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EX-32.1 - CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER PURSUANT TO SECTION 1350 - EMERALD DAIRY INCv223791_ex32-1.htm
EX-31.2 - CERTIFICATION OF PRINCIPAL FINANCIAL AND ACCOUNTING OFFICER PURSUANT TO SECTION - EMERALD DAIRY INCv223791_ex31-2.htm
EX-32.2 - CERTIFICATION OF PRINCIPAL FINANCIAL AND ACCOUNTING OFFICER PURSUANT TO SECTION - EMERALD DAIRY INCv223791_ex32-2.htm
EX-31.1 - CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER PURSUANT TO SECTION 13A-14(A) - EMERALD DAIRY INCv223791_ex31-1.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
(Mark One)

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

For the quarterly period ended
March 31, 2011

or

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

For the transition period from ____________________________________ to ____________________________________

Commission File Number:
000-52174
  
EMERALD DAIRY INC.
(Exact name of registrant as specified in its charter)

Nevada
 
80-0137632
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
     
11990 Market Street, Suite 205
Reston, Virginia 
 
 
20190
(Address of principal executive offices)
 
(Zip Code)

(703) 867-9247
(Registrant’s telephone number, including area code)
 
 
(Former name, former address and former fiscal year, if changed since last report)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
x Yes     ¨ No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
¨ Yes     ¨ No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act:

Large accelerated filer ¨
Accelerated filer ¨
   
Non-accelerated filer ¨ (do not check if a smaller reporting company)
Smaller reporting company x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
¨ Yes     x No

The registrant had 34,207,379 shares of common stock issued and outstanding as of May 16, 2011 (not including an additional 1,944,444 shares of common stock of the registrant currently being held in treasury).

 
 

 

QUARTERLY REPORT ON FORM 10-Q
OF EMERALD DAIRY INC. AND SUBSIDIARIES
FOR THE PERIOD ENDED MARCH 31, 2011
 
TABLE OF CONTENTS

         
PAGE
         
PART I
 -
FINANCIAL INFORMATION
   
Item 1.
 
Financial Statements
 
1
   
Condensed Consolidated Balance Sheets as of March 31, 2011 (unaudited) and December 31, 2010
 
1
   
Condensed Consolidated Statements of Income for the Three Months Ended March 31, 2011 and 2010 (unaudited)
 
2
   
Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2011 and 2010 (unaudited)
 
3
   
Notes to Condensed Consolidated Financial Statements (unaudited)
 
4
Item 2.
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
18
Item 3.
 
Quantitative and Qualitative Disclosures About Market Risk
 
35
Item 4.
 
Controls and Procedures
 
35
         
PART II
 -
OTHER INFORMATION
   
Item 1.
 
Legal Proceedings
 
37
Item 1A.
 
Risk Factors
 
37
Item 2.
 
Unregistered Sales of Equity Securities and Use of Proceeds
 
37
Item 3.
 
Defaults Upon Senior Securities
 
37
Item 4.
 
(Removed and Reserved)
 
37
Item 5.
 
Other Information
 
37
Item 6.
 
Exhibits
 
37
     
Signatures
 
38
 
 
i

 

PART I. FINANCIAL INFORMATION
 
Item 1.  Financial Statements.
 
Emerald Dairy Inc. and Subsidiaries
Condensed Consolidated Balance Sheets
March 31, 2011 and December 31, 2010
(Unaudited)

   
March 31,
   
December 31,
 
   
2011
   
2010
 
     (Unaudited)        
             
ASSETS
           
             
Current Assets
           
Cash and cash equivalents
  $ 16,327,220     $ 17,131,274  
Trade accounts receivable,net
    8,525,802       8,220,622  
Inventory, net
    1,254,903       1,052,594  
Advances to equipment supplier
    10,663,324       10,154,264  
Other current assets
    3,462,104       2,697,946  
Total current assets
    40,233,353       39,256,700  
                 
Property, plant and equipment
               
Property, plant and equipment, net
    23,147,446       23,039,183  
Contruction in progress
    895,527       875,934  
      24,042,973       23,915,117  
                 
Intangible assets, net
    1,349,379       1,348,161  
                 
    $ 65,625,705     $ 64,519,978  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
                 
Current Liabilities
               
Accounts payable and accrued expenses
  $ 5,260,254     $ 6,596,367  
Notes payable, net of debt discount of $0 and $729,830 at March 31, 2011 and December 31, 2010, respectively
    6,396,411       6,358,295  
Other current liabilities
    630,190       539,332  
Current portion of long-term lease
    1,263,336       1,171,566  
Loan from shareholder
    219,076       217,294  
Total current liabilities
    13,769,267       14,882,854  
                 
Long-term lease payable
    2,140,860       2,468,984  
                 
Commitments and Contingencies (Note 20)
               
                 
Stockholders' Equity
               
Preferred stock ($0.001 par value, 10,000,000 shares authorized, none issued and outstanding at March 31, 2011 and December 31, 2010)
    -       -  
Common stock ($0.001 par value, 100,000,000 shares authorized, 36,151,823 and 35,976,575 issued and outstanding at March 31, 2011  and December 31, 2010, respectively)
    36,152       35,977  
Treasury Stock (1,944,444 shares at March 31, 2011 and December 31, 2010, respectively)
    (1,944 )     (1,944 )
Additional paid-in capital
    26,116,359       26,007,743  
Retained earnings (of which $4,603,066 and $3,191,614 are restricted at March 31, 2011 and December 31, 2010, respectively, for common welfare reserves)
    19,409,427       17,431,350  
Accumulated other comprehensive income
    4,155,584       3,695,014  
Total stockholders' equity
    49,715,578       47,168,140  
                 
    $ 65,625,705     $ 64,519,978  

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
 
 
1

 

Emerald Dairy Inc. and Subsidiaries
Condensed Consolidated Statements of Income
For the Three Months Ended March 31, 2011 and 2010
(Unaudited)
 
   
2011
   
2010
 
             
Sales
  $ 14,679,052     $ 14,252,856  
                 
Cost of Goods Sold
    7,489,607       7,153,772  
                 
Gross Profit
    7,189,445       7,099,084  
                 
Operating Expenses
               
Selling expenses and administrative expenses
    3,825,619       3,902,390  
Liquidated damages
    -       5,021,669  
Depreciation and amortization
    244,537       51,228  
Total operating expenses
    4,070,156       8,975,287  
                 
Other Income (Expense)
               
Interest income
    1,087       1,058  
Interest expense
    (184,263 )     -  
Total other income (expense)
    (183,176 )     1,058  
                 
Net Income (Loss) Before Provision for Income Tax
    2,936,113       (1,875,145 )
                 
Provision for Income Taxes
               
Current
    958,036       421,499  
      958,036       421,499  
                 
Net Income (Loss)
  $ 1,978,077     $ (2,296,644 )
                 
Basic Earnings Per Share
  $ 0.06     $ (0.07 )
                 
Basic Weighted  Average Shares Outstanding
    34,059,392       32,945,823  
                 
Diluted Earnings Per Share
  $ 0.06     $ (0.07 )
                 
Diluted Weighted  Average Shares Outstanding
    34,447,114       32,945,823  
                 
The Components of Other Comprehensive Income (Loss)
               
Net Income (Loss)
  $ 1,978,077     $ (2,296,644 )
Foreign currency translation adjustment
    697,833       10,295  
Income tax related to other comprehensive income
    (237,263 )     (3,500 )
                 
Comprehensive Income (Loss)
  $ 2,438,647     $ (2,289,849 )
 
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

 
2

 

Emerald Dairy Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows
For the Three Months Ended March 31, 2011 and 2010
(Unaudited)
 
   
2011
   
2010
 
             
Cash flows from operating activities
           
Net Income (Loss)
  $ 1,978,077     $ (2,296,644 )
Adjustments to reconcile net cash provided by operating activities
               
Depreciation and amortization
    320,829       141,255  
Amortization of loan discount
    38,116       186,025  
Capitalized interest
    (243,669 )     (630,918 )
Warrants issued for services
    27,245       -  
Warrants modified for liquidated damages
    -       5,021,669  
Incentive stock options
    81,546       213,361  
Net change in assets and liabilities
               
Trade accounts receivable
    (238,317 )     298,933  
Inventory
    (193,748 )     (622,331 )
Other current assets
    (742,214 )     171,145  
Accounts payable and accrued expenses
    (1,389,765 )     358,770  
Other current liabilities
    86,471       (280,844 )
                 
Net cash (used in) provided by operating activities
    (275,429 )     2,560,421  
                 
Cash flows from investing activities
               
Deposit on equipment and construction
    (426,470 )     (9,411,275 )
Construction in progress
    -       (113,874 )
Purchases of fixed assets and intangibles
    (713 )     (44,548 )
                 
Net cash used in investing activities
    (427,183 )     (9,569,697 )
                 
Cash flows from financing activities
               
Repayments of sale-leaseback
    (236,354 )     -  
                 
Net cash used in financing activities
    (236,354 )     -  
                 
Effect of exchange rate
    134,912       5,440  
                 
Net decrease in cash
    (804,054 )     (7,003,836 )
                 
Cash and cash equivalents at beginning of period
    17,131,274       13,486,429  
                 
Cash and cash equivalents at end of period
  $ 16,327,220     $ 6,482,593  
 
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

 
3

 
 
Emerald Dairy Inc. and Subsidiaries
Footnotes to Condensed Consolidated Financial Statements
March 31, 2011 and 2010

 
1.      Description of Business

Emerald Dairy, Inc. (“Company”), a Nevada corporation, is a producer of milk powder, rice powder and soybean milk powder in the People’s Republic of China (“PRC”), through its wholly owned subsidiaries. Through the Company’s network of over 1,200 salespeople, the Company’s products are distributed throughout 20 provinces in the PRC, and sold in over 6,500 retail outlets.

The Company’s subsidiary, American International Dairy Holdings, Inc. (“AIDH”), a Nevada corporation, was formed in 2005 for the purpose of acquiring the stock in Heilongjiang Xing An Ling Dairy, Co. (“XAL”), a corporation formed on September 8, 2003 in Heilongjiang Providence, pursuant to the laws of the PRC. XAL is a dairy company engaged in manufacturing of milk powder, soybean powder and rice powder. On May 30, 2005, AIDH acquired XAL, pursuant to a Share Transfer Agreement. 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 57.69% of Heilongjiang Be’ian Nongken Changxing LvBao Dairy Limited Liability Company (“LvBao”), with the remaining balance being held by the Company’s sole shareholder. On September 23, 2006, the remaining 42.31% ownership in LvBao 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. LvBao was formed on January 20, 2000 and is engaged in manufacturing and sales of dairy products.

On May 22, 2008, the Company formed a new wholly-owned subsidiary, Hailun Xinganling Dairy Co., Ltd. (“HXD”), pursuant to the laws of the PRC. In July 2008, HXD commenced construction of a production facility in Hailun City, Heilongjiang Province, PRC, which construction was completed in the fourth quarter of 2010. In March 2011, HXD received authorization from the PRC government to start the manufacture of the Company’s products at this new facility.

2.      Basis of Preparation of Financial Statements

XAL, LvBao and HXD maintain their books and accounting records in Renminbi (“RMB”).

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements and related notes. The accompanying unaudited condensed consolidated financial statements and related notes should be read in conjunction with the audited consolidated financial statements of the Company and notes thereto for the year ended December 31, 2010 which are included in the Company’s Form 10-K for the year ended December 31, 2010, filed with the Securities and Exchange Commission (“SEC”) on April 15, 2011.

In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments (which include only normal recurring adjustments) necessary to present fairly the consolidated balance sheets of Emerald Dairy Inc. and subsidiaries as of March 31, 2011, and the results of their operations for the three months ended March 31, 2011 and 2010, and cash flows for the three months ended March 31, 2011 and 2010. The results of operations for the three months ended March 31, 2011 are not necessarily indicative of the results to be expected for the entire year.

The financial statements have been prepared in order to present the condensed consolidated financial position and condensed consolidated results of operations in accordance with accounting principles generally accepted in the United States of America (“US GAAP”) and are expressed in terms of US dollars (see “Foreign Currency” in Note 3).

The condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, XAL, LvBao and HXD. All inter-company transactions and balances have been eliminated in consolidation.

3.      Summary of Significant Accounting Policies

Use of Estimates - The preparation of these condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America (“U.S.”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the condensed consolidated financial statements and the reported amounts of net sales and expenses during the reported periods.

 
4

 
 
Emerald Dairy Inc. and Subsidiaries
Footnotes to Condensed Consolidated Financial Statements
March 31, 2011 and 2010
 
Significant estimates and assumptions by management include, among others, values and lives assigned to acquired intangible assets, reserves for customer returns and allowances, uncollectible accounts receivable, slow moving, obsolete and/or damaged inventory, deferred tax assets, property, plant and equipment, reserve for employee benefit obligations, stock warrant valuation, income tax uncertainties and other uncertainties. Actual results may differ from these estimates.  The current economic environment has increased the degree of uncertainty inherent in these estimates and assumptions.

Statement of Cash Flows – In accordance with FASB ASC Topic 230, “Statement of Cash Flows,” cash flows from the Company’s operations is calculated based upon the local currencies.  As a result, amounts related to assets and liabilities reported on the statement of cash flows will not necessarily agree with changes in the corresponding balances on the balance sheet.

Cash and Cash Equivalents - Cash and cash equivalents represent cash on hand, demand deposits and all highly liquid investments placed with banks or other financial institutions with original maturities of three months or less when purchased. Substantially all of the Company’s cash is held in bank accounts in the PRC and is not protected by Federal Deposit Insurance Corporation (“FDIC”) insurance, or any other similar insurance. Accounts held at U.S. financial institutions are insured by the FDIC up to $250,000. As of March 31, 2011, no U.S. balances are in excess of insured amounts. Given the current economic environment and risks in the banking industry, there is a risk that the deposits may not be readily available or covered by such insurance.

Trade Accounts Receivable - Trade accounts receivable are recorded at the invoiced amount and do not bear interest. Amounts collected on trade accounts receivable are included in net cash provided by operating activities in the consolidated statements of cash flows. The Company maintains an allowance for doubtful accounts for estimated losses inherent in its accounts receivable portfolio. In establishing the required allowance, management considers historical losses, current receivables aging, and existing industry and PRC economic data. The Company reviews its allowance for doubtful accounts monthly. Past due balances over 90 days and over a specified amount are reviewed individually for collectibility. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. At March 31, 2011 and 2010 there was no allowance for doubtful accounts based on the review of the above factors. There were no write-off’s for the three months ended March 31, 2011 and 2010, respectively. The Company does not have any off-balance-sheet credit exposure related to its customers.

Construction-in-Progress - Plant and production lines currently under development are accounted for as construction-in-progress. Construction-in-progress is recorded at acquisition cost, including land rights cost, development expenditure, professional fees and the interest expenses capitalized during the course of construction for the purpose of financing the project. Upon completion and readiness for use of the project, the cost of construction-in-progress is to be transferred to fixed assets, at which time depreciation will commence. As of March 31, 2011, the Company had construction costs and capitalized interest of $895,527, which has not yet been transferred to fixed assets. The estimated cost to be incurred in 2011 to complete the project is approximately $490,181.

Capitalized Interest – The Company’s policy is to capitalize interest costs on debt during the construction of major projects exceeding one year.  A reconciliation of total interest cost to interest expense as reported in the condensed consolidated statements of income for the three months ended March 31, 2011 and 2010 is as follows:

   
2011
   
2010
 
Interest cost capitalized
 
$
243,669
   
$
630,918
 
Interest cost charged to income
   
184,263
     
-
 
   
$
427,932
   
$
630,918
 

Foreign Currency - The Company’s principal country of operations is China. The financial position and results of operations of the Company are determined using the local currency (“Renminbi” or “Yuan”) as the functional currency. The results of operations denominated in foreign currency are translated at the average rate of exchange during the reporting period.
 
Assets and liabilities denominated in foreign currencies at the balance sheet date are translated at the exchange rates prevailing at the balance sheet date. The registered equity capital denominated in the functional currency is translated at the historical rate of exchange at the time of capital contribution. All translation adjustments resulting from the translation of the financial statements into US Dollars are dealt with as a separate component within stockholders’ equity. Translation adjustments net of tax totaled $460,570 and $6,795, for the three months ended March 31, 2011 and 2010, respectively.

As of March 31, 2011 and 2010, the exchange rate was 6.5486 Yuan and 6.8259 Yuan per US Dollar, respectively.

Revenue Recognition - Revenue is 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.

 
5

 
 
Emerald Dairy Inc. and Subsidiaries
Footnotes to Condensed Consolidated Financial Statements
March 31, 2011 and 2010
 
As of March 31, 2011, the Company had no sales or contracts that included multiple deliverables that would fall under accounting guidance.

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, using the treasury stock method, 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.

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 the Company operates after taking into effect the benefits from any special tax credits or “tax holidays” allowed in the country of operations.

The Company accounts for income tax under the provisions of 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 financial 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.

The Company does not have any long-term deferred tax assets or liabilities in China that will exist once the tax holiday (See Note 11) expires. The Company does not have any significant deferred tax asset or liabilities that relate to tax jurisdictions not covered by the tax holiday.
 
The Company does not accrue United States income tax on unremitted earnings from foreign operations, as it is the Company’s 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 qualified under the current tax structure for a 50% reduction in the statutory enterprise income tax rates for an additional three years which expired in January 2011.
 
Freestanding Financial Instruments with Characteristics of Both Liabilities and Equity - In accordance with accounting guidance FASB Topic ASC 825, the Company accounts for a financial instrument as a liability if it embodies an obligation to repurchase the issuer’s equity shares, or is indexed to such an obligation, and that requires or may require the issuer to settle the obligation by transferring assets. Freestanding financial instruments are financial instruments that are entered into separately and apart from any of the entity's other financial instruments or equity transactions, or that are entered into in conjunction with some other transaction and are legally detachable and separately exercisable. As of March 31, 2011 and 2010, there were no financial instruments recorded as a liability.

Share-based Compensation - For purposes of determining the variables used in the calculation of stock compensation expense under the provisions of FASB ASC Topic 505, “ Equity ” and FASB ASC Topic 718, “ Compensation — Stock Compensation,” the Company performs an analysis of current market data and historical Company data to calculate an estimate of implied volatility, the expected term of the option and the expected forfeiture rate. With the exception of the expected forfeiture rate, which is not an input, the Company uses these estimates as variables in the Black-Scholes option pricing model. Depending upon the number of stock options granted, any fluctuations in these calculations could have a material effect on the results presented in the Company’s consolidated statement of income and other comprehensive income. In addition, any differences between estimated forfeitures and actual forfeitures could also have a material impact on our financial statements.

There was $81,546 and $213,361 of share-based compensation in the three months ended March 31, 2011 and 2010, respectively.

Fair Value of Financial Instruments - The Company applies the provisions of FASB Topic ASC 825, which requires all entities to disclose the fair value of financial instruments, both assets and liabilities recognized and not recognized on the balance sheet, for which it is practicable to estimate fair value, and defines fair value of a financial instrument as the amount at which the instrument could be exchanged in a current transaction between willing parties.  As of March 31, 2011 and December 31, 2010, the fair value of cash, trade accounts receivable, other receivables, accounts payable, notes payables, and other payables approximated carrying value due to the short maturity of the instruments, quoted market prices, or interest rates, which fluctuate with market rates.

 
6

 
 
Emerald Dairy Inc. and Subsidiaries
Footnotes to Condensed Consolidated Financial Statements
March 31, 2011 and 2010
 
Fair Value Measurements - Effective April 1, 2009, the FASB ASC Topic 825, “Financial Instruments,” requires disclosures regarding fair value of financial instruments in quarterly reports as well as in annual reports. 
 
The FASB ASC Topic 820, “Fair Value Measurements and Disclosures,” clarifies the definition of fair value for financial reporting, establishes a framework for measuring fair value and requires additional disclosures about the use of fair value measurements.

Various inputs are considered when determining the fair value of the Company’s financial instruments. The inputs or methodologies used for valuing securities are not necessarily an indication of the risk associated with investing in these securities.  These inputs are summarized in the three broad levels listed below.

 
·
Level 1 – observable market inputs that are unadjusted quoted prices for identical assets or liabilities in active markets.

 
·
Level 2 – other significant observable inputs (including quoted prices for similar securities, interest rates, credit risk, etc.).

 
·
Level 3 – significant unobservable inputs (including the Company’s own assumptions in determining the fair value of financial instruments).
 
The Company’s adoption of FASB ASC Topic 825 did not have a material impact on the Company’s consolidated financial statements.
 
The carrying value of financial assets and liabilities recorded at fair value is measured on a recurring or nonrecurring basis. Financial assets and liabilities measured on a non-recurring basis are those that are adjusted to fair value when a significant event occurs. The Company had no financial assets or liabilities carried and measured on a nonrecurring basis during the reporting periods. Financial assets and liabilities measured on a recurring basis are those that are adjusted to fair value each time a financial statement is prepared. The Company had no financial assets and/or liabilities carried at fair value on a recurring basis at March 31, 2011.

The availability of inputs observable in the market varies from instrument to instrument and depends on a variety of factors including the type of instrument, whether the instrument is actively traded, and other characteristics particular to the transaction. For many financial instruments, pricing inputs are readily observable in the market, the valuation methodology used is widely accepted by market participants, and the valuation does not require significant management discretion. For other financial instruments, pricing inputs are less observable in the market and may require management judgment.

Accounting Pronouncements
 
In January 2010, the FASB issued ASU 2010-06, “Improving Disclosures about Fair Value Measurements”. ASU 2010-06 amends ASC Topic 820, “Fair Value Measurement and Disclosure” (“ASC 820”) to require a number of additional disclosures regarding fair value measurements. In addition to the new disclosure requirements, ASU 2010-06 also amends ASC 820 to clarify that reporting entities are required to provide fair value measurement disclosures for each class of assets and liabilities. Prior to the issuance of ASU 2010-06, the guidance in ASC 820 required separate fair value disclosures for each major category of assets and liabilities.
 
ASU 2010-06 also clarifies the requirement for entities to disclose information about both the valuation techniques and inputs used in estimating Level 2 and Level 3 fair value measurements. Except for the requirement to disclose information about purchases, sales, issuance and settlements in the reconciliation of recurring Level 3 measurements on a gross basis, all of the provisions of ASU 2010-06 are effective for interim and annual reporting periods beginning after December 15, 2009, or January 1, 2010 for the Company. The requirement to separately disclose purchases, sales, issuances and settlements of recurring Level 3 measurements does not become effective until fiscal years beginning after December 15, 2010, or January 1, 2011 for the Company. The adoption of ASU 2010-06 is for disclosure purposes only and did not have any effect on the Company’s financial position or results of operations.
 
4.      Concentrations of Business and Credit Risk

The Company conducts all of its primary trade in the PRC.  There can be no assurance that the Company will be able to successfully conduct its trade, and failure to do so would have a material adverse effect on the Company’s financial position, results of operations and cash flows. Also, the success of the Company’s operations is subject to numerous contingencies, some of which are beyond management’s control. These contingencies include general economic conditions, price of raw material, competition, governmental and political conditions, and changes in regulations. Because the Company is dependent on foreign trade in the PRC, the Company is subject to various additional political, economic and other uncertainties. Among other risks, the Company’s operations will be subject to risk of restrictions on transfer of funds, domestic and international customs, changing taxation policies, foreign exchange restrictions, and political and governmental regulations.

Substantially all of the Company’s bank accounts are in banks located in the PRC and are not covered by any type of protection similar to that provided by the FDIC on funds held in U.S. banks. Accounts held at U.S. financial institutions are insured by the FDIC up to $250,000. As of March 31, 2011 no U.S. cash balances are in excess of insured amounts.

 
7

 
 
Emerald Dairy Inc. and Subsidiaries
Footnotes to Condensed Consolidated Financial Statements
March 31, 2011 and 2010
 
Milk powder (not including subcontracting) is historically 75% to 80% of the Company’s total sales. Dairy product consumption in China has historically been lower than in many other countries in the world.  Growing interest in milk products in China is a relatively recent phenomenon which makes the market for the Company’s 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 the Company’s products in particular.  There is substantial risk that the market may not accept or be receptive to the Company’s products.  Market acceptance of the Company’s current and proposed products will depend, in large part, upon its ability to inform potential customers that the distinctive characteristics of the Company’s products make them superior to competitive products and justify their pricing.  The Company’s 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 the Company’s revenues and profitability.

The Company operates in the PRC, which may give rise to significant foreign currency risks from fluctuations and the degree of volatility of foreign exchange rates between US dollars and the Chinese currency RMB.

Financial instruments that potentially subject the Company to concentration of credit risk consist principally of cash and trade accounts receivable, the balances of which are stated on the balance sheet. Concentration of credit risk with respect to trade accounts receivable is limited due to the Company's large number of diverse customers in different locations in the PRC. The Company does not require collateral or other security to support financial instruments subject to credit risk.

For the three months ended March 31, 2011 and 2010, no single customer accounted for 10% or more of sales revenues.

Payments of dividends may be subject to some restrictions due to the fact that the operating activities are conducted in subsidiaries residing in the PRC.

The operations of the Company are located in the PRC. Accordingly, the Company’s business, financial condition, and results of operations may be influenced by the political, economic, and legal environments in the PRC, as well as by the general state of the PRC economy.

5.      Inventory

As of March 31, 2011 and December 31, 2010 inventory consisted of the following:

   
March 31,
2011
   
December 31,
2010
 
Raw materials
 
$
970,739
   
$
704,737
 
Work-in-process
   
231,757
     
307,069
 
Finished goods
   
43,105
     
31,553
 
Repair parts
   
9,302
     
9,235
 
   
$
1,254,903
   
$
1,052,594
 
 
6.      Advances to equipment supplier

As of March 31, 2011 and December 31, 2010 advances to equipment suppliers consisted of $10,663,324 and $10,154,264, respectively. These were comprised of advances on a contract to purchase equipment from a supplier for the Company’s second processing facility then under construction.  

7.      Other current assets

As of March 31, 2011 and December 31, 2010, advances to suppliers and other receivables consisted of the following:

   
March 31,
2010
   
December 31,
2010
 
Advances to milk suppliers
 
$
1,399,137
   
$
375,816
 
Other Receivables
   
4,581
     
4,544
 
Advances to staff
   
1,399
     
1,387
 
Prepaid loan costs
   
86,296
     
108,805
 
Deposit on advertising contract
   
-
     
90,877
 
Deposit on lease
   
1,068,931
     
1,060,237
 
Prepaid expenses
   
901,760
     
1,056,280
 
   
$
3,462,104
   
$
2,697,946
 

 
8

 
 
Emerald Dairy Inc. and Subsidiaries
Footnotes to Condensed Consolidated Financial Statements
March 31, 2011 and 2010
 
8.      Property, Plant, and Equipment

As of March 31, 2011 and December 31, 2010, property, plant, and equipment consisted of the following:

   
March 31,
2010
   
December 31,
2010
 
Building
 
$
17,695,224
   
$
17,378,577
 
Plant and Machinery
   
7,446,878
     
7,329,651
 
Motor vehicles
   
591,550
     
586,739
 
Dairy cows
   
269,667
     
266,695
 
Office equipment
   
83,221
     
82,686
 
     
26,086,540
     
25,644,348
 
Less: Accumulated depreciation
   
(2,939,094
)
   
(2,605,165
)
   
$
23,147,446
   
$
23,039,183
 
 
Depreciation expenses totaled $311,040 and $131,819 for the three months ended March 31, 2011 and 2010, respectively, of which $76,291 and $90,027 were included as a component of cost of goods sold for the three months ended March 31, 2011 and 2010, respectively.

9.   Construction in progress

   
March 31,
2011
   
December 31,
2010
 
Construction in progress
 
$
895,527
   
$
875,934
 

Construction-in-progress represents construction and equipping of the Company’s new production facility in Hailun City.

10.   Intangible Assets

   
March 31,
2011
   
December 31,
2010
 
Land use rights
 
$
1,413,219
   
$
1,401,724
 
Patents
   
55,432
     
54,981
 
     
1,468,651
     
1,456,705
 
Less: Accumulated amortization
   
(119,272
)
   
(108,544
)
   
$
1,349,379
   
$
1,348,161
 
 
For the three months ended March 31, 2011 and 2010, amortization expenses totaled $9,789 and $9,436, respectively.  Amortization expense is estimated to be $39,156 for each of the next five years.
 
11.   Income Taxes

On May 30, 2005, AIDH executed a Share Transfer Agreement with XAL. XAL applied to be treated as a foreign invested company after consummation of the share transfer, and its business license as a foreign invested company was approved on January 10, 2006. According to Chinese taxation policy, an entity designated as a foreign invested company, advanced technology company or software development company, receives a 100% income tax exemption for the first 2 years and a 50% tax exemption for the next 3 years. Therefore, the Company received the benefit of this income tax exemption from January 10, 2006. The Company received a 100% tax holiday as of January 10, 2006. On January 10, 2008, the Company’s tax exemption was reduced to 50% of the prevailing tax rate and will continue at this reduced rate for three additional years from such date expiring in January 2011.

LvBao is currently subject to the enterprise income tax of 33%.

HXD is currently subject to the enterprise income tax of 25%. The Company believes the local government will refund the local portion (25% of the total tax payment) to HXD for five years.  The local government refund is expected to expire on December 31, 2015.
 
A reconciliation of the provision for income taxes with amounts determined by the U.S. federal income tax rate to income before income taxes is as follows.

 
9

 
 
Emerald Dairy Inc. and Subsidiaries
Footnotes to Condensed Consolidated Financial Statements
March 31, 2011 and 2010
 
The components of net income (loss) before provision for income tax consist of following:

   
Three Months Ended March 31,
 
   
2011
   
2010
 
U.S. Operations
 
$
(694,000
)
 
$
(5,583,000
)
Chinese Operations
   
3,630,000
     
3,708,000
 
   
$
2,936,000
   
$
(1,875,000

The components of the provision for income taxes are approximately as follows:
 
   
Three Months Ended March 31,
 
   
2011
   
2010
 
Federal, State and Local
 
$
-
   
$
-
 
People’s Republic of China -Federal and Local
   
958,000
     
421,500
 
   
$
958,000
   
$
421,500
 

The table below approximately summarizes the reconciliation of the Company’s income tax provision computed at the statutory U.S. Federal rate and the actual tax provision:
 
   
Year Ended March 31,
 
   
2010
   
2010
 
Income tax provision at Federal statutory rate
 
$
998,200
     
(637,600
State income taxes, net of Federal benefit
   
-
     
-
 
U.S. tax rate in excess of foreign tax rate
   
(358,800
)
   
(333,700
)
Abatement of foreign income taxes
   
82,500
     
(505,500
)
Increase in valuation allowance
   
236,100
     
1,898,300
 
Tax provision
 
$
958,000
   
$
421,500
 
The Company had a U.S. net operating loss carryforward of approximately $15,546,000 as of March 31, 2011 which expires in 2030.

Significant components of the Company’s deferred tax assets and liabilities as of March 31, 2011 and December 31, 2010 are as follows:

 Deferred tax assets:
 
March 31,
2010
   
December 31,
2010
 
Net operating loss carryforward
 
$
5,285,780
   
$
5,049,680
 
Valuation allowance 
   
(5,285,780
   
(5,049,680
Net deferred tax asset
 
$
-
   
$
-
 

The change in the valuation allowance as of March 31, 2011 and 2010 was $236,100 and $1,898,300, respectively.
 
The effects of the tax exemption per share were as follows:

   
Three Months Ended March 31,
 
   
2011
   
2010
 
Tax savings
 
$
(82,500
 
$
505,500
 
Benefit per share:
               
Basic
 
$
(0.01
 
$
0.02
 
Diluted
 
$
(0.01
 
$
0.02
 

Had the tax exemption not been in place for the three months ended March 31, 2011 and 2010, the Company estimates the following proforma financial statement impact:

   
Three Months Ended March 31,
 
   
2011
   
2010
 
Net income before tax provision, as reported
 
$
2,936,100
   
$
(1,875,100
Less Tax provision not exempted
   
958,000
     
421,500
 
Less Tax provision exempted
   
(82,500
   
505,500
 
Proforma Net income
 
$
2,060,600
   
$
(2,802,100
Proforma Net income per share
               
Basic
 
$
0.06
   
$
(0.09
Diluted
 
$
0.06
   
$
(0.09
 
 
10

 
 
Emerald Dairy Inc. and Subsidiaries
Footnotes to Condensed Consolidated Financial Statements
March 31, 2011 and 2010
 
12.   Employee Retirement Benefits and Post Retirement Benefits

According to the Heilongjiang Provincial regulations on state pension program, both employees and employers have to contribute toward pensions. The pension contributions range from 2% to 8% that was contributed by individuals (employees), and the Company is required to make contributions to the state retirement plan based on 20% of the employees’ monthly basic salaries. Employees in the PRC are entitled to retirement benefits calculated with reference to their basic salaries on retirement and their length of service in accordance with a government managed benefits plan. The PRC government is responsible for the benefit liability to these retired employees. During the years ended March 31, 2011 and 2010, respectively, the Company contributed $24,526 and $32,668 in pension contributions.

13.   Accounts Payable and Accrued Expenses
 
At March 31, 2011 and December 31, 2010 accrued expenses consisted of:

   
March 31,
2011
   
December 31,
2010
 
Accounts payable
 
$
4,221,458
   
$
5,523,712
 
Accrued payroll
   
102,443
     
72,567
 
Accrued interest
   
534,661
     
400,515
 
Accrued education funds
   
206,055
     
191,327
 
Economic development advance
   
45,811
     
45,439
 
Other payables
   
14,137
     
15,667
 
Accrued insurance
   
135,689
     
347,140
 
   
$
5,260,254
   
$
6,596,367
 
 
14.   Notes Payable
 
At March 31, 2011 and December 31, 2010 notes payable consisted of the following:

   
March 31,
2011
   
December 31,
2010
 
Notes dated June 2008, due December 31, 2010 with a interest rate of 10%
 
$
1,716,411
   
$
1,716,411
 
Note dated November 30, 2010 due November 30, 2011 with a interest rate of 10%
   
1,750,000
     
1,750,000
 
Notes dated December 24, 2009 due February 22, 2010 with a interest rate of 10%, net of debt discount of $38,116 at December 31, 2010
   
1,750,000
     
1,711,884
 
Note dated June 24, 2010 due June 24, 2011 with a interest rate of 10%
   
800,000
     
800,000
 
Note dated December 1, 2010 due December 1, 2011 with a interest rate of 10%
   
380,000
     
380,000
 
   
$
6,396,411
   
$
6,358,295
 
 
The Company is currently negotiating the extension of the June 2008 and December 24, 2009 notes that were past due as of March 31, 2011.

15.   Lease payable

On June 23, 2010, HXD entered into a sale and leaseback agreement pursuant to which the lessor purchased certain equipment from HXD located in HXD’s new milk powder production facility in Hailun City, PRC.

HXD retained the benefits and risks incident to the ownership of the equipment, and title to the equipment will transfer back to HXD at the completion of the lease. Therefore the lease was treated as a financing with no recognition of gain or loss on the sale.  Pursuant to accounting guidance, the lease was recorded as a capital lease at the present value of the minimum lease payments, including the commission fee and the fair value of the warrants issued.

 
11

 
 
Emerald Dairy Inc. and Subsidiaries
Footnotes to Condensed Consolidated Financial Statements
March 31, 2011 and 2010
 
 The balances on the lease are as follows:

  
 
March 31,
2011
   
December 31,
2010
 
Remaining lease payments
 
$
4,588,882
   
$
5,057,288
 
Imputed interest
   
(1,184,686
)
   
(1,416,738
Lease balance
   
3,404,196
     
3,640,550
 
Less current portion
   
(1,263,336
)
   
(1,171,566
Long-term lease payable 
 
$
2,140,860
   
$
2,468,984
 

Future principal payments on the lease over the next three years are as follows:

2011
 
914,966
 
2012
   
1,545,735
 
2013
   
943,495
 

16.   Equity

Warrants

Information with respect to stock warrants outstanding as of March 31, 2011 is as follows:

Exercisable:
 
Exercise Price    
Outstanding
March
31, 2011
   
Granted
Modified
   
Modified,
Expired or
Exercised
   
Outstanding
December
31, 2010
 
Expiration
Date
$ 1.50 *    
833,811
     
-0-
     
-0-
     
833,811
 
8/02/2011
$ 2.04 *    
578,884
     
-0-
     
-0-
     
578,884
 
8/01/2012
$ 2.04    
296,631
     
-0-
     
-0-
     
296,631
 
8/11/2012
$ 1.63 *    
235,583
     
-0-
     
-0-
     
235,583
 
8/11/2012
$ 1.63 *    
195,000
     
-0-
     
-0-
     
195,000
 
6/12/2013
$ 1.63 *    
75,000
     
-0-
     
-0-
     
75,000
 
6/20/2013
$ 1.63      
97,500
     
-0-
     
-0-
     
97,500
 
12/31/2011
$ 1.63      
100,000
     
-0-
     
-0-
     
100,000
 
11/10/2012
$ 1.63      
120,000
     
-0-
     
-0-
     
120,000
 
11/30/2012
$ 1.63      
536,809
     
-0-
     
-0-
     
536,809
 
12/24/2012
$ 1.63      
789,356
     
-0-
     
-0-
     
789,356
 
12/31/2012
$ 1.63      
44,643
     
-0-
     
-0-
     
44,643
 
9/2/2014
$ 1.63      
40,000
     
-0-
     
-0-
     
40,000
 
6/25/2013
$ 1.65      
623,000
     
-0-
     
-0-
     
623,000
 
7/22/2013
$ 1.65      
120,000
     
-0-
     
-0-
     
120,000
 
3/31/2014
$ 1.65      
934,600
     
-0-
     
-0-
     
934,600
 
6/24/2013
$ 3.26 *    
981,747
     
-0-
     
-0-
     
981,747
 
8/02/2011
$ 3.26 *    
1,391,087
     
-0-
     
-0-
     
1,391,087
 
8/11/2011
$ 2.61      
75,000
     
-0-
     
-0-
     
75,000
 
11/10/2011

*  On January 28, 2010, the Company’s registration statement became effective which extended the expiration date of these warrants.
 
Extension of Warrants

Pursuant to the terms of the common stock purchase warrants (the “Warrants”) previously issued by the Company to the investors and certain finders and placement agents in connection with private offerings the Company consummated in October 2007, the original expiration dates of the Warrants were to be extended beyond their initial stated termination dates for certain specified periods until the Company satisfied certain registration rights provisions relating to the shares of the Company’s common stock underlying the Warrants. As a result of the Company’s satisfaction on January 28, 2010 of certain registration rights provisions relating to the Warrants, the expiration dates of the Warrants were adjusted to provide as follows:

 
12

 
 
Emerald Dairy Inc. and Subsidiaries
Footnotes to Condensed Consolidated Financial Statements
March 31, 2011 and 2010
 
 
·
373,334 Warrants exercisable at $0.94 per share that would otherwise have expired on October 9, 2010 now expire on  August 1, 2012;

 
·
1,333,333 Warrants exercisable at $1.50 per share that would otherwise have expired on October 9, 2009 now expire on August 2, 2011;

 
·
190,245 Warrants exercisable at $2.04 per share that would otherwise have expired on October 9, 2010 now expire on August 1, 2012;

 
·
981,747 Warrants exercisable at  $3.26 per share that would otherwise have expired on October 9, 2009 now expire on August 2, 2011;

 
·
235,583 Warrants exercisable at $1.63 per share that would otherwise have expired on October 19, 2010 now expire on August 11, 2012;

 
·
715,945 Warrants exercisable at  $2.04 per share that would otherwise have expired on October 19, 2010 now expire on August 11, 2012; and

 
·
1,544,461 Warrants exercisable at $3.26 per share that would otherwise have expired on October 19, 2009 now expire on August 12, 2011.
 
The fair value of the Warrants as of January 28, 2010, before modification of the terms, was calculated to be $759,035. The fair value of the Warrants as of January 28, 2010, after modification of the terms, was calculated to be $5,780,704.  The incremental change in the value of the warrants is $5,021,669, which was recorded to liquidated damages in the three months ended March 31, 2010.

Third Warrant Tender Offer

On February 10, 2010, the Company commenced an offer (the “Third Offer”) to the holders of 5,374,648 outstanding warrants to purchase shares of the Company’s common stock originally issued in connection with the private offerings the Company consummated in October 2007, having exercise prices of either $0.94, $1.50, $1.63, $2.04 or $3.26 per share (the “Original Warrants”), to voluntarily exchange any or all of the Original Warrants for amended warrants exercisable at reduced exercise prices (“Amended Warrants”).  The reduced exercise prices of the Amended Warrants will depend on the current exercise prices applicable to the Original Warrants. As of February 10, 2010, the Original Warrants included:
  
 
·
373,334 Original Warrants to purchase shares of Common Stock at an exercise price of $0.94 per share, which may be exchanged for Amended Warrants exercisable at a reduced price of $0.75 per share,

 
·
1,333,333 Original Warrants to purchase shares of Common Stock at an exercise price of $1.50 per share, which may be exchanged for Amended Warrants exercisable at a reduced price of $1.20 per share,

 
·
235,583 Original Warrants to purchase shares of Common Stock at an exercise price of $1.63 per share, which may be exchanged for Amended Warrants exercisable at a reduced price of $1.30 per share,

 
·
906,190 Original Warrants to purchase shares of Common Stock at an exercise price of $2.04 per share, which may be exchanged for Amended Warrants exercisable at a reduced price of $1.63 per share, and

 
·
2,526,208 Original Warrants to purchase shares of Common Stock at an exercise price of $3.26 per share, which may be exchanged for Amended Warrants exercisable at a reduced price of $1.63 per share.

On March 17, 2010, the Company closed the Third Offer with the following warrants exchanged:

 
·
a total of 373,334 Original Warrants with exercise prices of $0.94 per share were exchanged for Amended Warrants with reduced exercise prices of $0.75 per share;

 
·
a total of 499,522 Original Warrants with exercise prices of $1.50 per share were exchanged for Amended Warrants with reduced exercise prices of $1.20 per share;

 
·
no Original Warrants with exercise prices of $1.63 per share were exchanged for Amended Warrants with reduced exercise prices of $1.30 per share;

 
13

 
 
Emerald Dairy Inc. and Subsidiaries
Footnotes to Condensed Consolidated Financial Statements
March 31, 2011 and 2010
 
 
·
a total of 30,675 Original Warrants with exercise prices of $2.04 per share were exchanged for Amended Warrants with reduced exercise prices of $1.63 per share; and

 
·
a total of 153,374 Original Warrants with exercise prices of $3.26 per share were exchanged for Amended Warrants with reduced exercise prices of $1.63 per share.

On April 6, 2010, the holder of the Company’s 10% promissory notes in the principal amount of $856,890, due on December 31, 2010 (the “Note”), requested that the Company apply the $879,427 balance due to him under the Note (which balance included $19,537 of accrued and unpaid interest) to the holder’s exercise of (a) 373,334 of his Amended Warrants, at an exercise price of $0.75 per share, and (b) 499,522 of his Amended Warrants, at an exercise price of $1.20 per share.  The Company’s Board approved the request and, accordingly, on April 6, 2010 the holder exercised his Amended Warrants, the Company issued 872,856 shares of its common stock to the holder, and the Note was cancelled.

On April 6, 2010, one holder of Amended Warrants exercised all 184,049 of his Amended Warrants, at an exercise price of $1.63 per share, resulting in gross proceeds to the Company of approximately $300,000.

The Company incurred $3,592 of expenses related to the closing of the Third Offer.  This offset against additional paid-in capital.

Warrants Issued for Services

In April 2010, the Company issued 4 year warrants to purchase 160,000 shares of common stock for $1.65 per share. The warrants vest 25% per quarter over the one year life of the contract. Pursuant to accounting guidance the fair value of the warrants will be measured and recorded when vested. During the quarter ended June 30, 2010 the fair value of the 40,000 warrants vested was calculated to be $46,097 and was expensed to selling, general and administrative expense. The following assumptions were used to calculate the fair value of the warrants:

Dividend yield
   
0
%
Expected volatility
   
146.93
%
Risk-free interest rate
   
1.37
%
Expected life
 
3.75 years
 
Stock price
 
$
1.38
 
Exercise price
 
$
1.65
 

During the quarter ended September 30, 2010, the fair value of the 40,000 warrants vested was calculated to be $31,676 and was expensed to selling, general and administrative expense. The following assumptions were used to calculate the fair value of the warrants:

Dividend yield
   
0
%
Expected volatility
   
139.06
%
Risk-free interest rate
   
.68
%
Expected life
 
3.5 years
 
Stock price
 
$
1.04
 
Exercise price
 
$
1.65
 

During the quarter ended December 31, 2010, the fair value of the 40,000 warrants vested was calculated to be $38,181 and was expensed to general and administrative expense. The following assumptions were used to calculate the fair value of the warrants:

Dividend yield
   
0
%
Expected volatility
   
135.78
%
Risk-free interest rate
   
.68
%
Expected life
 
3.25 years
 
Stock price
 
$
1.27
 
Exercise price
 
$
1.65
 

During the quarter ended March 31, 2011, the fair value of the 40,000 warrants vested was calculated to be $27,245 and was expensed to general and administrative expense. The following assumptions were used to calculate the fair value of the warrants:

Dividend yield
   
0
%
Expected volatility
   
131.17
%
Risk-free interest rate
   
1.26
%
Expected life
 
3 years
 
Stock price
 
$
1.00
 
Exercise price
 
$
1.65
 

 
14

 
 
Emerald Dairy Inc. and Subsidiaries
Footnotes to Condensed Consolidated Financial Statements
March 31, 2011 and 2010
 
17.   Common Welfare Reserves

The Company is required to transfer 10% of its net income, as determined in accordance with PRC accounting rules and regulations, to the general reserve. The Company voluntarily contributed an additional 5% in the years ended March 31, 2011 and 2010. The balance of these reserves at March 31, 2011 and December 31, 2010, was $4,603,066 and $3,191,614, respectively. These amounts are restricted and are included in retained earnings.

This fund can only be utilized on capital items for the collective benefit of the Company’s employees, such as construction of dormitories, cafeteria facilities, and other staff welfare facilities. The fund is non-distributable other than upon liquidation.
 
18.   Earnings Per Share

When calculating diluted earnings per share for stock option common stock equivalents, the Earnings Per Share Topic, ASC 260, requires the Company to include the potential shares that would be outstanding if all outstanding stock options or warrants were exercised.   This is offset by shares the Company could repurchase using the proceeds from these hypothetical exercises to obtain the common stock equivalent.

The following reconciles the components of the EPS computation:

For the three months ended March 31, 2011, dilutive shares include 641,333 stock options. 506,667 stock options and warrants to purchase 8,068,651 shares of common stock were not included in dilutive shares as the effect would have been anti-dilutive.
  
For the three months ended March 31, 2010 stock options of 1,463,200 and outstanding warrants to purchase 7,395,598 shares of common stock were not included in dilutive shares as the effect would have been anti-dilutive.
 
The following reconciles the components of the EPS computation:

   
Income
   
Shares
   
Per Share
 
   
(Numerator)
   
(Denominator)
   
Amount
 
For the three months ended March 31, 2011:
                 
Net income
 
$
1,978,077
             
Basic EPS income available to common shareholders
 
$
1,978,077
     
34,059,392
   
$
0.06
 
Effect of dilutive securities:
                       
                         
Warrants
   
-
     
-
         
Stock options
   
-
     
387,722
         
Diluted EPS income available to common shareholders
 
$
1,978,077
     
34,447,114
   
$
0.06
 
                         
For the three months ended March 31, 2010:
                       
Net loss
 
$
(2,296,644
               
Basic EPS income available to common shareholders
 
$
(2,296,644
   
32,945,823
   
$
(0.07
Effect of dilutive securities:
                       
Warrants
   
-
     
-
         
Stock options
   
-
     
-
         
Diluted EPS income available to common shareholders
 
$
(2,296,644
   
32,945,823
   
$
(0.07

19.   Equity Incentive Plan

On March 2, 2009, the Company’s board of directors and majority stockholders adopted the 2009 Equity Incentive Plan (the “Plan”) to attract and retain the best available personnel, provide additional incentives to employees, directors and consultants and promote the success of the Company’s business. 1,500,000 shares of the Company’s common stock have been reserved for issuance under the Plan.

Eligibility

The Company may grant awards to its employees, directors and consultants, including those of the Company’s subsidiaries. However, the Company may grant options that are intended to qualify as incentive stock options (“ISOs”) only to its employees and employees of its subsidiaries.

 
15

 
 
Emerald Dairy Inc. and Subsidiaries
Footnotes to Condensed Consolidated Financial Statements
March 31, 2011 and 2010
 
Acceleration of Awards upon Corporate Transactions.

The outstanding awards will terminate and/or accelerate upon occurrence of certain significant corporate transactions, including amalgamations, consolidations, liquidations or dissolutions, sales of substantially all or all of the Company’s assets, reverse takeovers or acquisitions resulting in a change of control.

Exercise Price and Term of Awards.

In general, the plan administrator will determine the exercise price of an option in the award agreement. The exercise price may be a fixed price, or it may be a variable price related to the fair market value of the Company’s ordinary shares. If the Company grants an ISO to an employee, the exercise price may not be less than 100% of the fair market value of its common stock on the date of the grant, except that if the grantee, at the time of that grant, owns shares representing more than 10% of the voting power of all classes of the Company’s shares of common stock, the exercise price may not be less than 110% of the fair market value of its common stock on the date of that grant. If the Company grants a non-qualified share option to a grantee, the exercise price may not be less than 100% of the fair market value of its common stock on the date of grant.
  
The term of each award under the Plan will be specified in the award agreement, but may not exceed ten years from the earlier of the adoption or the approval of the plan, unless sooner terminated.
 
Total share-based compensation costs included in the Condensed Consolidated Statements of Income were $81,546 and $213,361 during the three months ended March 31, 2011 and 2010, respectively. All share-based compensation costs are included in general and administrative expenses.
 
The Company estimates the fair value of stock options using a Black-Scholes option pricing valuation model, consistent with accounting guidance. Key inputs and assumptions used to estimate the fair value of stock options include the grant price of the award, the expected option term, volatility of the Company’s stock, the risk-free rate and the Company’s dividend yield. Estimates of fair value are not intended to predict actual future events or the value ultimately realized by grantees, and subsequent events are not indicative of the reasonableness of the original estimates of fair value made by the Company.
 
No options were granted during the three months ended March 31, 2011.

Share Options

A summary of the Company’s outstanding share option award grants as of March 31, 2011 and changes during the three months then ended are presented below:

   
Shares
   
Weighted-Average
Exercise Price
   
Weighted-Average Remaining
Contractual Term
   
Aggregate
Intrinsic Value
 
               
(in years)
   
(in millions)
 
Outstanding at December 31, 2010
    1,448,000     $ 1.14              
Granted
    -0-      
-
             
Exercised
    (300,000     0.42              
Expired
    -0-      
-
             
Forfeited
    -0-      
-
             
                             
Outstanding at March 31, 2011
    1,148,000     $ 1.33       8.38     $ 225,040  
Vested and expected to vest at March 31, 2011
    1,148,000     $ 1.33       8.38     $ 225,040  
Exercisable at March 31, 2011
    768,000     $ 1.10       8.38     $ 225,040  

As of March 31, 2011, there was $100,393 of total unrecognized compensation costs related to non-vested Company share options granted under Company share option plans. The cost is expected to be recognized over a weighted-average period of 0.52 years.

20.   Commitments and Contingencies

The Company has various purchase commitments for materials, supplies and services incident to the ordinary conduct of business, generally for quantities required for the Company’s business and at prevailing market prices. No material annual loss is expected from these commitments.

The Company has advances to milk suppliers of $1,399,139, which will be offset against future milk purchases from those suppliers (see Note 7, Other Current Assets).

 
16

 
 
Emerald Dairy Inc. and Subsidiaries
Footnotes to Condensed Consolidated Financial Statements
March 31, 2011 and 2010
 
In order for the Company to conduct its current operations, an Infant & Baby Formula Milk Powder Production Permit is required from the State General Administration of Quality Supervision and Inspection and Quarantine of the People’s Republic of China (the “Administration”). The Company’s production permits for its production facilities in Hailun City and Beian City will expire on March 22, 2014 and March 30, 2014, respectively.  Other than the foregoing, no government approvals are required to conduct the Company’s principal operations, and the Company is not aware of any probable governmental regulation of our business sectors in the near future. Although management believes that the Company is in material compliance with the statutes, laws, rules and regulations of every jurisdiction in which it operates, no assurance can be given that the Company’s compliance with the applicable statutes, laws, rules and regulations will not be challenged by governing authorities or private parties, or that such challenges will not lead to a material adverse effect on the Company’s financial position, results of operations, or cash flows.

The Company is not involved in any legal matters arising in the normal course of business. While incapable of estimation, in the opinion of the management, the individual regulatory and legal matters in which it might involve in the future are not expected to have a material adverse effect on the Company’s financial position, results of operations, or cash flows.

21.   Operating Leases

The Company leases various distribution facilities. All of these leases are on an annual basis and commence on January 1, of each year. The Company also leases office space, which expires in September 2011.  For the three months ended March 31, 2011 and 2010, the Company incurred rental expense of $19,382 and $19,030, respectively. As of March 31, 2011, the Company had outstanding lease commitments totaling $121,323 due in 2011.

23.   Segment Reporting

The Company has key product lines of milk, soybean milk, and rice powder, the Company’s chief operating decision maker reviews and evaluates one set of combined financial information deciding how to allocate resources and in assessing performance.

For the three months ended March 31, 2011 and 2010, the Company’s sales revenue from various products are as follows:

   
Three months
Ended March 31,
 
   
2010
   
2010
 
Milk powder
 
$
13,216,590
   
$
12,424,193
 
Soybean milk powder
   
397,487
     
382,471
 
Rice powder
   
455,847
     
444,587
 
Sub-contract processing
   
609,128
     
1,001,605
 
   
$
14,679,052
   
$
14,252,856
 
 
17

 

Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward Looking Statements

This Quarterly Report on Form 10-Q (“Form 10-Q”) contains “forward-looking statements” that involve substantial risks and uncertainties. You can identify such statements by forward looking words such as “may,” “expect,” “plans,” “intends,” “anticipate,” “believe,” “estimate,” and “continue” or similar words.  Such statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements.  The forward-looking statements included herein are based on current expectations that involve numerous risks and uncertainties.  Our plans and objectives are based, in part, on assumptions involving the continued growth and expansion of our business.  Assumptions relating to the foregoing involve judgments with respect to, among other things, future economic, competitive and market conditions and future business decisions, all of which are difficult or impossible to predict accurately and many of which are beyond our control.  Although we believe the assumptions underlying the forward-looking statements are reasonable, any of the assumptions could prove inaccurate and, therefore, there can be no assurance the forward-looking statements included in this Form 10-Q will prove to be accurate.  In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation by us or any other person that our objectives and plans will be achieved.

Overview

We are a producer of milk powder, rice powder and soybean milk powder, which currently comprise approximately 94.2%, 3.1% and 2.7% of our sales, respectively.  Through our network of over 1,200 salespeople, our products are distributed throughout 20 provinces in the People’s Republic of China (“PRC”), and sold in over 6,500 retail outlets.

Our 30 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 is one of the fastest growing markets in the PRC.  It has been growing at a rate of 14% per year over the past six years, according to the National Bureau of Statistics of China, 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, according to the Dairy Association of China, has grown even faster in recent years, at a rate of 20%-30% per year.  Currently, it is estimated that demand for infant formula in the PRC outstrips supply by at least 2-to-1.

Only holders of an Infant & Baby Formula Milk Powder Production Permit from the State General Administration of Quality Supervision, Inspection and Quarantine of the PRC (“AQSIQ”) are permitted to produce formula milk powder in the PRC.  We have received Infant & Baby Formula Milk Powder Production Permits for both of our production facilities.

 
18

 

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.  In 2009 and 2010, while our new production facility was being constructed and equipped, our annual production capacity at our existing production facility, located in Beian City, Heilongjiang Province, PRC, remained at approximately 9,000 tons.  In November 2010, we completed construction and equipping of the first production line at our new production facility, located in Hailun City, Heilongjiang Province, PRC.  In March 2011, we received authorization from the PRC government to commence production at our new facility in Hailun City.  This new facility currently has one production line, which we believe has the capacity to produce over 9,000 tons of milk powder annually, giving us a total annual production capacity of over 18,000 tons.

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

 
·
Heilongjiang Xing An Ling Dairy, Co., a PRC company (“XAL”), which handles our promotion, sales and administrative functions;

 
·
Heilongjiang Beian Nongken Changxing Lvbao Dairy Limited Liability Company, a PRC company (“Lvbao”), which handles production of our products at our production facility in Beian City; and

 
·
Hailun Xinganling Dairy Co., Ltd., a PRC company (“HXD”), which handles production of our products at our new production facility in Hailun City.

Recent Developments
 
Commercialization of Organic Product Line
 
In June 2009, we started to develop an organic baby formula line for the high-end market.  After 16 months of monitoring and subsequent product testing, our organic farming operation and production line were approved by China's Guangdong Zhongjiang Certification Co.  In January 2011, we entered into a supplier agreement with a Guangdong-based pharmacy chain, Si Ming Yao Ye, for our recently-launched Xing An Ling "Organic" infant formula.  Initial stocking orders of Xing An Ling "Organic" shipped from our Guangdong distributors to 230 stores of the approximate 2,000 store pharmacy chain based in the province.  Xing An Ling "Organic" will be positioned in the infant and baby product aisles of the chain and compete against international and local organic brands on the shelves of the chain.  Organic infant formulas are considered a premium product category in China and mostly marketed in tier one and two Chinese cities like Guangzhou.
 
Commencement of Production at Hailun City Production Facility
 
In November 2010, we completed construction and equipping of the first production line at our new production facility in Hailun City.  Currently, this new facility has one production line, which we believe has the capacity to produce over 9,000 tons of milk powder annually.  This first phase of this project has cost us an aggregate of approximately $22.0 million, including land use rights, construction expenses and equipment costs.  A second production line can be added at this new facility, which we believe would enable us to produce in excess of an additional 9,000 tons of milk powder per year.  Although there can be no assurance that we will add a second production line to our new facility, we currently intend to do so.  If we were to add a second production line at this new facility, we believe it would enable us to produce over 9,000 additional tons of milk powder per year, giving us a total annual production capacity of over 27,000 tons of milk powder.  We expect the cost to add a second production line at our Hailun City production facility to be approximately $15.0 million.  We plan to fund the second production line with a combination of retained earnings and, to the extent necessary, funds raised from the capital market through private or public equity offerings, private or public debt offerings and/or equipment lease transactions.  There can be no assurance that any additional financing will become available to us, and if available, on terms acceptable to us.

 
19

 

Trends and Uncertainties

Economic Downturn

The worldwide economic downturn and market instability, which began in 2008, 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, as well as our results of operations and financial condition, may be adversely affected by unpredictable and unstable market conditions.  If the current equity and credit markets deteriorate, or do not improve from current levels, it may make it difficult, if not impossible, for us to obtain debt or equity financing on acceptable terms at a time when we wish to do so.  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.  We do not expect this economic downturn to have a significant effect on our business or operations in the near future.  However, we cannot predict the timing or duration of any economic slowdown or recession or the timing or strength of a subsequent recovery, worldwide, or in the specific markets we serve.  If the markets for our products significantly deteriorate due to these economic effects, our business, financial condition and results of operations may be materially and adversely affected.

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.  We believe this initiative will continue to provide us with growth opportunities.

Industry Growth

The dairy market is one of the fastest growing markets in the PRC.  It has been growing at a rate of 14% per year over the past six years, according to the National Bureau of Statistics of China, and is expected to grow at a rate of 15% per year for the foreseeable future.  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.

 
20

 

Based on these factors, we expect to see significant growth in our business and operations now that we have commenced production at our new production facility in Hailun City.  However, a slowdown in overall economic growth, an economic downturn or recession or other adverse economic developments in the PRC may materially reduce the demand for our products and materially and adversely affect our business.

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.  In March 2011, we received authorization from the PRC government to begin production at our new facility in Hailun City, which we believe will enable us to increase our annual production capacity of milk powder by over 9,000 tons.  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.

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 readily available to us for the foreseeable future.  In addition, we believe the prices of the raw materials we use will stay relatively stable for the foreseeable future.

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.  We plan to continue to focus on penetrating less-competitive second and third tier cities.

Organic Label Milk Products

In February 2008, we obtained organic label certification from Guangdong Zhongjiang Certification Co., Ltd.  In June 2009, we started to develop an organic baby formula line for the high-end market.  To meet the standards for an organic product, we were required to maintain a herd of 527 organic-fed cows that were closely monitored by certification authorities to ensure they met the rigid organic farming standards.  After 16 months of monitoring and subsequent product testing, our organic farming operation and production line were approved by China's Guangdong Zhongjiang Certification Co.  In January 2011, we entered into a supplier agreement with a Guangdong-based pharmacy chain, Si Ming Yao Ye, for our recently-launched Xing An Ling "Organic" infant formula.  Initial stocking orders of Xing An Ling "Organic" shipped from our Guangdong distributors to 230 stores of the approximate 2,000 store pharmacy chain based in the province.  We use the “China Organic Product” seal on our organic formula packaging and in associated marketing materials.  We believe that, similar to the growth of the organic milk market in the U.S., organic milk products will be popular in the PRC.  Over time, we believe our proposed organic product line will help increase our revenues.

 
21

 

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 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.  The contraction in the Chinese milk powder industry caused by this crisis has lead to increased demand for our products.  However, we cannot 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.

Subcontracting

Our subcontracting arrangements consist of producing milk powder products on a contract basis for third parties, which then resell such products under their own brand names.  In mid-2010, in anticipation of our completion of the first production line at the Hailun City facility, management determined to increase subcontracting activities once again.  The primary reason for this increase was to help absorb excess production capacity at our new production facility.  As we increase sales of our higher margin products in the future, management will continue to assess its subcontracting activities.

Outstanding Debt
 
We have incurred substantial indebtedness through loans made to us during the past 36 months by certain investors and lenders.  Our agreements with these investors and lenders, and the promissory notes we issued in connection with such agreements, contain various covenants, including, in certain instances, cross-default provisions.  These loan covenants may negatively affect our business, financial condition, operating results and cash flows in many ways, including:

 
·
increasing the cost, or limiting the availability of, additional financing for working capital, acquisitions or other purposes, including our plans to install a second production line at our new facility in Hailun City;

 
22

 

 
·
limiting the ways in which we can use our cash flow, much of which may have to be used to satisfy debt; and

 
·
adversely affecting our ability to respond to changing business or economic conditions.

Historically, we have not been able to repay certain of our loans as they have come due.  In fact, outstanding promissory notes in the aggregate principal amount of $3,466,411 are currently past due.  We are currently negotiating with the lenders for extensions of the maturity dates of the applicable promissory notes.   However, there can be no assurance that we will be able to extend the maturity dates of these notes on terms acceptable to us, if at all.  In May 2011, we received demands for payment from the holders of certain of these promissory notes, in the aggregate principal amount of $1,750,000.

Results of Operations

Three-Month Period Ended March 31, 2011 Compared to Three-Month Period Ended March 31, 2010

The following summarizes changes in our operations for the three months ended March 31, 2011 and 2010.  Net income increased by $4,274,721, from a loss of $2,296,644 in the three months ended March 31, 2010, to income of $1,978,077 for the three months ended March 31, 2011.  The increase in net income during the three months ended March 31, 2011, as compared to the same time period in the prior year, was primarily due to our non-cash charge for liquidated damages in the amount of approximately $5,022,000 in the three months ended March 31, 2010, which we did not incur in the first quarter of the current year.

Sales and Cost of Goods Sold
 
   
For the Three Months
Ended March 31,
 
   
2011
 
2010
 
Sales  
$
14,679,052
 
$
14,252,856
 
Cost of Goods Sold  
 
7,489,607
   
7,153,772
 
Gross Profit  
$
7,189,445
 
$
7,099,084
 

Sales. Sales volume decreased by 128 metric tons, or 4.9%, to 2,471 metric tons for the three months ended March 31, 2011, from 2,599 metric tons for the three months ended March 31, 2010.  Sales revenues increased by $426,196, or 3.0%, from $14,252,856 in the three months ended March 31, 2010, to $14,679,052 for the three months ended March 31, 2011.  The increase in sales revenue was due to an increase in the average selling price for our products, by $457 per metric ton, as compared to the three months ended March 31, 2010, resulting from our increased production of our high end product line in the first quarter of 2011.

Sales by product line.  A break-down of our sales by product line for the three months ended March 31, 2011 and 2010 is as follows:

  
  
Three Months Ended March 31,
     
  
   
  
2011
   
2010
   
Period-on-period
  
Product category    
  
Quantity
(tons)
   
$ Amount
   
% of
sales
   
Quantity
(tons)
   
$ Amount
   
% of
sales
   
Qty.
Variance
  
Milk powder
   
2,001
     
13,216,590
     
90.0
     
1,958
     
12,424,193
     
87.2
     
43
 
Rice powder
   
77
     
455,847
     
3.1
     
78
     
444,587
     
3.1
     
(1
Soybean powder
   
234
     
397,487
     
2.7
     
233
     
382,471
     
2.7
     
1
 
Subcontracting
   
159
     
609,128
     
4.2
     
330
     
1,001,605
     
7.0
     
(171
Total
   
2,471
     
14,679,052
     
100.0
     
2,599
     
14,252,856
     
100.0
     
(128
)
 
 
23

 

There were various changes to the break-down of sales among our product lines over the three months ended March 31, 2011, as we slightly increased milk powder production, but attempted to adjust our sales mix to higher margin products.  Milk powder accounted for 90.0% of first quarter 2011 sales mix, at an average selling price of $6,605 per metric ton, as compared to 87.2% of first quarter 2010, at an average selling price of $6,345 per metric ton.  The increase in sales price per metric ton for milk powder resulted from our continued shift to increase production of our high end product line in the first quarter of 2011.  Rice powder accounted for 3.1% of our sales mix for the three months ended March 31, 2011, at an average selling price of $5,920 per metric ton, as compared to 3.1% of our sales mix in the three months ended March 31, 2010, at an average selling price of $5,700 per metric ton.  Soybean powder remained at 2.7% of our sales mix for the three months ended March 31, 2011, at an average selling price of $1,699 per metric ton, as compared an average selling price of $1,642 per metric ton in 2010.  We decreased our subcontract production during the three months ended March 31, 2011 to 4.2% of the sales mix, at an average selling price of $3,831 per metric ton, as compared to 7.0% of the sales mix in the three months ended March 31, 2010, at an average sales price of $3,035 per metric ton.  In the short-term, we expect subcontracting to increase as a percentage of our total sales, as we increase subcontracting activities to help absorb excess production capacity at our new production facility in Hailun City.

A breakdown of our average selling price by product line for the three months ended March 31, 2011 and 2010 is as follows:

 
  
Three Months Ended
March 31,
 
Average selling prices      
  
2011
   
2010
   
Variance
 
   
 
$
   
$
   
$
     
%
 
Milk powder
   
6,605
     
6,345
     
260
     
4.1
 
Rice powder 
   
5,920
     
5,700
     
220
     
3.9
 
Soybean powder
   
1,699
     
1,642
     
57
     
3.5
 
Subcontracting
   
3,831
     
3,035
     
796
     
26.2
 
Total – all products
   
5,941
     
5,484
     
457
     
8.3
 

Cost of Goods Sold.  Cost of goods sold increased by $335,835, or 4.7%, from $7,153,772 in the three months ended March 31, 2010, to $7,489,607 for the three months ended March 31, 2011.  This increase was directly related to our increased production and increased cost of raw materials during the three months ended March 31, 2011.  Overall our cost per metric ton increased by $278, or 10.1%, to $3,031 per metric ton in the three months ended March 31, 2011, as compared to $2,753 per metric ton in three months ended March 31, 2010, due to decreases in the price of raw materials we use to produce our products.  We believe the prices of the raw materials we use will stay relatively stable for the foreseeable future.

A breakdown of cost of sales by product line for the three months ended March 31, 2011 and 2010 is as follows:

 
24

 


   
Three Months Ended March 31,
 
   
2011
   
2010
   
Variance
 
   
$
   
$
   
$
   
%
 
Cost of sales
                       
Milk powder  
    6,556,012       5,821,847       734,165       12.6  
Rice powder  
    178,761       174,348       4,413       2.5  
Soybean powder
    276,029       265,605       10,424       3.9  
Subcontracting  
    478,805       891,972       (413,167 )     (46.3 )
Total
    7,489,607       7,153,772       335,835       4.7  
   
                               
Cost per units sold(per ton)
                               
Milk powder
    3,276       2,973       303       10.2  
Rice powder
    2,322       2,235       87       3.9  
Soybean powder
    1,180       1,140       40       3.5  
Subcontracting
    3,011       2,703       308       11.4  
Average cost per unit sold  
    3,031       2,753       278       10.1  

Gross Profit. Gross profit was $7,189,445, or 49.0% of our sales for the three months ended March 31, 2011, as compared to gross profit of $7,099,084, or 49.8%, for the three months ended March 31, 2010.  During the three months ended March 31, 2011, our gross margin on milk powder decreased to 50.4%, from 53.1% in the same period of the prior year, due to an increase in the average sales price of our products of 4.1%, while there was a 10.2% increase in the cost per metric ton from the three months ended March 31, 2010.  The gross margin for subcontracting increased 10.5% to 21.4% in the three months ended March 31, 2011, as compared to 10.9% in the three months ended March 31, 2010, due to an increase in the average sales price of 26.2% in the three months ended March 31, 2011, as compared to the same period in 2010, offset by an increase in the cost per ton of 11.4% in the three months ended March 31, 2011.

A breakdown of gross margin by product line for the three months ended March 31, 2011 and 2010 is as follows:

   
Three Months Ended March 31,
         
   
2011
   
2010
   
Period-on-period
 
Product category 
 
$ Amount
   
Gross
Margin %
   
$ Amount
   
Gross
Margin %
   
Margin
Variance
  
Milk powder
   
6,660,578
     
50.4
     
6,602,346
     
53.1
     
(2.7
Rice powder
   
277,086
     
60.8
     
270,239
     
60.8
     
-
 
Soybean powder
   
121,458
     
30.6
     
116,866
     
30.6
     
-
 
Subcontracting
   
130,323
     
21.4
     
109,633
     
10.9
     
10.5
 
Total
   
7,189,445
     
49.0
     
7,099,084
     
49.8
     
 0.8
 

Operating Expenses

   
 
For the Three Months
Ended March 31,
 
   
 
2011
   
2010
 
Operating Expenses
           
Selling and administrative expenses 
  $ 3,825,619     $ 3,902,390  
Liquidated damages
    -       5,021,669  
Depreciation and amortization 
    244,537       51,228  
Total operating expenses 
  $ 4,070,156     $ 8,975,287  
 
 
25

 

Selling Expenses. Selling expenses decreased overall by $55,925, or 1.8%, from $3,146,037 in the three months ended March 31, 2010, to $3,090,112 for the three months ended March 31, 2011.  The major factor in the decrease in selling expenses was that advertising expenses decreased by $263,577, or 74.3%, to $91,165 in 2011, from $354,742 in 2010, due to a change in our marketing campaign in 2011.

This decrease was partially offset by the following factors:

 
·
Promotion expenses increased by $98,033, or 14.4%, to $777,303 in 2011, from $679,270 in 2010, as we increased the promotion portion of our marketing campaign as compared to 2010.

 
·
Selling salary expenses increased by $44,268, or 6.7%, to $706,766 in 2011, from $662,498 in 2010, as a result of our increased marketing campaign in 2011.

 
·
Travel expense increased by $19,740, or 6.4%, to $325,938 in 2011, from $306,198 in 2010, as a result of our increased sales activity.

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 $20,846, or 2.8%, from $756,353 in three months ended March 31, 2010, to $735,507 for the three months ended March 31, 2011.  The major factors in the decrease in administrative expenses were as follows:

 
·
Salary and stock option expenses decreased by $147,734, or 39.7%, to $224,145 in 2011, from $371,879 in 2010, because of higher compensation expense recognized in 2010 as a result of stock options granted in 2009.

 
·
Travel expenses decreased by $25,132, or 41.8%, to $34,986 in 2011, from $60,118 in 2010, as a result of decrease in the amount of travel during 2011.

These decreases were partially offset by an increase of $162,346 in consulting expense as compared with 2010 and an increase in legal and accounting expenses of $5,170 as compared with 2010. The increase in consulting expense resulted from our use of a new consultant for investor relations and other services in 2011.

Liquidated Damages. The company recorded $5,021,669 in liquidated damages during the three months ended March 31, 2010 due to our extension of the expiration dates of warrants we previously issued to satisfy certain registration rights provisions.  There was no similar expense in the first fiscal quarter of 2011.

Provision for Income Taxes

   
For the Three Months
Ended March 31,
 
   
2011
   
2010
 
Provision for Income Taxes
           
Current
 
$
958,036
   
$
421,499
 
Deferred
   
-
     
-
 
   
$
958,036
   
$
421,499
 
 
 
26

 

Provision for Income Taxes. Income taxes increased by $536,537, or 127.3%, from $421,499 for the three months ended March 31, 2010, to $958,036 for the three months ended March 31, 2011.  This increase was due to the increase in our taxable income in our operating subsidiaries and the expiration of the fifty percent reduction in the tax rate of XAL as of the first quarter of 2011.

Liquidity and Capital Resources

Uses of Capital

   
For the Three Months Ended
March 31,
 
   
2011
   
2010
 
Net cash provided by (used in) operating activities
  $ (275,429 )      $ 2,560,421  
Net cash (used in) investing activities
    (427,183 )       (9,569,697 )
Net cash provided by (used in) financing activities
  $ (236,354 )      $ -  

Net Cash Provided By (Used In) Operating Activities.  For the three months ended March 31, 2011, $275,429 was used in operating activities, compared with $2,560,421 provided by operating activities for the three months ended March 31, 2010.  Our net cash flows provided from operating activities during 2010 increased due to the following factors:

 
·
Operations provided $1,978,077 of net cash during the three months ended March 31, 2010.

 
·
Trade accounts receivable increased by $238,317, due to the increased sales during the period.

 
·
Inventory increased by $193,748, due to adjustments from increased sales of our products during the current period.

 
·
Other current assets increased by $742,214, due the increase in our level of production during 2010.

 
·
Accounts payable and accrued expenses decreased by $1,389,765 at March 31, 2011 due to payments to vendors.

Net Cash Used In Investing Activities.  For the three months ended March 31, 2011, we used $427,183 in investing activities, compared with $9,569,697 used in investing activities for the three months ended March 31, 2010.  The $427,183 was primarily for the construction and equipping of our new production facility.
 
Net Cash Provided By Financing Activities.  For the three months ended March 31, 2011, $236,354 was used in financing activities compared with no cash used in financing activities for the three months ended March 31, 2010.  We made payments on the sale-leaseback during the three months ended March 31, 2011.
 
 
27

 

General

Cash and cash equivalents at March 31, 2011 decreased by approximately 4.7% to $16,327,220, from $17,131,274 at December 31, 2010.  Working capital increased from approximately $24.4 million at December 31, 2010, to approximately $26.5 million at March 31, 2011, including cash generated from operations.  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.

We believe that a lack of adequate production capacity has been a significant impediment to our ability to increase our revenue in recent years. 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 through the opening of our new production facility, and increasing both sales staff and advertising expenditures.

In March 2011, we received authorization from the PRC government to commence production at our new production facility in Hailun City.  The new facility currently has one production line, which we believe has the capacity to produce over 9,000 tons of milk powder annually.  This first phase of this project has cost us an aggregate of approximately $22.0 million, including land use rights, construction expenses and equipment costs.

The new facility has the capacity to handle a second production line.  Although there can be no assurance we will add a second production line to our new facility, we currently intend to do so.  If we were to add a second production line at this new facility, we believe it would enable us to produce over 9,000 additional tons of milk powder per year, giving us a total annual production capacity of over 27,000 tons of milk powder.  We believe the cost to add a second production line would be an additional $15.0 million.  Although there can be no assurance will add a second production line to our new facility, we plan to fund the second production line with a combination of retained earnings and, to the extent necessary, funds raised from the capital market through private or public equity offerings, private or public debt offerings and/or equipment lease transactions.  We currently have no sources for the additional financing we would 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.

Historically we relied primarily 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 expect to 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 fiscal 2009, we raised approximately $7.7 million through the sale of promissory notes and exercise of warrants.  We used these funds for the construction and equipping of our new production facility and for general working capital purposes.

In fiscal 2010, we:

 
·
we received $296,408 from the exercise of warrants;

 
·
entered into a loan agreement with an unrelated third party, pursuant to which we borrowed $1,180,000, at an interest rate of 10% per annum; and
 
 
28

 

 
·
consummated a sale and leaseback transaction with Fenghui Leasing Co., Ltd. (“Fenghui”), pursuant to which, among other things Fenghui purchased certain equipment from HXD, for a purchase price of approximately $5,161,176, and Fenghui leased the equipment back to HXD for 36 monthly payments of approximately $164,124 (a total of approximately $5,908,464), a commission fee of $154,835, and a refundable deposit of $774,176 (the “Sale and Leaseback Transaction”).

We applied these proceeds to completing the first production line of our new production facility and to general working capital purposes.

Currently, we spend approximately 8%-12% of total revenues on advertising and promotional efforts throughout the year.  We spent approximately $6.1 million on advertising and promotion in fiscal 2010.  We currently expect to spend an aggregate of approximately $6.0 million on advertising and promotion in fiscal 2011, of which we have already spent approximately $1.3 million during the three months ended March 31, 2011.

Registration Rights and Liquidated Damages

We entered into Registration Rights Agreements with the investors (the “October 2007 Investors”) in the private placements we consummated in October 2007 (the “October 2007 Private Placements”), 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 2007 Private Placements (the “Purchased Shares”), and (ii) the common stock issuable upon exercise of the October 2007 Warrants (collectively (i) and (ii), 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 were required to pay liquidated damages to the holders of the Purchased Shares if (i) we failed to file the Registration Statement on or before the Filing Date, (ii) the SEC did 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 failed to request acceleration of effectiveness within five (5) business days of a notice of no further review from the SEC, (iv) we failed 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 accumulate at the rate of one and one-half percent (1.5%) of the purchase price paid by the October 2007 Investors for units of our securities purchase in the October 2007 Private Placements for each thirty (30) day period during which a registration default is continuing; provided, however, that (i) we would not be liable for liquidated damages with respect to any warrants or shares of common stock underlying the warrants, and (ii) in no event would 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 of the October 2007 Investors shall be 20% of the aggregate purchase price paid by such purchaser.  The Registration Rights Agreements further required that if we failed 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.

 
29

 

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.

On January 28, 2010, a Registration Statement we filed to register the Registrable Securities for resale was declared effective by the SEC.  Pursuant to Section 10(a)(3) of the Securities Act of 1933, as amended (the “Securities Act”), we must now file a post-effective amendment to the Registration Statement (“Post-Effective Amendment”) to update the financial statements and other information included in the Registration Statement, and to eliminate or modify information regarding the selling stockholders listed in the Registration Statement.  We plan to file the Post-Effective Amendment as soon as practicable.

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 commencing on page 16 of our Annual Report on Form 10-K for the fiscal year ended December 31, 2010 (the “Form 10-K”) for more information.

Warrants

As of the date hereof, we have outstanding exercisable warrants to purchase an aggregate of 8,108,651 shares of our common stock, of which:

 
·
833,811 are exercisable at a price of $1.50 per share;

 
·
2,233,891 are exercisable at a price of $1.63 per share;

 
·
1,717,600 are exercisable at a price of $1.65 per share;

 
·
875,515 are exercisable at a price of $2.04 per share;

 
·
75,000 are exercisable at a price of $2.61 per share; and

 
·
2,372,834 are exercisable at a price of $3.26 per share.

If all of the vested warrants are exercised, we will receive gross proceeds of approximately $17,443,238, although there can be no assurance that any of these warrants will be exercised.
 
 
30

 

Promissory Notes
 
The December 2010 Term Loan Note

The promissory note we issued in connection with a loan transaction we consummated in December 2010 (the “December 2010 Term Loan Note”), has a principal balance of $380,000 and bears interest at a rate of 10% per annum, which is also payable on maturity.  The December 2010 Term Loan Note has a stated maturity date of December 1, 2011.  Upon the maturity of the December 2010 Term Loan Note, by acceleration or otherwise, interest on unpaid amounts shall thereafter be payable at the rate of 12% per annum default interest, until the obligation is paid in full.  Any regular interest or default interest not paid when due under the December 2010 Term Loan Note shall be added to the principal of the December 2010 Term Loan Note.  We may from time-to-time prepay any amount due under the December 2010 Term Loan Note, in whole or in part, without penalty.  The entire unpaid principal balance, together with accrued interest, shall become due and payable, without presentment, demand, protest, notice of protest or other notice of dishonor of any kind upon the occurrence of an “Event of Default,” as defined in our Loan Agreement with the lender.

Sale and Leaseback Transaction

In connection with the Sale and Leaseback Transaction (described above), our wholly-owned subsidiary, HXD, entered into a Sale and Leaseback Agreement with Fenghui, pursuant to which, among other things:

 
·
Fenghui purchased certain milk powder processing equipment located at our new milk powder processing facility (the “Equipment”) from HXD, for a purchase price of approximately $5,161,176;

 
·
Fenghui leased the Equipment back to HXD for 36 months in return for monthly payments of approximately $164,124 (a total of approximately $5,908,464), a commission fee of $154,835, and a refundable deposit of $774,176; and

 
·
We issued to Fenghui three-year warrants to purchase 934,600 shares of the Company’s common stock, at an exercise price of $1.65 per share.

See Note 16 of the Notes to our consolidated financial statements for additional information concerning the Sale and Leaseback Transaction.

The June 2010 Term Loan Note

A promissory note we issued in connection with the June 2010 Term Loan (the “June 2010 Term Loan Note”) has a principal balance of $800,000.  The interest rate on the June 2010 Term Loan Note is 10% per annum and is payable on maturity.  The June 2010 Term Loan Note has a stated maturity date of June 24, 2011.  Upon the maturity of the June 2010 Term Loan Note, by acceleration or otherwise, interest on unpaid amounts shall thereafter be payable at the rate of 12% per annum, until the obligation is paid in full.  Any regular interest or default interest not paid when due under the June 2010 Term Loan Note shall be added to the principal of the June 2010 Term Loan Note.  We may from time-to-time prepay any amount due under the June 2010 Term Loan Note, in whole or in part, without penalty.  The entire unpaid principal balance, together with accrued interest, shall become due and payable, without presentment, demand, protest, notice of protest or other notice of dishonor of any kind upon the occurrence of an “Event of Default,” as defined in our Loan Agreement with the lender.
 
 
31

 

The December 2009 Notes

The promissory notes we originally issued in connection with the private placement we consummated in December 2009 (the “December 2009 Notes”), as amended on December 24, 2010, which matured on February 22, 2011, have an aggregate principal balance of $1,750,000.  The December 2009 Notes had an interest rate of 10% through February 22, 2011 (which interest we have paid in full), and currently bear interest at a rate of 15% per annum.  So long as we have any obligations under the December 2009 Notes, there are limitations on our ability to: (a) pay dividends or make other distributions on our capital stock; (b) redeem, repurchase or otherwise acquire any of our securities; (c) create, incur or assume any liability for borrowed money; (d) sell, lease or otherwise dispose of any significant portion of our assets; (e) lend money, give credit or make advances; or (f) assume, guarantee, endorse, contingently agree to purchase or otherwise become liable upon the obligation of any other person or entity.  Our repayment of amounts due under the December 2009 Notes is secured by a pledge of an aggregate of 5,883,329 shares of our common stock beneficially owned by Yang Yong Shan, our Chairman, Chief Executive Officer and President.  We are currently negotiating extensions of the maturity dates of the December 2009 Notes, although there can be no assurance that the noteholders will agree to extend the maturity dates of the December 2009 Notes on terms acceptable to us, if at all.  In May 2011, we received demand for payment from the holders of the December 2009 Notes.

The November 2009 Term Loan Note

The promissory note we issued in connection with a loan transaction we consummated in November 2009 (the “November 2009 Term Loan Note”), as amended on November 30, 2010, has a principal balance of $1,750,000 and bears interest at a rate of 10% per annum, which is also payable on maturity.  The November 2009 Term Loan Note has a stated maturity date of November 30, 2011.  Upon the maturity of the November 2009 Term Loan Note, by acceleration or otherwise, interest on unpaid amounts shall thereafter be payable at the rate of 12% per annum default interest, until the obligation is paid in full.  Any regular interest or default interest not paid when due under the November 2009 Term Loan Note shall be added to the principal of the November 2009 Term Loan Note.  We may from time-to-time prepay any amount due under the November 2009 Term Loan Note, in whole or in part, without penalty.  The entire unpaid principal balance, together with accrued interest, shall become due and payable, without presentment, demand, protest, notice of protest or other notice of dishonor of any kind upon the occurrence of an “Event of Default,” as defined in our Loan Agreement with the lender.

The Amended June 2008 Note

A promissory note we originally issued in connection with the private placement we consummated in June 2008, as amended on December 31, 2008 and December 31, 2009 (the “Amended June 2008 Note”), which matured on December 31, 2010, has a principal balance of $1,716,411 (which amount includes interest accrued through December 31, 2009).  The Amended June 2008 Note had an interest rate of 8% through December 31, 2008, 10% through December 31, 2011, and currently bears interest at a rate of 15% per annum.  So long as we have any obligation under the Amended June 2008 Note, there are limitations on our ability to: (a) pay dividends or make other distributions on our capital stock; (b) redeem, repurchase or otherwise acquire any of our securities; (c) create, incur or assume any liability for borrowed money (except as is related to the completion of the construction of our new production facility); (d) sell, lease or otherwise dispose of any significant portion of its assets; (e) lend money, give credit or make advances; or (f) assume, guarantee, endorse, contingently agree to purchase or otherwise become liable upon the obligation of any other person or entity.  Our repayment of amounts due under the Amended June 2008 Note is secured by a pledge of an aggregate of 2,104,950 shares of our common stock beneficially owned by Yang Yong Shan, our Chairman, Chief Executive Officer and President.  We are currently negotiating an extension of the maturity date of the Amended June 2008 Note, although there can be no assurance that the noteholder will agree to extend the maturity date of the Amended June 2008 Note on terms acceptable to us, if at all.

 
32

 

Dividends

We have not paid any dividends. In all likelihood, we will use any 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, certain of our outstanding promissory notes contain restrictive covenants on our payment of dividends, as further described in “— Promissory Notes” above.

Contractual Obligations and Commercial Commitments

Our contractual obligations, as of March 31, 2011, 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
 
Construction contract
  $ 490,181     $ 490,181       -       -       -  
Debt obligations
    6,956,406       6,956,406       -       -       -  
Capital leases
    4,588,882       1,529,628     $ 3,059,254       -       -  
Operating leases
    121,323       121,323       -       -       -  
Total:
  $ 12,156,792     $ 9,097,538     $ 3,059,254       -       -  

Critical Accounting Policies and Estimates

Our consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”).  These accounting principles require us to make certain estimates, judgments and assumptions.  We believe that the estimates, judgments and assumptions upon which we rely are reasonable based upon information available to us at the time that these estimates, judgments and assumptions are made.  These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements as well as the reported amounts of revenues and expenses during the periods presented.  To the extent there are material differences between these estimates, judgments or assumptions and actual results, our financial statements will be affected.  The accounting policies that reflect our more significant estimates, judgments and assumptions and which we believe are the most critical to aid in fully understanding and evaluating our reported financial results include the following:

 
·
Inventory

 
·
Property and equipment

 
·
Intangible Assets

 
·
Revenue recognition

 
·
Earnings per share

 
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·
Taxation

 
·
Warrants

 
·
Freestanding Financial Instruments with Characteristics of Both Liabilities and Equity

 
·
Retirement benefit costs

 
·
Stock Based Compensation

 
·
Fair value of financial instruments

 
·
Fair Value Measurements

In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management’s judgment in its application.  There are also areas in which management’s judgment in selecting among available alternatives would not produce a materially different result.  Our senior management has reviewed these critical accounting policies and related disclosures with the Board of Directors.

During the first three months of fiscal 2011, there were no significant changes in our critical accounting policies and estimates.  You should refer to Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in Part II, Item 7 of our Form 10-K for the fiscal year ended December 31, 2010 (“Form 10-K”) for a more complete discussion of our critical accounting policies and estimates.

Recently Enacted Accounting Standards

Refer to Note 3 to the Financial Statements included in Part I, Item 1 of this Form 10-Q, which discusses new accounting pronouncements we recently adopted, as well as accounting pronouncements recently issued or proposed but not yet required to be adopted.

Off-Balance Sheet Arrangements

We are not a party to any off-balance sheet arrangements.
 
 
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Item 3. Quantitative and Qualitative Disclosures about Market Risk

We are a smaller reporting company as defined by Rule 12b-2 of the Securities Exchange Act of 1934 (“Exchange Act”) and are not required to provide the information under this item.

Item 4.  Controls and Procedures.

Disclosure Controls and Procedures

Our management maintains disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the “Exchange Act”) that are designed to provide reasonable assurance that the material information required to be disclosed by us in our periodic reports filed or submitted under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms.  Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.

As of March 31, 2011, our management, under the supervision of and with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as required by Rules 13a-15(b) and 15d-15(b) under the Exchange Act.  Based upon this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were not effective as of March 31, 2011 as a result of the material weaknesses identified in our internal control over financial reporting.  These material weaknesses are discussed in “Management’s Report on Internal Control over Financial Reporting” contained in our Form 10-K.  Our management considers our internal control over financial reporting to be an integral part of our disclosure controls and procedures.

Our management has taken and is continuing to take the following actions to improve our internal controls over financial reporting, including actions to remediate the identified material weaknesses:

 
·
Require all members of our management and the finance department across all corporate entities to certify receipt of the Code of Business Conduct and Ethics by signature.  Signed copies will be retained by our management.  Thereafter, our management plans to periodically require signatories to acknowledge that they understand the contents of the Code of Business Conduct and Ethics, and whether they are aware of anyone in our company that might have violated some part of the Code.

 
·
Recruit an independent financial expert to the Board of Directors to chair an Audit Committee and formalize roles and responsibilities over our internal control over financial reporting for the Board and our management.  Our management also plans to develop and implement a formal corporate internal audit capability, reporting directly to an independent Audit Committee, to provide effective oversight of our internal control over financial reporting.

 
·
Continue to engage the services of qualified consultants with China GAAP, U.S. GAAP and SEC reporting experience to support our financial reporting and SOX compliance requirements, including assistance with the following:

 
o
Remediating identified material weaknesses;
 
 
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o
Monitoring our internal control over financial reporting on an ongoing basis;

 
o
Managing our period-end financial closing and reporting processes; and

 
o
Identifying and resolving non-routine or complex accounting matters.

 
·
Complete the implementation of, and related training for, its IT policies and procedures related to access, change, data, and security management to ensure that all relevant financial information is secure, identified, captured, processed, and reported within the accounting system and spreadsheets supporting financial reporting.

 
·
Continue providing training to accounting personnel regarding our significant policies and procedures related to accounting, finance, and internal control to ensure that financial reporting competencies are strengthened.

 
·
Refine and implement procedures to ensure that our employees receive sufficient training and instruction with respect to our sales policies.
 
Our management will continue to monitor and evaluate the effectiveness of its disclosure controls and procedures, as well as its internal control over financial reporting, on an ongoing basis, and is committed to taking further action and implementing additional improvements, as necessary and as funds allow.  However, our management cannot guarantee that the measures taken or any future measures will remediate the material weaknesses identified or that any additional material weaknesses or significant deficiencies will not arise in the future due to a failure to implement and maintain adequate internal control over financial reporting.

Notwithstanding the material weaknesses described above, our management believes that there are no material inaccuracies or omissions of material fact and, to the best of its knowledge, believes that the consolidated financial statements included in this annual report present fairly, in all material respects, our financial position, results of operations, and cash flows for the periods presented in conformity with accounting principles generally accepted in the United States.

Changes in Internal Control Over Financial Reporting

In March 2011, our executive officers and directors certified receipt of our Code of Business Conduct and Ethics by signature.  There were no other changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the interim period ended March 31, 2011, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 
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PART II - OTHER INFORMATION

Item 1.  Legal Proceedings.

None

Item 1A.  Risk Factors.

We are a smaller reporting company as defined by Rule 12b-2 of the Exchange Act and are not required to provide the information under this item.

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds.

None

Item 3.  Defaults Upon Senior Securities.

Outstanding promissory notes in the aggregate principal amount of $3,466,411 are currently past due.  We are currently negotiating with the lenders for extensions of the maturity dates of these promissory notes.   However, there can be no assurance that we will be able to extend the maturity dates of these notes on terms acceptable to us, if at all.  In May 2011, we received demands for payment from the holders of certain of these promissory notes, in the aggregate principal amount of $1,750,000, which matured in February 2011.

For more information, see Note 14 to the Financial Statements included in Part I, Item 1 of this Form 10-Q.

Item 4.  (Removed and Reserved).

Item 5.  Other Information.

Reference is made to the disclosure set forth under Part II, Item 3 above, which disclosure is incorporated herein by reference.

 
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Item 6.  Exhibits

Exhibit No.
 
Description of Exhibit
31.1
 
Certification of principal executive officer pursuant to Section 13a-14(a)*
31.2
 
Certification of principal financial and accounting officer pursuant to Section 13a-14(a)*
32.1
 
Certification of principal executive officer pursuant to Section 1350*
32.2
 
Certification of principal financial and accounting officer pursuant to Section 1350*

*Filed herewith

 
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SIGNATURES
 
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
 
EMERALD DAIRY INC.
   
 Dated: May 23, 2011
By: 
/s/ Yang Yong Shan
   
Yang Yong Shan
Chairman, Chief Executive Officer and
President
     
 Dated: May 23, 2011
By:
/s/ Shu Kaneko
   
Shu Kaneko
Chief Financial Officer and Secretary

 
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