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EX-4.12 - EMERALD DAIRY INCv171400_ex4-12.htm
EX-5.1 - EMERALD DAIRY INCv171400_ex5-1.htm
EX-23.1 - EMERALD DAIRY INCv171400_ex23-1.htm
EX-10.14 - EMERALD DAIRY INCv171400_ex10-14.htm

As filed with the Securities and Exchange Commission on January 14, 2010
(Registration No. 333-162432)

  
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
     

   
AMENDMENT NO. 2
TO
FORM S-1
REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933
   

   
EMERALD DAIRY INC.

(Exact name of registrant as specified in its charter)

Nevada
 
2020
 
80-0137632
(State or other jurisdiction of
incorporation or organization)
 
(primary standard industrial
classification code number)
 
(I.R.S. Employer
Indentification No.)

11990 Market Street, Suite 205
Reston, Virginia 20190
(703) 867-9247

(Address, including zip code, and telephone number, including area code of registrant’s principal executive offices)

Shu Kaneko
Chief Financial Officer
11990 Market Street, Suite 205
Reston, Virginia 20190
Tel: (703) 867-9247
Fax: (678) 868-0633

(Name, address, including zip code, and telephone number, including zip code, of agent for service)
  

   
Copies of all communications to:

Jeffrey A. Rinde, Esq.
Blank Rome LLP
The Chrysler Building
405 Lexington Ave.
New York, NY 10174
Tel: (212) 885-5000
Fax: (212) 885-5001
  

  
Approximate date of proposed sale to the public: From time to time after the effective date of this Registration Statement.
 
If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act, check the following box:  x
 
If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o
 
If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o
 
If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a small reporting company.  See the definition of “large accelerated filer,” “accelerated filer,” and “small reporting company”:
 
Large accelerated filer o
Accelerated filer o
   
Non-accelerated filer o (do not check if a smaller reporting company)
Smaller reporting company x
  

  
THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(A) OF THE SECURITIES ACT OF 1933 OR UNTIL THE REGISTRATION STATEMENT SHALL BECOME EFFECTIVE ON SUCH DATE AS THE COMMISSION, ACTING PURSUANT TO SAID SECTION 8(A), MAY DETERMINE.

 

 

PROSPECTUS
 
Subject to completion, dated January 14, 2010
 
EMERALD DAIRY INC.
 12,589,979 SHARES OF COMMON STOCK
 
This prospectus relates to disposition of up to 12,589,979 shares of our common stock held by the selling stockholders referred to in this prospectus.  The shares covered by this prospectus include:
 
·
6,969,810 outstanding shares held by the selling stockholders; and
 
·
5,620,169 shares issuable upon exercise of warrants held by the selling stockholders.
 
We will not receive any of the proceeds from the sale or other disposition of the shares of common stock covered by this prospectus. However, we will receive gross proceeds of $12,872,575 if all of the warrants held by the selling stockholders are exercised for cash.
 
Our common stock is traded in the over-the-counter market and prices are quoted on the over-the-counter electronic bulletin board under the symbol "EMDY.OB."  On January 13, 2010, the last reported sale price for our common stock was $1.70 per share.
 
The selling stockholders may, from time-to-time, sell, transfer or otherwise dispose of any or all of their shares of common stock on any exchange, market or trading facility on which shares are traded or in private transactions and in other ways described in the “Plan of Distribution”.  These dispositions may be at fixed prices, at the prevailing market price at the time of sale, at prices related to the prevailing market price, at varying prices determined at the time of sale, or at negotiated prices.
 


 
INVESTING IN OUR STOCK INVOLVES A HIGH DEGREE OF RISK.  SEE "RISK
FACTORS" BEGINNING ON PAGE 5.
  

  
NEITHER THE SECURITIES AND EXCHANGE COMMISSION NOR ANY STATE
SECURITIES COMMISSION HAS APPROVED OR DISAPPROVED OF THESE SECURITIES
OR DETERMINED IF THIS PROSPECTUS IS TRUTHFUL OR COMPLETE. ANY
REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.
  

   
The date of this prospectus is ____________, 2009

 

 

You should rely only on the information contained in this prospectus. We have not, and the selling stockholders have not, authorized anyone to provide you with different information. If anyone provides you with different information, you should not rely on it. We are not, and the selling stockholders are not, making an offer to sell these securities in any jurisdiction where the offer or sale is not permitted. You should assume that the information contained in this prospectus is accurate only as of the date on the front cover of this prospectus. Our business, financial condition, results of operations and prospects may have changed since that date.

TABLE OF CONTENTS
 
 
Page
Prospectus Summary
1
Our Company
1
Corporate Information
2
The Offering
3
Summary Historical Financial Information
4
Risk Factors
5
Forward Looking Statements
17
Use of Proceeds
18
Market for Our Common Stock
18
Capitalization
 
Management's Discussion and Analysis of Financial Condition and Results of Operations
21
Business
52
Legal Proceedings
65
Management
65
Executive Compensation
67
Security Ownership of Certain Beneficial Owners and Management
74
Certain Relationships and Related Transactions
75
Description of Securities
79
Selling Stockholders
90
Plan of Distribution
104
Legal Matters
106
Experts
106
Changes in and Disagreements with Accountants on Accounting and Financial Disclosures
106
Where You Can Find Additional Information
107
Financial Statements
F-1
 
 
i

 

PROSPECTUS SUMMARY
 
This summary highlights selected information contained elsewhere in this prospectus. To fully understand this offering, you should read the entire prospectus carefully, including the more detailed information regarding the Company, the risks of purchasing our common stock discussed under "risk factors," and our financial statements and the accompanying notes. In this prospectus, the “Company,” "we", "us" and "our", refer to Emerald Dairy Inc. and its subsidiaries, unless the context otherwise requires. Unless otherwise indicated, the term "year," "fiscal year" or "fiscal" refers to our fiscal year ending December 31st.  Except as specifically indicated otherwise, we have adjusted all references to our common stock in this prospectus to reflect the effect of a 1-for-40 reverse stock split on June 25, 2007.
 
Our Company
 
We are a producer of milk powder, rice powder and soybean milk powder, which currently comprise approximately 95%, 3% and 2% of our sales, respectively. We have an Infant & Baby Formula Milk Powder Production Permit, issued by the State General Administration of Quality Supervision and Inspection and Quarantine of the People’s Republic of China (“PRC”). Only current license holders are permitted to produce formula milk powder in the PRC.  Through our network of over 800 salespeople, our products are distributed throughout 20 provinces in the PRC, and sold in over 5,800 retail outlets.
 
Our products are marketed under two brand names:
 
 
·
“Xing An Ling,” which is designed for high-end customers; and
 
 
·
“Yi Bai,” which is designed for middle and low-end customers.
 
The Chinese government has initiated programs to promote milk consumption and is providing incentives to increase dairy production. The dairy market today in the PRC is over $13.0 billion and is expected to grow at a rate of 15% per year for the foreseeable future. We focus on the infant formula segment of the market, which is expected to grow even faster, at a rate of approximately 23% through 2011.  Currently, it is estimated that demand for infant formula in the PRC outstrips supply by at least 2-to-1.  During the past three fiscal years our sales have grown at an average rate of more than 50% per year, with sales of $44.3 million, $29.6 million and $18.8 million for the fiscal years ended December 31, 2008, 2007 and 2006, respectively.
 
Because of our close proximity to our sources of fresh milk, we are able to complete the production process in approximately 30 – 35 hours, which is faster than competitors of ours that are not similarly situated.  We produced approximately 7,000 tons of milk powder at our facility in Be’ian City, Heilongjiang Province, PRC in fiscal 2007, up from approximately 5,000 tons in fiscal 2006. In 2008, by adding a third shift to the existing two shifts working schedule, we produced approximately 9,000 tons of milk powder.  In addition, in July 2008, through our wholly-owned subsidiary, Hailun Xinganling Dairy Co., Ltd. (“HXD”), we commenced construction of a new production facility in Hailun City, Heilongjiang Province, PRC, which we expect will enable us to produce an additional 9,000 tons of milk powder in 2010 and a total of 18,000 tons of milk powder annually in 2011. As a result, we believe we will have the capacity to produce approximately 27,000 tons of milk powder per year by the end of fiscal 2011. It is expected that our production of rice powder and soymilk powder will also increase in volume, while continuing to comprise an aggregate of approximately 5% of our overall sales.
 
 
1

 

All of our business is conducted through our wholly-owned Chinese subsidiaries:
 
 
·
Heilongjiang Xing An Ling Dairy Co. Limited (“XAL”), which handles our promotion, sales and administrative functions;
 
 
·
Heilongjiang Be’ian Nongken Changxing Lvbao Dairy Limited Liability Company (“Lvbao”), which handles production of our products in Be’ian City, Heilongjiang Province, PRC; and
 
 
·
HXD, which, upon completion of our new production facility, will handle additional production of our products in Hailun City, Heilongjiang Province, PRC.
 
Corporate Information
 
Our predecessor filer was incorporated under the name Micro-Tech Identification Systems, Inc. (“Micro-Tech”) pursuant to the laws of the State of Nevada on September 24, 1986. For several years prior to the Reverse Merger (described below), Micro-Tech’s primary business operations involved seeking the acquisition of assets, property, or businesses that may be beneficial to Micro-Tech and its shareholders.
 
On October 9, 2007, American International Dairy Holding Co., Inc., a Nevada corporation (“AIDH”) became a wholly-owned subsidiary of Micro-Tech, when it merged with Micro-Tech’s wholly-owned subsidiary, which was organized for that purpose (the “Reverse Merger”). Immediately following the Reverse Merger, Micro-Tech succeeded to the business of AIDH as its sole line of business, and changed its name to Amnutria Dairy Inc.  On January 25, 2008, we changed our name from Amnutria Dairy Inc. to Emerald Dairy Inc.
 
AIDH was organized pursuant to the laws of the State of Nevada on April 18, 2005, for the purpose of acquiring the stock of Heilongjiang Xing An Ling Dairy, Co.  On May 30, 2005, AIDH acquired Heilongjiang Xing An Ling Dairy Co. Limited, (“XAL”), a corporation formed on September 8, 2003 in Heilongjiang Providence, PRC. This transaction was treated as a recapitalization of XAL for financial reporting purposes. The effect of this recapitalization was rolled back to the inception of XAL for financial reporting purposes.
 
Prior to September 23, 2006, XAL owned approximately 57.7% of Heilongjiang Beian Nongken Changxing LvbaoDairy Limited Liability Company (“LvBao”), with the remaining balance being held by AIDH’s sole shareholder. On September 23, 2006, the remaining 42.3% ownership in LvBoa was transferred to XAL and was treated as an additional capital contribution. The effect of this contribution by the sole shareholder was rolled back to September 8, 2003 for financial reporting purposes.
 
On May 22, 2008, we formed AIDH’s wholly-owned subsidiary, HXD, under the laws of the PRC.  Upon completion of our new production facility, HXD will handle additional production of our products in Hailun City, Heilongjiang Province, PRC
 
All of the business of AIDH is conducted through AIDH's wholly-owned subsidiaries, XAL and HXD, and XAL's subsidiary, LvBao.
 
Our U.S. offices are located at 11990 Market Street, Suite 205, Reston, Virginia 20190, telephone number (703) 867-9247.  Our corporate headquarters are located at 10 Huashan-lu, Xiangfang-qu, 9th Floor, Wanda Building, Harbin City, Heilongjiang Province, PRC 150001.
 
 
2

 

The Offering

Common Stock Offered by the Company
None
   
Common Stock Offered by the Selling Stockholders
Up to 12,589,979 shares of our common stock, including: (i) up to 6,969,810 shares of issued and outstanding common stock held by the selling stockholders, (ii) up to 373,334 shares issuable upon exercise of warrants held by the selling stockholders, at an exercise price of $0.94 per share, (iii) up to 1,333,333 shares issuable upon exercise of warrants held by the selling stockholders, at an exercise price of $1.50 per share, (iv) up to 700,583 shares issuable upon exercise of warrants held by the selling stockholders, at an exercise price of $1.63 per share, (v) up to 857,110 shares issuable upon exercise of warrants held by the selling stockholders, at an exercise price of $2.04 per share, (vi) up to 75,000 shares issuable upon exercise of warrants held by the selling stockholders, at an exercise price of $2.61 per share, and (vii) up to 2,280,809 shares issuable upon exercise of warrants held by the selling stockholders, at an exercise price of $3.26 per share.
   
Common Stock Outstanding Prior to this Offering
32,927,191 shares
   
Use of Proceeds
We will not receive any proceeds from the shares sold in this offering.
   
Symbol for our Common Stock
“EMDY.OB”

Risk Factors
 
We urge you to read the "Risk Factors" section beginning on page 5 of this prospectus so that you understand the risks associated with an investment in our common stock.

 
3

 

Summary Historical Financial Information
 
The following tables set forth our summary historical financial information. You should read this information together with the financial statements and the notes thereto appearing elsewhere in this prospectus and the information under "Management's Discussion and Analysis of Financial Condition and Results of Operations."
 
Consolidated Statements of Operations:
 
   
For the Nine Months
Ended September 30,
   
For the Fiscal Year
Ended December 31,
 
   
2009
   
2008
   
2008
   
2007
 
   
(Unaudited)
   
(Unaudited)
   
(Audited)
   
(Audited)
 
                         
Sales
  $ 31,261,491     $ 32,560,256     $ 44,325,179     $ 29,618,008  
Cost of Goods Sold
    17,057,583       19,845,232       26,546,291       19,064,905  
Gross Profit
    14,203,908       12,715,024       17,778,888       10,553,103  
Total Operating Expenses
    9,579,027       10,355,970       14,210,578       6,875,197  
Total Other (Expense)
    (63,466 )     (262,862 )     (413,605 )     (9,443 )
Provision for Income Taxes
    860,948       586,957       840,198       118,325  
Net Income
  $ 3,700,467     $ 1,509,235     $ 2,314,507     $ 3,550,138  
Basic Earnings Per Share
  $ 0.12     $ 0.05     $ 0.08     $ 0.15  
Basic Weighted Average Shares Outstanding
    29,979,356       29,299,332       29,299,332       24,211,872  
Diluted Earnings Per Share
  $ 0.12     $ 0.05     $ 0.08     $ 0.15  
Diluted Weighted Average Shares Outstanding
    30,429,024       29,563,708       29,518,067       24,271,991  
Comprehensive Income
  $ 3,690,611     $ 2,588,087     $ 3,481,375     $ 4,185,217  

Consolidated Balance Sheets:
 
   
As at September 30,
   
As at December 31,
 
   
2009
   
2008
   
2007
 
   
(Unaudited)
   
(Audited)
   
(Audited)
 
                   
Cash and cash equivalents
  $ 9,681,007     $ 7,343,588     $ 6,560,931  
Total current assets
  $ 22,297,720     $ 18,710,381     $ 16,594,937  
Property, plant and equipment, net
  $ 5,743,716     $ 6,101,566     $ 3,320,081  
Total assets
  $ 36,402,432     $ 28,674,375     $ 20,030,246  
Total current liabilities
  $ 7,577,525     $ 8,253,183     $ 3,480,666  
Put/Call Liability
              $ 3,169,444  
Total stockholders' equity
  $ 28,824,907     $ 20,421,192     $ 13,380,136  

 
4

 

RISK FACTORS
 
An investment in our common stock is speculative and involves a high degree of risk. You should carefully consider the following important risks and uncertainties before buying shares of our common stock in this offering. If any of the damages threatened by any of the following risk factors actually occur, our business, results of operations, financial condition and cash flows could be materially adversely affected, the trading price of our common stock could decline significantly, and you might lose all or part of your investment.
 
Risks Related to Our Business
 
Unstable market conditions may have serious adverse consequences on our business.
 
The recent worldwide economic downturn and market instability have made the business climate more volatile and more costly.  Although all of our business operations are currently conducted in the PRC, our general business strategy may be adversely affected by unpredictable and unstable market conditions.  If the current equity and credit markets deteriorate further, or do not improve, it may make any necessary debt or equity financing more difficult, more costly, and more dilutive. While we believe we have adequate capital resources to meet current working capital and capital expenditure requirements for the next twelve months, a radical economic downturn or increase in our expenses could require additional financing on less than attractive rates or on terms that are excessively dilutive to existing stockholders.  Failure to secure any necessary financing in a timely manner and on favorable terms could have a material adverse effect on our growth strategy, financial performance and stock price and could require us to delay or abandon our expansion plans.  These factors may have a material adverse effect on our results of operations, financial condition or cash flows and could cause the price of our common stock to decline significantly.
 
Our products may not achieve or maintain market acceptance.
 
We market our products in the PRC. Dairy product consumption in the PRC has historically been lower than in many other countries in the world.  Growing interest in milk products in the PRC is a relatively recent phenomenon which makes the market for our products less predictable.  Consumers may lose interest in the products.  As a result, achieving and maintaining market acceptance for our products will require substantial marketing efforts and the expenditure of significant funds to encourage dairy consumption in general, and the purchase of our products in particular.  There is substantial risk that the market may not accept or be receptive to our products.  Market acceptance of our current and proposed products will depend, in large part, upon our ability to inform potential customers that the distinctive characteristics of our products make them superior to competitive products and justify their pricing.  Our current and proposed products may not be accepted by consumers or able to compete effectively against other premium or non-premium dairy products.  Lack of market acceptance would limit our revenues and profitability.
 
In addition, we market our product, in part, as a healthy and good source of nutrition, however, periodically, medical and other studies are released and announcements by medical and other groups are made which raise concerns over the healthfulness of cow’s milk in the human diet.  An unfavorable study or medical finding could erode the popularity of milk in the Chinese diet and negatively affect the marketing of our product causing sales, and cause our revenues, to decline.

 
5

 

Contamination of milk powder products produced in the PRC could result in negative publicity and have a material adverse effect on our business.
 
In mid-2008, a number of milk powder products produced within the PRC were found to contain unsafe levels of tripolycyanamide, also known as melamine, sickening thousands of infants.  This prompted the Chinese government to conduct a nationwide investigation into how the milk powder was contaminated, and caused a worldwide recall of certain milk powder products produced within the PRC. On September 16, 2008, the PRC’s Administration of Quality Supervision, Inspection and Quarantine (AQSIQ) revealed that it had tested samples from 175 dairy manufacturers, and published a list of 22 companies whose products contained melamine.  We passed the emergency inspection and were not included on AQSIQ’s list.  Although we believe that the inevitable contraction in the Chinese milk powder industry caused by this crisis will lead to increased demand for our products, we can not be certain that the illnesses caused by contamination in the milk powder industry, whether or not related to our products, won’t lead to a sustained decrease in demand for milk powder products produced within the PRC, thereby having a material adverse effect on our business.
 
As we increase the scale of our operations, we may be unable to maintain the level of quality we currently attain by producing our products in small batches.  If quality of our product declines, sales may decline.
 
Our products are manufactured in small batches.  If we are able to increase our sales, we will be required to increase our production.  Increased production levels may force us to modify our current manufacturing methods in order to meet demand. We may be unable to maintain the quality of our dairy products at increased levels of production.  If quality declines, consumers may not wish to purchase our products and a decline in the quality of our products could damage our reputation, business, operations and finances.
 
We depend on supplies of raw milk and other raw materials, a shortage of which could result in reduced production and sales revenues and/or increased production costs.
 
Raw milk is the primary raw material we use to produce our products. As we pursue our growth strategy, we expect raw milk demands to continue to grow. Because we own only a small number of dairy cows, we depend on dairy farms and dairy farmers for our supply of fresh milk. We expect that we will need to continue to increase the number of dairy farmers from which we source raw milk. If we are not able to renew our contracts with suppliers or find new suppliers to provide raw milk we will not be able to meet our production goals and our sales revenues will fall.  If we are forced to expand our sources for raw milk, it may be more and more difficult for us to maintain our quality control over the handling of the product in our supply and manufacturing chain.  A decrease in the quality of our raw materials would cause a decrease in the quality of our product and could damage our reputation and cause sales to decrease.
 
Raw milk production is, in turn, influenced by a number of factors that are beyond our control including, but not limited to, the following:
 
 
·
seasonal factors: dairy cows generally produce more milk in temperate weather than in cold or hot weather and extended unseasonably cold or hot weather could lead to lower than expected production;
 
 
·
environmental factors: the volume and quality of milk produced by dairy cows is closely linked to the quality of the nourishment provided by the environment around them, and, therefore, if environmental factors cause the quality of nourishment to decline, milk production could decline and we may have difficulty finding sufficient raw milk; and
 
 
6

 

 
·
governmental agricultural and environmental policy: declines in government grants, subsidies, provision of land, technical assistance and other changes in agricultural and environmental policies may have a negative effect on the viability of individual dairy farms, and the numbers of dairy cows and quantities of milk they are able to produce.
 
We also source large volumes of soy beans, rice, and other raw materials from suppliers. Interruption of or a shortage in the supply of raw milk or any of our other raw materials could result in our being unable to operate our production facilities at full capacity or, if the shortage is severe, at any production level at all, thereby leading to reduced production output and sales and reduced revenues.
 
Even if we are able to source sufficient quantities of raw milk or our other raw materials to meet our needs, downturns in the supply of such raw materials caused by one or more of these factors could lead to increased raw material costs which we may not be able to pass on to the consumers of our products, causing our profit margins to decrease.
 
Volatility of raw milk costs make our operating results difficult to predict, and a steep cost increase could cause our profits to diminish significantly.
 
The policy of the PRC since the mid-1990s has focused on moving the industry in a more market-oriented direction. These reforms have resulted in the potential for greater price volatility relative to past periods, as prices are more responsive to the fundamental supply and demand aspects of the market. These changes in the PRC’s dairy policy could increase the risk of price volatility in the dairy industry, making our net income difficult to predict. Also, if prices are allowed to escalate sharply, our costs will rise and we may not be able to pass them on to consumers of our products, which will lead to a decrease in our profits.
 
The milk business is highly competitive and, therefore, we face substantial competition in connection with the marketing and sale of our products.
 
We face competition from non-premium milk producers distributing milk in our marketing area and other milk producers packaging their milk in glass bottles, and other special packaging, which serve portions of our marketing area. Most of our competitors are well established, have greater financial, marketing, personnel and other resources, have been in business for longer periods of time than we have, and have products that have gained wide customer acceptance in the marketplace. Our largest competitors are state-owned dairies owned by the government of the PRC. Large foreign milk companies have also entered the milk industry in the PRC. The greater financial resources of such competitors will permit them to procure retail store shelf space and to implement extensive marketing and promotional programs, both generally and in direct response to our advertising claims. The milk industry is also characterized by the frequent introduction of new products, accompanied by substantial promotional campaigns. We may be unable to compete successfully or our competitors may develop products which have superior qualities or gain wider market acceptance than ours.
 
 
7

 

We face the potential risk of product liability associated with food products; Lack of general liability insurance exposes us to liability risks in the event of litigation against us.
 
We sell products for human consumption, which involves risks such as product contamination or spoilage, product tampering and other adulteration of our products. We may be subject to liability if the consumption of any of our products causes injury, illness or death. In addition, we may recall products in the event of contamination or damage. A significant product liability judgment or a widespread product recall may negatively impact our profitability for a period of time depending on product availability, competitive reaction and consumer attitudes. Even if a product liability claim is unsuccessful or is not fully pursued, the negative publicity surrounding any assertion that our products caused illness or injury could adversely affect our reputation with existing and potential customers and our corporate and brand image. We would also have to incur defense costs, including attorneys’ fees, even if a claim is unsuccessful. We do not have liability insurance with respect to product liability claims. Any product liabilities claims could have a material adverse effect on its business, operating results and financial condition.
 
The loss of any of our key executives could cause an interruption of our business and an increase in our expenses if we are forced to recruit a replacement; We have no key-man life insurance covering these executives.
 
We are highly dependent on the services of Yang Yong Shan, our Chairman, Chief Executive Officer and President.  He has been primarily responsible for the development and marketing of our products and the loss of his services would have a material adverse impact on our operations. We have not applied for key-man life insurance on his life and have no current plans to do so.
 
We do not have any independent directors serving on our board of directors, which could present the potential for conflicts of interest and prevent our common stock from being listed on a national securities exchange.
 
We currently do not have any independent directors serving on our board of directors and we cannot guarantee that our board of directors will have any independent directors in the future. In the absence of a majority of independent directors, our executive officers could establish policies and enter into transactions without independent review and approval thereof. This could present the potential for a conflict of interest between us and our stockholders, generally, and the controlling officers, stockholders or directors.
 
In addition, since none of the directors currently on our board of would qualify as an independent director under the rules of the New York Stock Exchange, NYSE Amex Equities or The Nasdaq Stock Market, we would fail to satisfy at least one of the necessary initial listing requirements for any of these national securities exchanges.  Therefore, until we appoint a majority of independent directors to our board we expect that our common stock will continue to be listed on Over-the-Counter Bulletin Board (“OTCBB”) maintained by the Financial Industry Regulatory Authority (“FINRA”), which might make our common stock less attractive to potential investors.
 
Our management has identified a material weakness in our internal control over financial reporting, which if not properly remediated could result in material misstatements in our future interim and annual financial statements and have a material adverse effect on our business, financial condition and results of operations and the price of our common stock.
 
Our management is responsible for establishing and maintaining adequate internal control over financial reporting.  Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with U.S. generally accepted accounting principles.
 
 
8

 

As further described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Material Weakness in Internal Control Over Financial Reporting,” our management has identified a material weakness in our internal control over financial reporting.  A material weakness, as defined in the standards established by the Public Company Accounting Oversight Board (“PCAOB”), is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis.
 
Although we are in the process of implementing initiatives aimed at addressing this material weakness, these initiatives may not remediate the identified material weakness.  Failure to achieve and maintain an effective internal control environment could result in us not being able to accurately report our financial results, prevent or detect fraud or provide timely and reliable financial information pursuant to the reporting obligations we will have as a public company, which could have a material adverse effect on our business, financial condition and results of operations. Further, it could cause our investors to lose confidence in the financial information we report, which could adversely affect the price of our common stock.
 
Ensuring that we have adequate internal financial and accounting controls and procedures in place might entail substantial costs, may take a significant period of time, and may distract our officers and employees from the operation of our business, which could adversely affect our operating results and our ability to operate our business.
 
Ensuring that we have adequate internal financial and accounting controls and procedures in place to help ensure that we can produce accurate financial statements on a timely basis is a costly and time-consuming effort that needs to be re-evaluated frequently. We became a public company on October 2007, by virtue of the Reverse Merger described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Recent Developments – Reverse Merger, Private Placements and Related Transactions.”  As a public company, we need to document, review, test and, if appropriate, improve our internal controls and procedures in connection with Section 404 of the Sarbanes-Oxley Act, which requires annual management assessments of the effectiveness of our internal control over financial reporting and a report by our independent auditors. Both the Company and its independent auditors will be testing our internal controls in connection with the Section 404 requirements and, as part of that documentation and testing, will identify areas for further attention and improvement.
 
Implementing any appropriate changes to our internal controls might entail substantial costs in order to add personnel and modify our existing accounting systems, take a significant period of time to complete, and distract our officers and employees from the operation of our business.  These changes might not, however, be effective in maintaining the adequacy of our internal controls, and could adversely affect our operating results and our ability to operate our business.
 
Risks Related to Doing Business in the PRC
 
Changes in the PRC’s political or economic situation could harm us and our operational results.
 
Economic reforms which have been adopted by the Chinese government could change at any time.  Because many reforms are unprecedented or experimental, they are expected to be refined and adjusted. Other political, economic and social factors, such as political changes, changes in the rates of economic growth, unemployment or inflation, or in the disparities in per capita wealth between regions within the PRC, could lead to further readjustment of the reform measures. This refining and readjustment process may negatively affect our operations  This could damage our operations and profitability. Some of the things that could have this effect are:
 
 
·
level of government involvement in the economy;
 
 
9

 

 
·
control of foreign exchange;
 
 
·
methods of allocating resources;
 
 
·
balance of payments position;
 
 
·
international trade restrictions; or
 
 
·
international conflict.
 
The Chinese economy differs from the economies of most countries belonging to the Organization for Economic Cooperation and Development, or OECD, in many ways. As a result of these differences, we may not develop in the same way or at the same rate as might be expected if the Chinese economy were similar to those of the OECD member countries.  It is possible that the Chinese government may abandon its reforms all together and return to a more nationalized economy. Negative impact upon economic reform policies or nationalization could result in a total investment loss in our common stock.
 
Changes in the interpretations of existing laws and the enactment of new laws may negatively impact our business and results of operation.
 
There are substantial uncertainties regarding the application of Chinese laws, especially with respect to existing and future foreign investments in the PRC. The Chinese legal system is a civil law system based on written statutes. Unlike common law systems, it is a system in which precedents set in earlier legal cases are not generally used. Laws and regulations effecting foreign invested enterprises in the PRC have only recently been enacted and are evolving rapidly, and their interpretation and enforcement involve uncertainties. Changes in existing laws or new interpretations of such laws may have a significant impact on our methods and costs of doing business. For example, new legislative proposals for product pricing, approval criteria and manufacturing requirements may be proposed and adopted. Such new legislation or regulatory requirements may have a material adverse effect on our financial condition, results of operations or cash flows. In addition, we will be subject to varying degrees of regulation and licensing by governmental agencies in the PRC. Future regulatory, judicial and legislative changes could have a material adverse effect on our Chinese operating subsidiaries.  Regulators or third parties may raise material issues with regard to our Chinese subsidiaries or our compliance or non-compliance with applicable laws or regulations or changes in applicable laws or regulations may have a material adverse effect on our operations. Because of the evolving nature in the law, it will be difficult for us to manage and plan for changes that may arise.
 
It will be difficult for any shareholder of ours to commence a legal action against our executives.  Enforcing judgments won against them or the Company will be difficult.
 
Most of our officers and directors reside outside of the United States. As a result, it will be difficult, if not impossible, to acquire jurisdiction over those persons in a lawsuit against any of them, including with respect to matters arising under U.S. federal securities laws or applicable state securities laws.  Because the majority of our assets are located in the PRC, it would also be extremely difficult to access those assets to satisfy an award entered against us in United States court. Moreover, we have been advised that the PRC does not have treaties with the United States providing for the reciprocal recognition and enforcement of judgments of courts.
 
 
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Recent PRC regulations relating to mergers and acquisitions of domestic enterprises by foreign investors may increase the administrative burden we face and create regulatory uncertainties.
 
On August 8, 2006, six PRC regulatory agencies, namely, the PRC Ministry of Commerce (“MOFCOM”), the State Assets Supervision and Administration Commission (“SASAC”), the State Administration for Taxation, the State Administration for Industry and Commerce, the China Securities Regulatory Commission (“CSRC”), and the State Administration of Foreign Exchange (“SAFE”), jointly adopted the Regulations on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors (the “New M&A Rule”), which became effective on September 8, 2006. The New M&A Rule purports, among other things, to require offshore special purpose vehicles (“SPVs”), formed for overseas listing purposes through acquisitions of PRC domestic companies and controlled by PRC companies or individuals, to obtain the approval of the CSRC prior to publicly listing their securities on an overseas stock exchange.
 
On September 21, 2006, pursuant to the New M&A Rule and other laws and regulations of the PRC (“PRC Laws”), the CSRC, on its official website, promulgated relevant guidance with respect to the issues of listing and trading of domestic enterprises’ securities on overseas stock exchanges (the “Administrative Permits”), including a list of application materials with respect to the listing on overseas stock exchanges by SPVs.
 
On October 9, 2007, AIDH, parent company of the Chinese corporations through which we do all of our business, became a subsidiary through a Reverse Merger, as further described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Recent Developments — Reverse Merger, Private Placements and Related Transactions.”
 
Based on our understanding of current PRC Laws, we believe that the New M&A Rule does not require us or our Chinese shareholders or our entities in China to obtain the CSRC approval in connection with the Reverse Merger because AIDH completed the approval procedures of the acquisition of a majority equity interest in its PRC subsidiary before September 8, 2006 when the New M&A Rule became effective.
 
There are, however, substantial uncertainties regarding the interpretation and application of current or future PRC Laws, including the New M&A Rule. PRC government authorities may take a view contrary to our understanding that we do not need the CSRC approval, and Chinese government authorities may impose additional approvals and requirements.
 
Further, if the PRC government finds that we or our Chinese shareholders did not obtain the CSRC approval, which should have been obtained before consummating the Reverse Merger, we could be subject to severe penalties. The New M&A Rule does not specify penalty terms, so we are not able to predict what penalties we may face, but they could be materially adverse to our business and operations.
 
Future inflation in the PRC may inhibit our ability to conduct business in the PRC.
 
In recent years, the Chinese economy has experienced periods of rapid expansion and high rates of inflation. During the past ten years, the rate of inflation in the PRC has been as high as 20.7% and as low as 2.2%. These factors have led to the adoption by the Chinese government, from time to time, of various corrective measures designed to restrict the availability of credit or regulate growth and contain inflation. High inflation may in the future cause the Chinese government to impose controls on credit and/or prices, or to take other action, which could inhibit economic activity in the PRC, which could harm the market for our products and adversely effect our operations and business.
 
 
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We may have difficulty establishing adequate management, legal and financial controls in the PRC.
 
The PRC historically has been deficient in western-style management and financial reporting concepts and practices, as well as in modern banking, computer and other control systems. We may have difficulty in hiring and retaining a sufficient number of qualified employees to work in the PRC. As a result of these factors, we may experience difficulty in establishing management, legal and financial controls, collecting financial data and preparing financial statements, books of account and corporate records and instituting business practices that meet western standards.  If we are not able to maintain adequate controls our financial statements may not properly represent our financial condition, results of operation or cash flows.  Weakness in our controls could also delay disclosure of information to the public which is material to an investment decision with respect to our stock.
 
Fluctuations in the exchange rate between the Chinese currency and the United States dollar could adversely affect our operating results.
 
The functional currency of our operations in China is “Renminbi,” or “RMB.” However, results of our operations are translated at average exchange rates into United States dollars for purposes of reporting results. As a result, fluctuations in exchange rates may adversely affect our expenses and results of operations as well as the value of our assets and liabilities. Fluctuations may adversely affect the comparability of period-to-period results.  We currently do not use hedging techniques, and even if in the future we do, we may not be able to eliminate the effects of currency fluctuations. Thus, exchange rate fluctuations could cause our profits to decline, which, in turn, may cause our stock prices, to decline.
 
Changes in foreign exchange regulations in the PRC may affect our ability to pay dividends in foreign currency or conduct other foreign exchange business.
 
The Renminbi is currently not a freely convertible currency, and the restrictions on currency exchange may limit our ability to use revenues generated in RMB to fund our business activities outside the PRC, or to make dividends or other payments in United States dollars. The PRC government strictly regulates conversion of RMB into foreign currencies. Over the years, foreign exchange regulations in the PRC have significantly reduced the government’s control over routine foreign exchange transactions under current accounts. In the PRC, SAFE regulates the conversion of the RMB into foreign currencies. Pursuant to applicable PRC laws and regulations, foreign invested enterprises incorporated in the PRC are required to apply for “Foreign Exchange Registration Certificates.” Currently, conversion within the scope of the “current account” (e.g. remittance of foreign currencies for payment of dividends, etc.) can be effected without requiring the approval of SAFE. However, conversion of currency in the “capital account” (e.g. for capital items such as direct investments, loans, securities, etc.) still requires the approval of SAFE.
 
In addition, on October 21, 2005, SAFE issued the Notice on Issues Relating to the Administration of Foreign Exchange in Fundraising and Reverse Investment Activities of Domestic Residents Conducted via Offshore Special Purpose Companies (“Notice 75”), which became effective as of November 1, 2005. Notice 75 replaced the two rules issued by SAFE in January and April 2005.
 
According to Notice 75:
 
 
·
prior to establishing or assuming control of an offshore company for the purpose of obtaining overseas equity financing with assets or equity interests in an onshore enterprise in the PRC, each PRC resident, whether a natural or legal person, must complete the overseas investment foreign exchange registration procedures with the relevant local SAFE branch;
 
 
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·
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 (1) the injection of equity interests or assets of an onshore enterprise to the offshore company, or (2) the completion of any overseas fund raising by such offshore company; and
 
 
·
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 in the capital of the offshore company that does not involve any return investment, such as (1) an increase or decrease in its capital, (2) a transfer or swap of shares, (3) a merger or division, (4) a long term equity or debt investment, or (5) the creation of any security interests.
 
Moreover, Notice 75 applies retroactively. As a result, PRC residents who have established or acquired 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 addition, SAFE issued updated internal implementing rules (“Implementing Rules”) in relation to Notice 75. The Implementing Rules were promulgated and became effective on May 29, 2007. Such Implementing Rules provide more detailed provisions and requirements regarding the overseas investment foreign exchange registration procedures. However, even after the promulgation of Implementing Rules there still exist uncertainties regarding the SAFE registration for PRC residents’ interests in overseas companies. It remains uncertain whether PRC residents shall go through the overseas investment foreign exchange registration procedures under Notice 75 or Implementing Rules.
 
Penalties for non-compliance which may be issued by SAFE can impact the PRC resident investors as well as the onshore subsidiary. However, certain matters related to implementation of Circular No. 75 remain unclear or untested. As a result, we may be impacted by potential penalties which may be issued by SAFE. For instance, remedial action for violation of the SAFE requirements may be to restrict the ability of our Chinese subsidiaries to repatriate and distribute its profits to us in the United States. The results of non-compliance are uncertain, and penalties and other remedial measures may have a material adverse impact upon our financial condition and results of operations.
 
Extensive regulation of the food processing and distribution industry in the PRC could increase our expenses resulting in reduced profits.
 
We are subject to extensive regulation by the PRC's Agricultural Ministry, and by other county and local authorities in jurisdictions in which our products are processed or sold, regarding the processing, packaging, storage, distribution and labeling of our products. Applicable laws and regulations governing our products may include nutritional labeling and serving size requirements. Our processing facilities and products are subject to periodic inspection by national, county and local authorities. To the extent that new regulations are adopted, we will be required to conform our activities in order to comply with such regulations. Our failure to comply with applicable laws and regulations could subject us to civil remedies, including fines, injunctions, recalls or seizures, as well as potential criminal sanctions, which could have a material adverse effect on our business, operations and finances.
 
 
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Limited and uncertain trademark protection in the PRC makes the ownership and use of our trademarks uncertain.
 
We have obtained trademark registrations for the use of our tradenames “Xing An Ling” and “Yi Bai”, which have been registered with the PRC’s Trademark Bureau of the State Administration for Industry and Commerce with respect to our milk products. We believe our trademarks are important to the establishment of consumer recognition of our products. However, due to uncertainties in Chinese trademark law, the protection afforded by our trademarks may be less than we currently expect and may, in fact, be insufficient. Moreover even if it is sufficient, in the event it is challenged or infringed, we may not have the financial resources to defend it against any challenge or infringement and such defense could in any event be unsuccessful. Moreover, any events or conditions that negatively impact our trademarks could have a material adverse effect on our business, operations and finances.
 
Risks Relating to the Market for Our Common Stock
 
Because we became public by means of a reverse merger, we may not be able to attract the attention of major brokerage firms.
 
There may be risks associated with our becoming public through a the Reverse Merger, as described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Recent Developments — Reverse Merger, Private Placements and Related Transactions.” Because of our Reverse Merger, we could be exposed to undisclosed liabilities resulting from our operations prior to the merger and we could incur losses, damages or other costs as a result.  In addition, securities analysts of major brokerage firms may not provide coverage of us since there is no incentive to brokerage firms to recommend the purchase of our common stock. Further, brokerage firms may not want to conduct any secondary offerings on our behalf in the future.  These factors may negatively effect the market price and liquidity of our common stock.
 
There is currently a limited trading market for our common stock and a more liquid trading market may never develop or be sustained and stockholders may not be able to liquidate their investment at all, or may only be able to liquidate the investment at a price less than the Company’s value.
 
There is currently a limited trading market for our common stock and a more liquid trading market may never develop.  As a result, the price if traded may not reflect the value of the Company. Consequently, investors may not be able to liquidate their investment at all, or if they are able to liquidate it may only be at a price that does not reflect the value of our business.  Because the price for our stock is low, many brokerage firms may not be willing to effect transactions in the securities. Even if an investor finds a broker willing to effect a transaction in our stock, the combination of brokerage commissions, transfer fees, taxes, if any, and any other selling costs may exceed the selling price. Further, many lending institutions will not permit the use of common stock like ours as collateral for any loans.  Even if a more active market should develop, the price may be highly volatile.
 
Our common stock is currently approved for quotation on the OTCBB.  We do not satisfy the initial listing standards of the New York Stock Exchange, NYSE Amex Equities or The Nasdaq Stock Market.  If we never are able to satisfy any of those listing standards our common stock will never be listed on an exchange.  As a result, the trading price of our stock may be lower than if we were listed on an exchange. Our stock may be subject to increased volatility.  When a stock is thinly traded, a trade of a large block of shares can lead to a dramatic fluctuation in the share price.  These factor may make it more difficult for our shareholders to sell their shares.
 
 
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Our stock price may be volatile in response to market and other factors.
 
The market price for our stock may be volatile and subject to price and volume fluctuations in response to market and other factors, including the following, some of which are beyond our control:
 
 
·
the increased concentration of the ownership of our shares by a limited number of affiliated stockholders following the Reverse Merger may limit interest in our securities;
 
 
·
variations in quarterly operating results from the expectations of securities analysts or investors;
 
 
·
revisions in securities analysts’ estimates or reductions in security analysts’ coverage;
 
 
·
announcements of technological innovations or new products or services by us or our competitors;
 
 
·
reductions in the market share of our products;
 
 
·
announcements by us or our competitors of significant acquisitions, strategic partnerships, joint ventures or capital commitments;
 
 
·
general technological, market or economic trends;
 
 
·
volatility in our results of operations;
 
 
·
investor perception of our industry or prospects;
 
 
·
insider selling or buying;
 
 
·
investors entering into short sale contracts;
 
 
·
regulatory developments affecting our industry; and
 
 
·
additions or departures of key personnel.
 
These factors may negatively effect the market price and liquidity of our common stock.
 
“Penny Stock” rules may make buying or selling our common stock difficult.
 
Trading in our common stock is subject to the “penny stock” rules. The Securities and Exchange Commission (“SEC”) has adopted regulations that generally define a penny stock to be any equity security that has a market price of less than $5.00 per share, subject to certain exceptions. These rules require that any broker-dealer that recommends our common stock to persons other than prior customers and accredited investors, must, prior to the sale, make a special written suitability determination for the purchaser and receive the purchaser’s written agreement to execute the transaction. Unless an exception is available, the regulations require the delivery, prior to any transaction involving a penny stock, of a disclosure schedule explaining the penny stock market and the risks associated with trading in the penny stock market. In addition, broker-dealers must disclose commissions payable to both the broker-dealer and the registered representative and current quotations for the securities they offer. The additional burdens imposed upon broker-dealers by such requirements may discourage broker-dealers from effecting transactions in our common stock, which could severely limit the market price and liquidity of our common stock.
 
 
15

 

We have a concentration of stock ownership and control, which may have the effect of delaying, preventing, or deterring certain corporate actions and may lead to a sudden change in our stock price.
 
Our common stock ownership is highly concentrated. As of the date hereof, one shareholder, Yang Yong Shan, beneficially owns 14,063,329 shares, or approximately 42.5% of our total outstanding common stock. He is also our Chairman, Chief Executive Officer and President.  His interests may differ significantly from your interests.  As a result of the concentrated ownership of our stock, a relatively small number of stockholders, acting together, will be able to control all matters requiring stockholder approval, including the election of directors and approval of mergers and other significant corporate transactions.  In addition, because our stock is so thinly traded, the sale by any of our large stockholders of a significant portion of that stockholder’s holdings could cause a sharp decline in the market price of our common stock.
 
We have the right to issue up to 10,000,000 shares of "blank check" preferred stock, which may adversely affect the voting power of the holders of other of our securities and may deter hostile takeovers or delay changes in management control.
 
Our certificate of incorporation provides that we may issue up to 10,000,000 shares of preferred stock from time to time in one or more series, and with such rights, preferences and designations as our board of directors may determinate from time to time. While none of our preferred stock has yet been issued, our board of directors, without further approval of our common stockholders, is authorized to fix the dividend rights and terms, conversion rights, voting rights, redemption rights, liquidation preferences and other rights and restrictions relating to any series of our preferred stock. Issuances of shares of preferred stock could, among other things, adversely affect the voting power of the holders of other of our securities and may, under certain circumstances, have the effect of deterring hostile takeovers or delaying changes in management control.  Such an issuance would dilute existing stockholders, and the securities issued could have rights, preferences and designations superior to our common stock.
 
A substantial number of shares of our common stock are issuable upon exercise of outstanding warrants, the exercise of which will substantially reduce the percentage ownership of holders of our currently outstanding shares of common stock, and the sale of which may cause a decline in the price at which shares of our common stock can be sold.
 
As of the date of this prospectus, we have outstanding exercisable warrants to purchase an aggregate of 7,460,813 shares of our common stock, of which:
 
 
·
373,334 are exercisable at a price of $0.94 per share;
 
 
·
1,333,333 are exercisable at a price of $1.50 per share;
 
 
·
2,246,748 are exercisable at a price of $1.63 per share;
 
 
·
906,190 are exercisable at a price of $2.04 per share;
 
 
·
75,000 are exercisable at a price of $2.61 per share; and
 
 
16

 
 
 
·
2,526,208 are exercisable at a price of $3.26 per share.
 
5,620,169 of the shares underlying these exercisable warrants are being registered hereby for possible resale by those selling stockholders who own the warrants. We also have outstanding warrants to purchase 714,286 shares of our common stock at an exercise price of $1.68 per share, which may become exercisable on March 2, 2010 if certain conditions are met.  The issuance of all or substantially all additional shares of common stock that are issuable upon exercise of our outstanding warrants will substantially reduce the percentage equity ownership of holders of shares of our common stock.  In addition, the exercise of a significant number of warrants, and subsequent sale of shares of common stock received upon such exercise, could cause a sharp decline in the market price of our common stock.  The rights and obligations under the warrants are further described in “Description of Securities – Warrants.”
 
We have not paid, and do not intend to pay, cash dividends in the foreseeable future.
 
We have not paid any cash dividends on our common stock and do not intend to pay cash dividends in the foreseeable future. We intend to retain future earnings, if any, for reinvestment in the development and expansion of our business. Dividend payments in the future may also be limited by other loan agreements or covenants contained in other securities which we may issue. Any future determination to pay cash dividends will be at the discretion of our board of directors and depend on our financial condition, results of operations, capital and legal requirements and such other factors as our board of directors deems relevant.  In addition, the promissory notes we issued in the June 2008 Note Offering, as amended, and November 2008 Note Offering, further described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Recent Developments — Sale of Notes and Warrants,” contain restrictive covenants on our payment of dividends, as further described in “—Description of Securities — Promissory Notes.”
 
FORWARD-LOOKING STATEMENTS
 
Some of the statements contained in this prospectus are not statements of historical or current fact. As such, they are "forward-looking statements" based on our current expectations, which are subject to known and unknown risks, uncertainties and assumptions. They include statements relating to:
 
 
·
future sales and financings;
 
 
·
the future development of our business;
 
 
·
our ability to execute our business strategy;
 
 
·
projected expenditures; and
 
 
·
the market for our products.
 
You can identify forward-looking statements by terminology such as "may," "will," "should," "could," "expects," "intends," "plans," "anticipates," "believes," "estimates," "predicts," "potential" or "continue" or the negative of these terms or other comparable terminology. These statements are not predictions. Actual events or results may differ materially from those suggested by these forward-looking statements. In evaluating these statements and our prospects generally, you should carefully consider the factors set forth below. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these cautionary factors and to others contained throughout this prospectus. We are under no duty to update any of the forward-looking statements after the date of this prospectus or to conform these statements to actual results.
 
 
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Although it is not possible to create a comprehensive list of all factors that may cause actual results to differ from the results expressed or implied by our forward-looking statements or that may affect our future results, some of these factors are set forth under "Risk Factors" in this prospectus and in our periodic filings made with the SEC.
 
USE OF PROCEEDS
 
The shares of common stock covered by this prospectus are, either issued and outstanding, or issuable upon exercise of common stock purchase warrants owned by the selling stockholders. Each of the selling stockholders will receive all of the net proceeds from the sale of shares by that stockholder. We will not receive any of the proceeds from the sale or other disposition of the shares common stock covered by this prospectus. However, upon the exercise of warrants by payments of cash, we will receive $12,872,575, in the aggregate, assuming all of the warrants are exercised. To the extent that we receive cash upon the exercise of the warrants, we expect to use that cash for the construction of a new production facility and for general corporate purposes.
 
MARKET INFORMATION
 
Market Information
 
Our common stock was approved for quotation on the OTCBB in the first quarter of 2007. Through October 9, 2007, our trading symbol was “MCTC.OB.”  As of October 9, 2007, we changed our name to Amnutria Dairy Inc. and were assigned a new trading symbol of “AUDY.OB.”  On January 25, 2008, we changed our name to Emerald Dairy Inc. and received a new trading symbol of “EMDY.OB”
 
On October 20, 2008, shares of common stock purchased in two private offerings we conducted in fiscal 2007 became eligible for sale pursuant to Rule 144 under the Securities Act of 1933, as amended.  Prior to that date, there had been no established public trading market for shares of our common stock for over five years. There is currently only a limited trading market for our common stock and no assurance can be given that a more liquid trading market for our common stock will develop or be maintained.
 
The high and low sales prices for our common stock for the fourth quarter of fiscal 2008, first, second, third and fourth quarters of fiscal 2009, and the subsequent interim period, were as follows:
 
Quarter Ended
 
High
   
Low
 
             
2008
           
December 31, 2008
  $ 2.50     $ 0.70  
                 
2009
               
March 31, 2009
  $ 1.00     $ 0.26  
June 30, 2009
  $ 2.11     $ 0.60  
September 30, 2009
  $ 1.90     $ 1.30  
December 31, 2009
  $ 2.00     $ 1.50  
                 
2010
               
March 31, 2010 (through January 13, 2010)
  $ 1.80     $ 1.65  
 
 
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Trading in our common stock has been sporadic and the quotations set forth above are not necessarily indicative of actual market conditions. All prices reflect inter-dealer prices without retail mark-up, mark-down, or commission and may not necessarily reflect actual transactions.
 
As of the date hereof, we have outstanding exercisable warrants to purchase an aggregate of 7,460,813 shares of our common stock, of which:
 
 
·
373,334 are exercisable at a price of $0.94 per share;
 
 
·
1,333,333 are exercisable at a price of $1.50 per share;
 
 
·
2,246,748 are exercisable at a price of $1.63 per share;
 
 
·
906,190 are exercisable at a price of $2.04 per share;
 
 
·
75,000 are exercisable at a price of $2.61 per share; and
 
 
·
2,526,208 are exercisable at a price of $3.26 per share.
 
We also have outstanding warrants to purchase 714,286 shares of our common stock at an exercise price of $1.68 per share, which may become exercisable on March 2, 2010 if certain conditions are met.
 
In addition, we have issued and outstanding under our 2009 Equity Incentive Plan (“2009 Plan”):
 
 
·
703,200 stock options, exercisable at a price of $0.42 per share, of which: (i) 175,800 vested on September 2, 2009, and (ii) an additional 175,800 will vest on each of March 2, 2010, September 2, 2010 and March 2, 2011;
 
 
·
380,000 stock options, exercisable at a price of $1.80 per share, of which 95,000 will vest on each of May 10, 2010, November 10, 2010, May 10, 2011 and November 10, 2011; and
 
 
·
380,000 share appreciation rights, exercisable at a price of $1.80 per share, which will vest with respect to 25% of the underlying shares on each of May 10, 2010, November 10, 2010, May 10, 2011 and November 10, 2011.
 
Of the 32,927,191 shares of common stock we currently have issued and outstanding (which amount does not include an additional 1,944,444 shares which are currently held in treasury), 29,658,726 may be eligible for sale pursuant to Rule 144 under the Securities Act of 1933, as amended.
 
Holders
 
As of the date hereof, there were approximately 208 holders of record of our common stock.
 
 
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Dividends
 
We have not paid any dividends since inception and do not anticipate paying any dividends in the foreseeable future.  We currently intend to retain all available funds and any future earnings of our business for use in the operation of our business.  The declaration, payment and amount of future dividends, if any, will depend upon our future earnings, results of operations, financial position and capital requirements, among other factors, and will be at the sole discretion of our Board of Directors.  In addition, the promissory notes we issued in the June 2008 Note Offering, as amended, and November 2008 Note Offering, further described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Recent Developments — Sale of Notes and Warrants,” contain restrictive covenants on our payment of dividends, as further described in “Description of Securities – Promissory Notes.”
 
Securities Authorized For Issuance Under Equity Compensation Plan
 
As of December 31, 2008, we did not have any stock option, bonus, profit sharing, pension or similar plan.
 
In March 2009, our board of directors adopted and our stockholders approved the 2009 Plan to attract and retain the best available personnel, provide additional incentives to employees, directors and consultants and promote the success of our business.  A total of 1,500,000 shares of our common stock have been reserved for issuance under the 2009 Plan. The 2009 Plan is further described in “Description of Securities – Stock Options and Share Appreciation Rights.”
 
 
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MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
 
The following discussion should be read in conjunction with our audited consolidated financial statements for the years ended December 31, 2008 and 2007 and the related notes thereto and our unaudited consolidated financial statements for the three and nine months ended September 30, 2009 and the related notes thereto.  Our fiscal year ends on December 31, and each of our fiscal quarters ends on the final day of each of March, June and September. The following discussion contains forward-looking statements. Please see "Forward-Looking Statements" for a discussion of uncertainties, risks and assumptions associated with these statements.
 
Overview

We are a producer of milk powder, rice powder and soybean milk powder, which currently comprise approximately 95%, 3% and 2% of our sales, respectively. Through our network of over 800 salespeople, our products are distributed throughout 20 provinces in the PRC, and sold in over 5,800 retail outlets.

Our products are marketed under two brand names:

 
·
“Xing An Ling,” which is designed for high-end customers; and
 
 
·
“Yi Bai,” which is designed for middle and low-end customers.
 
The Chinese government has initiated programs to promote milk consumption and is providing incentives to increase dairy production. The dairy market today in the PRC is over $13.0 billion and is expected to grow at a rate of 15% per year for the foreseeable future. We focus on the infant formula segment of the market, which is expected to grow even faster, at an annual rate of approximately 23% through 2011. Currently, it is estimated that demand for infant formula in the PRC outstrips supply by at least 2-to-1.

We have received an Infant & Baby Formula Milk Powder Production Permit from the State General Administration of Quality Supervision and Inspection and Quarantine of the PRC. Only current license holders are permitted to produce formula milk powder in the PRC.

Because of our close proximity to our sources of fresh milk, we are able to complete the production process in approximately 30 – 35 hours, which is faster than competitors of ours that are not similarly situated. We produced approximately 7,000 tons of milk powder at our facility in Be’ian City, Heilongjiang Province, PRC in fiscal 2007, up from approximately 5,000 tons in fiscal 2006. In 2008, by adding a third shift to the existing two shifts working schedule, we produced approximately 9,000 tons of milk powder.

In addition, in July 2008, through our wholly-owned subsidiary, Hailun Xinganling Dairy Co., Ltd. (“HXD”), we commenced construction of a new production facility in Hailun City, Heilongjiang Province, PRC, which we expect will enable us to produce an additional 9,000 tons of milk powder in 2010 and a total of 18,000 tons of milk powder annually in 2011. As a result, between our existing production facility in Be’ian City and our new production facility in Hailun City, we believe we will have the capacity to produce approximately 27,000 tons of milk powder per year by the end of fiscal 2011. It is expected that our production of rice powder and soymilk powder will also increase in volume over the same period, while continuing to comprise an aggregate of approximately 5% of our overall sales.

 
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All of our business is conducted through our wholly-owned Chinese subsidiaries:

 
·
Heilongjiang Xing An Ling Dairy Co. Limited (“XAL”), which handles our promotion, sales and administrative functions;
 
 
·
Heilongjiang Be’ian Nongken Changxing Lvbao Dairy Limited Liability Company (“Lvbao”), which handles production of our products in Be’ian City, Heilongjiang Province, PRC; and
 
 
·
HXD, which will handle additional production of our products in Hailun City, Heilongjiang Province, PRC.
 
Recent Developments
 
Reverse Merger, Private Placements and Related Transactions

Prior to October 9, 2007, we were a public shell company, as defined by Rule 405 of the Securities Act of 1933 and Rule 12b-2 of the Securities Exchange Act of 1934, without material assets or activities. On October 9, 2007, we completed a reverse merger (the “Reverse Merger”), pursuant to which our wholly-owned subsidiary merged with and into a private company, American International Dairy Holding Co., Inc. (“AIDH”), with such private company being the surviving company. In connection with this Reverse Merger, we discontinued our former business and succeeded to the business of AIDH as our sole line of business. For financial reporting purposes, AIDH is considered to be the accounting acquirer. Accordingly, the historical financial statements presented and the discussion of financial condition and results of operations herein are those of AIDH and do not include our historical financial results.

Simultaneously with the Reverse Merger, we sold 1,333,333 units of our securities to John V. Winfield, consisting of: (i) 1,333,333 shares of our common stock, (ii) warrants to purchase 266,667 shares of our common stock, at an exercise price of $0.94 per share (“Warrant W-1”), and (iii) warrants to purchase 1,333,333 shares of our common stock, at an exercise price of $1.50 per share (“Warrant W-2”), for an aggregate purchase price of $1,000,000 (the “First Offering”). In addition, we sold 2,061,227 units of our securities to certain additional “accredited investors” (the “Initial Purchasers”), consisting of (i) 2,061,227 shares of our common stock, (ii) warrants to purchase 412,245 of our common stock, at an exercise price of $2.04 per share (the “Class A Warrants”), and (iii) warrants to purchase 2,061,227 shares of our common stock, at an exercise price of $3.26 per share (the “Class B Warrants”), for an aggregate purchase price of $3,359,800 (the “Initial Placement of the Second Offering”). The rights and obligations under Warrant W-1, Warrant W-2, the Class A Warrants, and the Class B Warrants are further described in “— Description of Securities — Warrants” below.

Upon the consummation of the Reverse Merger, and the closing of the First Offering and Initial Placement of the Second Offering, we entered into a Share Repurchase Agreement with Grand Orient Fortune Investment, Ltd. (“Grand Orient”), a PRC company controlled by Mingwen Song, pursuant to which we repurchased 1,944,444 shares (the “Repurchased Shares”) of our issued and outstanding common stock from Grand Orient for an aggregate purchase price of $3,169,444 (the “Repurchase Transaction”). We determined to repurchase these shares, to reduce the overall dilution created by the First Offering and Second Offering. The Repurchased Shares are currently being held in treasury.

Immediately following the closing of the Repurchase Transaction, we entered into Put/Call Agreements with each of Grand Orient and Fortune Land Holding, Ltd., a PRC company controlled by Dexuan Yu (jointly, the “Put/Call Shareholders). Prior to the termination of the Put/Call Agreements on March 3, 2009, we had the right to repurchase an aggregate of 1,944,444 shares of our common stock from the Put/Call Shareholders under certain circumstances, and the Put/Call Shareholders had the right to cause us to repurchase such shares at $1.63 per share if certain events occur. The Put/Call Agreements are further described in “— Liquidity and Capital Resources — Put/Call Agreements” below.

 
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On October 19, 2007, we sold 2,846,746 units of our securities to additional “accredited investors” (the “Additional Purchasers”), consisting of (i) 2,846,746 shares of our common stock, (ii) 569,346 Class A Warrants, and (iii) 2,846,746 Class B Warrants, for an aggregate purchase price of $4,640,200 (the “Additional Placement of the Second Offering,” and together with the Initial Placement of the Second Offering, the “Second Offering”).

As of March 2, 2009, an aggregate of 183,457 of the Class A Warrants and 175,937 of the Class B Warrants were tendered at reduced exercise prices, as further described in “— Recent Developments — First Warrant Tender Offer” below. On August 13, 2009, an aggregate of 49,000 Class A Warrants and 2,205,828 Class B Warrants were exchanged for warrants with reduced exercise prices and, as of August 14, 2009, all of the warrants were exercised, as further described in “— Recent Developments — Second Warrant Tender Offer” below.

In connection with the First Offering and Second Offering (collectively, the “October Offerings”), we engaged finders and placement agents to whom we paid fees in the aggregate of $700,452, and granted (i) warrants to purchase an aggregate of 106,667 shares of our common stock, at an exercise price of $0.94 per share, the terms and conditions of which are identical to those of Warrant W-1, and (ii) warrants to purchase 392,639 shares of our common stock, at an exercise price of $2.04, the terms and conditions of which are identical to those of the Class A Warrants. On March 2, 2009, the exercise prices of 235,583 of these warrants were reduced from $2.04 to $1.63, as partial consideration for services rendered in connection with a consulting agreement we entered into with one of these parties.

Construction of New Production Facility

On May 22, 2008, we organized our wholly-owned subsidiary, HXD, under the laws of the PRC. In July 2008, HXD commenced construction of a production facility to be located in Hailun City, Heilongjiang Province, PRC. Initially, the new facility will have one production line, which will have the capacity to produce 9,000 tons of milk power annually. The new facility will have the capacity to accommodate a second production line, which, if and when completed, would enable us to produce an additional 9,000 tons of milk powder per year, giving us a total annual production capacity at all of our production facilities of 27,000 tons of milk powder. We anticipate that production at this new facility will commence in the first quarter of fiscal 2010. We believe that the cost to add the second production line would be approximately an additional $15.0 million. We plan to raise the funds needed for the new facility from the capital market through private or public equity and/or debt offerings. There can be no assurance that that any additional financing will become available to us, and if available, on terms acceptable to us.
 
 
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Sale of Notes and Warrants

June 2008 Note Offering

In June 2008, we conducted a private offering of up to a maximum of (i) $3,000,000 of our 8% promissory notes (the “June 2008 Notes”) and (ii) warrants to purchase 300,000 shares of our common stock, at an exercise price of $2.61 per share (the “June 2008 Warrants”) (the “June 2008 Note Offering”). On June 12, 2008, one “accredited investor” (the “Initial June 2008 Noteholder”) purchased, for a purchase price of $1,500,000, a June 2008 Note in the principal amount of $1,500,000, and June 2008 Warrants to purchase 150,000 shares of our common stock. On June 20, 2008, an additional “accredited investor” (the “Additional June 2008 Noteholder” and, together with the Initial June 2008 Investor, the “June 2008 Noteholders”) purchased, for a purchase price of $750,000, a June 2008 Note in the principal amount of $750,000, and June 2008 Warrants to purchase 75,000 shares of our common stock.  As of December 31, 2008, the terms of the June 2008 Notes and June 2008 Warrants were amended.  As of December 31, 2009, the terms of the June 2008 Notes were further amended.  The rights and obligations under the June 2008 Notes, as amended, are further described in “— Description of Securities — Promissory Notes” below. The rights and obligations under the June 2008  Warrants, as amended, are further described in “— Description of Securities — Warrants” below.  In addition, as of December 31, 2009, we granted the June 2008 Noteholders additional warrants to purchase an aggregate of 789,356 shares of our common stock in consideration for further extending the maturity date of the indebtedness represented by the June 2008 Notes. The rights and obligations under these additional warrants are further described in “— Description of Securities — Warrants” below.

In connection with the June 2008 Note Offering, we engaged a placement agent to whom we paid a placement fee in the amount of $97,500, and granted warrants to purchase 45,000 shares of our common stock, the terms and conditions of which are identical to the those of the June 2008 Warrants, as amended as of December 31, 2008. In addition, as of July 4, 2009, we granted the same placement agent warrants to purchase an additional 97,500 shares of our common stock in consideration for its services in connection with the amendment of the June 2008 Notes and June 2008 Warrants as of December 31, 2008. The rights and obligations under these additional warrants are further described in “— Description of Securities — Warrants” below.  Further, as of December 31, 2009, we issued the same placement agent 200,000 share of our common stock in consideration for its services in connection with the further amendment of the June 2008 Notes as of December 31, 2009.

November 2008 Note Offering

On November 10, 2008, we sold to one “accredited investor” (the “November 2008 Noteholder”) for a purchase price of $500,000, a 10% promissory note (the “November 2008 Note”) in the principal amount of $500,000, and warrants to purchase 50,000 shares of our common stock, at an exercise price of $2.61 per share (the “November 2008 Warrants”) (the “November 2008 Note Offering”). As of November 10, 2009, certain of the terms of the November 2008 Note were amended. The rights and obligations under the November 2008 Note, as amended, are further described in “— Description of Securities — Promissory Notes” below.  The rights and obligations under the November 2008 Warrants are further described in “— Description of Securities — Warrants” below.  In addition, as of November 10, 2009, we granted the November 2008 Noteholder additional warrants to purchase 100,000 shares of our common stock in consideration for amending the November 2008 Note. The rights and obligations under these additional warrants are further described in “— Description of Securities — Warrants” below.

In connection with the November 2008 Note Offering, we engaged a placement agent to whom we paid a placement fee in the amount of $40,000, and granted warrants to purchase 25,000 shares of our common stock, the terms and conditions of which are identical to those of the November 2008 Warrants.  In addition, as of November 10, 2009, we paid the same placement agent a fee in the amount of $97,500, and issued to it warrants to purchase 120,000 shares of our common stock in consideration for its services in connection with, among other things, the amendment of the November 2008 Notes.

First Warrant Tender Offer

As of April 24, 2008, we commenced an offer (the “First Warrant Tender Offer”) to the holders of our then outstanding warrants, pursuant to which the holders had the opportunity to exchange their existing warrants for amended warrants to be exercised at reduced exercise prices as follows:

 
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·
with respect to eligible warrants having an exercise price of $0.94 per share, a holder accepting the First Warrant Tender Offer could exercise some or all of the amended warrants at $0.75 per share of common stock;
 
 
·
with respect to eligible warrants having an exercise price of $1.50 per share, a holder accepting the First Warrant Tender Offer could exercise some or all of the amended warrants at $1.20 per share of common stock;
 
 
·
with respect to eligible warrants having an exercise price of $2.04 per share, a holder accepting the First Warrant Tender Offer could exercise some or all of the amended warrants at $1.63 per share of common stock; and
 
 
·
with respect to eligible warrants having an exercise price of $3.26 per share, a holder accepting the First Warrant Tender Offer could exercise some or all of the amended warrants at $2.61 per share of common stock.
 
On March 2, 2009, we closed the First Warrant Tender Offer. In connection with the First Warrant Tender Offer:

 
·
a total of 183,457 warrants were tendered at the reduced exercise price of $1.63 per share, for an aggregate exercise price of $299,035; and
 
 
·
a total of 175,937 warrants were tendered at the reduced exercise price of $2.61 per share, for an aggregate exercise price of $459,196.
 
As a result, we received gross proceeds of $758,231 and issued an aggregate of 359,394 shares of our common stock.

Second Warrant Tender Offer

As of June 19, 2009, we commenced an offer (the “Second Warrant Tender Offer”) to all holders of warrants to purchase shares of our common stock, having exercise prices of either $0.94, $1.50, $1.63, $2.04 or $3.26 per share, originally issued in connection with the October Offerings (the “Original Warrants”), the opportunity to voluntarily exchange any or all of the Original Warrants for amended warrants exercisable at reduced exercise prices (“Amended Warrants”), for a limited period of time.

The terms of the Amended Warrants, included the following:

 
·
with respect to the 373,344 warrants having an exercise price of $0.94 per share, a holder accepting the Second Warrant Tender Offer was entitled to exchange some or all of the warrants for amended warrants exercisable at $0.75 per share;
 
 
·
with respect to the 1,333,333 warrants having an exercise price of $1.50 per share, a holder accepting the Second Warrant Tender Offer was entitled to exchange some or all of the warrants for amended warrants exercisable at $1.20 per share;
 
 
·
with respect to the 235,583 warrants having an exercise price of $1.63 per share, a holder accepting the Second Warrant Tender Offer was entitled to exchange some or all of the warrants for amended warrants exercisable at $1.30 per share;
 

 
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·
with respect to the 955,190 warrants having an exercise price of $2.04 per share, a holder accepting the Second Warrant Tender Offer was entitled to exchange some or all of the warrants for amended warrants exercisable at $1.63 per share; and
 
 
·
with respect to the 4,732,036 warrants having an exercise price of $3.26 per share, a holder accepting the Second Warrants Tender Offer was entitled to exchange some or all of the warrants for amended warrants exercisable at $1.63 per share.
 
On August 13, 2009, we closed the Second Warrant Tender Offer. In connection with the Second Warrant Tender Offer:

 
·
a total of 49,000 Original Warrants with an exercise price of $2.04 per share were exchanged for Amended Warrants with a reduced exercise price of $1.63 per share; and
 
 
·
a total of 2,205,828 Original Warrants with an exercise price of $3.26 per share were exchanged for Amended Warrants with a reduced exercise price of $1.63 per share.
 
On August 14, 2009, the warrant holders that participated in the Second Warrant Tender Offer exercised all of the 2,254,828 Amended Warrants they received in connection therewith, at an exercise price of $1.63 per share. As a result, we received gross proceeds of $3,675,370.

Adoption of 2009 Equity Incentive Plan

On March 2, 2009, our board of directors adopted and our stockholders approved the 2009 Plan to attract and retain the best available personnel, provide additional incentives to employees, directors and consultants and promote the success of our business. A total of 1,500,000 shares of our common stock have been reserved for issuance under the 2009 Plan.  The 2009 Plan is further described in “— Description of Securities — Stock Options and Share Appreciation Rights.”

Payment of Liquidated Damages

In connection with the October Offerings, as further described in “— Recent Developments — Reverse Merger, Private Placements and Related Transactions” above, we entered into Registration Rights Agreements with the investors in the October Offerings (the “Investors”). Pursuant to the Registration Rights Agreements, we were required to pay liquidated damages to the Investors, if we failed to satisfy certain registration requirements, as further described in “— Liquidity and Capital Resources — Registration Rights and Liquidated Damages” below. As a result of our failure to satisfy the registration requirements, we accrued a total of $1,201,998 in liquidated damages through October 19, 2008, the date the shares purchased in the October Offerings became eligible for sale pursuant to Rule 144 under the Securities Act. Pursuant to the Registration Rights Agreement, the liquidated damages were payable in cash or shares of our common stock, at our discretion. As of October 5, 2009, in full payment of the liquidated damages, we issued an aggregate of 667,777 shares of our common stock to the Investors, valued at $1.80 per share, the closing price on the OTCBB on October 20, 2008. In addition, pursuant to the Registration Rights Agreements, if we failed to pay any liquidated damages in full within seven days after the date payable, we were required to pay interest thereon at a rate of 15% per annum until such amounts, plus all such interest thereon, are paid in full. Therefore, as of October 5, 2009, we paid interest in the aggregate amount of approximately $172,900, by issuing an aggregate of 108,056 additional shares of our common stock, valued at $1.60 per share, the closing price of our common stock on the OTCBB on October 2, 2009.
 
 
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Term Loan

On November 30, 2009, we entered into a Loan Agreement with a lender (the “Term Loan Lender”), pursuant to which we borrowed $1,750,000 from the Term Loan Lender (the “Term Loan”), in consideration for which we issued to the Term Loan Lender a promissory note (the “Term Loan Note”). The terms of the Term Loan Note are further described in “— Description of Securities — Promissory Notes” below.

December 2009 Note Offering

On December 24, 2009, we sold to three “accredited investors” (the “December 2009 Noteholders”) for a purchase price of $1,750,000, 10% promissory notes in the aggregate principal amount of $1,750,000 (the “December 2009 Notes”) and warrants to purchase an aggregate of 536,809 shares of our common stock, at an exercise price of $1.63 per share (the “December 2009 Warrants”) (the “December 2009 Note Offering”). The rights and obligations under the December 2009 Note are further described in “— Description of Securities — Promissory Notes” below.  The rights and obligations under the December 2009 Warrants are further described in “— Description of Securities — Warrants” below.  At the closing of the December 2009 Note Offering, we paid the December 2009 Noteholders a closing fee in the aggregate amount of $35,000, and prepaid interest on the December 2009 Notes in the aggregate amount of $175,000. As a result, we received net proceeds of $1,540,000.

Trends and Uncertainties

Economic Downturn

The recent worldwide economic downturn and market instability have made the business climate more volatile and more costly. Although all of our business operations are currently conducted in the PRC, our general business strategy may be adversely affected by unpredictable and unstable market conditions. If the current equity and credit markets deteriorate further, or do not improve, it may make any necessary debt or equity financing more difficult, more costly, and more dilutive. Failure to secure any necessary financing in a timely manner and on favorable terms could have a material adverse effect on our growth strategy, financial performance and stock price and could require us to delay or abandon our expansion plans.

Narrowing of Gap in Milk Consumption

The Chinese government has initiated programs to promote milk consumption and is providing incentives to increase dairy production. In addition to improving the overall health of its populous, the government views increased dairy production as a means of improving employment in rural areas thus improving social stability. The programs are designed to narrow the significant gap between the PRC’s per capita milk consumption of 15 kg per person and the global average of 100 kg per person.

Industry Growth

The dairy market today in the PRC is over $13.0 billion. According to the website of China National Bureau of Statistics, between 2000 and 2007 the dairy industry in the PRC experienced an average growth of 16% per year. English-language copies of the reports of the China National Bureau of Statistics are available on its website, free of charge, at www.stats.gov.cn/english. The dairy industry in the PRC is projected to grow at rate of 15% per year from 2008 to 2012, to reach $32.0 billion by 2012.
 
 
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On its website, the Dairy Association of China estimates that the infant formula market segment, which is the market segment we target, has grown even faster in recent years, at a rate of 20%-30% per year. We believe the following three factors are the main drivers of the infant formula market:

 
·
Increased household income made infant formula more affordable in the PRC;

 
·
Increased number of working mothers or busy mothers created more demands for infant formula products; and

 
·
Increased popularity and acceptance of infant formula products.

Supply of Infant Formula

It is estimated that the demand for infant formula in the PRC outstrips supply by at least 2-to-1. In recent years, our production capabilities have not been able to keep up with demand for our products. We have commenced construction of a new production facility in Hailun City with an initial annual production capacity of 9,000 tons of milk powder, which is expected to start production in the first quarter of 2010. We expect that this increase in production capacity of approximately 100% will result in the doubling of our sales revenues, with a corresponding increase in cost of goods sold and sales and administrative expenses.

This project has cost an aggregate of approximately $20.0 million, including land use rights, construction expenses and equipment costs. We have applied the net proceeds we received from the June 2008 Note Offering and November 2008 Note Offering, further described in “— Recent Developments — Sale of Notes and Warrants” above, the First Warrant Tender Offer, further described in “— Recent Developments — First Warrant Tender Offer” above, the Second Warrant Tender Offer, further described in “— Recent Developments — Second Warrant Tender Offer” above, the Term Loan, further described in “— Recent Developments — Term Loan” above, and the December 2009 Note Offering, further described in “— Recent Developments — December 2009 Note Offering” above, toward the construction and equipping of this new production facility.

Product Pricing and Raw Material Supply

Historically we have been able to obtain sufficient raw milk and other raw materials to meet our production needs. The price of raw milk is affected by regional market in Heilongjiang Province, PRC, while other raw materials are affected by global markets. We expect that the raw materials we require to produce our products will continue to be available to us for the foreseeable future. However, we believe the recent worldwide increases in the cost and availability of commodities, such as rice and oil, will lead to increases in prices for such commodities. To some extent, we believe we will be able to increase the prices for our products to pass on higher raw material costs to consumers. However, there is no guarantee that we will be able to raise prices to the full extent necessary to cover rises in costs for raw materials, which could have a negative material impact on our financial condition and results of operations.

Brand Name and Product Quality

There are more than 30 brand names of infant formula products sold in the PRC. Most of our international and larger competitors have been concentrating in the first tier cities, or well-known urban centers such as Beijing and Shanghai. The rest of the Chinese domestic companies in the industry, including us, have been focusing on less developed second and third tier cities where competition is less severe than the top tier cities. As consumers have many options for infant formula products, infant formula producers with better quality and safety images have the advantages to sell their product at higher price. Brand image and recognition are increasingly important in gaining customer loyalty.

 
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Organic Label Milk Products

Currently, there are no organic label milk powder products in the mainland China market. In February 2008, we obtained organic label certification from Guangdong Zhongjian Certification Co., Ltd. We plan to create an organic label product line beginning in fiscal 2010. We will need to test the market to determine demand for organic milk products. Initially, we expect sales of organic milk powder to be minor. However, over the long term, we believe that, similar to the growth of the organic milk market in the U.S., organic milk products will be very popular in the PRC. Over time, this will help increase our revenues.

Factors Affecting Raw Milk Production

Raw milk production is influenced by a number of factors that are beyond our control including, but not limited to, the following:

 
·
Seasonal factors: dairy cows generally produce more milk in temperate weather than in cold or hot weather and extended unseasonably cold or hot weather could lead to lower than expected production;
 
 
·
Environmental factors: the volume and quality of milk produced by dairy cows is closely linked to the quality of the nourishment provided by the environment around them, if environmental factors cause the quality of nourishment to decline, milk production could decline and we may have difficulty finding sufficient raw milk; and
 
 
·
Governmental agricultural and environmental policy: declines in government grants, subsidies, provision of land, technical assistance and other changes in agricultural and environmental policies may have a negative effect on the viability of individual dairy farms, and the numbers of dairy cows and quantities of milk they are able to produce.
 
Contamination of Milk Powder Products Produced in the PRC

In mid-2008, a number of milk powder products produced within the PRC were found to contain unsafe levels of tripolycyanamide, also known as melamine, sickening thousands of infants. This prompted the Chinese government to conduct a nationwide investigation into how the milk powder was contaminated, and caused a worldwide recall of certain milk powder products produced within the PRC. On September 16, 2008, China’s Administration of Quality Supervision, Inspection and Quarantine (AQSIQ) revealed that it had tested samples from 175 dairy manufacturers, and published a list of 22 companies whose products contained melamine. We passed the emergency inspection and were not included on AQSIQ’s list. Although we believe that the inevitable contraction in the Chinese milk powder industry caused by this crisis will lead to increased demand for our products, we can not be certain that the illnesses caused by contamination in the milk powder industry, whether or not related to our products, will not lead to decreased demand for milk powder products produced within the PRC, thereby having a material adverse effect on our business.
 
 
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Results of Operations

Nine-Month Period Ended September 30, 2009 Compared to Nine-Month Period Ended September 30, 2008

The following summarizes changes in our operations for the nine months ended September 30, 2009 and 2008.  Net income increased by $2,191,232, from $1,509,235 in the nine months ended September 30, 2008, to $3,700,467 for the nine months ended September 30, 2009. The increase in net income during the nine months ended September 30, 2009, as compared to the same time period in the prior year, was due an increase in gross profit as further described below.

Sales and Cost of Goods Sold

   
For the Nine months
Ended September 30,
 
    
2009
   
2008
 
             
Sales
 
$
31,261,491
   
$
32,560,256
 
Cost of Goods Sold
   
17,057,583
     
19,845,232
 
Gross Profit
 
$
14,203,908
   
$
12,715,024
 

Sales. Sales volume decreased by 774 metric tons, or 11.4%, period on period, to 5,987 metric tons for the nine months ended September 30, 2009, from 6,761 metric tons for the nine months ended September 30, 2008. Sales revenues decreased by $1,298,765, or 4.0%, from $32,560,256 in the nine months ended September 30, 2008, to $31,261,491 for the nine months ended September 30, 2009. This decrease was primarily due to a decrease in subcontracting revenue, as compared to the nine months ended September 30, 2008, as we shifted our sales mix to produce more of our higher margin product line in fiscal 2009.

Sales by product line.  A break-down of our sales by product line for the nine months ended September 30, 2009 and 2008 is as follows:

   
Nine months Ended September 30,
       
   
2009
   
2008
   
Period-on-period
 
Product category
 
Quantity
(tons)
   
$ Amount
   
% of sales
   
Quantity
(tons)
   
$ Amount
   
% of
sales
   
Qty.
        Variance        
 
                                           
Milk powder
   
4,454
     
27,318,421
     
87.4
     
4,543
     
26,144,060
     
80.3
     
(89
)
Rice powder
   
168
     
954,482
     
3.1
     
147
     
813,645
     
2.5
     
21
 
Soybean powder
   
472
     
822,026
     
2.6
     
350
     
644,233
     
2.0
     
122
 
Subcontracting
   
893
     
2,166,562
     
6.9
     
1,721
     
4,958,318
     
15.2
     
(828
)
Total
   
5,987
     
31,261,491
     
100.0
     
6,761
     
32,560,256
     
100.0
     
(774
)
 
There were various changes to the break-down of sales among our product lines over the nine months ended September 30, 2009, as we increased production in most lines, but attempted to adjust our sales mix to higher margin products, and away from subcontracting. Rice powder accounted for 3.1% of our sales mix for the nine months ended September 30, 2009, at an average selling price of $5,681 per metric ton, as compared to 2.5% of our sales mix in the nine months ended September 30, 2008, at an average selling price of $5,535 per metric ton. Soybean powder accounted for 2.6% of our sales mix for the nine months ended September 30, 2009, at an average selling price of $1,742 per metric ton, as compared to 2.0% of our sales mix in the nine months ended September 30, 2008, at an average selling price of $1,841 per metric ton. Milk powder accounted for 87.4% of nine months ended September 30, 2009 sales mix, at an average selling price of $6,133 per metric ton, as compared to 80.3% of first quarter 2008, at an average selling price of $5,755 per metric ton. We decreased our subcontract production during the nine months ended September 30, 2009 to 6.9% of the sales mix, at an average selling price of $2,426 per metric ton, as compared to 15.2% of the sales mix in the nine months ended September 30, 2008, at an average sales price of $2,881 per metric ton.

 
30

 
 
A breakdown of our average selling price by product line for the nine months ended September 30, 2009 and 2008 is as follows:
 
 
  
Nine months Ended 
September 30,
  
Average selling prices   
  
2009
  
  
2008
  
  
Variance
  
   
 
$
   
$
   
$
     
%
 
Milk powder
   
6,133
     
5,755
     
378
     
6.6
 
Rice powder 
   
5,681
     
5,535
     
146
     
2.6
 
Soybean powder
   
1,742
     
1,841
     
(99
   
(5.4
Subcontracting
   
2,426
     
2,881
     
(455
   
(15.8
Total
   
5,222
     
4,816
     
406
     
8.4
 
 
Cost of Goods Sold.  Cost of goods sold decreased by $2,787,649, or 14.0%, from $19,845,232 in the nine months ended September 30, 2008, to $17,057,583 for the nine months ended September 30, 2009. This decrease was directly related to our reduction in subcontracting work during the nine months ended September 30, 2009. Overall our cost per metric ton decreased by $86, or 2.9%, to $2,849 per metric ton in the nine months ended September 30, 2009, as compared to $2,935 per metric ton in nine months ended September 30, 2008, due to increases in our sales prices and the reductions in the price of raw materials we use to produce our products.

A breakdown of cost of sales by product line for the nine months ended September 30, 2009 and 2008 is as follows:
 
 
  
Nine months Ended September 30,
  
 
  
2009
  
  
2008
  
  
Variance
  
 
  
$
  
  
$
  
  
$
  
  
  
  
Cost of sales  
                             
Milk powder  
   
13,887,172
     
14,893,859
     
(1,006,687
   
(6.8
Rice powder  
   
374,307
     
262,169
     
112,138
     
42.8
 
Soybean powder
   
616,126
     
423,707
     
192,419
     
45.4
 
Subcontracting  
   
2,179,978
     
4,265,497
     
(2,085,519
   
(48.9
Total
   
17,057,583
     
19,845,232
     
(2,787,649
   
(14.0
   
                               
Cost per units sold (per ton)  
                               
Milk powder
   
3,118
     
3,278
     
(160
   
(4.9
Rice powder
   
2,228
     
1,783
     
445
     
25.0
 
Soybean powder
   
1,305
     
1,211
     
94
     
7.8
 
Subcontracting
   
2,441
     
2,478
     
(37
   
(1.5
Average cost per unit sold  
   
2,849
     
2,935
     
(86
   
(2.9
 
 
31

 

Gross Profit. Gross profit was $14,203,908, or 45.4% of our sales for the nine months ended September 30, 2009, as compared to gross profit of $12,715,024, or 39.1%, for the nine months ended September 30, 2008. During the nine months ended September 30, 2009, our gross margin on milk powder increased to 49.2%, from 43.0% in the same period of the prior year, due to an increase in the average sales price of 6.6%, while there was a 4.9% decrease in the cost per metric ton from the nine months ended September 30, 2008. The gross margin for soybean powder declined 9.2% to 25.0% in the nine months ended September 30, 2009, as compared to 34.2% in the nine months ended September 30, 2008, due to an increase in the average cost per ton of 7.8% in the nine months ended September 30, 2009 as compared to the same period in 2008.
 
A breakdown of gross margin by product line for the nine months ended September 30, 2009 and 2008 is as follows:
 
   
Nine months Ended September 30,
       
   
2009
   
2008
   
Period-on-period
 
Product category 
  
$ Amount
  
  
Gross 
Margin %
  
  
$ Amount
  
  
Gross 
Margin %
  
  
Margin 
        Variance        
  
                               
Milk powder
   
13,431,249
     
49.2
     
11,250,201
     
43.0
     
6.2
 
Rice powder
   
580,175
     
60.8
     
551,476
     
67.8
     
(7.0
Soybean powder
   
205,900
     
25.0
     
220,526
     
34.2
     
(9.2
Subcontracting
   
(13,416
   
(0.6
   
692,821
     
14.0
     
(14.6
)
Total
   
14,203,908
     
45.4
     
12,715,024
     
39.1
     
6.3
 

Operating Expenses

   
 
For the Nine months 
Ended September 30,
 
   
 
2009
   
2008
 
Operating Expenses 
           
Selling and administrative expenses 
 
$
9,448,920
   
$
10,283,634
 
Depreciation and amortization 
   
130,107
     
72,336
 
Total operating expenses 
 
$
9,579,027
   
$
10,355,970
 

Selling Expenses. Selling expenses overall decreased by $543,003, or 6.9%, from $7,834,865 in the nine months ended September 30, 2008, to $7,291,862 for the nine months ended September 30, 2009. The major factors in the decrease in selling expenses are as follows:

 
·
Advertising and promotion expenses decreased by $693,282, or 19.1%, to $2,940,297 in 2009, from $3,633,579 in 2008, due to a less aggressive marketing campaign in 2009.

 
·
Entertainment expenses decreased by $117,155, or 25.1%, to $350,155 in 2009, from $467,311 in 2008, as we reduced our marketing as compared to 2008.

 
·
Transportation expenses decreased by $69,367, or 8.7%, to $730,313 in 2009, from $799,680 in 2008, as a result of our shipping costs decreasing in 2009 as compared to 2008.

These decreases were partially offset by increases in:

 
·
Traveling expenses, by $93,733, or 11.7%, to $897,992 in 2009, from $804,259 in 2008 as cost for travel increased during 2009.

 
32

 
 
 
·
Product promoter salaries, by $116,255, or 119.2%, to $213,816 in 2009, from $97,561 in 2008, as we increased the amount paid to promoters.

 
·
Salaries of our salespersons, by $179,962, or 12.5%, to $1,615,054 in 2009, from $1,435,092 in 2008, as we increased our sales during 2009.

Rather than using a wholesaler, our sales people deal directly with the retail outlets.  This business model has higher sales expenses compared to the traditional business model, but creates better profit margins for us.

Administrative Expenses. Administrative expenses decreased by $291,711, or 11.9%, from $2,448,769 in nine months ended September 30, 2008, to $2,157,058 for the nine months ended September 30, 2009. The primary factor in this decrease was that we incurred liquidated damages of $901,199 in the nine months ended September 30, 2008, as a result of our failure to satisfy requirements to register shares of our common stock, but did not incur liquidated damages in the comparable period in 2009.

These decreases were partially offset by:

 
·
An increase in stock option expenses of $125,452 in 2009 from stock options granted in 2009 partially offset the decrease in liquidated damages.

 
·
An increase in consulting expenses of $226,893 in 2009 from $83,430 in 2008 to $310,323 in 2009 as we paid for assistance in locating potential financing options.

 
·
An increase in legal and accounting expenses of $157,066 in 2009 from $451,419 in 2008 to $608,485 in 2009 due to increased costs related to public company reporting requirements as compared to 2008.

Provision for Income Taxes

   
For the Nine months
Ended September 30,
 
   
2009
   
2008
 
Provision for Income Taxes
           
Current
 
$
860,948
   
$
586,957
 
Deferred
   
     
 
   
$
860,948
   
$
586,957
 

Provision for Income Taxes. Income taxes increased by $273,991, or 46.8%, from $586,957 for the nine months ended September 30, 2008, to $860,948 for the nine months ended September 30, 2009. This increase was due to the increase in our taxable income in our operating subsidiaries.

Fiscal Year Ended December 31, 2008 Compared to Fiscal Year Ended December 31, 2007

The following summarizes changes in our operations for the fiscal years ended December 31, 2008 and 2007.  Net income decreased by $1,235,631, or 34.8%, from approximately $3,550,138 in the fiscal year ended December 31, 2007 to approximately $2,314,507 for the fiscal year ended December 31, 2008. The decrease in net income during the year ended December 31, 2008, as compared to the same time period in the prior year, was due to a one-time charge of $986,699 in liquidated damages resulting from our failure to satisfy certain registration requirements, combined with an increase in our operating expenses, which offset an increase in our gross profit as further described below.

 
33

 
 
Sales and Cost of Goods Sold

   
For the Fiscal Years
Ended December 31,
 
   
2008
 
2007
 
   
   
Sales 
  $ 44,325,179     $ 29,618,008  
Cost of Goods Sold 
    26,546,291       19,064,905  
Gross Profit 
  $ 17,778,888     $ 10,553,103  

Sales. Sales volume increased by 1,046 metric tons, or 13.2%, period on period to 8,976 metric tons for the fiscal year ended December 31, 2008, from 7,930 metric tons for the fiscal year ended December 31, 2007.  As a result, sales revenues increased by $14,707,171, or 49.7%, from $29,618,008 in the fiscal year ended December 31, 2007 to $44,325,179 for the fiscal year ended December 31, 2008. This increase was due to the following factors:

 
·
We expanded the market areas in the 20 provinces in which we sell our products and our products are now sold in over 5,800 retail outlets, up from approximately 5,600 in fiscal 2007;
 
 
·
Our products became increasing popular in mainland China due to our continued sales and marketing efforts; and
 
 
·
The average selling price for all products has increased by $1,203 per metric ton, as compared to the fiscal year ended December 31, 2007, because we produced more of our high end product line in fiscal 2008.
 
Sales by product line.  A break-down of our sales by product line for the years ended December 31, 2008 and 2007 is as follows:

   
Fiscal Year Ended December 31,
       
   
2008
   
2007
   
Period-on-period
 
Product category  
 
Quantity
(tons)
   
$ Amount
   
% of sales
   
Quantity
(tons)
   
$ Amount
   
% of
sales
   
Qty.
Variance
 
   
                                         
Milk powder
   
6,175
     
36,245,495
     
81.8
     
5,245
     
22,821,548
     
77.0
     
930
 
Rice powder
   
198
     
1,105,837
     
2.5
     
200
     
985,746
     
3.3
     
(2
Soybean powder
   
477
     
882,185
     
2.0
     
404
     
641,053
     
2.2
     
73
 
Subcontracting
   
2,126
     
6,091,662
     
13.7
     
2,081
     
5,169,661
     
17.5
     
45
 
Total
   
8,976
     
44,325,179
     
100.0
     
7,930
     
29,618,008
     
100.0
     
1,046
 
 
 
34

 

There were various changes to the break-down of sales among our product lines over the fiscal year ended December 31, 2008, as we increased production in most all lines, but attempted to adjust our sales mix to higher margin products.  Soybean powder only accounted for 2.0% of our sales mix for the fiscal year 2008, at an average selling price of $1,849 per metric ton, as compared to 2.2% of our sales mix in fiscal year 2007, at an average selling price of $1,587 per metric ton.  Milk powder accounted for 81.8% of fiscal year 2008 sales mix, at an average selling price of $5,869 per metric ton, as compared to 77.0% of fiscal year 2007, at an average selling price of $4,351 per metric ton. We decreased our subcontract production during fiscal year 2008 to 13.7% of the sales mix, at an average selling price of $2,865 per metric ton, as compared to 17.5% of the sales mix in fiscal year 2007, at an average sales price of $2,484 per metric ton.

A breakdown of our average selling price by product line for the years ended December 31, 2008 and 2007 is as follows:

   
Fiscal Year Ended 
December 31,
 
Average selling prices  
 
2008
   
2007
   
Variance
 
   
 
$
   
$
   
$
     
%
 
Milk powder
   
5,869
     
4,351
     
1,518
     
34.9
 
Rice powder 
   
5,575
     
4,929
     
646
     
13.1
 
Soybean powder
   
1,849
     
1,587
     
262
     
16.5
 
Subcontracting
   
2,865
     
2,484
     
381
     
15.3
 
Total
   
4,938
     
3,735
     
1,203
     
32.2
 

Cost of Goods Sold.  Cost of goods sold increased by $7,481,386, or 39.2%, from $19,064,905 in the fiscal year ended December 31, 2007, to $26,546,291 for the fiscal year ended December 31, 2008. This increase was directly related to an increase in sales during fiscal year of 49.7%. Overall our cost per metric ton increased by $553, or 23.0%, to $2,957 per metric ton in the fiscal year ended December 31, 2008, as compared to $2,404 per metric ton in fiscal year ended December 31, 2007, due to increases in our sales and the price of raw materials we use to produce our products.

A breakdown of cost of sales by product line for the years ended December 31, 2008 and 2007 is as follows:

   
 
Fiscal Year Ended December 31,
 
   
 
2008
   
2007
   
Variance
 
   
 
$
   
$
   
$
     
%
 
Cost of sales  
                             
Milk powder  
   
20,185,806
     
13,909,783
     
6,276,023
     
45.1
 
Rice powder  
   
433,662
     
399,497
     
34,165
     
8.6
 
Soybean powder
   
580,684
     
419,621
     
161,063
     
38.4
 
Subcontracting  
   
5,346,139
     
4,336,004
     
1,010,135
     
23.3
 
   
   
26,546,291
     
19,064,905
     
7,481,386
     
39.2
 
   
                               
Cost per units sold(per ton)  
                               
Milk powder
   
3,269
     
2,652
     
617
     
23.3
 
Rice powder
   
2,186
     
1,997
     
189
     
9.5
 
Soybean powder
   
1,217
     
1,039
     
178
     
17.1
 
Subcontracting
   
2,515
     
2,084
     
431
     
20.7
 
Average cost per unit sold  
   
2,957
     
2,404
     
553
     
23.0
 
 
 
35

 

Gross Profit. Gross profit was $17,778,888, or 40.1% of our sales for the fiscal year ended December 31, 2008, as compared to gross profit of $10,553,103, or 35.6% for the fiscal year ended December 31, 2007. During the fiscal year ended December 31, 2008 our gross margin on milk powder increased to 44.3% from 39.1% in the prior year, due to an increase in the average sales price of 34.9% while there was a 23.3 % increase in the cost per metric ton from the fiscal year ended December 31, 2007.  The gross margin for soybean powder declined 0.3% to 34.2% in fiscal year 2008 as compared to 34.5% in fiscal year 2007 due to increase in the average cost per ton of 17.1% in fiscal year 2008 as compared to fiscal year 2007.

A breakdown of gross margin by product line for the years December 31, 2008 and 2007 is as follows:

   
Fiscal Year Ended December 31,
       
   
2008
   
2007
   
Period-on-
      period      
 
Product category
 
$ Amount
   
Gross
Margin
%
   
$  Amount
   
Gross
Margin
%
   
Margin
Variance
 
                               
Milk powder
   
16,059,689
     
44.3
     
8,911,766
     
39.0
     
5.3
 
Rice powder
   
672,175
     
60.8
     
586,248
     
59.5
     
1.3
 
Soybean powder
   
301,501
     
34.2
     
221,432
     
34.5
     
(0.3
Subcontracting
   
745,523
     
12.2
     
833,657
     
16.1
     
(3.9
)
Total
   
17,778,888
     
40.1
     
10,553,103
     
35.6
     
 4.5
 

Operating Expenses

   
 
For the Fiscal Years
Ended December 31,
 
   
 
2008
   
2007
 
Operating Expenses 
           
Selling expenses 
  $ 10,602,185     $ 5,331,489  
Administrative expenses 
    3,494,733       1,492,642  
Depreciation and amortization 
    113,660       51,066  
Total operating expenses 
  $ 14,210,578     $ 6,875,197  

Selling Expenses. Selling expenses overall increased by $5,270,696, or 98.9%, from $5,331,489 in fiscal year ended December 31, 2007, to $10,602,185 for the fiscal year ended December 31, 2008. The major factors in the increase in selling expenses are as follows:

 
·
Advertising increased by $3,360,124, or 4,304.4%, to $3,438,187 in 2008, from $78,063 in 2007, due to our marketing campaign to increase brand awareness and sales.
 
 
·
Selling salaries increased by $637,682, or 47.2%, to $1,988,116 in 2008, from 1,350,434 in 2007, as amounts we paid to our sales staff rose due to increased sales.
 
 
·
Traveling expenses incurred by the sales staff increased by $405,714, or 58.7%, to $1,097,255 in 2008, from $691,541 in 2007, due to the expansion of our sales network.
 
 
·
Transportation expenses increased by $247,765, or 41.3%, to $847,055 in 2008, from $599,290 in 2007, as a result of our shipping of more products in 2008 as compared to 2007.
 
 
36

 

 
·
Outdoor promotion expenses increased by $280,885, or 305.2%, to $372,906 in 2008, from $92,021 in 2007, as part of our marketing campaign to increase brand awareness and sales.
 
 
·
Sales entertainment expenses increased by $180,813, or 41.7%, to $614,953 in 2008, from $434,140 in 2007, as we increased our sales network.
 
Rather than using a wholesaler, our sales people deal directly with the retail outlets.  This business model has higher sales expenses compared to the traditional business model, but creates better profit margins for us.  For a more complete discussion regarding the costs and profits of our retail sales model, see “Description of Business - Company Strategy - Market Strategy - Sales Channel.”

Administrative Expenses. Administrative expenses increased by $2,002,091, or approximately 134.1%, from $1,492,642 in fiscal year ended December 31, 2007, to $3,494,733 for the fiscal year ended December 31, 2008. The major factors in the increase in administrative expenses are as follows:

 
·
Additional liquidated damages incurred in 2008 of $986,699, due to our failure to satisfy registration requirements under registration rights agreements.
 
 
·
Increase of administrative salaries of $175,116, or 97.4%, to $354,992 in 2008, from $179,876 in 2007, as a result of our hiring of four additional administrative personnel during 2008.
 
 
·
Increase in legal and accounting expenses of $943,704, or 3,057.2%, to $797,899 in 2008, from $25,273 in 2007, due to increased costs related to our first full fiscal year of public company reporting requirements.
 
 
·
Increase of travel expenses of $89,778, or 78.6%, to $204,009 in 2008, from $114,231 in 2007, due to the increased travel by our administrative personnel in connection with efforts to raise financing to fund our growth.
 
 
·
Increase of investor relations expenses of $152,552, or 11,389.9%, to $153,891 in 2008, from $1,339 in 2007, due to our first full fiscal year as a public company.
 
Provision for Income Taxes

   
For the Fiscal Years
Ended December 31,
 
   
2008
   
2007
 
Provision for Income Taxes
           
Current
  $ 840,198     $ 118,325  
Deferred
           
    $ 840,198     $ 118,325  

Provision for Income Taxes. Income taxes increased by $721,873, or 610.0%, from $118,325 in fiscal year ended December 31, 2007, to $840,198 for the fiscal year ended December 31, 2008. This increase was due to the increase in our taxable income in our operating subsidiaries.

 
37

 

Liquidity and Capital Resources

Uses of Capital

  
  
For the Nine
Months Ended
September 30,
  
   
2009
   
2008
 
             
Net cash provided by operating activities
 
$
2,101,308
   
$
4,955,796
 
                 
Net cash used in investing activities
   
(4,194,717
)
   
(10,188,918
)
                 
Net cash provided by financing activities
 
$
4,433,590
   
$
1,959,082
 

Net Cash Provided By Operating Activities.  For the nine months ended September 30, 2009, $2,101,308 was provided by operating activities, compared with $4,955,796 provided by operating activities for the nine months ended September 30, 2008. Our decrease in net cash provided from operating activities during 2009 was due to an increase in net income to $3,700,467 for the nine months ended September 30, 2009, from $1,509,235 for the same period in the prior year, which was partially offset by the following:

 
·
Trade accounts receivable increased by $559,266, due to the increased level of sales during 2009.

 
·
Inventory increased by $837,027, due to seasonal summer build up in products as compared to December 2008.

 
·
Accounts payable and accrued expenses increased by $424,925 at September 30, 2009, as compared to the same period in 2008, due to increases in production of products and expenses.

 Net Cash Used In Investing Activities.   For the nine months ended September 30, 2009, we used $4,194,717 in investing activities, compared with $10,188,918 used in investing activities for the nine months ended September 30, 2008. The $4,194,717 was for the construction of our new production facility.

Net Cash Provided By Financing Activities. For the nine months ended September 30, 2009, $4,433,590 was provided by financing activities, compared with $1,959,082 provided by financing activities for the nine months ended September 30, 2008. We raised $4,433,590 through the exercise of warrants during the nine months ended September 30, 2009, in connection with the consummation of the First Warrant Tender Offer and Second Warrant Tender Offer as further described in “- Recent Developments – First Warrant Tender Offer” and “- Recent Developments – Second Warrant Tender Offer,” respectively, above.

 
38

 
  
General

In recent years, the Chinese government has initiated programs to promote milk consumption and is providing incentives to increase dairy production. Over the same period, our products have become increasing popular in mainland China due to our continued sales and marketing efforts. As a result, we have experienced tremendous growth well above the industry average during recent years. Sales increased from approximately $7.9 million in 2005 to approximately $44.3 million in 2008, a 461% increase over three years. Net income increased from approximately $0.7 million in 2005 to approximately $2.3 million in 2008, a 220% increase over three years.

Cash and cash equivalents at September 30, 2009 increased by 31.8% to $9,681,007, from $7,343,588 at December 31, 2008. Working capital increased from approximately $3.5 million in 2005 to approximately $14.7 million at September 30, 2009, including cash generated from operations, as well as funds raised from private offerings of promissory notes and warrants we consummated in fiscal 2008. Based upon our short term liabilities, we believe our cash and cash equivalents are adequate to satisfy our working capital needs and sustain our ongoing operations for the next twelve months.

Production capacity has been the bottle neck for our growth in recent years, because production has not been able to keep up with demand. Our growth strategy for the next three years will be primarily focused on expanding production capacity and strengthening sales efforts. Management plans to achieve this strategy by increasing our production capacity with introduction of our new production facility, sales staff, and advertising expenditures.

In July 2008, we commenced construction of a new production facility in Hailun City, Heilongjiang Province, PRC. The first phase of this project has cost an aggregate of approximately $20.0 million, including land use rights, construction expenses and equipment costs. Upon completion of the first phase, the new facility will have one production line, which will have the capacity to produce 9,000 tons of milk power annually. We anticipate that production at this new facility will commence in the first quarter of fiscal 2010. In the second phase, a second production line may be added at this new facility, which, when completed, would enable us to produce an additional 9,000 tons of milk powder per year, giving us a total annual production capacity of 27,000 tons of milk powder. We believe the cost to add the second production line would be an additional $15.0 million.

Historically we relied on investments by our Chief Executive Officer and shareholders, and bank loans, to meet our cash and capital expenditures. However, as the amount of our capital expenditures increases, we will depend more on the capital markets to raise funds through private and public offerings of equity and/or debt. There can be no assurance that any future financing will be available to us when needed, and on commercially reasonable terms.

In connection with the October Offerings, we received aggregate gross proceeds of $9,000,000. The gross proceeds from the October Offerings were used in connection with the Repurchase Transaction, to pay expenses related to our Reverse Merger and October Offerings, and for general working capital purposes. The Repurchase Transaction, Reverse Merger and October Offerings are further described in “— Recent Developments — Reverse Merger, Private Placements and Related Transactions” above.

In June 2008, we closed the June 2008 Note Offering, pursuant to which we received aggregate gross proceeds of $2,250,000. In addition, on November 10, 2008, we closed the November 2008 Note Offering, pursuant to which we received aggregate gross proceeds of $500,000. We used the gross proceeds from the June 2008 Note Offering and the November 2008 Note Offering primarily for the construction and equipping of our new production facility, and to pay expenses related to these offerings. The June 2008 Note Offering and November 2008 Note Offering are further described in “- Recent Developments - Sale of Notes and Warrants” above.

 
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As of April 24, 2008, we commenced the First Warrant Tender Offer, pursuant to which the holders of warrants received in connection with the October Offerings had the opportunity to tender their warrants for shares of our common stock at a reduced exercise prices. On March 2, 2009, we closed the First Warrant Tender Offer. In connection with the First Warrant Tender Offer we received gross proceeds of $758,231. We used the gross proceeds we received from the First Warrant Tender Offer for the construction and equipping of our new production facility, and to pay expenses related to the First Warrant Tender Offer. The First Warrant Tender Offer is further described in “- Recent Developments – First Warrant Tender Offer” above.

On August 13, 2009, we closed our Second Warrant Tender Offer, pursuant to which:

 
·
a total of 49,000 Original Warrants with an exercise price of $2.04 per share were exchanged for Amended Warrants with a reduced exercise price of $1.63 per share; and
 
 
·
a total of 2,205,828 Original Warrants with an exercise price of $3.26 per share were exchanged for Amended Warrants with a reduced exercise price of $1.63 per share.
 
On August 14, 2009, the warrant holders that participated in the Second Warrant Tender Offer exercised all of the 2,254,828 Amended Warrants they received in connection therewith, at an exercise price of $1.63 per share. As a result, we received gross proceeds of $3,675,370. We used the gross proceeds we received from the Second Warrant Tender Offer for the construction and equipping of our new production facility, and to pay expenses related to the Second Warrant Tender Offer. The Second Warrant Tender Offer is further described in “- Recent Developments – Second Warrant Tender Offer” above.

On November 30, 2009, we borrowed $1,750,000 through the Term Loan from the Term Loan Lender. We applied the proceeds of this Term Loan primarily to the equipping of the first production line of our new production facility. The Term Loan is further described in “— Recent Developments — Term Loan” above.

On December 24, 2009, we consummated the December 2009 Note Offering pursuant to which we received net proceeds of $1,540,000. We intend to apply the net proceeds primarily toward (i) the cost of equipping the first production line of our newly-constructed milk powder processing facility, (ii) the payment of expenses incurred in connection with the December 2009 Note Offering, and (iii) general working capital purposes.

Following the completion of the first production line of our new facility, we plan to add a second production line, which, when completed, would enable us to produce an additional 9,000 tons of milk powder per year, giving us a total annual production capacity of 27,000 tons of milk powder. We believe the cost to add the second production line would be an additional $15.0 million.  We currently have no sources for the additional financing we may need to add a second production line at our new processing facility. There can be no assurance that that any additional financing will become available to us, and if available, on terms acceptable to us.

In addition to constructing our new production facility, we have purchased an office building located in Heilongjiang Province, PRC, for approximately $1.8 million, which will serve as our corporate headquarters. The purchase price of this building was paid out of our retained earnings.

Currently, we spend approximately 8% - 12% of total revenues on advertising and promotional efforts through out the year. We spent approximately $3.0 million, $1.9 million and $0.8 million on advertising and promotion in fiscal 2008, 2007 and 2006, respectively. We currently expect to spend an aggregate of between $4.0 million and $5.0 million on advertising and promotion in fiscal 2009, of which $2,940,297 has already been spent as of September 30, 2009. This will still fall within our standard budget for advertising and promotion of 8% - 12% of total revenues, but in 2009 we plan to spread the expense over the entire year rather than in the first half of the year as we did in 2008. The funds for advertising and promotion will generally come out of our earnings.

 
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Management will also consider making strategic acquisitions if there are good opportunities in the marketplace. However, revenue from acquisitions has not been included in our planned growth.

Registration Rights and Liquidated Damages

In connection with the October Offerings, as further described in “- Recent Developments - Reverse Merger, Private Placements and Related Transactions” above, we entered into Registration Rights Agreements (each, a “Registration Rights Agreement,” and collectively the “Registration Rights Agreements”) with Mr. Winfield, the Initial Purchasers and the Additional Purchasers (collectively, the “Investors”), pursuant to which we agreed that within thirty (30) business days of the respective closing date (the “Filing Date”), we would file a registration statement with the SEC (the “Registration Statement”) covering the resale of (i) the shares of common stock purchased in the October Offerings (the “Purchased Shares”), and (ii) the common stock issuable upon exercise of Warrant W-1, Warrant W-2, the Class A Warrants, and the Class B Warrants (collectively (i), (ii), (iii) and (iv), the “Registrable Securities”). Further, we agreed to use our best efforts to (i) cause the Registration Statement to be declared effective within ninety (90) calendar days from the Filing Date, or, if reviewed by the SEC, within one hundred eighty (180) calendar days after the Filing Date, and (ii) keep the Registration Statement continuously effective until all of the Registrable Securities have been sold, or may be sold without volume restrictions pursuant to Rule 144.

Pursuant to the Registration Rights Agreements, we are required to pay liquidated damages to the holders of the Purchased Shares if (i) we fail to file the Registration Statement within thirty (30) business days from the Closing Date, (ii) the SEC does not declare the Registration Statement effective within ninety (90) days of the Filing Date (or one hundred eighty (180) days in the event of a review by the SEC) (the “Effectiveness Date”), (iii) we fail to request acceleration of effectiveness within five (5) business days of a notice of no further review from the SEC, (iv) we fail to respond to the SEC within ten (10) business days of receipt by us of any comments on the Registration Statement, or (v) after it has been declared effective, the Registration Statement ceases to be effective or available or if we suspend the use of the prospectus forming a part of the Registration Statement (A) for more than thirty (30) days in any period of 365 consecutive days if we suspend in reliance on its ability to do so due to the existence of a development that, in the good faith discretion of its board of directors, makes it appropriate to so suspend or which renders us unable to comply with SEC requirements, or (B) for more than ninety (60) days in any period of 365 consecutive days for any reason. The liquidated damages will accumulate at the rate of one and one-half percent (1.5%) of the purchase price paid by the Investors for units of our securities purchase in the October Offerings for each thirty (30) day period during which a registration default is continuing; provided, however, that (i) we shall not be liable for liquidated damages with respect to any warrants or shares of common stock underlying the warrants, and (ii) in no event will we be liable for liquidated damages in excess of 1.5% of the aggregate purchase price of the securities purchased in the October Offerings in any 30 day period, and (iii) the maximum aggregate liquidated damages payable to any purchaser in the October Offerings shall be 20% of the aggregate purchase price paid by such purchaser.  The Registration Rights Agreement further requires that if we fail to pay any partial liquidated damages in full within seven days after the date payable, we will pay interest thereon at a rate of 15% per annum, until such amounts, plus all such interest thereon, are paid in full.

Notwithstanding anything to the contrary stated in the Registration Rights Agreements, we are entitled to limit the Registrable Securities to the extent necessary to avoid any issues arising from the recent interpretations by the SEC of Rule 415 of the Securities Act of 1933, as amended.

 
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We did not satisfy these registration requirements and, as a result, accrued a total of $1,201,998 in liquidated damages and $172,900 in interest.  As of October 5, 2009, we issued an aggregate of 775,833 shares in full payment of the liquidated damages and interest, as further described in “— Recent Developments — Reverse Merger, Private Placements and Related Transactions” above.

Share Repurchase and Put/Call Agreements

On October 9, 2007, we consummated the Repurchase Transaction with a shareholder, as further described in “- Recent Developments - Reverse Merger, Private Placements and Related Transactions” above. We repurchased the Repurchased Shares, to reduce the overall dilution created by the October Offerings. The Repurchased Shares are currently being held in treasury.

Immediately following the closing of the Repurchase Transaction, we entered into Put/Call Agreements with the Put/Call Shareholders. Pursuant to the Put/Call Agreements, we had an option to repurchase an aggregate of 1,944,444 shares of our common stock (the “Put/Call Shares”) from the Put/Call Shareholders (the “Call Option”), for an exercise price of $1.63 per share (the “Call Option Price”), if the following conditions were met (the “Call Option Conditions”):

 
·
either (a) a registration statement (“Registration Statement”) covering the resale of the Put/Call Shares had been declared effective by the SEC, and had been kept continuously effective by us, or (b) all of the Put/Call Shares were available for sale without registration pursuant to Rule 144; and
 
 
·
the closing price of a share of our common stock as traded on the OTCBB (or such other exchange or stock market on which the common stock may be listed or quoted) equaled or exceeded $4.08 (appropriately adjusted for any stock split, reverse stock split, stock dividend or other reclassification or combination of the common stock occurring after the date hereof) for at least ten (10) consecutive trading days immediately preceding the date notice of exercise of a Call Option was given by us.
 
In addition, pursuant to the Put/Call Agreements, the Put/Call Shareholders had the right to cause us to repurchase the Put/Call Shares (the “Put Right”), for a price of $1.63 per share (the “Put Purchase Price”), if:

 
·
we failed to exercise our Call Option within ten (10) days of a date on which all of the Call Option Conditions had been met; or
 
 
·
we consummated a private offering of our securities of $5,000,000 or greater (a “Qualified Offering”);
 
 
·
we failed to consummate a Qualified Offering on or prior to October 9, 2009 (each of the aforementioned conditions, a “Put Right Trigger”).
 
Initially, our failure to (i) file the Registration Statement within thirty (30) business days of October 9, 2007 (the “Filing Date”), (ii) have the Registration Statement declared effective within ninety (90) calendar days from the Filing Date, or, if reviewed by the SEC, within one hundred eighty (180) calendar days after the Filing Date, or (iii) keep the Registration Statement continuously effective until all of the “Registrable Securities” were available for sale without registration pursuant to Rule 144, would also have served as a Put Right Trigger. However, as of April 9, 2008, the Put/Call Shareholders agreed to amend the Put/Call Agreements to delete this provision. We did not pay any consideration to the Put/Call Shareholders in connection with their waiver of this provision.

 
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We had recorded the value of the Put/Call Agreements as a liability in the aggregate amount of $3,169,444 as of October 9, 2007, based on the fair market value of the underlying common stock of $1.63 as of such date. The parties mutually agreed that it was in the best interests of the Company and its stockholders for the Put/Call Agreements to be terminated. Therefore, as of March 3, 2009, the Put/Call Agreements were terminated.

Changes in foreign exchange regulations in the PRC and ability to pay dividends in foreign currency or conduct other foreign exchange business

The Renminbi is currently not a freely convertible currency, and the restrictions on currency exchange may limit our ability to use revenues generated in RMB to fund our business activities outside the PRC, or to make dividends or other payments in United States dollars. The PRC government strictly regulates conversion of RMB into foreign currencies. Over the years, foreign exchange regulations in the PRC have significantly reduced the government’s control over routine foreign exchange transactions under current accounts. In the PRC, SAFE, regulates the conversion of the RMB into foreign currencies. Pursuant to applicable PRC laws and regulations, foreign invested enterprises incorporated in the PRC are required to apply for “Foreign Exchange Registration Certificates.” Currently, conversion within the scope of the “current account” (e.g. remittance of foreign currencies for payment of dividends, etc.) can be effected without requiring the approval of SAFE. However, conversion of currency in the “capital account” (e.g. for capital items such as direct investments, loans, securities, etc.) still requires the approval of SAFE.  See the discussion in Risk Factors on page 5 for more information.

Material Weakness in Internal Control Over Financial Reporting

On October 9, 2007, we became a public company by virtue of the Reverse Merger, as more fully described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Recent Developments — Reverse Merger, Private Placements and Related Transactions” above.

Consequently, we are now subject to the laws related to reporting companies, including the Sarbanes-Oxley Act of 2002, as amended.  Section 404 of the Sarbanes-Oxley Act requires annual management assessments of the effectiveness of our internal control over financial reporting. We were first required to comply with Section 404 commencing with our Annual Report on Form 10-K for the year ending December 31, 2007.  However, our management has not yet been able to complete its assessment.  Our management is currently carrying out an evaluation, under the supervision and with the participation of our president (also our principal executive officer) and chief financial officer (also our principal financial and accounting officer), of the effectiveness of the design and operation of our disclosure controls and procedures. We are currently in the process of further documenting our system of internal control over financial reporting and we will add additional controls and procedures as needed in order to satisfy the requirements of Section 404. During the course of our testing, we may in the future identify deficiencies which we may not be able to remediate in time to comply with Section 404.

Section 404 also requires a report by our independent registered public accounting firm regarding the effectiveness of our internal control over financial reporting. Under current requirements, our independent registered public accounting firm is not required to evaluate and assess our internal control over financial reporting until its audit of our consolidated financial statements for the year ending December 31, 2009. Consequently, we will not be evaluated independently in respect of our controls for a substantial period of time after this offering is completed. As a result, we may not become aware of other material weaknesses in our internal control that may be later identified by our independent registered public accounting firm.

 
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As mentioned above, our management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with generally accepted accounting principles.

In connection with the audits of the fiscal years ended December 31, 2008 and 2007, Windes & McClaughry Accountancy Corporation (“Windes”), our independent registered public accounting firm, noted matters involving our internal controls that it considered to be significant deficiencies, and taken together constitute a material weakness, under the standards of the Public Company Accounting Oversight Board (“PCAOB”). Under the PCAOB standards, a material weakness is a significant deficiency, or combination of significant deficiencies, that, in Windes’s judgment, results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.

The material weaknesses identified by Windes were as follows:

 
·
Improper treatment of the effects of exchange rate changes on cash balances held in foreign currencies in the 2006 statement of cash flows; and
 
 
·
Inadequate or incomplete review and analysis of certain contractual and other liabilities.
 
Our management has discussed these material weaknesses with our board of directors and has engaged in the following remediation efforts to ensure that the significant deficiencies do not reoccur:

 
·
We hired an outside consultant to assist with the preparation of our financial statements; and
 
 
·
We implemented new review and analysis processes for all significant contractual and other liabilities, including without limitation:
 
 
(a)
the requirement that white papers be prepared to document all material transactions;
 
 
(b)
the establishment of checklists and timelines to insure timely reporting of financial information; and
 
 
(c)
the utilization of comparison review of Chinese accounting standards versus GAAP standards; and
 
 
·
we purchased and are implementing a new revenue accounting system, that we believe will enable us to record and report revenue as required to support our preparation of timely and accurate financial statements.
 
In addition, in the fourth quarter of 2008, we retained an outside consultant to assist us with the self-assessment required by Section 404 of the Sarbanes-Oxley Act of 2002. This consultant completed the documentation of our internal controls and procedures. However, upon review of the work product, our management determined that the prepared documentation did not contain sufficient detail. Therefore, in the first quarter of 2009, we retained an additional consultant to help management refine the documentation.  That consultant has not yet completed the documentation of our internal controls and procedures.

 
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These remediation efforts are designed to address the material weakness identified by Windes and to improve and strengthen our overall control environment. We believe these actions will prevent the significant deficiencies from reoccurring. Our management, including our principal executive officer and principal financial officer, does not expect that disclosure controls or internal controls over financial reporting will prevent all errors, even as the aforementioned remediation measures are implemented and further improved to address all deficiencies. The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.

The implementation of our remediation plan will require substantial expenditures, could take a significant period of time to complete, and could distract our officers and employees from the operation of our business. In particular, we will incur significant expenses in implementing a new revenue accounting system, including software license fees as well as fees of third-party consultants and employment-related expenses attributable to additional internal staffing. We are currently unable to estimate with reasonable certainty the anticipated costs associated with our remediation efforts.  See “Risk Factors — Ensuring that we have adequate internal financial and accounting controls and procedures in place might entail substantial costs, may take a significant period of time, and may distract our officers and employees from the operation of our business, which could adversely affect our operating results and our ability to operate our business.”

Our failure to remediate the material weakness Windes identified, or the identification in the future of other material weaknesses in our internal control over financial reporting may adversely affect our ability to report financial information, including the filing of our quarterly or annual reports with the SEC, on a timely and accurate basis and, in particular, may impair our ability to comply with Section 404 of the Sarbanes-Oxley Act. If we are unable to comply with Section 404 or otherwise to produce accurate and timely financial statements, our stock price may be adversely affected and we may be unable to maintain compliance with SEC requirements.  See “Risk Factors — Our management has identified a material weakness in our internal control over financial reporting, which if not properly remediated could result in material misstatements in our future interim and annual financial statements and have a material adverse effect on our business, financial condition and results of operations and the price of our common stock.”

Dividends

We have not paid any dividends. In all likelihood, we will use our earnings to develop our business and do not intend to declare dividends for the foreseeable future. Any decision to pay dividends on our common stock in the future will be made by our board of directors on the basis of earnings, financial requirements and other such conditions that may exist at that time.  In addition, the Notes we issued in the Note Offering, further described in “— Recent Developments — Sale of Notes and Warrants” above, contain restrictive covenants on our payment of dividends, as further described in “Description of Securities — Promissory Notes” above.

 
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Contractual Obligations and Commercial Commitments

Our contractual obligations, as of  September 30, 2009, were as follows:

Payments Due By Period
 
Contractual obligations
 
Total
   
Less than
1 year
   
1-3 years
   
After
3-5 years
   
More than
5 years
 
Equipment purchase
 
$
1,590,466
   
$
1,590,466
     
     
     
 
Construction contract
   
1,868,145
     
1,868,145
     
     
     
 
Debt Obligations
   
3,199,038
     
3,199,038
     
     
     
 
Advertising contract
   
82,036
     
82,036
     
     
     
 
Operating leases
   
39,335
     
39,335
     
     
     
 
Total:
 
$
6,799,020
   
$
6,779,020
     
     
     
 

Critical Accounting Policies and Estimates
 
Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) which require use to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of our financial statements and the reported amounts of revenues and expenses during the reporting periods. The consolidated financial statements include the our accounts and those of our wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. In our opinion, the condensed consolidated financial statements contain all the adjustments necessary (consisting only of normal recurring accruals) to make our financial position and the results of operations and cash flows not misleading. Critical accounting policies are those that require the application of management’s most difficult, subjective, or complex judgments, often because of the need to make estimates about the effect of matters that are inherently uncertain and that may change in subsequent periods. In preparing the financial statements, we utilized available information, including our past history, industry standards and the current economic environment, among other factors, in forming our estimates and judgments, giving due consideration to materiality. Actual results may differ from these estimates. In addition, other companies may utilize different estimates, which may impact the comparability of our results of operations to those of companies in similar businesses. We believe that of our significant accounting policies, the following may involve a higher degree of judgment and estimation.
 
Inventory
 
Inventory is stated at the lower of cost or market. Cost is determined using the weighted average method. Market value represents the estimated selling price in the ordinary course of business less the estimated costs necessary to complete the sale.
 
Raw materials consist of raw milk, soybeans, and rice and rice powder. Work in process consists of materials and products in process of conversion to powder but not yet packaged.
 
The cost of inventories comprises all costs of purchases, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. The costs of conversion of inventories include fixed and variable production overheads, taking into account the stage of completion.

 
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Property and equipment
 
Property and equipment is stated at the historical cost, less accumulated depreciation. Depreciation on property, plant, and equipment is provided using the straight-line method over the estimated useful lives of the assets after taking into account any salvage value as follows:
 
Buildings
30 years
Communication equipment, plant and machinery
10 - 30 years
Motor vehicles
10 years
Dairy cows
5 years
Furniture, Fixtures, and Equipment
5 - 10 years

Expenditures for renewals and betterments were capitalized, while repairs and maintenance costs are normally charged to the statement of operations in the year in which they are incurred. In situations where it can be clearly demonstrated that the expenditure has resulted in an increase in the future economic benefits expected to be obtained from the use of the asset, the expenditure is capitalized as an additional cost of the asset.

Upon sale or disposal of an asset, the historical cost and related accumulated depreciation or amortization of such asset were removed from their respective accounts and any gain or loss is recorded in the statements of operations.

Intangible Assets

Intangible assets consist of land use rights we acquired and are amortized on a straight line basis over the lives of the rights agreements, which is fifty years and patents which are amortized on a straight line basis over the remaining life of the patents which is five years.

Revenue recognition

Revenue is recognized in accordance with Staff Accounting Bulletin No. 104, “Revenue Recognition,” which states that revenue should be recognized when the following criteria are met: (1) persuasive evidence of an arrangement exists; (2) the service has been rendered; (3) the selling price is fixed or determinable; and (4) collection of the resulting receivable is reasonably assured.

Interest income is recognized when earned, taking into account the average principal amounts outstanding and the interest rates applicable.

Earnings per share

Basic net earnings per common share is computed by dividing net earnings applicable to common shareholders by the weighted-average number of common shares outstanding during the period. Diluted net earnings per common share is determined using the weighted-average number of common share shares outstanding during the period, adjusted for the dilutive effect of common stock equivalents, consisting of shares that might be issued upon exercise of common stock warrants. In periods where losses are reported, the weighted-average number of common shares outstanding excludes common stock equivalents, because their inclusion would be anti-dilutive.

 
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Taxation

Taxation on profits earned in the PRC has been calculated on the estimated assessable profits for the year at the rates of taxation prevailing in the PRC in which we operate after taking into effect the benefits from any special tax credits or “tax holidays” allowed in the country of operations.

We account for income tax under FASB ASC Topic 740, “Income Taxes,” which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of the events that have been included in the financials statements or tax returns. Deferred income taxes are recognized for all significant temporary differences between tax and financial statements bases of assets and liabilities. Valuation allowances are established against net deferred tax assets when it is more likely than not that some portion or all of the deferred tax asset will not be realized.

We do not have any long-term deferred tax assets or liabilities in the PRC that will exist once the tax holiday  expires (See Note 10 to the footnotes to financial statements included in Item 8 of this report). We do not have any significant deferred tax asset or liabilities that relate to tax jurisdictions not covered by the tax holiday.

We do not accrue United States income tax on unremitted earnings from foreign operations, as it is our intention to invest these earnings in the foreign operations indefinitely.

Enterprise income tax

Under the “Provisional Regulations of The People’s Republic of China Concerning Income Tax on Enterprises promulgated by the State Council,” which came into effect on January 1, 1994, income tax is payable by a Wholly Foreign Owned Enterprises at a rate of 15% of their taxable income. Preferential tax treatment may, however, be granted pursuant to any law or regulations from time to time promulgated by the State Council.  XAL enjoyed a 100% exemption from enterprise income taxes starting on January 10, 2006 due to its classification as a “Wholly Foreign Owned Enterprise.” On March 16, 2007, the PRC enacted a new Enterprise Income Tax Law for the purpose of unifying the tax treatment of domestic and foreign enterprises. This new law eliminates the preferential tax treatment for new Wholly Foreign Owned Enterprises but allows previously granted exemptions to stay in place through 2012, with the exception that the statutory tax rate will increase by 2% per year from 15% in 2006 to 25% by 2012. This exemption ended on January 10, 2008, at which time XAL will qualify under the current tax structure for a 50% reduction in the statutory enterprise income tax rates for an additional three years.

Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets, including tax loss and credit carryforwards, and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Deferred income tax expense represents the change during the period in the deferred tax assets and deferred tax liabilities. The components of the deferred tax assets and liabilities are individually classified as current and noncurrent based on their characteristics. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized.

A provision has not been made at September 30, 2009 for U.S. or additional foreign withholding taxes on approximately $17,484,741 of undistributed earnings of foreign subsidiaries because it is the present intention of management to reinvest the undistributed earnings indefinitely in foreign operations. Generally, such earnings become subject to U.S. tax upon the remittance of dividends and under certain other circumstances. It is not practicable to estimate the amount of deferred tax liability on such undistributed earnings.

 
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The Financial Accounting Standards Board (FASB) issued ASU 2009-06, which clarifies the application of FASB ASC Topic 740 by defining a criterion that an individual income tax position must meet for any part of the benefit of that position to be recognized in an enterprise’s financial statements and provides guidance on measurement, derecognition, classification, accounting for interest and penalties, accounting in interim periods, disclosure and transition. In accordance with the transition provisions.

We recognize that virtually all tax positions in the PRC are not free of some degree of uncertainty due to tax law and policy changes by the State. However, we cannot reasonably quantify political risk factors and thus must depend on guidance issued by current State officials.

Based on all known facts and circumstances and current tax law, we believe that the total amount of unrecognized tax benefits as of September 30, 2009, is not material to its results of operations, financial condition or cash flows. We also believe that the total amount of unrecognized tax benefits as of September 30, 2009, if recognized, would not have a material effect on its effective tax rate. We further believe that there are no tax positions for which it is reasonably possible, based on current Chinese tax law and policy, that the unrecognized tax benefits will significantly increase or decrease over the next 12 months producing, individually or in the aggregate, a material effect on our results of operations, financial condition or cash flows.

Value added tax

The “Provisional Regulations of The People’s Republic of China Concerning Value Added Tax” promulgated by the State Council came into effect on January 1, 1994. Under these regulations and the Implementing Rules of the Pro