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EX-31.1 - EX-31.1 - EMERALD DAIRY INCv238128_ex31-1.htm
EX-32.1 - EX-32.1 - EMERALD DAIRY INCv238128_ex32-1.htm
EX-32.2 - EX-32.2 - EMERALD DAIRY INCv238128_ex32-2.htm
EX-31.2 - EX-31.2 - EMERALD DAIRY INCv238128_ex31-2.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
June 30, 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    x 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 October 11, 2011 (not including an additional 68,000 shares the registrant is obligated to issue in connection with a private offering it is conducting and 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 JUNE 30, 2011
 
TABLE OF CONTENTS

        PAGE
       
PART I
 -
FINANCIAL INFORMATION
 
Item 1.
 
Financial Statements
1
   
Condensed Consolidated Balance Sheets as of June 30, 2011 (unaudited) and December 31, 2010
1
   
Condensed Consolidated Statements of Income for the Three and Six Months Ended June 30, 2011 and 2010 (unaudited)
2
   
Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 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
20
Item 3.
 
Quantitative and Qualitative Disclosures About Market Risk
45
Item 4.
 
Controls and Procedures
45
       
PART II
 -
OTHER INFORMATION
 
Item 1.
 
Legal Proceedings
47
Item 1A.
 
Risk Factors
47
Item 2.
 
Unregistered Sales of Equity Securities and Use of Proceeds
47
Item 3.
 
Defaults Upon Senior Securities
48
Item 4.
 
(Removed and Reserved)
48
Item 5.
 
Other Information
48
Item 6.
 
Exhibits
49
   
Signatures
51
 
 
i

 

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements.

Emerald Dairy Inc. and Subsidiaries
Condensed Consolidated Balance Sheets
June 30, 2011 and December 31, 2010
(Unaudited)
 
   
June 30,
2011
   
December 31,
2010
 
   
(Unaudited)
       
             
ASSETS
           
             
Current Assets
           
Cash and cash equivalents
  $ 21,396,775     $ 17,131,274  
Trade accounts receivable,net
    6,755,966       8,220,622  
Inventory, net
    1,097,442       1,052,594  
Advances to equipment supplier
    0       10,154,264  
Other current assets
    3,748,903       2,697,946  
Total current assets
    32,999,086       39,256,700  
                 
Property, plant and equipment
               
Property, plant and equipment, net
    33,902,349       23,039,183  
Contruction in progress
    919,841       875,934  
      34,822,190       23,915,117  
                 
Intangible assets, net
    1,357,199       1,348,161  
                 
    $ 69,178,475     $ 64,519,978  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
                 
Current Liabilities
               
Accounts payable and accrued expenses
  $ 6,050,565     $ 6,596,367  
Notes payable, net of debt discount of $0 and $38,116 at
               
June 30, 2011 and December 31, 2010, respectively
    6,396,411       6,358,295  
Other current liabilities
    758,768       539,332  
Current portion of long-term lease
    1,369,026       1,171,566  
Loan from shareholder
    662,647       217,294  
Total current liabilities
    15,237,417       14,882,854  
                 
Long-term lease payable
    1,791,567       2,468,984  
                 
Commitments and Contingencies (Note 21)
               
                 
Stockholders' Equity
               
Preferred stock ($0.001 par value, 10,000,000 shares authorized, none issued and outstanding at June 30, 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 June 30, 2011  and December 31, 2010, respectively)
    36,152       35,977  
Treasury Stock (1,944,444 shares at June 30, 2011 and December 31, 2010, respectively)
    (1,944 )     (1,944 )
Additional paid-in capital
    26,168,143       26,007,743  
Retained earnings (of which $4,603,066 and $3,191,614 are restricted at June 30, 2011 and December 31, 2010, respectively, for common welfare reserves)
    21,040,138       17,431,350  
Accumulated other comprehensive income
    4,907,002       3,695,014  
Total stockholders' equity
    52,149,491       47,168,140  
                 
    $ 69,178,475     $ 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 and Six Months Ended June 30, 2011 and 2010
(Unaudited)
 
   
Three months ended
   
Six months ended
 
   
June 30,
   
June 30,
   
June 30,
   
June 30,
 
   
2011
   
2010
   
2011
   
2010
 
                         
Sales
  $ 14,487,068     $ 13,309,502     $ 29,166,120     $ 27,562,358  
                                 
Cost of Goods Sold
    7,634,895       6,794,707       15,124,502       13,948,479  
                                 
Gross Profit
    6,852,173       6,514,795       14,041,618       13,613,879  
                                 
Operating Expenses
                               
Selling expenses and administrative expenses
    3,810,069       4,004,280       7,635,688       7,906,670  
Liquidated damages
    -       -       -       5,021,669  
Depreciation and amortization
    85,271       51,724       329,808       102,952  
Total operating expenses
    3,895,340       4,056,004       7,965,496       13,031,291  
                                 
Other Income (Expense)
                               
Interest income
    1,275       1,077       2,362       2,135  
Interest expense
    (393,308 )     (784,679 )     (577,571 )     (784,679 )
Total other income (expense)
    (392,033 )     (783,602 )     (575,209 )     (782,544 )
                                 
Net Income (Loss) Before Provision for Income Tax
    2,564,800       1,675,189       5,500,913       (199,956 )
                                 
Provision for Income Taxes
                               
Current
    934,089       391,243       1,892,125       812,742  
      934,089       391,243       1,892,125       812,742  
                                 
Net Income (Loss)
  $ 1,630,711     $ 1,283,946     $ 3,608,788     $ (1,012,698 )
                                 
Basic Earnings Per Share
  $ 0.05     $ 0.04     $ 0.11     $ (0.03 )
                                 
Basic Weighted  Average Shares Outstanding
    34,207,379       33,941,295       34,133,794       33,446,310  
                                 
Diluted Earnings Per Share
  $ 0.05     $ 0.04     $ 0.11     $ (0.03 )
                                 
Diluted Weighted  Average Shares Outstanding
    34,393,323       34,660,893       34,347,184       33,446,310  
                                 
The Components of Other Comprehensive Income (Loss)
                               
Net Income (Loss)
  $ 1,630,711     $ 1,283,946     $ 3,608,788     $ (1,012,698 )
Foreign currency translation adjustment
    1,138,512       444,016       1,836,345       454,311  
Income tax related to other comprehensive income
    (387,094 )     (150,966 )     (624,357 )     (154,466 )
                                 
Comprehensive Income (Loss)
  $ 2,382,129     $ 1,576,996     $ 4,820,776     $ (712,853 )
 
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 Six Months Ended June 30, 2011 and 2010
(Unaudited)
 
   
2011
   
2010
 
             
Cash flows from operating activities
           
Net Income (Loss)
  $ 3,608,788     $ (1,012,698 )
Adjustments to reconcile net cash provided by operating activities
               
Depreciation and amortization
    1,073,805       283,526  
Amortization of loan discount
    38,116       372,050  
Capitalized interest
    (243,669 )     (458,872 )
Stock issued for services
    27,245       34,657  
Warrants modified for liquidated damages
    -       5,021,669  
Warrants issued for services
            90,137  
Warrants issued for loan costs
            79,991  
Incentive stock options
    133,330       385,891  
Net change in assets and liabilities
               
Trade accounts receivable
    1,637,602       (188,123 )
Inventory
    (22,703 )     (260,477 )
Other current assets
    (994,197 )     (877,809 )
Accounts payable and accrued expenses
    (684,577 )     576,581  
Other current liabilities
    208,089       (248,574 )
                 
Net cash provided by operating activities
    4,781,829       3,797,949  
                 
Cash flows from investing activities
               
Deposit on equipment and construction
    -       (11,543,962 )
Construction in progress
    -       (119,489 )
Purchases of fixed assets and intangibles
    (846,486 )     (45,995 )
                 
Net cash used in investing activities
    (846,486 )     (11,709,446 )
                 
Cash flows from financing activities
               
Advances on notes payable
    -       800,000  
Advances from related parties
    440,782       -  
Repayments of notes payable
    -       (477,464 )
Exercise of warrants
    -       296,408  
Advances on sale-leaseback
    -       5,006,340  
Repayments of sale-leaseback
    (479,957 )     -  
                 
Net cash (used in)provided by financing activities
    (39,175 )     5,625,284  
                 
Effect of exchange rate
    369,333       128,735  
                 
Net increase(decrease) in cash and cash equivalents
    4,265,501       (2,157,478 )
                 
Cash and cash equivalents at beginning of period
    17,131,274       13,486,429  
                 
Cash and cash equivalents at end of period
  $ 21,396,775     $ 11,328,951  
 
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
June 30, 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. During the fourth fiscal quarter of 2010 HXD started the manufacture of the Company's milk powder, soybean powder and rice powder 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/A 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 June 30, 2011, and the results of their operations for the three and six months ended June 30, 2011 and 2010, and cash flows for the six months ended June 30, 2011 and 2010. The results of operations for the three and six months ended June 30, 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 consolidated financial position and 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 paragraph entitled “Foreign Currency” in Note 3).

The 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 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 consolidated financial statements and the reported amounts of net sales and expenses during the reported periods.
 
 
4

 

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. 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 June 30, 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.

Inventory - Inventory is stated at the lower of cost or market. Cost is determined using the weighted average method. Market value represents the estimated selling price in the ordinary course of business less the estimated costs necessary to complete the sale.

Raw materials consist of raw milk, soybeans, rice and rice powder. Work in process consists of materials and products in process of conversion to powder but not yet packaged.

The cost of inventory comprises all costs of purchases, costs of conversion and other costs incurred in bringing the inventory to its present location and condition. The costs of conversion of inventory include fixed and variable production overheads, taking into account the stage of completion.

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 June 30, 2011 and December 31, 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 and six months ended June 30, 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 June 30, 2011, the Company has construction costs and capitalized interest of $919,841 which have not yet been transferred to fixed assets. The estimated cost to be incurred in 2011 to complete the project is approximately $497,000.

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 and  six months ended June 30, 2011 and 2010 is as follows:

 
 
Three Months
Ended June 30,
   
Six Months
Ended June 30,
 
 
 
2011
   
2010
   
2011
   
2010
 
Interest cost capitalized
  $ 20,908     $ (172,046 )   $ 264,577     $ 458,872  
Interest cost charged to income
    393,308       784,679       577,571       784,679  
 
  $ 414,216     $ 612,633     $ 842,148     $ 1,243,551  

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 $751,418 and $293,050, for the three months ended June 30, 2011 and 2010, respectively and $1,211,988 and $299,845, for the six months ended June 30, 2011 and 2010, respectively

 
5

 
 
As of June 30, 2011 and 2010, the exchange rate was 6.4634 Yuan and 6.7814 Yuan per US Dollar, respectively.

Revenue Recognition - Revenue is recognized in the period 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.

As of June 30, 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 financial instruments 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 is entered into in conjunction with some other transaction and is legally detachable and separately exercisable. As of June 30, 2011 and 2010, there were no financial instruments recorded as 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.

 
6

 
 
There was share-based compensation of $51,784 and $172,530 in the three months ended June 30, 2011 and 2010, respectively and $133,330 and $385,891 in the six months ended June 30, 2011 and 2010, respectively

Fair Value of Financial Instruments - The Company applies the provisions of accounting guidance, FASB Topic ASC 825 that 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 June 30, 2011 and December 31, 2010 the fair value of cash, trade accounts receivable, other receivables, accounts payable, notes payables, and other payable approximated carrying value due to the short maturity of the instruments, quoted market prices, or interest rates, which fluctuate with market rates.

Fair Value Measurements - 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 June 30, 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.
  
In May 2011, the FASB amended fair value measurement and disclosure guidance to achieve convergence with International Financial Reporting Standards ("IFRS"). The amended guidance clarified existing fair value measurement guidance, revised certain measurement guidance and expanded the disclosure requirements concerning Level 3 fair value measurements. The guidance is effective for interim and annual periods beginning after December 15, 2011. Adoption of this guidance is not expected to have a material effect on the Company’s consolidated financial statements.
 
 
7

 

In May 2011, the FASB issued amendments on the presentation of other comprehensive income that (1) eliminate the current option to present the components of other comprehensive income in the statement of changes in equity, and (2) require presentation of net income and other comprehensive income either in a continuous statement or in two separate but consecutive statements. The amendments do not alter any current recognition or measurement requirements with respect to items of other comprehensive income. The amendments are effective for fiscal years and interim periods within such years beginning after December 15, 2011. Adoption of this guidance is not expected to have a material effect on the Company's consolidated financial statements.
  
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 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 June 30, 2011 no U.S. cash balances are in excess of insured amounts.

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 and six months ended June 30, 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 June 30, 2011 and December 31, 2010 inventory consisted of the following:

 
 
June 30,
2011
   
December 31,
2010
 
Raw materials
  $ 739,826     $ 704,737  
Work-in-process
    310,127       307,069  
Finished goods
    39,890       31,553  
Repair parts
    7,599       9,235  
 
  $ 1,097,442     $ 1,052,594  
  
6.
Advances to equipment supplier

As of June 30, 2011 and December 31, 2010 advances to equipment supplier consisted of $0 and $10,154,264, respectively, of advances on a contract to purchase equipment from a supplier for the Company’s second processing facility then under construction.

 
8

 
7.
Other current assets

As of June 30, 2011 and December 31, 2010, advances to suppliers and other receivables consisted of the following:

 
 
June 30,
2011
   
December 31,
2010
 
Advances to milk suppliers
  $ 1,839,776     $ 375,816  
Other Receivables
    4,642       4,544  
Advances to staff
    1,417       1,387  
Prepaid loan costs
    69,947       108,805  
Deposit on advertising contract
    -       90,877  
Deposit on lease
    1,083,021       1,060,237  
Prepaid expenses
    750,100       1,056,280  
 
  $ 3,748,903     $ 2,697,946  
  
8.
Property, Plant, and Equipment

As of June 30, 2011 and December 31, 2010, property, plant, and equipment consisted of the following:

 
 
June 30,
2011
   
December 31,
2010
 
Building
  $ 19,069,821     $ 17,378,577  
Plant and Machinery
    17,330,401       7,329,651  
Motor vehicles
    599,348       586,739  
Dairy cows
    272,913       266,695  
Office equipment
    97,365       82,686  
 
    37,369,848       25,644,348  
Less: Accumulated depreciation
    (3,467,499 )     (2,605,165 )
 
  $ 33,902,349     $ 23,039,183  
  
Depreciation expenses totaled $743,062 and $1,054,102 for the three and six months ended June 30, 2011, respectively, and $132,831 and $264,650 for the three and six months ended June 30, 2010, respectively. $667,706 and $743,997 were included as a component of cost of goods sold for the three and six months ended June 30, 2011, respectively, and $90,548 and $180,575 for the three and six months ended June 30, 2010, respectively.

9.
Construction in progress

 
 
June 30,
2011
   
December 31,
2010
 
Construction in progress
  $ 919,841     $ 875,934  

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

10.
Intangible Assets

 
 
June 30,
2011
   
December 31,
2010
 
Land use rights
  $ 1,431,848     $ 1,401,724  
Patents
    56,162       54,981  
 
    1,488,010       1,456,705  
Less: Accumulated amortization
    (130,811 )     (108,544 )
 
  $ 1,357,199     $ 1,348,161  
  
Amortization expenses totaled $9,914 and $19,703 for the three and six months ended June 30, 2011, respectively, and $9,440 and $18,876 for the three and six months ended June 30, 2010, respectively.  Amortization expense is estimated to be $39,656 for each of the next five years.
 
 
9

 
   
11.
Income Taxes
 
On May 30, 2005, AIDH executed a Share Transfer Agreement with XAL, a corporation organized and existing under the laws of the PRC. XAL applied to be a foreign invested company right after the share transfer, the business license was approved as a foreign invested company on January 10, 2006. According to Chinese tax policy, there is a total income tax exemption for 2 years followed by a 50% reduction for 3 years applicable to foreign invested companies, Advanced Technology Companies or Software Development Companies. XAL is considered an Advanced Technology Company. Therefore the Company receives this income tax exemption policy from January 10, 2006, the date approval as a foreign invested company. 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 expired as of December 31, 2010.

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

The components of net income (loss) before provision for income tax consist of following:
 
 
Three Months
Ended June 30,
   
Six Months
Ended June 30,
 
 
 
2011
   
2010
   
2011
   
2010
 
U.S. Operations
  $ (868,100 )   $ (1,482,000 )   $ (1,562,000 )   $ (7,065,000 )
Chinese Operations
    3,432,900       3,157,000       7,063,000       6,865,000  
 
  $ 2,564,800     $ 1,675,000     $ 5,501,000     $ 200,000  
 
The components of the provision for income taxes are approximately as follows:
 
 
Three Months
Ended June 30,
   
Six Months
Ended June 30,
 
 
 
2011
   
2010
   
2011
   
2010
 
Federal, State and Local
  $ -     $ -     $ -     $ -  
Peoples Republic of China -Federal and Local
    934,100       391,200       1,892,000       812,700  
 
  $ 934,100     $ 391,200     $ 1,892,000     $ 812,700  
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:

 
 
Three Months
Ended June 30,
 
 
Six Months
Ended June 30,
 
 
 
2011
 
 
2010
 
 
2011
 
 
2010
 
Income tax provision at Federal statutory rate
 
$
871,000
 
 
$
569,600
 
 
$
1,870,000
 
 
$
(68,000
)
State income taxes, net of Federal benefit
 
 
-0-
 
 
 
-0-
 
 
 
-0-
 
 
 
-0-
 
U.S. tax rate in excess of foreign tax rate
 
 
(344,000
)
 
 
(284,100
)
 
 
(704,000
)
 
 
(617,800
)
Abatement of foreign income taxes
 
 
113,100
 
 
 
(398,000
)
 
 
195,000
 
 
 
(903,500
)
Increase in valuation allowance
 
 
294,000
 
 
 
503,700
 
 
 
531,000
 
 
 
2,402,000
 
Tax provision
 
$
934,100
 
 
$
391,200
 
 
$
1,892,000
 
 
$
812,700
 
  
The Company had a U.S. net operating loss carryforward of approximately $16,414,000 as of June 30, 2011 which expires in 2030.

Significant components of the Company’s deferred tax assets and liabilities as of June 30, 2011 and December 31, 2010 are as follows:

   
June 30,
2011
   
December 31,
2010
 
Deferred tax assets:
               
Net operating loss carryforward
  $ 5,580,680     $ 5,049,680  
Valuation allowance
    (5,580,680 )     (5,049,680 )
Net deferred tax asset
  $ -     $ -  

The change in the valuation allowance as of June 30, 2011 and 2010 was $531,000 and $2,402,000, respectively.
  
 
10

 

 
The effects of the tax exemption per share were as follows:

 
 
Three Months
Ended June 30,
 
 
Six Months
Ended June 30,
 
 
 
2011
 
 
2010
 
 
2011
 
 
2011
 
Tax Saving
 
$
(113,100
)
 
$
398,000
 
 
$
(195,000
)
 
$
903,500
 
Benefit per share:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Basic
 
$
(0.01
)
 
$
0.01
 
 
$
(0.01
)
 
$
0.03
 
Diluted
 
$
(0.01
)
 
$
0.01
 
 
$
(0.01
)
 
$
0.03
 
  
Had the tax exemption not been in place for the three and six months ended June 30, 2011 and 2010, the Company estimates the following proforma financial statement impact:
 
 
Three Months
Ended June 30,
 
 
Six Months
Ended June 30,
 
 
 
2011
 
 
2010
 
 
2011
 
 
2010
 
Net income (loss) before tax provision, as reported
 
$
2,564,800
 
 
$
1,676,000
 
 
$
5,501,000
 
 
$
(200,000
)
Less Tax provision not exempted
 
 
934,100
 
 
 
391,000
 
 
 
1,892,000
 
 
 
812,700
 
Less Tax provision exempted
 
 
(113,100
)
 
 
398,000
 
 
 
(195,000
)
 
 
903,500
 
 
 
$
1,743,800
 
 
$
887,000
 
 
$
3,804,000
 
 
$
(1,916,200
)

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 three and six months ended June 30, 2011, respectively, the Company contributed $18,012 and $42,538 in pension contributions. During the three and six months ended June 30, 2010, respectively, the Company contributed $27,353 and $60,021 in pension contributions.

13.
Accounts Payable and Accrued Expenses
  
At June 30, 2011 and December 31, 2010 accrued expenses consisted of:

 
 
June 30,
2011
   
December 31,
2010
 
Accounts payable
  $ 4,208,885     $ 5,523,712  
Payable to equipment supplier
    541,511       -  
Accrued payroll
    77,200       72,567  
Accrued interest
    694,572       400,515  
Accrued education funds
    220,393       191,327  
Accrued welfare
    21,459       -  
Economic development advance
    63,401       45,439  
Other payables
    3,786       15,667  
Accrued insurance
    219,358       347,140  
 
  $ 6,050,565     $ 6,596,367  
 
 
11

 
 
14.
Notes Payable
  
At June 30, 2011 and December 31, 2010 notes payable consisted of the following:

 
 
June 30,
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  
 
In August 2011 the Company completed extension of all of the notes that were past due as of June 30, 2011 (See Note 24).

15.
Loan from Shareholder

At June 30, 2011 and December 31, 2010 the balance of the loan from shareholder was $662,647 and $217,294, respectively.  During the six months ended June 30, 2011 a shareholder advanced $440,782 in loans to be used for the payment of accounts payable and accrued interest on notes payable for the extension of the notes.

16.
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.

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.  Per 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.

The balances on the lease are as follows:
 
 
 
June 30,
2011
   
December 31,
2010
 
Remaining lease payments
  $ 4,132,776     $ 5,057,288  
Imputed interest
    (972,183 )     (1,416,738 )
Lease balance
    3,160,593       3,640,550  
Less current portion
    (1,369,026 )     (1,171,566 )
Long-term lease payable
  $ 1,791,567     $ 2,468,984  

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

2011
  $ 638,550  
2012
      1,566,110  
2013
      955,933  
  
17.
Equity

Warrants

Information with respect to stock warrants outstanding as of June 30, 2011 is as follows:

Exercisable:
 
Exercise Price
   
Outstanding
June
30, 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
 
12

 

 
*  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:

 
·
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,
 
 
13

 
 
 
·
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;
 
 
·
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:

 
14

 
 
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  

18.
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 December 31, 2010 and 2009. The balance of these reserves at June 30, 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.
  
19.
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 June 30, 2011, dilutive shares include 388,000 stock options. 760,000 stock options and warrants to purchase 8,068,651 share of common stock were not included in dilutive shares as the effect would have been anti-dilutive.
 
For the three months ended June 30, 2010 dilutive shares include 703,200 of stock options and outstanding warrants to purchase 833,811 shares of common stock at an exercise price of $1.50. 760,000 of stock options and warrants to purchase 6,564,125 shares of common stock were not included in dilutive shares as the effect would have been anti-dilutive.

For the six months ended June 30, 2011, dilutive shares include 388,000 stock options. 760,000 stock options and warrants to purchase 8,068,651 share of common stock were not included in dilutive shares as the effect would have been anti-dilutive.

For the six months ended June 30, 2010, 1,463,200 of stock options and outstanding warrants to purchase 7,397,936 shares of common stock were not included in dilutive shares as the effect would have been anti-dilutive.
 
 
15

 
 
The following reconciles the components of the EPS computation:

 
 
Income
   
Shares
   
Per Share
 
 
 
(Numerator)
   
(Denominator)
   
Amount
 
For the three months ended June 30, 2011:
                 
Net income
  $ 1,630,711              
Basic EPS income available to common shareholders
  $ 1,630,711       34,207,379     $ 0.05  
Effect of dilutive securities:
                       
 
                       
Warrants
          -          
Stock options
          185,944          
Diluted EPS income available to common shareholders
  $ 1,630,711       34,393,323     $ 0.05  
 
                       
For the three months ended June 30, 2010:
                       
Net income
  $ 1,283,946                  
Basic EPS income available to common shareholders
  $ 1,283,946       33,941,295     $ 0.04  
Effect of dilutive securities:
                       
Warrants
          240,036          
Stock options
          479,562          
Diluted EPS income available to common shareholders
  $ 1,283,946       34,660,893     $ 0.04  

 
 
Income
   
Shares
   
Per Share
 
 
 
(Numerator)
   
(Denominator)
   
Amount
 
For the six months ended June 30, 2011:
                 
Net income
  $ 3,608,788              
Basic EPS income available to common shareholders
  $ 3,608,788       34,133,794     $ 0.11  
Effect of dilutive securities:
                       
 
                       
Warrants
          -          
Stock options
          213,390          
Diluted EPS income available to common shareholders
  $ 3,608,788       34,347,184     $ 0.11  
 
                       
For the six months ended June 30, 2010:
                       
Net loss
  $ (1,012,698 )                
Basic EPS income available to common shareholders
  $ (1,012,698 )     33,446,310     $ (0.03 )
Effect of dilutive securities:
                       
Warrants
                   
Stock options
                   
Diluted EPS income available to common shareholders
  $ (1,102,698 )     33,446,310     $ (0.03 )

20.
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.

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 Consolidated Statements of Income were $51,784 and $133,330 during the three and six months ended June 30, 2011, respectively, and $172,530 and $385,891 during the three and six months ended June 30, 2010, respectively.  All share-based compensation costs are included in general and administrative expenses.
  
 
16

 

 
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 June 30, 2011.

Share Options

A summary of the Company’s outstanding share option award grants as of June 30, 2011 and changes during the six 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 June 30, 2011
    1,148,000     $ 1.33       8.14     $ 100,880  
Vested and expected to vest at June 30, 2011
    1,148,000     $ 1.33       8.14     $ 100,880  
Exercisable at June 30, 2011
    958,000     $ 1.24       8.14     $ 100,880  

As of June 30, 2011, there was $48,609 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 0.36 years.

21.
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 $1,839,776 which will be offset against future milk purchases from those suppliers (see Note 7, Other Current Assets).
  
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 current license will expire on April 25, 2013.  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.

22.
Operating Leases

The Company leases various distribution facilities. All of these leases are on an annual basis and commenced on January 1, of each year. For the three and six months ended June 30, 2011 the Company incurred rental expense of $19,856 and $38,890, respectively. For the three and six months ended June 30, 2010, the Company incurred rental expense of $19,034 and $38,064, respectively. As of June 30, 2011, the Company had outstanding lease commitments totaling $82,009 due in 2011.
 
 
17

 
 
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 and six months ended June 30, 2011 and 2010, the Company’s sales revenue from various products are as follows:
 
 
 
Three Months
Ended June 30,
 
 
Six Months
Ended June 30,
 
 
 
2011
 
 
2010
 
 
2011
 
 
2010
 
Milk powder
 
$
12,778,372
 
 
$
11,517,627
 
 
$
25,994,962
 
 
$
23,941,820
 
Soybean milk powder
 
 
295,549
 
 
 
356,712
 
 
 
754,644
 
 
 
739,183
 
Rice powder
 
 
298,797
 
 
 
408,453
 
 
 
693,036
 
 
 
853,040
 
Sub-contract processing
 
 
1,114,350
 
 
 
1,026,710
 
 
 
1,723,478
 
 
 
2,028,315
 
 
 
$
14,487,068
 
 
$
13,309,502
 
 
$
29,166,120
 
 
$
27,562,358
 
  
24.
Subsequent Events

Extension of the December 2009 Notes Payable
 
On August 30, 2011, the Company and the holders of the December 2009 notes payable in principal amount of $1,750,000 entered into a second amendment to the notes payable dated December 24, 2009.
 
 Pursuant to the second amendment:
 
 (a) the maturity date of the indebtedness represented by the December 2009 Notes was further extended from February 22, 2011 to December 31, 2011;
 
 (b) effective as of February 23, 2011, the interest rate on the indebtedness represented by the December 2009 notes payable increased from 10% to 15% per annum;
 
 (c)  accrued and unpaid interest on the indebtedness represented by the December 2009 notes payable, in the aggregate amount of $225,103, was paid to the December 2009 Investors (representing the full amount of interest payable through December 31, 2011);
 
 (d) the exercise price of the December 24, 2009 Warrants was reduced from $1.63 per share to $1.00 per share, subject to adjustment under certain circumstances;
 
(e) a loan extension fee in an aggregate amount of $50,000 is to be paid to the December 2009 Investors on or before December 31, 2011;
 
In consideration for its services in connection with the consummation of the transactions, the Company entered into an agreement with a consultant, pursuant to which the Company (a) paid the consultant a cash fee in the amount of $105,000; (b) reduced the exercise price of the consultant’s existing warrants to purchase 44,643 shares of the Company’s common stock from $1.63 per share to $1.00 per share; (c) will issue to the consultant additional three-year warrants to purchase 75,000 shares of common stock of the Company, at an exercise price of $1.00 per share; and (d) is to pay the consultant an additional cash fee in the amount of $26,250 on or before December 31, 2011.
 
 Extension of the June 2010 Notes Payable
 
 On August 30, 2011, the Company and holders of the June, 2010 notes payable in the principal amount of $800,000 entered into a loan extension agreement.
 
 Pursuant to the loan extension agreement:
 
 (a) the maturity date of the June 2010 Note was extended from June 24, 2011 to June 24, 2012; and
 
 
18

 
 
Extension of the June 2008 Notes Payable
 
 On August 31, 2011, the Company and the holders of  the June 2008 notes payable in the principal amount of $1,716,411 an agreement for extension of the notes payable.
 
 Pursuant to the loan extension agreement:
 
 (a) the maturity date of the June 2008 notes payable was further extended from December 31, 2010 to December 31, 2012;
 
 (b) effective as of December 31, 2010, the interest rate on the indebtedness represented by the June 2008 Note increased from 10% to 15% per annum;
 
 (c) Commencing on September 1, 2011, and continuing until such time as accrued and unpaid interest in the aggregate amount of $343,282, representing the full amount of accrued and unpaid interest payable on the indebtedness represented by the June 2008 Note for the period from January 1, 2010 through August 31, 2011, has been paid by the Company to the June 2008 notes payable holders, the Company shall pay $50,000 (or such lesser amount of accrued interest as is then remaining) to the June 2008 notes payable holders on the first day of each month, subject to a forty-five (45) day cure period;
 
 (e) the exercise price of 150,000 warrants to purchase shares of common stock of the Company, originally issued by the Company to the June 2008 notes payable holders on June 12, 2008, was reduced from $1.63 per share to $1.00 per share, subject to adjustment under certain circumstances;
 
 (f) the expiration date of the 150,000 warrants was extended to December 31, 2013;
 
 (g) the exercise price of 526,506 warrants to purchase shares of common stock of the Company, originally issued by the Company to the June 2008 notes payable holders on December 31, 2009 was reduced from $1.63 per share to $1.00 per share;
 
 (h) the expiration date of the 526,506 warrants was extended to December 31, 2013;
 
 (i) a loan extension fee in the amount of $17,164 is to be paid to the June 2008 notes payable holders on or before December 31, 2012;
 
 (j) the number of shares of common stock of the Company pledged by the Company’s Chairman, Chief Executive Officer and President, to secure the Company’s obligations under the June 2008 notes payable was increased from 2,104,950 shares to 4,000,000 shares.
 
Private offering
 
The Company has entered into a Securities Purchase Agreement with certain accredited investors (the “Investors”), pursuant to which the Company may offer and sell, in one or more closings to occur on or prior to October 31, 2011, Convertible Promissory Notes in the principal amount of up to an aggregate of $500,000 (the “Offering”).
 
In connection with the Offering:
 
·       On September 20, 2011, the Company sold one Investor a Convertible Promissory Note in the amount of $250,000 (the “Initial Note”), with a stated maturity date of September 20, 2012 (the “Initial Placement”); and
 
·       On September 30, 2011, the Company sold two additional Investors Convertible Promissory Notes in the aggregate principal amount of $90,000 (the “Additional Notes” and, together with the Initial Note, the “September 2011 Notes”), with a stated maturity date of September 30, 2012 (the “Additional Placement” and, together with the Initial Placement, the “September 2011 Private Placements”).
 
The September 2011 Notes bear interest at a rate of 15% per annum, which is also payable on maturity.  Upon the maturity of the September 2011 Notes, by acceleration or otherwise, interest on unpaid amounts shall thereafter be payable at the default interest rate of 17% per annum, until the obligations are paid in full.  The Company may from time-to-time prepay any amount due under the September 2011 Notes, in whole or in part, without penalty.  The principal amount of the September 2011 Notes, and any accrued and unpaid interest thereon, may be converted into such number of shares of common stock of the Company as is determined by dividing the amount to be converted by a price equal to the greater of (i) $1.00, or (ii) 75% of the offering price for the securities offered by the Company in its next offering of equity securities which results in cumulative gross offering proceeds to the Company of at least $2,000,000.  Upon the occurrence of an “Event of Default” under the terms of the September 2011 Notes (as defined therein), the entire unpaid principal balance of the September 2011 Notes, together with any accrued and unpaid interest thereon, shall become due and payable, without presentment, demand, protest or notice of any kind.
 
 The Company is using the proceeds from the September 2011 Private Placements primarily for repayment of certain existing indebtedness and expenses.  In connection with the September 2011 Private Placements, the Investors shall receive an aggregate of 34,000 shares of the Company’s common stock as a loan origination fee (the “Investor Shares”).  In addition, the Company’s obligations under the September 2011 Notes are secured by a pledge of an aggregate of 340,000 shares of the Company’s common stock made by Yang Yong Shan, the Company’s Chief Executive Officer, pursuant to a Pledge Agreement.
 
 In consideration for its services in connection with the September 2011 Private Placements, the Company has (a) paid a placement agent (the “Placement Agent”) a commission of 10% of the gross proceeds from the September 2011 Private Placements, and (b) has agreed to issue the Placement Agent 34,000 shares of the Company’s common stock (the “Placement Agent Shares”).
  
 
19

 

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 95.9% (including milk powder products we produce on a contract basis for third parties), 2.1% and 2.0% 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.

We have received the required permits to manufacture our products at our two production facilities. 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.

 
20

 

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 approximately 10,000 tons of milk powder annually, giving us a total annual production capacity of approximately 19,000 tons.

In the second quarter of 2011, management implemented its strategy to consolidate production of all of our infant formula products at our new state-of-the-art facility in Hailun City, rather than incurring the costs to upgrade our production facility in Beian City to meet increased government standards. We will continue to manufacture other milk powder, rice powder and soybean powder products at the Beian City production facility.
 
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
 
September 2011 Private Placement

In September 2011, we entered into Securities Purchase Agreements with certain accredited investors (the “September 2011 Investors”), pursuant to which we may offer and sell, in one or more closings to occur on or prior to October 31, 2011, Convertible Promissory Notes in the principal amount of up to an aggregate of $500,000, with an interest rate of 15% per annum (the “2011 Offering”).
 
In connection with the 2011 Offering:

 
·
on September 20, 2011, we sold one September 2011 Investor a Convertible Promissory Note in the principal amount of $250,000 (the “Initial Note”), with a stated maturity date of September 20, 2012 (the “Initial Placement”); and

 
·
on September 30, 2011, we sold two additional September 2011 Investors Convertible Promissory Notes in the aggregate principal amount of $90,000 (the “Additional Notes” and, together with the Initial Note, the “September 2011 Notes”), with a stated maturity date of September 30, 2012 (the “Additional Placement” and, together with the Initial Placement, the “September 2011 Private Placements”).
 
 
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We used the proceeds from the September 2011 Private Placements primarily for repayment of certain existing indebtedness and expenses.  In connection with the September 2011 Private Placements, the September 2011 Investors shall receive an aggregate of 34,000 shares of our common stock as a loan origination fee (the “Investor Shares”).  In addition, our obligations under the September 2011 Notes are secured by a pledge of an aggregate of 340,000 shares of our common stock made by Yang Yong Shan, our Chief Executive Officer.

In consideration for its services in connection with the September 2011 Private Placements, we (a) paid a placement agent (the “Placement Agent”) a commission of $34,000, and (b) have agreed to issue the Placement Agent 34,000 shares of the Company’s common stock (the “Placement Agent Shares”).

For more information regarding the September 2011 Notes see “—Promissory Notes—The September 2011 Notes”.

Restructuring of Outstanding Loans
 
Second Amendment to December 24, 2009 Securities Purchase Agreement

On August 30, 2011, we, and the investors (the “December 2009 Investors”) in our December 2009 private placement of promissory notes in the aggregate principal amount of $1,750,000, as previously amended on December 24, 2010 (the “December 2009 Notes”), and three-year warrants to purchase an aggregate of 536,809 shares of our common stock, at an exercise price of $1.63 per share (the “December 24, 2009 Warrants”), entered into a second amendment (the “Second Amendment”) to the purchase agreement, dated December 24, 2009, under which the December 2009 Notes and December 24, 2009 Warrants had been originally issued.

Pursuant to the Second Amendment, among other things:

 
·
the maturity date of the indebtedness represented by the December 2009 Notes was further extended from February 22, 2011 to December 31, 2011;

 
·
effective as of February 23, 2011, the interest rate on the indebtedness represented by the December 2009 Notes increased from 10% to 15% per annum;

 
·
accrued and unpaid interest on the indebtedness represented by the December 2009 Notes, in the aggregate amount of $225,103, was paid to the December 2009 Investors (representing the full amount of interest payable through December 31, 2011);

 
·
amended and restated promissory notes (the “Amended December 2009 Notes”) were issued to the December 2009 Investors in exchange for the cancellation of the original December 2009 Notes;

 
·
the exercise price of the December 24, 2009 Warrants was reduced from $1.63 per share to $1.00 per share, subject to adjustment under certain circumstances;

 
·
amended and restated warrants (the “Amended December 24, 2009 Warrants”) were issued to the December 2009 Investors in exchange for the cancellation of the December 24, 2009 Warrants;

 
·
a loan extension fee in an aggregate amount of $50,000 is to be paid to the December 2009 Investors on or before December 31, 2011;

 
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·
the December 2009 Investors (i) waived any “Event of Default” resulting from (A) our failure to pay any principal and/or interest when due pursuant the terms of the December 2009 Notes, and/or (B) any cross-default pursuant the terms of the December 2009 Notes, and (ii) rescinded their written notice of default and their written demand for the shares pledged by Yang Yong Shan, our Chairman, Chief Executive Officer and President; and

 
·
our obligations under the Amended December 2009 Notes continued to be secured by a pledge of 5,883,329 shares of our common stock held by Yang Yong Shan, our Chairman, Chief Executive Officer and President.

In consideration for its services in connection with the consummation of the transactions contemplated by the Second Amendment, we entered into a letter agreement with a consultant (the “Consultant”), pursuant to which we (a) paid the Consultant a cash fee in the amount of $105,000; (b) issued the Consultant amended and restated warrants to purchase 44,643 shares of our common stock at a reduced exercise price of $1.00 per share, subject to adjustment under certain circumstances (the Amended Consultant Warrants”); (c) issued the Consultant additional three-year warrants to purchase 75,000 shares of our common stock, at an exercise price of $1.00 per share, subject to adjustment under certain circumstances (the “Additional Consultant Warrants; and (d) are to pay the consultant an additional cash fee in the amount of $26,250 on or before December 31, 2011.

First Amendment to June 24, 2009 Loan Agreement

On August 30, 2011, we, and a lender (the “June 2010 Lender”), entered into a first amendment (the “First Amendment”) to the loan agreement, dated June 24, 2010, under which a promissory note in the principal amount of $800,000 (the “June 2010 Note”) had been originally issued to the June 2010 Lender.

Pursuant to the First Amendment, among other things:

 
·
the maturity date of the indebtedness represented by the June 2010 Note was extended from June 24, 2011 to June 24, 2012; and

 
·
an amended and restated promissory note (the “Amended June 2010 Note”) was issued to the June 2010 Lender in exchange for the cancellation of the original June 2010 Note.

Third Amendment to June 12, 2008 Securities Purchase Agreement

On August 31, 2011, we, and the holder (the “June 2008 Investor”) of a promissory note in the principal amount of $1,716,411, as previously amended on December 31, 2008 and December 31, 2009 (the “June 2008 Note”), entered into a third amendment (the “Third Amendment”) to the purchase agreement under which the June 2008 Note had originally been issued.

Pursuant to the Third Amendment:

 
·
the maturity date of the indebtedness represented by the June 2008 Note was further extended from December 31, 2010 to December 31, 2012;

 
·
effective as of December 31, 2010, the interest rate on the indebtedness represented by the June 2008 Note increased from 10% to 15% per annum;

 
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·
commencing on September 1, 2011, and continuing until such time as accrued and unpaid interest in the aggregate amount of $343,282 (the “Accrued Interest”), representing the full amount of accrued and unpaid interest payable on the indebtedness represented by the June 2008 Note for the period from January 1, 2010 through August 31, 2011, has been paid by us to the June 2008 Investor, we shall pay $50,000 (or such lesser amount of Accrued Interest as is then remaining) to the June 2008 Investor on the first day of each month, to be applied against such Accrued Interest, subject to a forty-five (45) day cure period;

 
·
an amended and restated promissory note (the “Amended June 2008 Note”) was issued to the June 2008 Investor in exchange for the cancellation of the June 2008 Note;

 
·
the exercise price of 150,000 warrants to purchase shares of our common stock, which we originally issued to the June 2008 Investor on June 12, 2008 (the “June 2008 Warrants”), was reduced from $1.63 per share to $1.00 per share, subject to adjustment under certain circumstances;

 
·
the expiration date of the June 2008 Warrants was extended to December 31, 2013;

 
·
amended and restated warrants (the “Amended June 2008 Warrants”) were issued to the June 2008 Investor in exchange for the cancellation of the June 2008 Warrants;

 
·
the exercise price of 526,506 warrants to purchase shares of our common stock, which we originally issued to the June 2008 Investor on December 31, 2009 (the “December 31, 2009 Warrants”), was reduced from $1.63 per share to $1.00 per share, subject to adjustment under certain circumstances;

 
·
the expiration date of the December 31, 2009 Warrants was extended to December 31, 2013;

 
·
amended and restated warrants (the “Amended December 31, 2009 Warrants”) were issued to the June 2008 Investor in exchange for the cancellation of the December 31, 2009 Warrants;

 
·
a loan extension fee in the amount of $17,164 is to be paid to the June 2008 Investor on or before December 31, 2012;

 
·
the June 2008 Investor (i) waived any “Event of Default” resulting from our failure to pay any principal and/or interest when due pursuant to the terms of the June 2008 Note, and (ii) rescinded any oral and/or written notice of default delivered to us in connection therewith; and

 
·
the number of shares of our common stock pledged by Yang Yong Shan, our Chairman, Chief Executive Officer and President, to secure our obligations under the Amended June 2008 Note was increased from 2,104,950 shares to 4,000,000 shares.

 
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Expiration of Warrants

Issued and outstanding warrants to purchase an aggregate of 3,360,019 shares of our common stock, which were originally issued in connection with the private placements we consummated in October 2007, have recently expired, as follows:

 
·
On August 2, 2011, 833,811 warrants (originally issued on October 9, 2007), exercisable at $1.50 per share, expired unexercised;

 
·
On August 2, 2011, 981,747 warrants (originally issued on October 9, 2007), exercisable at  $3.26 per share, expired unexercised; and

 
·
On August 12, 2011, 1,544,461 warrants (originally issued on October 19, 2007), exercisable at $3.26 per share, expired unexercised.

Advances from Our Chairman

In the second quarter of 2011, Yang Yong Shan, our Chairman, Chief Executive Officer and President made interest-free advances to us in the aggregate amount of $440,782. We used these funds for repayment of certain existing indebtedness and expenses. This amount is repayable to Mr. Yang on demand.

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.

 
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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.

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 approximately 10,000 tons. We expect that this increase in production capacity of approximately 111% will result in corresponding increases in our sales revenues, cost of goods sold and sales and administrative expenses.

In the second quarter of 2011, management implemented its strategy to consolidate production of all of our infant formula products at our new state-of-the-art facility in Hailun City, rather than incurring the costs to upgrade our production facility in Beian City to meet increased government standards. We will continue to manufacture other milk powder, rice powder and soybean powder products at the Beian City production facility.

Product Pricing and Raw Material Supply

Historically we have been able to obtain sufficient raw milk and other raw materials to meet our production needs. The price of raw milk is affected by regional market in Heilongjiang Province, PRC, while other raw materials are affected by global markets. We expect that the raw materials we require to produce our products will continue to be readily available to us for the foreseeable future. In 2011, the prices of certain raw materials we use to produce our products have increased, and we expect them to continue to increase, due to inflation. We believe we will be able to increase the prices of our products to pass on any higher raw material costs to consumers. However, there is no guarantee that we will be able to raise prices to the full extent necessary to cover rises in costs for raw materials, which could have a negative material impact on our financial condition and results of operations.

 
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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 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.

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.
 
 
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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 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;

 
·
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.  We plan to repay the loans with a combination of retained earnings and, to the extent necessary, funds raised from the capital market through private or public equity and/or debt offerings.  However, there can be no assurance that any additional financing will become available to us, and if available, on terms acceptable to us.

Results of Operations

Three-Month Period Ended June 30, 2011 Compared to Three-Month Period Ended June 30, 2010

The following summarizes changes in our operations for the three months ended June 30, 2011 and 2010.  Net income increased by $346,765, from $1,283,946 in the three months ended June 30, 2010, to $1,630,711 for the three months ended June 30, 2011.  The increase in net income during the three months ended June 30, 2011, as compared to the same time period in the prior year, was due to a decrease in our selling and administrative expenses as well as other factors further described below.

Sales and Cost of Goods Sold

   
 
For the Three Months
Ended June 30,
 
   
 
2011
   
2010
 
Sales
  $ 14,487,068     $ 13,309,502  
Cost of Goods Sold
    7,634,895       6,794,707  
Gross Profit
  $ 6,852,173     $ 6,514,795  
 
 
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Sales. Sales volume decreased by 203 metric tons, or 8.3%, period on period, to 2,250 metric tons for the three months ended June 30, 2011, from 2,453 metric tons for the three months ended June 30, 2010.  Sales revenues increased by $1,177,566, or 8.8%, from $13,309,502 in the three months ended June 30, 2010, to $14,487,068 for the three months ended June 30, 2011.  The increase in sales was primarily due to an increase in the average selling price of $1,013 per metric ton for our products, offset by the reduction in volume for all of our products of 203 metric tons, resulting from a slow-down in production during the quarter to comply with new product packaging standards required by the PRC government, and to implement our strategy to consolidate production of all of our infant formula products at our new state-of-the-art facility in Hailun City, rather than incurring the costs to upgrade our production facility in Beian City to meet increased government standards.

Sales by product line.  A break-down of our sales by product line for the three months ended June 30, 2011 and 2010 is as follows:

  
 
Three Months Ended June 30,
       
   
 
2011
   
2010
   
Period-on-period
 
Product category