fiscal year ended March 31, 2006 from 72.1% for the fiscal year ended March 31, 2005 due primarily to the higher purchase price of certain new components for the production of HIFU therapy system. Gross margin for ECLIA system increased to 69.9% for the fiscal year ended March 31, 2006 from 62.7% for the fiscal year ended March 31, 2005 due primarily to the increase in economies of scale in our ECLIA operation, which resulted in the decrease in per unit cost allocation of the depreciation and amortization and other related production overheads.

Operating expenses. Our operating expenses increased significantly to RMB68.0 million for the fiscal year ended March 31, 2006, from RMB24.4 million for the fiscal year ended March 31, 2005. This increase was due primarily to significant increases in our research and development expenses, our sales and marketing expenses and our general and administrative expenses. Our operating expenses as a percentage of revenues increased to 18.3% for the fiscal year ended March 31, 2006 from 11.2% for the fiscal year ended March 31, 2005. Operating expenses for HIFU therapy system increased 83.5% to RMB32.3 million for the fiscal year ended March 31, 2006 from RMB17.6 million for the fiscal year ended March 31, 2005. Operating expenses for ECLIA system increased significantly to RMB12.3 million for the fiscal year ended March 31, 2006 from RMB3.9 million for the fiscal year ended March 31, 2005.

Our research and development expenses increased significantly to RMB14.4 million for the fiscal year ended March 31, 2006, from RMB2.8 million for the fiscal year ended March 31, 2005. The principal reason for this increase was our increased headcount in our research and development department, especially in our ECLIA division, as well as our effort to develop new products. Our research and development expenses as a percentage of revenues increased to 3.9% for the fiscal year ended March 31, 2006 from 1.3% for the fiscal year ended March 31, 2005.

Our sales and marketing expenses increased significantly to RMB15.3 million for the fiscal year ended March 31, 2006, from RMB5.0 million for the fiscal year ended March 31, 2005. This increase was due primarily to increased promotional activities, increased headcount and increased sales of our HIFU therapy system and ECLIA system, which increased expenditure on our customer support functions. In addition, we increased expenditure on our sales and marketing efforts during this period to further promote our ECLIA system. Our sales and marketing expenses as a percentage of revenues increased to 4.1% for the fiscal year ended March 31, 2006 from 2.3% for the fiscal year ended March 31, 2005.

Our general and administrative expenses increased significantly to RMB38.3 million for the fiscal year ended March 31, 2006, from RMB16.6 million for the fiscal year ended March 31, 2005. This increase was due primarily to increased headcount, increased costs associated with being a public company and an increase in our contribution to the staff bonus and welfare fund, which was calculated based on a certain percentage of our net income, as a result of the increase in our net income for the fiscal year ended March 31, 2006. Our general and administrative expenses as a percentage of revenues increased to 10.3% for the fiscal year ended March 31, 2006 from 7.6% for the fiscal year ended March 31, 2005.

Net interest income and other income. Our net interest income increased significantly to RMB14.0 million for the fiscal year ended March 31, 2006, from RMB0.2 million for the fiscal year ended March 31, 2005. This increase was due primarily to an increase in interest income generated from the net proceeds received from our initial public offering in August 2005. Other income increased significantly to RMB9.8 million for the fiscal year ended March 31, 2006 from RMB1.6 million for the fiscal year ended March 31, 2005, which was due primarily to increased non-refundable grants from the PRC government authority in recognition of development of our advanced HIFU therapy system and the arrangement fee we received from certain shareholders for the arrangement of the follow-on offering in March 2006 these shareholders participated.

Income tax expense. Our effective tax rate for the fiscal year ended March 31, 2006 was 8.3%, compared to 9.1% for the fiscal year ended March 31, 2005. The decrease in effective tax rate for the fiscal year ended

 

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March 31, 2006 was mainly due to the change in tax holiday and retroactive change in enacted tax rate occurred during the fiscal year March 31, 2006. The retroactive change in enacted tax rate recorded in the fiscal year ended March 31, 2006 while none was recorded for fiscal year ended March 31, 2005 was also responsible for the change in effective tax rate. In February 2006, we received a further reduction in statutory tax rates from 15% to 10% for the three calendar years ended December 31, 2007. The reduction in tax rate applied retroactively to fiscal year ended March 31, 2005 was taken into effect in the fiscal year ended March 31, 2006. Therefore, the effective tax rate for the fiscal year ended March 31, 2006 was lower than of fiscal year ended March 31, 2005.

Net income. Net income increased significantly to RMB199.0 million for the fiscal year ended March 31, 2006, from RMB118.4 million for the fiscal year ended March 31, 2005, as a result of the cumulative effect of the above factors. The earnings per ADS (basic and diluted) increased to RMB8.10 for the fiscal year ended March 31, 2006, from RMB5.9 for the fiscal year ended March 31, 2005. The tax holiday increased the net income by RMB5.7 million and RMB13.0 million for the year ended March 31, 2005 and March 31, 2006, respectively. The effects of the tax holiday on basic earnings per ADS are RMB0.3 and RMB0.5 for the fiscal years ended March 31, 2005 and 2006, respectively. The effects of the tax holiday on diluted earnings per ADS are RMB0.3 and RMB0.5 for the fiscal years ended March 31, 2005 and 2006, respectively.

 

B. Liquidity and Capital Resources

Liquidity and Capital Resources

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

 

     Year ended March 31,  
     2005     2006     2007     2007  
     RMB     RMB     RMB     US$  
     (in thousands)  

Net cash provided by operating activities

   144,771     166,912     360,999     46,744  

Net cash used in investing activities

   (127,667 )   (136,778 )   (884,455 )   (114,519 )

Net cash (used in) provided by financing activities

   (26,572 )   804,438     871,554     112,847  

Net (decrease) increase in cash and cash equivalents

   (9,468 )   829,145     329,849     42,709  

Cash and cash equivalents at beginning of period

   24,114     14,646     843,791     109,254  

Cash and cash equivalents at end of period

   14,646     843,791     1,173,640     151,963  

As of March 31, 2007, we had working capital of RMB764.1 million (US$98.9 million). We believe that our current cash and cash equivalents and cash flow from operations will be sufficient to meet our anticipated cash needs, including our cash needs for working capital, research and development expenditures and capital expenditures for the foreseeable future. We may, however, require additional cash resources due to changing business conditions or other future developments, including any investments or acquisitions we may decide to pursue. If our existing cash resources are insufficient to meet our requirements, we may seek to sell additional equity securities, debt securities or borrow from banks. We cannot assure you that financing will be available in the amounts we need or on terms acceptable to us, if at all. The sale of additional equity securities, including convertible debt securities, would result in additional dilution to our shareholders. The incurrence of indebtedness would result in debt service obligations and could result in operating and financial covenants that restrict our operations and our ability to pay dividends to our shareholders. If we are unable to obtain additional equity or debt financing as required, our business, operations and prospects may suffer.

In the fiscal years ended March 31, 2005, 2006 and 2007, we have financed our operations primarily through cash generated by our operating activities, our initial public offering in August 2005 and our issuance of convertible notes in November 2006. The net proceeds we received from our initial public offering in August 2005 net of underwriting discounts and commissions and other expenses) amounted to US$99.7 million. We received net proceeds of approximately US$144.7 million from our issuance of convertible notes in November 2006.

Our principal uses of cash during the fiscal year ended March 31, 2007 were for our working capital requirements, payment of RMB848.2 million (US$109.8 million) in relation to our acquisition of the FISH

 

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operation, payment of RMB36.3 million (US$4.7 million) in relation to the expansion of our ECLIA reagent production facility and purchase of research equipment. Concurrently with the sales of convertible notes, we repurchased US$30 million of our own stock in November 2006.

As of March 31, 2007, we had RMB1,173.6 million (US$152.0 million) in cash and cash equivalents. Our cash and cash equivalents primarily consist of cash on hand and bank balances which are mainly held in RMB denominated accounts with banks in China and U.S. dollar denominated accounts with banks in Hong Kong, Singapore and the United States.

Operating Activities

Net cash provided by operating activities increased to RMB361.0 million (US$46.7 million) for the fiscal year ended March 31, 2007, from RMB166.9 million for the fiscal year ended March 31, 2006. This increase was mainly attributable to the increase in cash received from customers for higher unit sales which outpaced the cash paid to suppliers and employees.

Investing Activities

Net cash used in investing activities increased to RMB884.5 million (US$114.5 million) for the fiscal year ended March 31, 2007, from RMB136.8 million for the fiscal year ended March 31, 2006. Net cash used in investing activities for the fiscal year ended March 31, 2007 consisted primarily of our payment of RMB848.2 million (US$109.8 million) in relation to our acquisition of FISH operation.

Financing Activities

Net cash provided by financing activities was RMB871.6 million (US$112.8 million) for the fiscal year ended March 31, 2007, compared to net cash used in financing activities of RMB804.4 million for the fiscal year ended March 31, 2006. Net cash provided by financing activities for the fiscal year ended March 31, 2007 consisted primarily of proceeds of RMB1,117.3 million (US$144.7 million) raised from our issuance of convertible bonds in November 2006, partially offset by a US$30 million prepaid forward purchase contract. Concurrently with the sales of convertible notes, we entered into a prepaid forward repurchase contract with an affiliate of Merrill Lynch & Co. Pursuant to the forward repurchase contract, the company repurchased contemporaneously with the sales of the convertible notes, an aggregate of US$30 million of ADSs, equivalent to 1,163,392 ADS at US$25.78 per ADS. Merrill Lynch’s affiliate may deliver the shares at its discretion, in full or in part, over a period of five years from the date of the contract. As of March 31, 2007, Merrill Lynch’s affiliate had not delivered any shares.

We are a holding company, and we rely on dividends paid by our wholly owned subsidiaries, YDME Beijing and Beijing GP, for our cash needs, including the funds necessary to pay dividends and other cash distributions to our shareholders, service any debt we may incur and pay our operating expenses. The payment of dividends in China is subject to limitations. Regulations in the PRC currently permit payment of dividends only out of accumulated profits as determined in accordance with accounting standards and regulations in China. YDME Beijing and Beijing GP are also required to set aside at least 10% of its after-tax profit based on PRC accounting standards each year to fund certain reserve funds. These reserves can be used to recoup previous years’ losses, if any, and, subject to the approval of the relevant government authority, may be converted into share capital in proportion to their existing shareholdings, or by increasing the par value of the shares currently held by them. Such reserves, however, are not distributable as cash dividends. In addition, if YDME Beijing and Beijing GP incur debt on their own behalf in the future, the instruments governing the debt may restrict their ability to pay dividends or make other distributions to us.

The ability of our subsidiaries, YDME Beijing and Beijing GP to convert Renminbi into U.S. dollars and make payments to us is subject to PRC foreign exchange regulations. Under these regulations, the Renminbi is convertible for current account items, including the distribution of dividends, interest payments, trade and

 

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service-related foreign exchange transactions. Conversion of Renminbi for capital account items, such as direct investment, loan, security investment and repatriation of investment, however, is still subject to the approval of the SAFE.

Our working capital requirements vary from period to period depending on manufacturing volumes, the timing of deliveries, our payment cycles to our suppliers and the payment cycles of our customers.

Capital Expenditures

We made capital expenditures of RMB157.0 million, RMB134.1 million and RMB884.5 million (US$114.5 million) in the three fiscal years ended March 31, 2005, 2006 and 2007 respectively. We expect to spend approximately RMB200.0 million (US$25.9 million) in the year ending March 31, 2008, consisting of the remaining payments in relation to our acquisition of FISH operation, excluding earn-out payments, the purchase of new manufacturing equipment to enlarge production capacity and the renovation of existing facilities. Our past capital expenditures principally consisted of purchases of a building, acquisition of ECLIA technology and enlargement of ECLIA reagent production facility.

Recent Accounting Pronouncements

In June 2006, FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109, the FASB issued FIN No. 48 which is effective for fiscal years beginning after December 15, 2006, and should be applied to all tax positions upon initial adoption. FIN No. 48 clarified the accounting for income taxes by prescribing a more-likely-than-not recognition threshold a tax position is required to meet before being recognized in the financial statements. Once the recognition threshold has been met, FIN No. 48 requires the recognition of the largest amount of tax benefit that is more than 50 percent likely of being realized upon ultimate settlement with the taxing authority. The Interpretation also requires making explicit disclosures about uncertainties in the company’s income tax positions. We have assessed all our tax positions in accordance with the existing EIT and the new CIT Law and concluded we have no uncertain tax position under FIN No. 48. Thus, the initial adoption of FIN No. 48 did not have any material impact on our consolidated results of operations or financial position for our fiscal year beginning April 1, 2006.

In September 2006, the SEC issued Staff Accounting Bulletin (“SAB”) No. 108, which provides guidance on the process of quantifying financial statement misstatements. In SAB No. 108, the SEC staff establishes an approach that requires quantification of financial statement errors, under both the iron-curtain and the roll-over methods, based on the effects of the error on each of our financial statements and the related financial statement disclosures. SAB No. 108 is generally effective for annual financial statements in the first fiscal year ending after November 15, 2006. The transition provisions of SAB No. 108 permits existing public companies to record the cumulative effect in the first year ending after November 15, 2006 by recording correcting adjustments to the carrying values of assets and liabilities as of the beginning of that year with the offsetting adjustment recorded to the opening balance of retained earnings. The initial adoption of SAB No. 108 did not have any effect on our consolidated financial statements.

In September 2006, the FASB issued SFAS No.157 Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 applies under other accounting pronouncements that require or permit fair value measurements, where fair value is the relevant measurement attribute. The standard does not require any new fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We do not believe the adoption of SFAS No. 157 will have a material impact on our consolidated financial statements.

 

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C. Research and Development

Research and Development

As of June 30, 2007, our research and development team consisted of 83 research personnel and medical professionals, which accounted for 19.0% of our employees. Many of the key research and development personnel who developed the HIFU and ECLIA technologies at the PUPH are currently employed by us. The key research and development personnel of the FISH operation we acquired in March 2007 were also transferred to our company and are employed by us. Our research and development staff consists of medical professionals, biomedical engineers, acoustics engineers, electrical engineers and computer science engineers, many of whom have experience in the healthcare and medical device research fields, including experience working with hospitals who are customers of our products.

Our research and development focuses primarily on developing new applications and improving the product designs of our HIFU therapy system, ECLIA system and FISH imaging analysis system and probes.

 

   

HIFU therapy system research and development. We have expertise in the core research and development of all of the components of our HIFU therapy system. We have developed an ultrasound-based temperature measuring technology that can collect real time temperature data through acoustic signals that are generated by the ultrasound waves used for treatment. As the amount of ultrasound energy required to achieve the destruction of tumor tissues can vary with the location of the tumor and the specific characteristics of the tumor tissues to be treated, real time temperature data allows the physician to adjust and more precisely achieve target temperature. This device is non-invasive and provides the physician with more control over the treatment process and the outcome. We incorporated this new technology into our third-generation HIFU therapy system, which launched in October 2006, and sell the non-invasive ultrasound temperature detecting device separately as a product upgrade to existing users of our system. Our HIFU therapy system has been recognized as one of the Chinese National Promotion Projects of High Technology Industrialization. Our research projects include increasing the types of tumors our HIFU therapy system can treat and increasing patients’ comfort level during treatment.

 

   

ECLIA system research and development. Our ECLIA system research and development focuses on expanding the range of reagent kits for applications that are commonly used in China. For example, we have recently launched reagents to monitor stages of liver fibrosis, and reagents to test Down syndrome. We will continue to add new reagents to increase the competitiveness of our ECLIA system. The reagents under development include tests for infectious diseases, infertility disorders and cardiac diseases. Our fully automatic system for large hospitals is currently pending approval from the SFDA. We are also working on improving the response time and efficiency of our ECLIA analyzer.

 

   

FISH system research and development. Our FISH system research and development focuses on expanding the range of probes for applications that address large unmet demand in China. The probes we currently offer are used in these applications: prenatal diagnosis, diagnosis and prognosis of cervical cancer, bladder cancer, breast cancer, leukemia and multiple myeloma. We are also working on enhancing the sensitivity and specificity of our probes.

We actively involve scientists and physicians during our research and development process to produce products that provide clinical and economic benefits to hospitals and their patients. In recent years, we have increased our investment in research and development to accelerate the commercialization of new technologies. Over the past year, we initiated various long term collaborations with leading institutions such as Chinese Academy of Sciences Institute of Acoustics and Biomed-X Center of Peking University to strengthen our research capabilities, further enhance the functionality of existing products and expedite the development of new products. We expect to continue devoting significant resources to research and development.

 

D. Trend Information

Other than as disclosed elsewhere in this annual report, we are not aware of any trends, uncertainties, demands, commitments or events for the period from April 1, 2005 to March 31, 2007 that are reasonably likely

 

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to have a material adverse effect on our net revenues, income, profitability, liquidity or capital resources, or that caused the disclosed financial information to be not necessarily indicative of future operating results or financial conditions.

 

E. Off-Balance Sheet Arrangements

We do not, and did not, have any interest in variable interest entities or any other off-balance sheet arrangements that require disclosure.

 

F. Tabular Disclosure of Contractual Obligations

The following table sets forth our contractual obligations as of March 31, 2007:

 

     Payment due by period

Contractual obligations

  

Less than

1 year

  

1-2

years

  

2-5

years

  

More than

5 years

   Total
     (RMB in thousands)

Convertible notes

   —      —      1,158,480    —      1,158,480

Operating lease obligations

   2,428    1,427    —      —      3,855

Purchase obligations(1)

   10,000    —      —      —      10,000
                        

Total

   12,428    1,427    1,158,480    —      1,172,335
                        

(1) Relates to the remaining balance on a contractual obligation to carry out certain construction work for RMB48.0 million (US$6.0 million). As of March 31, 2007, a payment of RMB38.0 million had been made to the contractor.

Contingent earnout payments related to FISH acquisition

Pursuant to the acquisition agreement that we entered with the seller of the FISH operation, the sellers will be entitled to an amount of US$20.0 million as the first earnout payment if we receives bona fide, irrevocable, binding purchase orders of an amount equal to or in excess of US$20.0 million to purchase products of FISH during the 12-month period ending March 1, 2008. In addition, the sellers will be entitled to an amount of US$20.0 million as the second earnout payments in addition to the first earnout payment, if we recognize revenue attributable to the earnout purchase orders pursuant to U.S. GAAP. The contingent earnout payments will be settled at our discretion, in cash or by issuance of our shares. The shares used for settling the earnout payment in this acquisition are referred as earnout shares. The value of the earnout shares will be equal to the product of (i) the number of earnout shares times (ii) the weighted average of the closing sale prices for one earnout share as quoted on the Nadsaq Global Select Market during normal trading hours, for the thirty consecutive trading days ending on the third trading day prior to each earnout payment date.

Other than the contractual obligations and commercial commitments set forth above, we do not have any other long-term debt obligations, operating lease obligations, purchase obligations or other long-term liabilities.

Inflation

Inflation in China has not had a material impact on our results of operations in recent years. According to the National Bureau of Statistics of China, the change in the Consumer Price Index in China was 3.9%, 1.8% and 1.5% in 2004, 2005 and 2006, respectively.

 

G. Safe Harbor

This annual report on Form 20-F contains forward-looking statements that relate to future events, including our future operating results and conditions, our prospects and our future financial performance and condition.

 

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The forward-looking statements are contained principally in the sections entitled “Item 3. Key Information—D. Risk Factors,” “Item 4. Information on the Company” and “Item 5. Operating and Financial Review and Prospects.” These statements involve known and unknown risks, uncertainties and other factors, which may cause our actual results, performance or achievements to be materially different from any future results, performances or achievements expressed or implied by the forward-looking statements.

Forward-looking statements typically are identified by words or phrases such as “may,” “will,” “expect,” “anticipate,” “aim,” “estimate,” “intend,” “plan,” “believe,” “potential,” “continue,” “is/are likely to” or other similar expressions or the negative of these words or expressions. We have based these forward-looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our financial condition, results of operations, business strategy and financial needs. We cannot guarantee the accuracy of the forward-looking statements, and you should be aware that our actual results could differ materially from those contained in the forward-looking statements due to a number of factors, including:

 

   

our anticipated growth strategies;

 

   

our future business development, results of operations and financial condition;

 

   

our ability to develop and market future generations of our HIFU therapy system and future applications of our ECLIA system and FISH system;

 

   

market acceptance of FISH imaging analysis system and probes;

 

   

the expected market growth for medical devices and supplies in China;

 

   

market acceptance of our technology and products;

 

   

our expectations regarding hospital or patient demand for tumor treatment;

 

   

our ability to expand our production, sales and distribution network and other aspects of our operations;

 

   

our ability to effectively build and manage a direct sales force for the distribution of FISH products;

 

   

our ability to diversify our product range and stay abreast of technological changes;

 

   

competition from other HIFU tumor therapy device manufacturers and alternative methods of tumor therapy;

 

   

competition from other companies that offer IVD systems in China;

 

   

our ability to effectively protect our intellectual property and not infringe on the intellectual property of others;

 

   

our ability to expand our sales and distribution of our HIFU system outside of China;

 

   

our ability to identify and acquire new medical technologies and products;

 

   

changes in the healthcare industry in China, including changes in the healthcare policies and regulations of the PRC government and changes in the healthcare insurance sector in the PRC; and

 

   

fluctuations in general economic and business conditions in China.

This annual report contains market information related to the medical devices and supplies industry, healthcare insurance, hospitals, the cancer treatment and IVD markets in China. Unlike in the United States, there is limited authoritative data on the healthcare industry in China, particularly on a nationwide basis. For example, there is limited data concerning health and patient trends or the medical devices and supplies industry. In addition, any data that is available may not be current. This annual report contains projections that are based on a number of assumptions. For example, we have made assumptions regarding the growth in the number of tumor patients and the demand for tumor treatment. Our business and marketing plan for the ECLIA system also assumes that small- and medium-sized hospitals in China will be interested in buying an ECLIA system such as ours. We have also projected a certain penetration rate for our FISH system in large-size hospitals in China. Any

 

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or all of our assumptions may turn out to be incorrect. The tumor therapy market may not expand at the rates projected by the market information, or at all. If demand for our HIFU therapy system, ECLIA system and FISH products does not grow at the projected rates, our business and the market price of our ADSs would suffer. In addition, the complex and changing nature of broad macroeconomic factors subject any projections or estimates relating to the growth prospects or future conditions of our market to significant uncertainties.

The forward-looking statements made in this annual report relate only to events or information as of the date on which the statements are made in this annual report. Except as required by law, we undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise, after the date on which the statements are made or to reflect the occurrence of unanticipated events. You should read this annual report and the documents that we reference in this annual report and have filed as exhibits to the registration statement, of which this annual report is a part, completely and with the understanding that our actual future results may be materially different from what we expect.

ITEM 6.    DIRECTORS, SENIOR MANAGEMENT AND EMPLOYEES

 

A. Directors and Senior Management

Directors and Executive Officers

The following table sets forth information regarding our directors and executive officers as of June 30, 2007.

 

Name

   Age   

Position/title

Xiaodong Wu

   51    Chairman of the board of directors, chief executive officer

Iain Ferguson Bruce(1)(2)(3)

   67    Director

Cole R. Capener(1)

   52    Director

Lawrence A. Crum(1)(2)(3)

   66    Director

Ruyu Du(3)

   72    Director

Takyung (Sam) Tsang

   36    Director, chief financial officer

Feng (Charles) Zhu

   38    Vice president

(1) Member of the audit committee.
(2) Member of the compensation committee.
(3) Member of the nomination committee.

Mr. Xiaodong Wu, our founder, currently serves as our chairman of the board of directors and chief executive officer. Mr. Wu has served on our board of directors since July 2004 and as the chairman of our board of directors since February 2005. Mr. Wu is also a director and the chief executive officer of YDME Beijing, positions he has served since the inception of YDME Beijing in July 1999. Mr. Wu serves on the board of directors of Chengxuan, Beijing Chengxuan, an investment holding company, Beijing Weixiao, a medical technology company, Beijing Jia Chen Hong Biological Technologies Co., Ltd., a medical technology company, and Beijing Wan De Jin Da Industry and Trade Co., Ltd., a property management company. Mr. Wu worked in the foreign investment department of the Jiangxi provincial government from 1990 to 1996. From 1980 to 1989, Mr. Wu worked in Jiangxi Municipal Science and Technology Commission and accumulated extensive experience in assessing and managing hi-tech projects. Mr. Wu is an advisor to Beijing Medical University for technology development projects. Mr. Wu received his bachelor’s degree in Physics from Jiangxi University.

Mr. Iain Ferguson Bruce has served as a member of our board of directors since February 2005. Mr. Bruce is a member of the audit, compensation and nomination committees. Mr. Bruce joined KPMG in Hong Kong in 1964 and was elected to its partnership in 1971. He was the Senior Partner of KPMG from 1991 until his retirement in 1996 and also concurrently served as Chairman of KPMG Asia Pacific from 1993 to 1997. Since 1964, Mr. Bruce has been a member of the Chartered Accountants of Scotland and is a fellow of the Hong Kong Institute of Certified Public Accountants with over 40 years’ experience in the accounting profession. Mr. Bruce

 

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is currently an independent non-executive director of Paul Y Engineering Group Limited, a construction and engineering company, Vitasoy International Holdings Ltd., a beverage manufacturing company, Wing On Company International Ltd., a department store operating and real property investment company, and Tencent Holdings Limited, a provider of Internet services and mobile value-added services. All of these companies are listed companies on the Hong Kong Stock Exchange. Mr. Bruce is also a non-executive director of Noble Group Limited, a commodity trading company that is listed on the Singapore Stock Exchange.

Mr. Cole R. Capener has served as a member of our board of directors since June 2005 and is a member of the audit committee. He obtained his law degree, with honors, from The George Washington University National Law Centre in 1981. Thereafter, he practiced law in the New York City office of Shearman & Sterling and later joined the international law firm of Baker & McKenzie in its Beijing office in 1986. Mr. Capener became a partner in Baker & McKenzie in 1989, and his practice consisted of advising multinational corporate clients doing business in China. In 2001, he left the firm to establish and manage a non-profit, 501(c)(3) corporation, Saving African Families Enterprise, which raises funds to procure antiretroviral medicines for families living with HIV/AIDS in Sub-Saharan African. He currently serves as an independent non-executive director on the board of directors of BMW’s manufacturing joint venture in Shenyang, China, BMW Brilliance Automotive Co. Ltd. He has published a large number of articles on Chinese legal topics. He is admitted to practice law in the states of New York, California and Utah.

Dr. Lawrence A. Crum has served as a member of our Board of Directors since February 2005 and serves as a member of the audit, compensation and nomination committees. Dr. Crum is the director of the Center for Industrial and Medical Ultrasound and a research professor in electrical engineering and bioengineering at the University of Washington in Seattle in the United States. He holds a Ph.D. degree in physics from the University of Ohio, has served as the president of the Acoustical Society of America and the International Commission for Acoustics and holds an honorary doctorate degree from the University of Brussels.

Mr. Ruyu Du has served as a member of our board of directors since June 2005 and is a member of the nomination committee. Mr. Du joined Peking University People’s Hospital in 1959 as a surgeon and served as the president of the hospital from 1983 until 1998, when he retired. Mr. Du currently serves as a professor of surgery at Peking University, and he is also honorary president of Peking University People’s Hospital. Mr. Du is a member of the Standing Committee of the Chinese Medical Association, a director of the Surgery Society of China Medical Association, and the vice chairman of the Chinese Medical Doctor Association. Mr. Du has been the chief editor for the Chinese Journal of Surgery since 1992 and served as deputy chief editor of the Clinical Journal of General Surgery from 1985 to 1992 and of the Chinese Journal of Experimental Surgery from 1996 to 2000. Mr. Du is the author of over 150 articles published in Chinese and international professional journals. Mr. Du has been a member of the Chinese delegation to the International Society of Surgery since 1998. Mr. Du holds his bachelor’s and master’s degrees in medical surgery from Peking University.

Mr. Takyung (Sam) Tsang has served as our chief financial officer since January 2005 and as our director since June 2007. Mr. Tsang was an advisor to the company for the areas of accounting and finance from February 2004 to December 2004. Prior to joining us, Mr. Tsang worked as a manager of KPMG Hong Kong and Ernst & Young China. He is a Certified Public Accountant in the United States and Hong Kong. He received his bachelor’s degree in business administration from the Chinese University of Hong Kong.

Mr. Feng (Charles) Zhu joined our company as our vice president for business development and investor relations in January 2005. Prior to joining us, Mr. Zhu worked as a business development manager for GE Healthcare in China from February 2002 to December 2004, responsible for merger and acquisition projects. From May 2000 to February 2002, Mr. Zhu also worked as a business analyst for a Siemens joint venture in China, advising clients on fund raising projects. Mr. Zhu received his bachelor’s degree in English from Foreign Affairs College in China and his master’s degree in business administration from Texas Christian University.

Mr. Minshi (Mike) Shen served as our chief operating officer from January 2005 to January 2007, when he left our company to start his own medical device distribution and supply business.

 

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The business address of our directors and executive officers is China Medical Technologies Inc. at No. 24 Yong Chang North Road, Beijing Economic-Technological Development Area, Beijing 100176, People’s Republic of China.

 

B. Compensation

Compensation of Directors and Executive Officers

For the fiscal year ended March 31, 2007, the aggregate cash compensation to our directors and executive officers was approximately RMB13.4 million (US$1.7 million). The aggregate amount set aside or accrued to provide retirement, pension or other similar benefits for our executive officers was approximately RMB75,000 (US$9,711) for the fiscal year ended March 31, 2007. If we terminate an executive officer without cause, we are required to pay compensation equal to nine months of the executive officer’s salary. Except for directors who are also executive officers, none of our directors receive benefits upon termination.

2005 Stock Option Plan

Our board of directors has adopted a stock option plan on February 1, 2005. Our stock option plan provides for the grant of share options as well as restricted stock, referred to as “awards”. The purpose of the plan is to attract and retain the best available personnel for positions of substantial responsibility, provide additional incentive to employees, directors and consultants and promote the success of our business. Our board of directors believes that our company’s long-term success is dependent upon our ability to attract and retain superior individuals who, by virtue of their ability, experience and qualifications, make important contributions to our business.

We have reserved an aggregate of 30,000,000 of our ordinary shares for issuance under our 2005 stock option plan. As of June 30, 2007, share options and restricted shares to purchase an aggregate of 3,350,000 of our ordinary shares were issued and outstanding.

Termination of Awards. Options and restricted shares shall have the specified termination set forth in an award agreement. Where the option agreement permits the exercise of the options granted for a certain period of time following the recipient’s termination of services with us, or the recipient’s disability or death, the options will terminate to the extent any is not exercised or purchased on the last day of the specified period or the last day of the original term of the options, whichever occurs first.

Administration. Our stock option plan is administered by an administrative committee designated by our board of directors. The administrative committee will determine the provisions, terms and conditions of each award grant, including, but not limited to, the option vesting schedule, repurchase provisions, rights of first refusal, forfeiture provisions, form of payment upon settlement of the award, payment contingencies and satisfaction of any performance criteria.

Vesting Schedule. Options and restricted shares granted under our stock option plan vest over a period of two to three years after vesting commencement date. The vesting schedule is subject to the optionee continuing to be a service provider of our company over the vesting period.

Option Agreement. Options granted under our stock option plan are evidenced by an option agreement that contains, among other things, provisions concerning exercisability and forfeiture upon termination of employment or consulting arrangements by reason of death, disability or otherwise, as determined by our board. In addition, the option agreement also provides that options granted under each plan are subject to a 180-day lock-up period following the effective date of a registration statement filed by us under the Securities Act, if so requested by us or any representative of the underwriters in connection with any registration of the offering of any of our securities.

 

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Option Exercise. The term of options granted under the 2005 stock option plan may not exceed five years from the date of grant. The consideration to be paid for our ordinary shares upon exercise of an option or purchase of shares underlying the option will be determined by the stock option plan administrator and may include cash, check, ordinary shares, a promissory note, consideration received by us under a cashless exercise program implemented by us in connection with our stock option plan, or any combination of the foregoing methods of payment.

Third-party Acquisition. If a third-party acquires us through the purchase of all or substantially all of our assets, a merger or other business combination, all outstanding share options or share purchase rights will be assumed or equivalent share options or share purchase rights will be substituted by the successor corporation or parent or subsidiary of successor corporation. In the event that the successor corporation refuses to assume or substitute for the stock options or share purchase rights, all share options or share purchase rights will become fully vested and exercisable immediately prior to such transaction and all unexercised options will terminate unless, in either case, the options are assumed by the successor corporation or its parent.

Termination of Plan. Unless terminated earlier, the 2005 stock option plan will expire in 2010. Our board of directors has the authority to amend or terminate our stock option plan subject to shareholder approval to the extent necessary to comply with applicable law and regulations. However, no such action may (i) impair the rights of any optionee unless agreed by the optionee and the stock option plan administrative committee, or (ii) affect the stock option plan administrative committee’s ability to exercise the powers granted to it under our stock option plan.

The following table summarizes the outstanding options that we granted to five of our directors under our 2005 stock option plan as of June 30, 2007:

 

Name

  Number of shares
to be issued upon
exercise of
options and
vesting of
restricted shares
 

Per share exercise
price and required
charges
(in US$)

  Date of grant   Date of expiration

Iain Ferguson Bruce

  *   US$1.36/US$0.10   Mar.14,2005/Jun 11,2007   Dec.31,2009/May 31,2012

Lawrence A. Crum

  *   US$1.36/US$0.10   Mar.14,2005/Jun 11,2007   Dec.31,2009/May 31,2012

Cole R. Capener

  *   US$1.50/US$0.10   Aug. 8, 2005/Jun.11,2007   Dec.31,2009/May 31,2012

Ruyu Du

  *   US$ 1.50   August 8, 2005   December 31, 2009

Sam Tsang

  *   US$ 0.10   June 11, 2007   May 31, 2012
         

Total

  2,070,000      
         

  * Upon exercise of all options and restricted shares granted, would beneficially own less than 1% of our outstanding ordinary shares.

These options and restricted shares vest over a period of two to three years after the grant date.

 

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C. Board Practices

Committees of the Board of Directors

Audit Committee

Our audit committee consists of Mr. Iain Ferguson Bruce, Mr. Cole R. Capener and Dr. Lawrence A. Crum, and is chaired by Mr. Bruce. All of the three directors satisfy the “independence” requirements of the Nasdaq corporate governance rules. The audit committee oversees our accounting and financial reporting processes and the audits of the financial statements of our company. The audit committee is responsible for, among other things:

 

   

selecting our independent auditors and pre-approving all auditing and non-auditing services permitted to be performed by our independent auditors;

 

   

reviewing with our independent auditors any audit problems or difficulties and management’s response;

 

   

reviewing and approving all proposed related-party transactions, as defined in Item 404 of Regulation S-K under the Securities Act;

 

   

discussing our annual audited consolidated financial statements with management and our independent auditors;

 

   

reviewing major issues as to the adequacy of our internal controls and any special audit steps adopted in light of material control deficiencies;

 

   

annually reviewing and reassessing the adequacy of our audit committee charter;

 

   

such other matters that are specifically delegated to our audit committee by our board of directors from time to time;

 

   

meeting separately and periodically with management and our internal and independent auditors; and

 

   

reporting regularly to the full board of directors.

Compensation Committee

Our compensation committee consists of Mr. Iain Ferguson Bruce and Dr. Lawrence A. Crum, both of whom satisfy the “independent” requirements of the Nasdaq corporate governance rules. The committee is chaired by Mr. Bruce. Our compensation committee assists the board in reviewing and approving the compensation structure of our directors and executive officers, including all forms of compensation to be provided to our directors and executive officers. Members of the compensation committee are not prohibited from direct involvement in determining their own compensation. Our chief executive officer may not be present at any committee meeting during which his compensation is deliberated. The compensation committee is responsible for, among other things:

 

   

approving and overseeing the compensation package for our executive officers;

 

   

reviewing and making recommendations to the board with respect to the compensation of our directors;

 

   

reviewing and approving corporate goals and objectives relevant to the compensation of our chief executive officer, evaluating the performance of our chief executive officer in light of those goals and objectives, and setting the compensation level of our chief executive officer based on this evaluation; and

 

   

reviewing periodically and making recommendations to the board regarding any long-term incentive compensation or equity plans, programs or similar arrangements, annual bonuses, employee pension and welfare benefit plans.

Nomination Committee

We established a nomination committee in November 2005. Our nomination committee consists of Mr. Iain Ferguson Bruce, Dr. Lawrence A. Crum and Mr. Ruyu Du, and is chaired by Mr. Bruce. All of the three directors

 

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satisfy the “independence” requirements of the Nasdaq corporate governance rules. The nomination committee assists the board of directors in identifying individuals qualified to become our directors and in determining the composition of the board and its committees. The nomination committee is responsible for, among other things:

 

   

identifying and recommending to the board nominees for election or re-election to the board, or for appointment to fill any vacancy; and

 

   

reviewing annually with the board the current composition of the board in light of the characteristics of independence, qualification, experience and availability of service to us.

Duties of Directors

Under Cayman Islands law, our directors have a duty of loyalty to act honestly, in good faith and with a view to our best interests. Our directors also have a duty to exercise the skill they actually possess and such care and diligence that a reasonably prudent person would exercise in comparable circumstances. In fulfilling their duty of care to us, our directors must ensure compliance with our memorandum and articles of association, as amended and re-stated from time to time. A shareholder has the right to seek damages if a duty owed by our directors is breached.

The functions and powers of our board of directors include, among others:

 

   

convening shareholders’ annual general meetings and reporting its work to shareholders at such meetings;

 

   

declaring dividends and distributions;

 

   

appointing officers and determining the term of office of officers;

 

   

exercising the borrowing powers of our company and mortgaging the property of our company; and

 

   

approving the transfer of shares of our company, including the registering of such shares in our share register.

Terms of Directors and Executive Officers

All directors hold office until their successors have been duly elected and qualified. Officers are elected by and serve at the discretion of the board of directors. Currently, directors are not subject to a term of office and hold office until such time as they are removed from office by special resolution or the unanimous written resolution of all shareholders. If a director has been appointed by Chengxuan, upon written notice to us, such director may be removed and replaced by its respective nominator, at any time for any reason.

With the expiration of the directors’ terms under our articles of association, elections for directors will be held each year on the date of annual general meeting of shareholders. A director will be removed from office automatically if, among other things, the director (i) becomes bankrupt or makes any arrangement or composition with his creditors; or (ii) dies or is found by our company to be or becomes of unsound mind.

 

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D. Employees

Employees

We had 137, 265 and 334 employees as of March 31, 2005, 2006 and 2007 respectively. As of June 30, 2007, we had 437 employees. The following table sets forth the number of our employees categorized by function as of June 30, 2007.

 

    

As of June 30,

2007

   Percentage of Total
(%)

Manufacturing and services

   160    36.6

Research and development

   83    19.0

General and administration

   75    17.2

Marketing and sales

   59    13.5

Customer support and service

   60    13.7
         

Total

   437    100.0
         

From time to time, we also employ independent contractors to support our marketing and sales and clinical support and research. We plan to hire additional employees for marketing and sales, customer service and manufacturing and assembly as we grow our business. None of our employees is represented by a labor union. We consider our relationship with our employees to be good.

In accordance with applicable regulations in the PRC, we participate in a pension contribution plan, a medical insurance plan, an unemployment insurance plan and a personal injury insurance plan for our employees. We have made adequate provisions in accordance with applicable regulations, which require us to contribute amounts equal to 20%, 10%, 1.5% and 0.8%, respectively, of our employees’ aggregate base salaries to these statutory plans.

Also, in accordance with PRC regulations, we contribute amounts equal to 8%, 4% and 0.8% of our employees’ aggregate base salaries towards a housing fund, a supplemental medical insurance fund and a maternity fund, respectively.

 

E. Share Ownership

The following table sets forth information with respect to the beneficial ownership of our ordinary shares as of June 30, 2007, the latest practicable date, by:

 

   

each of our directors and executive officers; and

 

   

each person known to us to own beneficially more than 5.0% of our ordinary shares.

 

     Ordinary shares
beneficially owned(1)
     Number    %

Directors and executive officers:

     

Xiaodong Wu(2)(4)

   71,420,001    26.1

Iain Ferguson Bruce

   *    *

Lawrence A. Crum

   *    *

Cole R. Capener

   *    *

Ruyu Du

   *    *

Sam Tsang

   *    *

All directors and executive officers as a group(3)

   73,490,001    26.9

Principal shareholders:

     

Chengxuan International Ltd.(4)

   71,420,001    26.1

 * Indicates less than 1%.

 

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(1) Beneficial ownership is determined in accordance with Rule 13d-3 of the General Rules and Regulations under the Securities Exchange Act of 1934, as amended, and includes shares as to which the indicated person holds voting or investment power with respect to the securities.
(2) Mr. Wu holds his shares through Chengxuan International Ltd.
(3) Includes ordinary shares issuable upon exercise of options beneficially held by all of our directors and executive officers as a group.
(4) Chengxuan International Ltd., a British Virgin Islands company, is owned by Mr. Xiaodong Wu. The address for Chengxuan is The Mill Mall, PO Box 92, Road Town, Tortola, British Virgin Islands.

As of September 28, 2007, other than our outstanding ordinary shares underlying the outstanding ADSs which were held by our custodian, Citibank Hong Kong Branch, on behalf of Citibank, N.A., the depositary, none of our ordinary shares were held in the United States. Our ordinary shares underlying the ADSs quoted on the Nasdaq Global Select Market are held in Hong Kong by the custodian, Citibank, N.A., Hong Kong Branch, on behalf of Citibank, N.A., the depositary.

None of our shareholders has different voting rights from other shareholders. We are not aware of any arrangement that may, at a subsequent date, result in a change of control of our company.

ITEM 7.    MAJOR SHAREHOLDERS AND RELATED PARTY TRANSACTIONS

A.    Major Shareholders

Please refer to “Item 6. Directors, Senior Management and Employees—Share Ownership.”

B.    Related Party Transactions

After the completion of our initial public offering on August 15, 2005, we adopted an audit committee charter, which requires that the audit committee review all related party transactions on an ongoing basis and all such transactions be approved by the committee. Set forth below is a description of all of our related party transactions for the fiscal years ended March 31, 2005, 2006 and 2007.

Transactions with GE

GE became a shareholder of YDME Beijing and a distributor of our HIFU therapy system in April 2003. In January 2005, GE became our shareholder. GE was no longer considered a related party when they exited their position in our equity shares during the fiscal year ended March 31, 2007.

For the fiscal years ended March 31, 2005 and, 2006, sales of our HIFU therapy system to GE amounted to RMB4.1 million, RMB3.9 million, respectively, which accounted for 1.9% and 1.1% of our net revenues, respectively. No sales of HIFU therapy system to GE were recorded for the fiscal year ended March 31, 2007. Sales of our HIFU therapy system to GE were generally at prices lower than those charged to third parties.

In addition, we purchased the ultrasound imaging system, one of the major components of our HIFU therapy system, from GE. Under the exclusive supply agreement between GE and us, as long as GE holds 5% or more of our ordinary shares, GE is entitled to be the sole supplier of the ultrasound imaging system. On June 21, 2006, GE’s ownership interest in our company fell below 5% of our outstanding shares and ceased to be a party to the shareholders’ agreement. For the fiscal years ended March 31, 2004, our purchases of the ultrasound imaging system from GE amounted to RMB6.8 million. We purchased GE’s ultrasound imaging system through an import company for the fiscal years ended March 31, 2005, 2006 and 2007.

In April 2004, we entered into a service agreement with GE under which we agreed to provide repair services for medical equipment GE sold to its customers in China. Under the service agreement, GE agreed to reimburse all expenses we incur in connection with our repair services. In addition, we also charge GE a service

 

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fee equal to 10% of expenses we incurred in connection with our repair services. We generated repair service income in the amount of RMB 3,000 and RMB 145,000 (US $18,000) under the service agreement for the fiscal years ended March 31, 2005 and 2006 respectively. The service agreement expired, and we discontinued providing these services on December 31, 2005.

Transactions with Beijing Weixiao

In February 2004, we signed a purchase agreement with Beijing Weixiao, our affiliate company that is controlled by Mr. Xiaodong Wu, the chairman of our board of directors and our chief executive officer, for the purchase of a building to be used as our office, manufacturing facilities and research and development center for RMB64.8 million. A prepayment of RMB60.0 million was made to Beijing Weixiao in March 2003 and the remaining RMB4.8 million was paid in April 2004.

In August 2004, we acquired the ECLIA technology from Beijing Weixiao. Under the acquisition agreement, we agreed to pay Beijing Weixiao a total purchase price of RMB250.0 million before September 30, 2005 for the ECLIA technology, related inventories and a noncompete commitment. We made payments of RMB80.0 million, RMB12.0 million, RMB8.0 million, RMB50.0 million and RMB100.0 million in September 2004, December 2004, February 2005, March 2005 and September 2005, respectively.

Transactions with Chengxuan

Chengxuan International Ltd., or Chengxuan, is one of our shareholders and controlled by Mr. Xiaodong Wu. Chengxuan paid RMB2.3 million in cash on our behalf during the fiscal year ended March 31, 2005 to settle expenses we incurred in connection with the preparation of our initial public offering and our operating activities. These amounts were unsecured, non-interest bearing and have no fixed terms of repayment and was repaid during the fiscal year ended March 31, 2006.

Secondary Offering

On March 22, 2006, we completed a secondary public offering of 57,500,000 shares held by certain existing shareholders. In this offering, the selling shareholders received all net proceeds from the sale of shares and all of the expenses, including underwriting discounts and commissions, related to this offering were shared by the selling shareholders. During the year ended March 31, 2006, we received RMB10.4 million (US$1.3 million) from the selling shareholders to pay the expenses on behalf of them and the amount was recorded in other payables. In March 2006, RMB802,000 (US$100,000) was paid and the outstanding balance of RMB9.6 million (US$1.2 million) was fully paid during the fiscal year ended March 31, 2007. Upon the completion of the secondary offering, we received RMB5.9 million (US$0.7 million) from certain selling shareholders for our arrangement of the secondary offering.

Shareholder’s Agreement

In connection with the March 2003 private placement, YDME Beijing entered into a shareholders’ agreement with all of its nine shareholders. This agreement provided for certain matters relating to the management of YDME Beijing. Under this agreement, the board of directors of YDME Beijing would consist of nine directors. Each of Beijing Chengxuan, PUPH and Golden Meditech was entitled to designate two directors, and Beijing Boda Technology Investment and Development Co., Ltd. was entitled to designate one director. In addition, Beijing Chengxuan was entitled to nominate two independent directors, and a representative of GE was entitled to attend all board meetings in a non-voting capacity.

In May 2004, in connection with Beijing Chengxuan’s acquisition of ownership interests in YDME Beijing held by certain minority shareholders, the remaining shareholders of YDME Beijing, Beijing Chengxuan, Golden Meditech and GE, adopted a revised memorandum and articles of association, which superseded the March 2003 shareholders’ agreement. Under the revised memorandum and articles of association, which became effective as of June 2004, the board of directors of YDME Beijing would consist of three directors. Each of Beijing Chengxuan, Golden Meditech and GE was entitled to designate one director. As a result, Golden Meditech and

 

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GE, which held equity interests of 25% and 15%, respectively, in YDME Beijing, effectively had equal voting power to make significant decisions expected to be made in the ordinary course of YDME Beijing’s business operations. The shareholders believed that the delegation of the decision-making authority to the board was necessary to protect the interests of minority shareholders and to enhance corporate governance.

In January 2005, we and Chengxuan, Golden Meditech and GE entered into an equity transfer agreement by which YDME Beijing was restructured as our wholly owned subsidiary. In January 2005, we and Chengxuan, Golden Meditech and GE, entered into a shareholders’ agreement. In June 2005, we and these shareholders entered into a new shareholders’ agreement, which replaced the January 2005 shareholders’ agreement. Under the June 2005 shareholders’ agreement:

 

   

A representative of GE may attend all of our board meetings in a non-voting capacity.

 

   

GE and Golden Meditech and their respective affiliates will have complete access to, and full use of, the clinical data of our subsidiary, YDME Beijing, relating to clinical cases from hospitals, other medical institutions and medical professionals using our HIFU therapy system in connection with their business, provided that we have first obtained the necessary consent. Such clinical data include hospital survey information, medical records, test reports and imaging records before and after treatment using our HIFU therapy system.

 

   

If any of Chengxuan, Golden Meditech and GE is offered a business opportunity that is primarily based in China and that competes with our HIFU business, it will provide us with notice of its intention to pursue such business opportunity and use reasonable efforts to enable us to participate in such project if we express an interest in doing so.

 

   

We will provide GE with notice of our intention to undertake any HIFU-related project, including, among other things:

 

   

any project relating to any joint venture between us and InSightec;

 

   

any expansion of our existing HIFU production facilities; or

 

   

any development of new HIFU facilities anywhere in the world.

In addition, we will use reasonable efforts to enable GE to participate in such project if GE expresses an interest in doing so.

 

   

We have also granted GE a right of first refusal to act as the sole and exclusive distributor of our HIFU therapy system outside China. In the event that we sell or otherwise transfer all or substantially all of our assets or HIFU business, or as a result of a merger, we are no longer a surviving company, we will cause the transferee or the surviving company of the merger, as the case may be, to honor GE’s right of first refusal. We will also cause the transferee or the surviving company to continue purchasing the ultrasound imaging system from GE.

These rights and obligations may be terminated by written agreement among Chengxuan, Golden Meditech and GE. If any of Chengxuan’s, Golden Meditech’s or GE’s ownership interest in our company falls below 5% of our outstanding shares, calculated on a fully diluted basis, such shareholder will cease to be a party to the June 2005 shareholders’ agreement and will no longer have any rights or obligations under that agreement.

In 2006, both GE and Golden Meditech’s ownership interest in our company fell below 5% of our outstanding shares and ceased to be parties to the shareholders’ agreement.

Equity Incentive Plan

See Item 6.B., “—Stock Options.”

C.    Interests of Experts and Counsel

Not applicable.

 

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ITEM 8.    FINANCIAL INFORMATION

A.    Consolidated Statements and Other Financial Information

We have appended consolidated financial statements filed as part of this annual report.

Legal and Administrative Proceedings

Neither we nor any of our directors and executive officers are a party to any material legal or administrative proceedings, and we are not aware of threatened material legal or administrative proceedings against us. We may from time to time become a party to various legal or administrative proceedings arising in the ordinary course of our business.

Dividend Policy

Dividends of RMB39.2 million in respect of the calendar years 2001 and 2002 and of RMB28.2 million in respect of the calendar year 2003 were approved by our shareholders in February and March 2004, respectively, and were subsequently paid. Our board of directors has declared a cash dividend on its ordinary shares of US$0.04 per share, equivalent to US$0.40 per ADS based on the Company’s net income for the fiscal year 2006. The cash dividend will be paid on or around August 17, 2007 to shareholders of record as of July 18, 2007. We intend to pay annual cash dividends to our shareholders. Cash dividends, if any, will be at the discretion of our board of directors and will depend upon our future operations and earnings, capital requirements and surplus, general financial conditions, shareholder’ interests, contractual restrictions and other factors as our board of directors may deem relevant. We can pay dividends only out of profits or other distributable reserves.

We rely principally on dividends paid to us by our operating subsidiaries in China, for our cash requirements, including the funds necessary to pay dividends and other cash distributions to our shareholders, service any debt we may incur and pay our operating expenses. In China, the payment of dividends is subject to limitations. PRC regulations currently permit payment of dividends only out of accumulated profits as determined in accordance with PRC accounting standards and regulations. Under current PRC laws, regulations and accounting standards, our PRC operating subsidiaries are required to allocate at least 10% of their after-tax profits to their general reserves. Allocation to these reserves is not required after these reserves have reached 50% of the registered capital of these subsidiaries. In addition, at the discretion of its board of directors, these operating subsidiaries may allocate a portion of their after-tax profits to their enterprise expansion funds and staff welfare and bonus funds. Staff welfare and bonus funds may not be distributed to equity owners.

Our board of directors has complete discretion as to whether we will distribute dividends in the future. Even if our board of directors decides to distribute dividends, the form, frequency and amount of our dividends will depend upon our future operations and earnings, capital requirements and surplus, financial condition, contractual restrictions and other factors that our board of directors may deem relevant. Any dividend we declare will be paid to the holders of ADSs, subject to the terms of the deposit agreement and applicable laws, to the same extent as holders of our ordinary shares, less the fees and expenses payable under the deposit agreement. Any dividend we declare will be distributed by the depositary bank to the holders of our ADSs. Cash dividends on our ordinary shares, if any, will be paid in U.S. dollars. See “Description of American Depositary Shares.”

B.    Significant Changes

We have not experienced any significant changes since the date of our audited consolidated financial statements included in this annual report.

ITEM 9.    THE OFFER AND LISTING

A.    Offering and Listing Details

Our ADSs, each representing ten of our ordinary shares, were listed on the Nasdaq National Market on August 10, 2005 under the symbol “CMED” and are currently quoted on the Nasdaq Global Select Market. On March 27, 2006, we completed a follow-on offering of 5,750,000 ADSs, which were sold by certain of our selling shareholders.

 

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For the period from August 10, 2005 to March 31, 2006, the trading price of our ADSs ranged from US$14.95 to US$44.93 per ADS. For the period from April 1, 2006 to March 31, 2007, the trading price of our ADSs ranged from US$18.30 to US$30.92 per ADS. For the period from April 1, 2007 to September 27, 2007, the trading price of our ADSs ranged from US$22.81 to US$42.94 per ADS.

The following table provides the high and low trading prices for our ADSs for (1) the year 2005 (from August 10, 2005) and the full year 2006, (2) the last quarter of 2005, each of the four quarters of 2006 and the first two quarters of 2007 and (3) each of the past six months.

 

    

Sales Price

    

High

  

Low

Annual High and Low

     

2005 (from August 10)

  

US$42.60

  

US$14.95

2006

  

US$44.93

  

US$18.30

Quarterly High and Low

     

Fourth Quarter 2005

  

US$42.60

  

US$18.69

First Quarter 2006

  

US$44.93

  

US$25.56

Second Quarter 2006

  

US$30.92

  

US$18.30

Third Quarter 2006

  

US$24.73

  

US$18.30

Fourth Quarter 2006

  

US$29.00

  

US$22.21

First Quarter 2007

  

US$27.40

  

US$21.65

Second Quarter 2007

  

US$33.78

  

US$22.81

Monthly Highs and Lows

     

March 2007

  

US$24.80

  

US$21.65

April 2007

  

US$25.07

  

US$22.96

May 2007

  

US$25.45

  

US$22.81

June 2007

  

US$33.78

  

US$23.99

July 2007

  

US$37.55

  

US$30.07

August 2007

  

US$35.49

  

US$27.35

September 2007 (through September 27)

  

US$42.94

  

US$33.02

B.    Plan of Distribution

Not applicable.

C.    Markets

Our ADSs, each representing ten of our ordinary shares, were listed on the Nasdaq National Market on August 10, 2005 under the symbol “CMED” and are currently quoted on the Nasdaq Global Select Market.

D.    Selling Shareholders

Not applicable.

 

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E.    Dilution

Not applicable.

F.    Expenses of the Issue

Not applicable.

ITEM 10. ADDITIONAL INFORMATION

A.    Share Capital

As of the date of this annual report on Form 20-F, our authorized capital consists of 500,000,000 ordinary shares, par value of US$0.10 each and 273,600,001 ordinary shares issued and outstanding.

Our predecessor and directly wholly owned subsidiary YDME Beijing was co-founded in July 1999 by Beijing Chengxuan (with 70% equity interest) and PUPH (with 30% equity interest). In November 2000, Beijing Chengxuan purchased 20% of PUPH’s ownership interest in YDME Beijing for RMB10 million and subsequently sold 32% of its ownership interests in YDME Beijing to five additional investors for RMB24.7 million. In March 2003, through a private placement, YDME Beijing issued 16,775,000 and 10,065,000 ordinary shares to Golden Meditech and GE, for 25% and 15% ownership interests, respectively, in YDME Beijing. In June 2004, Beijing Chengxuan acquired 25.2% ownership interests of YDME Beijing from PUPH and the group of five investors for RMB42.1 million (US$5.2 million), after which the ownership interests of Beijing Chengxuan, Golden Meditech and GE in YDME Beijing became 60%, 25% and 15%, respectively. In June 2004, Chengxuan acquired all of Beijing Chengxuan’s ownership interests in YDME Beijing for US$8.5 million. In November 2004, GE purchased 4.99% ownership interests of YDME Beijing from Chengxuan for US$1.1 million, after which the ownership interests of Chengxuan, Golden Meditech and GE in YDME Beijing became 55.01%, 25% and 19.99%, respectively. We created a holding company structure by incorporating China Medical Technologies, Inc. in the Cayman Islands in July 2004. In January 2005, through a corporate reorganization, YDME Beijing became our wholly owned subsidiary. As part of this corporate reorganization, Chengxuan, GE and Golden Meditech subscribed for 110,020,000, 39,980,000 and 50,000,000 of our ordinary shares, respectively, in exchange for their respective outstanding ownership interests in YDME Beijing.

In connection with its purchase of Beijing Chengxuan’s ownership interests in YDME Beijing, in July 2004, Chengxuan issued to Green Wall a US$8.5 million exchangeable note with an annual interest rate of 10%. The term of the note was one year, and the holder of the note had the right, at any time, to exchange the note for the ordinary shares in our company representing 10% ownership interests of YDME Beijing. In February 2005, Green Wall resold 30% of the exchangeable note to Asset Managers for US$5.0 million and 50% of the exchangeable note to Neon Liberty for US$8.5 million. The note was automatically exchanged into 20,000,000 of our ordinary shares held by Chengxuan upon completion of our initial public offering. As a result, upon completion of our initial public offering, Green Wall, Asset Managers and Neon Liberty held 4,000,001, 6,000,000 and 9,999,999 shares of our ordinary shares, respectively, some of which they are selling in this offering.

In February 2005, we adopted our 2005 stock option plan and reserved 30,000,000 ordinary shares for issuance under our 2005 stock option plan. We have granted options to four of our directors. As of December 31, 2005, options to purchase an aggregate of 800,000 ordinary shares of our company were outstanding. See “Management—Stock options.”

On August 15, 2005, we completed our initial public offering, which involved the sale by us of 6,400,000 of our ADSs, representing 64,000,000 of our ordinary shares at an initial public offering price of US$15.00 per ADS. On August 29, 2005, we sold an additional 960,000 ADSs representing 9,600,000 ordinary shares at the initial public offering price pursuant to the underwriter’s exercise of its over-allotment option.

 

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On November 21, 2006, we closed our public offering of US$150 million principal amount of 3.5% Convertible Senior Subordinated Notes due 2011 to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933, as amended (the “Securities Act”). The aggregate principal amount of notes sold reflects the exercise in full by the initial purchaser of its option to purchase up to an additional US$25 million aggregate principal amount of the notes to cover over-allotments. Concurrently with the offering of convertible notes, we entered into a prepaid forward repurchase contract with an affiliate of Merrill Lynch & Co. Pursuant to the forward repurchase contract, we repurchased contemporaneously with the sales of the convertible notes, an aggregate of US$30 million of ADSs, equivalent to 1,163,392 ADS at US$25.78 per ADS.

B.    Memorandum and Articles of Association

We incorporate by reference into this annual report the description of our amended and restated memorandum of association contained in our F-1 registration statement (File No. 333-132214), as amended, initially filed with the Commission on July 15, 2005. Our shareholders adopted our amended and restated memorandum and articles of association by unanimous resolutions in June 2004.

C.    Material Contracts

We have not entered into any material contracts other than in the ordinary course of business and other than those described in “Item 4. Information on the Company” or elsewhere in this annual report on Form 20-F.

D.    Exchange Controls

Foreign Currency Exchange

Foreign currency exchange regulation in China is primarily governed by the following rules:

 

   

Foreign Currency Administration Rules (1996), as amended, or the Exchange Rules; and

 

   

Administration Rules of the Settlement, Sale and Payment of Foreign Exchange (1996), or the Administration Rules;

Under the Exchange Rules, the Renminbi is convertible for current account items, including the distribution of dividends, interest payments, trade and service-related foreign exchange transactions. Conversion of Renminbi for capital account items, such as direct investment, loan, security investment and repatriation of investment, however, is still subject to the approval of the PRC State Administration of Foreign Exchange, or SAFE.

Under the Administration Rules, foreign-invested enterprises may only buy, sell and/or remit foreign currencies at those banks authorized to conduct foreign exchange business after providing valid commercial documents and, in the case of capital account item transactions, obtaining approval from the SAFE. Capital investments by foreign-invested enterprises outside of China are also subject to limitations, which include approvals by the Ministry of Commerce, the SAFE and the State Reform and Development Commission.

E.    Taxation

Cayman Islands Taxation

The Cayman Islands currently levies no taxes on individuals or corporations based upon profits, income, gains or appreciation and there is no taxation in the nature of inheritance tax or estate duty. There are no other taxes likely to be material to us levied by the Government of the Cayman Islands except for stamp duties which may be applicable on instruments executed in, or brought within, the jurisdiction of the Cayman Islands. The Cayman Islands is not party to any double tax treaties. There are no exchange control regulations or currency restrictions in the Cayman Islands.

People’s Republic of China Taxation

Under the Income Tax Law for Enterprises with Foreign Investment and Foreign Enterprises currently in effect, any dividends payable to non-PRC investors are exempt from any PRC withholding tax.

 

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On March 16, 2007, the National People’s Congress promulgated the New CIT Law, which will take effect beginning January 1, 2008. Under the New CIT Law, enterprises established outside of China whose “de facto management bodies” are located in China are considered “resident enterprises,” and will generally be subject to the uniform 25% enterprise income tax rate as to their global income. The New CIT Law does not define the term “de facto management bodies” and it is currently unclear under what situations an enterprise’s “de facto management body” would be considered to be located in China.

Substantially all of our management is currently based in China, and may remain in China after the effectiveness of the New CIT Law. In addition, although the New CIT Law provides that dividend income between “qualified resident enterprises” is exempted income, it is unclear what is considered a “qualified resident enterprise” under the New CIT Law. Furthermore, unlike the Income Tax Law for Enterprises with Foreign Investment and Foreign Enterprise currently in effect, which specifically exempts withholding tax on any dividends payable to non-PRC investors, the New CIT Law provides that an income tax rate of 20% will normally be applicable to dividends payable to non-PRC investors which are derived from sources within China, although such income tax may be exempted or reduced by the State Counsel of the PRC. As we might be considered as a “resident enterprise” under the New CIT Law, it is unclear whether any dividends payable to non-PRC investors will be deemed to be derived from sources within China and be subject to income tax. If we are required under the New CIT Law to withhold income tax on dividends payable to our non-PRC shareholders and ADS holders, your investment in us may be materially and adversely affected.

United States Federal Income Taxation

The following discussion describes certain U.S. federal income tax consequences to U.S. Holders (defined below) under present law of an investment in the ADSs or ordinary shares. This summary applies only to U.S. Holders that hold the ADSs or ordinary shares as capital assets and that have the U.S. dollar as their functional currency. This discussion is based on the Internal Revenue Code of 1986, as amended (the “Code”) as in effect on the date of this annual report on Form 20-F and on U.S. Treasury regulations in effect or, in some cases, proposed, as of the date of this annual report on Form 20-F, as well as judicial and administrative interpretations thereof available on or before such date. All of the foregoing authorities are subject to change, which change could apply retroactively and could affect the tax consequences described below.

The following discussion does not address the tax consequences to any particular investor or to persons in special tax situations such as:

 

   

banks;

 

   

certain financial institutions;

 

   

insurance companies;

 

   

broker dealers;

 

   

U.S. expatriates;

 

   

traders that elect to mark to market;

 

   

tax-exempt entities;

 

   

persons liable for alternative minimum tax;

 

   

persons holding an ADS or ordinary share as part of a straddle, hedging, conversion or integrated transaction;

 

   

persons that actually or constructively own 10.0% or more of our voting stock; or

 

   

persons holding ADSs or ordinary shares through partnerships or other pass-through entities.

The discussion below of the U.S. federal income tax consequences to “U.S. Holders” will apply if you are a beneficial owner of ADSs or ordinary shares and you are, for U.S. federal income tax purposes,

 

   

an individual citizen or resident of the U.S.;

 

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a corporation (or other entity taxable as a corporation for U.S. federal income tax purposes) organized under the laws of the U.S., any State thereof or the District of Columbia;

 

   

an estate whose income is subject to U.S. federal income taxation regardless of its source; or

 

   

a trust that (1) is subject to the primary supervision of a court within the U.S. and the control of one or more U.S. persons or (2) has a valid election in effect under applicable U.S. Treasury regulations to be treated as a U.S. person.

If you are a partner in a partnership or other entity taxable as a partnership that holds ADSs or ordinary shares, your tax treatment generally will depend on your status and the activities of the partnership, and you should consult your tax advisors.

The discussion below assumes that the representations contained in the deposit agreement are true and that the obligations in the deposit agreement and any related agreement will be complied with in accordance with their terms. If you hold ADSs, you should be treated as the holder of the underlying ordinary shares represented by those ADSs for U.S. federal income tax purposes. Accordingly, deposits or withdrawals of ordinary shares for ADSs should not be subject to U.S. federal income tax.

The U.S. Treasury has expressed concerns that intermediaries in the chain of ownership between the holder of an ADS and the issuer of the security underlying the ADS may be taking actions that are inconsistent with the claiming, by U.S. Holders of ADSs, of foreign tax credits for U.S. federal income tax purposes. Such actions would also be inconsistent with the claiming of the reduced rate of tax applicable to dividends received by certain non-corporate U.S. Holders, as described below. Accordingly, the availability of the reduced tax rate for dividends received by certain non-corporate U.S. Holders could be affected by future actions that may be taken by the U.S. Treasury or intermediaries in the chain of ownership between the holder of an ADS and our company.

The discussion below does not contain a detailed description of all the U.S. federal income tax consequences to you in light of your particular circumstances and does not address the effects of any state, local or non-U.S. tax laws. If you are considering the purchase, ownership or disposition of our ADSs or ordinary shares, you should consult your own tax advisors concerning the U.S. federal income tax consequences to you in light of your particular situation as well as any consequences arising under the laws of any other taxing jurisdiction.

Taxation of Dividends and Other Distributions on the ADSs or Ordinary Shares

Subject to the passive foreign investment company rules discussed below, the gross amount of all our distributions to you with respect to the ADSs or ordinary shares generally will be included in your gross income as foreign source dividend income on the date of receipt by the depositary, in the case of ADSs, or by you, in the case of ordinary shares, but only to the extent that the distribution is paid out of our current or accumulated earnings and profits (as determined under U.S. federal income tax principles). The dividends will not be eligible for the dividends-received deduction allowed to corporations in respect of dividends received from other U.S. corporations.

With respect to non-corporate U.S. Holders, certain dividends received before January 1, 2011 from a qualified foreign corporation may be subject to reduced rates of taxation. A foreign corporation is treated as a qualified foreign corporation with respect to dividends paid by it on shares (or ADSs backed by such shares) that are readily tradable on an established securities market in the U.S. Under Internal Revenue Service authority, common or ordinary shares, or ADSs representing such shares, are considered to be readily tradable on an established securities market in the U.S. if they are listed on the Nasdaq Global Select Market, as our ADSs are. We do not believe, however, that dividends that we pay on ordinary shares that are not backed by ADSs currently meet the conditions to be taxed as qualified dividend income. There can be no assurance that our ADSs will be considered readily tradable on an established securities market in the U.S. in later years. A qualified foreign

 

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corporation also includes a foreign corporation that is eligible for the benefits of certain income tax treaties with the U.S. In the event that we are deemed to be a Chinese “resident company” under PRC tax law (see discussion under—“Taxation—People’s Republic of China Taxation”), we may be eligible for the benefits of the income tax treaty between the U.S. and the PRC, and if we are eligible for such benefits, dividends we pay on our shares, regardless of whether such shares are represented by ADSs, would be subject to the reduced rates of taxation. Non-corporate U.S. Holders that elect to treat the dividend income as “investment income” pursuant to Section 163(d)(4) of the Code will not be eligible for the reduced rates of taxation. In addition, the rate reduction will not apply to dividends if the recipient of a dividend is obligated to make related payments with respect to positions in substantially similar or related property. This disallowance applies even if the minimum holding period has been met. You should consult your tax advisors regarding the availability of the lower rate for dividends paid with respect to our ADSs or ordinary shares.

In the event that we are deemed to be a Chinese “resident company” under PRC tax law, you may be subject to PRC withholding taxes on dividends paid to you with respect to the ADSs or shares. In that case, however, you may be able to obtain a reduced rate of PRC withholding taxes under the treaty between the U.S. and the PRC if certain requirements are met. In addition, subject to certain conditions and limitations, PRC withholding taxes on dividends, if any, may be treated as foreign taxes eligible for credit against your U.S. federal income tax liability. The rules governing the foreign tax credit are complex. You are urged to consult your tax advisors regarding the availability of the foreign tax credit under your particular circumstances.

To the extent that the amount of any distribution exceeds our current and accumulated earnings and profits, it will be treated first as a tax-free return of your tax basis in your ADSs or ordinary shares, and to the extent the amount of the distribution exceeds your tax basis, the excess will be taxed as capital gain. We do not intend to calculate our earnings and profits under U.S. federal income tax principles. Therefore, a U.S. Holder should expect that a distribution will generally be treated as a dividend.

Taxation of Disposition of Shares

Subject to the passive foreign investment company rules discussed below, you will recognize taxable gain or loss on any sale, exchange or other taxable disposition of an ADS or ordinary share equal to the difference between the amount realized for the ADS or ordinary share and your tax basis in the ADS or ordinary share. The gain or loss generally will be capital gain or loss. If you are a non-corporate U.S. Holder, including an individual U.S. Holder, who has held the ADS or ordinary share for more than one year, you will be eligible for reduced tax rates. The deductibility of capital losses is subject to limitations. Any such gain or loss that you recognize will generally be treated as U.S. source income or loss for foreign tax credit limitation purposes. However, in the event that we are deemed to be a Chinese “resident company” under PRC tax law (see discussion under “Taxation—People’s Republic of China Taxation”), we may be eligible for the benefits of the income tax treaty between the U.S. and the PRC. Under that treaty, if any PRC tax were to be imposed on any gain from the disposition of the ADSs or shares, the gain would be treated as PRC-source income. You are urged to consult your tax advisors regarding the tax consequences if a foreign withholding tax is imposed on a disposition of ADSs or shares, including the availability of the foreign tax credit under your particular circumstances.

Passive Foreign Investment Company

A non-U.S. corporation is considered a passive foreign investment company (“PFIC”) for any taxable year if either

 

   

at least 75% of its gross income is passive income, or

 

   

at least 50% of the value of its assets (based on an average of the quarterly values of the assets during a taxable year) is attributable to assets that produce or are held for the production of passive income.

For this purpose, cash is a passive asset and passive income generally includes dividends, interest, royalties and rents (other than royalties and rents derived in the active conduct of a trade or business and not derived from

 

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a related person). We will be treated as owning our proportionate share of the assets and earning our proportionate share of the income of any other corporation in which we own, directly or indirectly, 25% or more (by value) of the stock.

Based on the composition of our income and valuation of our assets, including goodwill, we believe that we were not a PFIC for our taxable year ended March 31, 2007, and we do not expect to be a PFIC for our current taxable year for U.S. federal income tax purposes. We must make a separate determination each year as to whether we are a PFIC. As a result, our PFIC status may change. In particular, our PFIC status may be determined in large part based on the market price of our ADSs and ordinary shares, which is likely to fluctuate (and may fluctuate considerably given that market prices of technology companies have been especially volatile). Accordingly, fluctuations in the market price of the ADSs and ordinary shares may result in our being a PFIC for any year. Thus, there can be no assurance that we will not be considered a PFIC for our current taxable year or any future taxable year. If we are a PFIC for any year during which you hold ADSs or ordinary shares, we generally will continue to be treated as a PFIC for all succeeding years during which you hold ADSs or ordinary shares.

If we are a PFIC for any taxable year during which you hold ADSs or ordinary shares, you will be subject to special tax rules with respect to any “excess distribution” that you receive and any gain you realize from a sale or other disposition (including a pledge) of the ADSs or ordinary shares, unless you make a “mark-to-market” election as discussed below. Distributions you receive in a taxable year that are greater than 125% of the average annual distributions you received during the shorter of the three preceding taxable years or your holding period for the ADSs or ordinary shares will be treated as excess distributions. Under these special tax rules: the excess distribution or gain will be allocated ratably over your holding period for the ADSs or ordinary shares, the amount allocated to the current taxable year, and any taxable year prior to the first taxable year in which we became a PFIC, will be treated as ordinary income, and the amount allocated to each other year will be subject to the highest tax rate in effect for that year and the interest charge generally applicable to underpayments of tax will be imposed on the resulting tax attributable to each such year. In addition, non-corporate U.S. Holders will not be eligible for reduced rates of taxation on any dividends received from us prior to January 1, 2011, if we are a PFIC in the taxable year in which such dividends are paid or in the preceding taxable year.

The tax liability for amounts allocated to years prior to the year of disposition or “excess distribution” cannot be offset by any net operating losses for such years, and gains (but not losses) realized on the sale of the ADSs or ordinary shares cannot be treated as capital, even if you hold the ADSs or ordinary shares as capital assets.

Alternatively, a U.S. Holder of “marketable stock” (as defined below) in a PFIC may make a mark-to-market election for such stock of a PFIC to elect out of the tax treatment discussed in the two preceding paragraphs. If you make a mark-to-market election for the ADSs or ordinary shares, you will include in income each year an amount equal to the excess, if any, of the fair market value of the ADSs or ordinary shares as of the close of your taxable year over your adjusted basis in such ADSs or ordinary shares. You are allowed a deduction for the excess, if any, of the adjusted basis of the ADSs or ordinary shares over their fair market value as of the close of the taxable year. However, deductions are allowable only to the extent of any net mark-to-market gains on the ADSs or ordinary shares included in your income for prior taxable years. Amounts included in your income under a mark-to-market election, as well as gain on the actual sale or other disposition of the ADSs or ordinary shares, are treated as ordinary income. Ordinary loss treatment also applies to the deductible portion of any mark-to-market loss on the ADSs or ordinary shares, as well as to any loss realized on the actual sale or disposition of the ADSs or ordinary shares, to the extent that the amount of such loss does not exceed the net mark-to-market gains previously included for such ADSs or ordinary shares. Your basis in the ADSs or ordinary shares will be adjusted to reflect any such income or loss amounts.

The mark-to-market election is available only for “marketable stock,” which is stock that is traded in other than de minimus quantities on at least 15 days during each calendar quarter on a qualified exchange, including the Nasdaq Global Select Market, or other market, as defined in applicable U.S. Treasury regulations. The ADSs are

 

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listed on the Nasdaq Global Select Market and, consequently, if you are a holder of ADSs the mark-to-market election would be available to you were we to be or become a PFIC, provided the ADSs were traded in sufficient quantities. If you make a mark-to-market election it will be effective for the taxable year for which the election is made and all subsequent taxable years unless the ADSs no longer qualify as “marketable stock” or the Internal Revenue Service consents to the revocation of the election.

Alternatively, you can sometimes avoid the rules described above by electing to treat us as a “qualified electing fund” under Section 1295 of the Code. However, this option is not available to you because we do not intend to comply with the requirements necessary to permit you to make this election.

If you hold ADSs or ordinary shares in any year in which we are a PFIC, you will be required to file Internal Revenue Service Form 8621 regarding distributions received on the ADSs or ordinary shares and any gain realized on the disposition of the ADSs or ordinary shares. You are urged to consult your tax advisor regarding the application of the PFIC rules to your investment in ADSs or ordinary shares.

Information Reporting and Backup Withholding

Dividend payments with respect to ADSs or ordinary shares and proceeds from the sale, exchange or redemption of ADSs or ordinary shares may be subject to information reporting to the Internal Revenue Service and possible U.S. backup withholding at a current rate of 28%. Backup withholding will not apply, however, to a U.S. Holder who furnishes a correct taxpayer identification number and makes any other required certification or who is otherwise exempt from backup withholding. U.S. Holders who are required to establish their exempt status generally must provide such certification on Internal Revenue Service Form W-9. U.S. Holders should consult their tax advisors regarding the application of the U.S. information reporting and backup withholding rules.

Backup withholding is not an additional tax. Amounts withheld as backup withholding may be credited against your U.S. federal income tax liability, and you may obtain a refund of any excess amounts withheld under the backup withholding rules by filing the appropriate claim for refund with the Internal Revenue Service and furnishing any required information.

 

F. Dividends and Paying Agents

Not applicable.

 

G. Statement by Experts

Not applicable.

 

H. Documents on Display

We have previously filed with the Commission our registration statement on Form F-1, as amended.

We are subject to the periodic reporting and other informational requirements of the Securities Exchange Act of 1934, as amended, or the Exchange Act. Under the Exchange Act, we are required to file reports and other information with the Securities and Exchange Commission. Specifically, we are required to file annually a Form 20-F no later than six months after the close of each fiscal year, which is September 30. Copies of reports and other information, when so filed, may be inspected without charge and may be obtained at prescribed rates at the public reference facilities maintained by the Securities and Exchange Commission at 100 F. Street, N.E., Washington, D.C. 20549, and at the regional office of the Securities and Exchange Commission located at Citicorp Center, 500 West Madison Street, Suite 1400, Chicago, Illinois 60661. The public may obtain information regarding the Washington, D.C. Public Reference Room by calling the Commission at 1-800-SEC-0330. The SEC also maintains a Web site at www.sec.gov that contains reports, proxy and information statements, and other information regarding registrants

 

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that make electronic filings with the SEC using its EDGAR system. As a foreign private issuer, we are exempt from the rules under the Exchange Act prescribing the furnishing and content of quarterly reports and proxy statements, and officers, directors and principal shareholders are exempt from the reporting and short-swing profit recovery provisions contained in Section 16 of the Exchange Act.

Our financial statements have been prepared in accordance with U.S. GAAP.

We will furnish our shareholders with annual reports, which will include a review of operations and annual audited consolidated financial statements prepared in conformity with U.S. GAAP.

 

I. Subsidiary Information

For a listing of our subsidiaries, see Item 4. C. of this annual report, “Information on the Company—Organizational Structure”.

ITEM 11.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Foreign Exchange Risk

Our revenues, costs and expenses are currently denominated entirely in Renminbi, but the Renminbi prices of some of the materials and supplies for reagent kits that are imported from companies in the United States, Finland and Sweden may be affected by fluctuations in the value of Renminbi against the currencies of those countries. We do not believe that we currently have any significant direct foreign currency exchange rate risk and have not hedged exposures denominated in foreign currencies or any other derivative financial instruments. Although our revenues and cost of revenues are denominated in Renminbi, fluctuations in the value of the Renminbi may affect the price competitiveness of our products once we commence international sales of our HIFU therapy system. On July 21, 2005, the PRC government changed its policy of pegging the value of the Renminbi to the U.S. dollar. Under the new policy, the Renminbi will be permitted to fluctuate within a band against a basket of certain foreign currencies. This change in policy resulted initially in an approximately 2.0% appreciation in the value of the Renminbi against the U.S. dollar. Since the adoption of this new policy, the value of Renminbi against the U.S. dollar has fluctuated on a daily basis within narrow ranges but overall has further strengthened against the U.S. dollar. There remains significant international pressure on the PRC government to further liberalize its currency policy, which could result in a further and more significant appreciation in the value of the Renminbi against the U.S. dollar. Furthermore, a decline in the value of Renminbi against the U.S. dollar could reduce the U.S. dollar equivalent amounts of our financial results, the value of your investment in our company and the dividends we may pay in the future, if any, all of which may have a material adverse effect on the prices of our ADSs.

Interest Rate Risk

Our risk exposure from changes in interest rates relates primarily to the interest expenses associated with our historical bank borrowings as well as the interest income generated by excess cash invested in demand and time deposits. We have not historically used, and do not expect to use in the future, any derivative financial instruments to manage our interest risk exposure. Interest-earning instruments and borrowings carry a degree of interest rate risk. We have not been exposed nor do we anticipate being exposed to material risks due to changes in interest rates.

ITEM 12.    DESCRIPTION OF SECURITIES OTHER THAN EQUITY SECURITIES

Not Applicable.

 

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PART II

ITEM 13.    DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES

None of these events occurred in any of the years ended March 31, 2005, 2006 and 2007.

ITEM 14.    MATERIAL MODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS AND USE OF PROCEEDS

See “Item 10. Additional Information” for a description of the rights of securities holders, which remain unchanged.

We completed our initial public offering of 64,000,000 ordinary shares, in the form of ADSs, at US$15.00 per ADS on August 15, 2005, after our ordinary shares and American Depositary Receipts were registered under the Securities Act. The aggregate price of the offering amount sold was US$110.4 million, of which we received net proceeds of US$99.5 million. The effective date of our registration statement on Form F-1 (File number: 333-132214) was August 9, 2005. UBS Investment Bank was the sole underwriter/book runner for the global offering of our ADSs.

We have used the net proceeds received from our initial public offering as follows:

 

   

approximately US$12.0 million has been used for the remaining payments relating to our acquisition of the ECLIA technology to Beijing Weixiao Biological Technology Development Co., Ltd., or Beijing Weixiao, a company controlled by Mr. Xiaodong Wu, our chairman of board of directors, our chief executive officer and a significant shareholder of our company;

 

   

approximately US$5.2 million has been used to fund our research and development of new applications and product design improvements for our HIFU therapy system and our ECLIA system;

 

   

approximately US$5.9 million has been used to purchase additional production equipment and renovate and expand our ECLIA reagent production facility; and

 

   

approximately US$1.2 million has been used to increase our sales and marketing efforts.

As of March 31, 2007, our cash resources amounted to RMB1,173.6 million (US$152.0 million), comprising of cash on hand and demand deposits.

ITEM 15.    CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

As of the end of the period covered by this annual report, an evaluation has been carried out under the supervision and with the participation of our management, including our chief executive officer and our chief financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures, as such term is defined under Rules 13a-14(c) and 15d-14(c) promulgated under the Securities Exchange Act of 1934, as amended. Based on that evaluation, our chief executive officer and chief financial officer have concluded that our disclosure controls and procedures are effective in ensuring that material information required to be disclosed in this annual report is recorded, processed, summarized and reported to them for assessment, and required disclosure is made within the time period specified in the rules and forms of the Securities and Exchange Commission.

Management’s Annual Report on Internal Control Over Financial Reporting.

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) under the Securities Exchange Act of 1934, as amended, for our company. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of consolidated financial statements in

 

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accordance with generally accepted accounting principles and includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of a company’s assets, (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of consolidated financial statements in accordance with generally accepted accounting principles, and that a company’s receipts and expenditures are being made only in accordance with authorizations of a company’s management and directors, and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of a company’s assets that could have a material effect on the consolidated financial statements.

Because of its inherent limitations, a system of internal control over financial reporting can provide only reasonable assurance with respect to consolidated financial statement preparation and presentation and may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

As required by Section 404 of the Sarbanes-Oxley Act of 2002 and related rules as promulgated by the Securities and Exchange Commission, management assessed the effectiveness of the our internal control over financial reporting as of March 31, 2007 using criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

Based on this assessment, management concluded that the our internal control over financial reporting was effective as of March 31, 2007 based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

Changes in Internal Controls

No significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of the evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses, were made as a result of the evaluation.

ITEM 16A.    AUDIT COMMITTEE FINANCIAL EXPERT

Our Board of Directors has determined that Mr. Iain Ferguson Bruce qualify as “audit committee financial expert” as defined in Item 16A of Form 20-F. Each of the members of the Audit Committee is an “independent director” as defined in the Nasdaq Marketplace Rules.

ITEM 16B.    CODE OF ETHICS

Our board of directors has adopted a code of ethics that applies to our directors, officers, employees and agents, including certain provisions that specifically apply to our chief executive officer, chief financial officer, chief operating officer, chief technology officer, vice presidents and any other persons who perform similar functions for us. We have filed our code of business conduct and ethics as an exhibit to this annual report on Form 20-F. We hereby undertake to provide to any person without charge, a copy of our code of business conduct and ethics within ten working days after we receive such person’s written request.

 

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ITEM 16C.    PRINCIPAL ACCOUNTANT FEES AND SERVICES

The following table sets forth the aggregate fees by categories specified below in connection with certain professional services rendered by KPMG, our principal external auditors, for the periods indicated. We did not pay any other fees to our auditors during the periods indicated below.

 

     For the Year Ended March 31,
         2005            2006            2007    
     US$    US$    US$
     (In thousands)

Audit fees(1)

   423    167    235

Audit-related fees(2)

   —      200    178

Tax Fees(3)

   —      —      —  

(1) “Audit fees” represent the aggregate fees billed for professional services rendered by our principal auditors for the audit of our annual financial statements for each of the three years ended March 31, 2005, in connection with our initial public offering and in August 2005 and audit of our historical financial statements for each of the three years ended March 31, 2007.
(2) “Audit-related fees” represent the aggregate fees billed by our principal auditors for services rendered that are reasonably related to the performance of the audit or review of our financial statements and are not reported under “Audit Fees”. The fees for the fiscal year ended March 31, 2007 relate primarily to providing review of the interim financial statements in connection with our offering of convertible notes in November 2006. The fees for the fiscal year ended March 31, 2006 relate primarily to providing review of the comparative interim financial statements for the nine months ended December 31, 2005 in connection with our secondary offering of shares held by certain existing shareholders in March 2006.
(3) “Tax fees” include fees billed for tax consultations.

The policy of our audit committee is to pre-approve all audit and non-audit services provided by KPMG, including audit services, audit-related services, tax services and other services as described above, other than those for de minimus services which are approved by the Audit Committee prior to the completion of the audit.

ITEM 16D.    EXEMPTIONS FROM THE LISTING STANDARDS FOR AUDIT COMMITTEES

Not applicable.

ITEM 16E.    PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PURCHASERS.

None.

 

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PART III

ITEM 17.    FINANCIAL STATEMENTS

We have elected to provide financial statements pursuant to Item 18.

ITEM 18.    FINANCIAL STATEMENTS

The following financial statements are filed as part of this Annual Report on Form 20-F, together with the report of the independent auditors:

INDEX TO THE FINANCIAL STATEMENTS

 

      Page

Report of Independent Registered Public Accounting Firm

   F-1

Consolidated Balance Sheets as of March 31, 2006 and 2007

   F-2

Consolidated Statements of Income and Comprehensive Income for the years ended March 31, 2005, 2006 and 2007

   F-3

Consolidated Statements of Shareholders’ Equity for the years ended March 31, 2005, 2006 and 2007

   F-4

Consolidated Statements of Cash Flows for the years ended March 31, 2005, 2006 and 2007

   F-5

Notes to the Consolidated Financial Statements

   F-6

ITEM 19.    EXHIBITS

 

Exhibit
Number
  

Description of Document

1.1*    Amended and Restated Memorandum and Articles of Association of China Medical Technologies Inc., as currently in effect
1.2†    Form of Second Amended and Restated Memorandum and Articles of Association of China Medical Technologies Inc.
2.1*    Specimen Certificate for Ordinary Shares of China Medical Technologies Inc.
2.2*    Specimen American Depositary Receipt of China Medical Technologies Inc.
2.3†    Form of Deposit Agreement among China Medical Technologies Inc., the depositary and holders and beneficial owners of the American Depositary Shares issued thereunder
4.1†    Stock Subscription and Purchase Agreement, dated as of September 23, 2002, among GE (China) Co., Ltd., Golden Meditech (BVI) Company Limited, Beijing Chengxuan Economic and Trade Co., Ltd., Beijing Boda Technology Investment and Development Co., Ltd., Beijing University People’s Hospital, Bi Xiaoqiong, He Shenxu, Bengbu Wanrong Equity Investment Advisory Co., Ltd., Beijing Dongfang Chuanzhi Science and Technology Development Co., Ltd. and Beijing Yuande Bio-Medical Engineering Co., Ltd.
4.2†    Share Subscription Agreement, dated as of January 19, 2005, among China Medical Technologies, Inc., Chengxuan International Ltd., General Electric International Operations Company, Inc. and Golden Meditech (BVI) Company Limited
4.3†    Registration Rights Agreement, dated as of January 19, 2005, among the Registrant and other parties therein
4.4†    Shareholders’ Agreement, dated as of March 19, 2003, among GE (China) Co., Ltd., Golden Meditech (BVI) Company Limited, Beijing Chengxuan Economic and Trade Co., Ltd., Beijing Boda Technology Investment and Development co., Ltd., Beijing University People’s Hospital, Bi Xiaoqiong, He Shenxu, Bengbu Wanrong Equity Investment Advisory Co., Ltd., Beijing Dongfang Chuanzhi Science and Technology Development Co., Ltd. and Beijing Yuande Biological and Engineering Co., Ltd.

 

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Exhibit
Number
  

Description of Document

  4.5†    Acquisition Agreement regarding the ECLIA technology dated as of January 18, 2005 between Beijing Weixiao Biological Technology Development Co., Ltd. and Beijing Yuande Bio-Medical Engineering Co., Ltd.
  4.6†    2005 stock option plan adopted on February 2, 2005
  4.7†    Form of Indemnification Agreement with the Registrant’s directors
  4.8†    Form of Employment Agreement between the Registrant and a Senior Executive Officer of the Registrant
  4.9††    Business Acquisition Agreement, dated as of February 6, 2007, among the Registrant, CMED Technologies Ltd., Supreme Well Investments Limited and Molecular Diagnostic Technologies Limited
  8.1*    List of Subsidiaries
12.1††    CEO Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
12.2††    CFO Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
13.1††    CEO Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
13.2††    CFO Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
15.1††    Consent of KPMG, Independent Registered Public Accounting Firm

* Previously filed with the Registrant’s registration statement on Form F-1 (File No. 333-132214).
Previously filed with the Registrant’s registration statement on Form F-1 (File No. 333-126630).
†† Filed with this Annual Report on Form 20-F.

 

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SIGNATURE

The registrant hereby certifies that it meets all of the requirements for filing its annual report on Form 20-F and that it has duly caused and authorized the undersigned to sign this annual report on its behalf.

 

CHINA MEDICAL TECHNOLOGIES, INC.

By

 

/S/    XIAODONG WU        

Name:   Mr. Xiaodong Wu
Title:   Chief Executive Officer

Date: September 28, 2007


Table of Contents

Report of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders of

China Medical Technologies, Inc.:

We have audited the accompanying consolidated balance sheets of China Medical Technologies, Inc. and its subsidiaries as of March 31, 2006 and 2007, and the related consolidated statements of income and comprehensive income, shareholders’ equity and cash flows for each of the years in the three-year period ended March 31, 2007. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the 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. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes 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 consolidated financial statements referred to above present fairly, in all material respects, the financial position of China Medical Technologies, Inc. and its subsidiaries as of March 31, 2006 and 2007, and the results of their operations and their cash flows for each of the years in the three-year period ended March 31, 2007, in conformity with U.S. generally accepted accounting principles.

The accompanying consolidated financial statements as of and for the year ended March 31, 2007 have been translated into United States dollars solely for the convenience of the reader. We have audited the translation and, in our opinion, such financial statements expressed in Renminbi have been translated into United States dollars on the basis set forth in Note 2 to the consolidated financial statements.

As described in Notes 3(m) and 18 to the consolidated financial statements, effective April 1, 2006, the Company changed its method of accounting for employee share-based arrangements as required by Statement of Financial Accounting Standards No. 123 (Revised 2004), “Share-Based Payment”.

/S/    KPMG

Hong Kong, China

September 28, 2007

 

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CHINA MEDICAL TECHNOLOGIES, INC.

Consolidated Balance Sheets

As of March 31, 2006 and 2007

(RMB and US$ expressed in thousands, except share data)

 

     Note    2006     2007     2007  
        RMB     RMB     US$  

Assets

         

Current assets

         

Cash and cash equivalents

      843,791     1,173,640     151,963  

Trade accounts receivable

      155,751     201,778     26,126  

Prepayments and other receivables

      26,260     41,484     5,372  

Inventories

      10,380     27,991     3,624  
                     

Total current assets

      1,036,182     1,444,893     187,085  

Property, plant and equipment, net

      105,570     135,792     17,582  

Land use rights

      7,811     7,619     987  

Intangible assets, net

   6    224,744     1,565,362     202,683  

Convertible notes issuance costs

   8    —       38,020     4,923  

Deferred income taxes

   13    1,534     542     70  
                     

Total assets

      1,375,841     3,192,228     413,330  
                     

Liabilities

         

Current liabilities

         

Trade accounts payable

      33,833     47,847     6,195  

Accrued liabilities and other payables

   7    73,872     131,097     16,974  

Payables to Sellers related to acquisition

   6    —       154,464     20,000  

Deferred credit related to acquisition

   6    —       308,928     40,000  

Income taxes payable

      21,602     38,467     4,981  
                     

Total current liabilities

      129,307     680,803     88,150  

Convertible notes

   8    —       1,158,480     150,000  

Payable to Sellers related to acquisition

   6    —       67,206     8,702  
                     

Total liabilities

      129,307     1,906,489     246,852  
                     

Shareholders’ equity

         

Ordinary shares

         

Par value: US$0.10 (RMB0.82)

Authorized: 500,000,000 shares

Issued and outstanding: 273,600,001 shares

      225,125     225,125     29,149  

Additional paid-in capital

      739,936     504,795     65,361  

Unearned compensation

      (226 )   —       —    

Accumulated other comprehensive loss

      (5,737 )   (21,335 )   (2,762 )

Retained earnings

      287,436     577,154     74,730  
                     

Total shareholders’ equity

      1,246,534     1,285,739     166,478  
                     

Total liabilities and shareholders’ equity

      1,375,841     3,192,228     413,330  
                     

See accompanying notes to the consolidated financial statements.

 

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CHINA MEDICAL TECHNOLOGIES, INC.

Consolidated Statements of Income and Comprehensive Income

For the years ended March 31, 2005, 2006 and 2007

(RMB and US$ expressed in thousands, except share data)

 

     Note    2005     2006     2007     2007  
        RMB     RMB     RMB     US$  
           

Revenues, net(a)

   14    217,547     371,767     546,970       70,822  

Cost of revenues

      (64,579 )   (110,494 )   (151,614 )     (19,631 )
                             

Gross profit

      152,968     261,273     395,356       51,191  
                             

Operating expenses:

           

Research and development

      (2,815 )   (14,374 )   (31,469 )     (4,075 )

Sales and marketing

      (4,960 )   (15,327 )   (18,264 )     (2,365 )

General and administrative

      (16,644 )   (38,309 )   (55,352 )     (7,167 )
                             

Total operating expenses

      (24,419 )   (68,010 )   (105,085 )     (13,607 )
                             

Operating income

      128,549     193,263     290,271       37,584  

Other income(a)

   12    1,559     9,790     6,024       780  

Interest income

      194     14,048     41,970       5,434  

Interest expense (includes amortization of convertible notes issuance cost of RMB3,111 (US$403) in 2007)

      (5 )   —       (18,453 )     (2,389 )
                             

Income before tax

      130,297     217,101     319,812       41,409  

Income tax expense

   13    (11,854 )   (18,088 )   (30,094 )     (3,896 )
                             

Net income

      118,443     199,013     289,718       37,513  
                             

Other comprehensive loss:

           

Foreign currency translation adjustment, net of nil tax

      —       (5,737 )   (15,598 )     (2,020 )
                             

Comprehensive income

      118,443     193,276     274,120       35,493  
                             

Basic earnings per share

   11, 13    RMB 0.59     RMB 0.81     RMB 1.08     US$ 0.14  
                             

Diluted earnings per share

   11, 13    RMB 0.59     RMB 0.81     RMB 1.07     US$ 0.14  
                             

 

(a) Includes the following income resulting from transactions with related parties (see note 14):

 

     Note    2005    2006    2007    2007
        RMB    RMB    RMB    US$

Revenues, net

      4,145    3,932    —      —  

Other income

      3    145    —      —  

Arrangement fee income received from selling shareholders

      —      5,905    —      —  

See accompanying notes to the consolidated financial statements.

 

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CHINA MEDICAL TECHNOLOGIES, INC.

Consolidated Statements of Shareholders’ Equity

For the years ended March 31, 2005, 2006 and 2007

(RMB and US$ expressed in thousands, except share data)

 

     Note  

Share capital

(note 9(a))

  Registered
capital
    Additional
paid-in
capital
    Contribution
surplus
    Unearned
compensation
    Accumulated
other
comprehensive
loss
    General
reserve
    Retained
earnings
    Total
shareholders’
equity
 
       Number   RMB   RMB     RMB     RMB     RMB     RMB     RMB     RMB     RMB  

Balance as of April 1, 2004

     —     —     67,100     —       37,192     —       —       8,213     23,005     135,510  

Capital on incorporation

   9(a)   1   —     —       —       —       —       —       —       —       —    

Effect of reorganization

   9(a)   200,000,000   165,530   (67,100 )   —       (37,192 )   —       —       (8,213 )   (53,025 )   —    

Net income

     —     —     —       —       —       —       —       —       118,443     118,443  
                                                          

Balance as of March 31, 2005

     200,000,001   165,530   —       —       —       —       —       —       88,423     253,953  

Issue of new shares, net of expenses

   9(a)   73,600,000   59,595   —       739,472     —       —       —       —       —       799,067  

Unearned share-based compensation

   18   —     —     —       464     —       (464 )   —       —       —       —    

Amortization of share-based compensation

   18   —     —     —       —       —       238     —       —       —       238  

Net effect of foreign currency translation adjustment, net of nil tax

     —     —     —       —       —       —       (5,737 )   —       —       (5,737 )

Net income

     —     —     —       —       —       —       —       —       199,013     199,013  
                                                          

Balance as of March 31, 2006

     273,600,001   225,125   —       739,936     —       (226 )   (5,737 )   —       287,436     1,246,534  

Transfer to additional paid-in capital upon adoption of SFAS No. 123(R)

     —     —     —       (226 )   —       226     —       —       —       —    

Share-based compensation expense

     —     —     —       1,260     —       —       —       —       —       1,260  

Prepaid forward repurchase of shares

   9(e)   —     —     —       (236,175 )   —       —       —       —       —       (236,175 )

Net effect of foreign currency translation adjustment, net of nil tax

     —     —     —       —       —       —       (15,598 )   —       —       (15,598 )

Net income

     —     —     —       —       —       —       —       —       289,718     289,718  
                                                          

Balance as of March 31, 2007

     273,600,001   225,125   —       504,795     —       —       (21,335 )   —       577,154     1,285,739  
                                                          

Balance as of March 31, 2007 (US$)

     273,600,001   29,149   —       65,361     —       —       (2,762 )   —       74,730     166,478  
                                                          

See accompanying notes to the consolidated financial statements.

 

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CHINA MEDICAL TECHNOLOGIES, INC.

Consolidated Statements of Cash Flows

For the years ended March 31, 2005, 2006 and 2007

(RMB and US$ expressed in thousands)

 

    Note   2005     2006     2007     2007  
      RMB     RMB     RMB     US$  

Cash flow from operating activities

         

Net income

    118,443     199,013     289,718     37,513  

Adjustments to reconcile net income to net cash provided by operating activities:

         

Depreciation of property, plant and equipment

    3,379     3,782     8,484     1,098  

Amortization of intangible assets

    8,702     14,918     18,930     2,451  

Amortization of convertible notes issuance costs

    —       —       3,111     403  

Share-based compensation