Attached files
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EX-32.2 - CHINA SKY ONE MEDICAL, INC. | v201300_ex32-2.htm |
EX-31.2 - CHINA SKY ONE MEDICAL, INC. | v201300_ex31-2.htm |
EX-32.1 - CHINA SKY ONE MEDICAL, INC. | v201300_ex32-1.htm |
EX-31.1 - CHINA SKY ONE MEDICAL, INC. | v201300_ex31-1.htm |
UNITD
STATES
SECURITIES
AND EXCHANGE COMMISSION
Washington,
D.C. 20549
FORM
10-Q
x
|
QUARTERLY REPORT PURSUANT TO
SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934
|
For the
nine months ended: September 30,
2010
¨
|
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: 001-34080
CHINA SKY ONE MEDICAL,
INC.
|
(Exact
name of registrant as specified in its
charter)
|
Nevada
|
87-0430322
|
|
(State
or other jurisdiction of
|
(I.R.S.
Employer
|
|
incorporation
or organization)
|
Identification
No.)
|
|
No. 2158, North Xiang An Road, Song Bei
District,
Harbin, People’s Republic of
China
|
150028
|
|
(Address
of principal executive offices)
|
(Zip
Code)
|
86-451-8703-2617
(China)
|
(Registrant's
telephone number, including area
code)
|
Not
Applicable
|
(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.
Yes x No
¨
Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Website, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files).
Yes ¨ No ¨
Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a small 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 x
|
Non-accelerated
filer ¨
(Do
not check if a smaller reporting company)
|
Smaller
reporting company ¨
|
Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).
Yes ¨ No
x
As of
November 1, 2010, the registrant had 16,790,851 shares of common stock issued
and outstanding.
QUARTERLY
REPORT ON FORM 10-Q
OF
CHINA SKY ONE MEDICAL, INC. AND SUBSIDIARIES
FOR
THE PERIOD ENDED SEPTEMBER 30, 2010
TABLE
OF CONTENTS
PAGE
|
|||||
PART I
|
-
|
FINANCIAL
INFORMATION
|
|||
Item
1.
|
Financial
Statements
|
2
|
|||
Condensed
Consolidated Statements of Operations and Comprehensive Income for the
Three and Nine Months Ended September 30, 2010 (unaudited) and 2009
(unaudited and restated)
|
2
|
||||
Condensed
Consolidated Balance Sheets as of September 30, 2010 (unaudited) and
December 31, 2009 (restated)
|
3
|
||||
Condensed
Consolidated Statements of Cash Flows for the Nine Months Ended
September 30, 2010 (unaudited) and 2009 (unaudited and
restated)
|
4
|
||||
Notes
to Condensed Consolidated Financial Statements (unaudited)
|
5
|
||||
Item
2.
|
Management’s
Discussion and Analysis of Financial Condition and Results of
Operations
|
34
|
|||
Item
3.
|
Quantitative
and Qualitative Disclosures About Market Risk
|
58
|
|||
Item
4.
|
Controls
and Procedures
|
58
|
|||
PART II
|
-
|
OTHER
INFORMATION
|
|||
Item
1.
|
Legal
Proceedings
|
60
|
|||
Item
1A.
|
Risk
Factors
|
60
|
|||
Item
2.
|
Unregistered
Sales of Equity Securities and Use of Proceeds
|
61
|
|||
Item
3.
|
Defaults
Upon Senior Securities
|
61
|
|||
Item
4.
|
Removed
and Reserved
|
61
|
|||
Item
5.
|
Other
Information
|
61
|
|||
Item
6.
|
Exhibits
|
61
|
|||
Signatures
|
62
|
-i-
SPECIAL
NOTE REGARDING FORWARD-LOOKING STATEMENTS
This
Quarterly Report on Form 10-Q, together with other statements and information we
publicly disseminate, contains certain forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933, as amended, and Section
21E of the Securities Exchange Act of 1934, as amended. We intend
such forward-looking statements to be covered by the safe harbor provisions for
forward-looking statements contained in the Private Securities Litigation Reform
Act of 1995, and include this statement for purposes of complying with these
safe harbor provisions.
Forward-looking
statements, which are based on certain assumptions and describe our future
plans, strategies and expectations, are generally identifiable by use of the
words “believe,” “expect,” “intend,” “anticipate,” “estimate,” “should”,
“would”, “could”, “may”, “plan”, “possible”, “project” or similar
expressions. You should not rely on forward-looking statements
since they involve known and unknown risks, uncertainties and other factors that
are, in some cases, beyond our control and which could materially affect actual
results, performances or achievements.
Factors
that may cause actual results to differ materially from current expectations
include, but are not limited to the “Risk Factors” discussed in our Annual
Report on Form 10-K for the year ended December 31, 2009, as amended.
Accordingly, there is no assurance that our expectations will be
realized. Except as otherwise required by the federal securities
laws, we disclaim any obligations or undertaking to publicly release any updates
or revisions to any forward-looking statement contained herein (or elsewhere) to
reflect any change our expectations with regard thereto, or any change in
events, conditions or circumstances on which any such statement is
based.
The terms
“the Company,” “we,” “us” and “our” refer to China Sky One Medical, Inc.,
together with our consolidated subsidiaries.
1
PART
I. FINANCIAL INFORMATION
Item
1. Financial Statements
China
Sky One Medical, Inc. and Subsidiaries
Condensed
Consolidated Statements of Operations and Comprehensive Income
(Unaudited,
$ in thousands except share and per share data)
Three Months Ended
September 30,
|
Nine Months Ended
September 30,
|
|||||||||||||||
|
2010
|
2009
(restated)
|
2010
|
2009
(restated)
|
||||||||||||
Revenues
|
$
|
36,193
|
$
|
43,227
|
$
|
105,856
|
$
|
100,242
|
||||||||
Cost
of Goods Sold
|
9,796
|
10,897
|
28,287
|
24,690
|
||||||||||||
Gross
Profit
|
26,397
|
32,330
|
77,569
|
75,552
|
||||||||||||
Operating
Expenses
|
||||||||||||||||
Depreciation
and amortization
|
879
|
447
|
2,547
|
1,348
|
||||||||||||
Research
and development
|
5,592
|
4,885
|
15,266
|
10,980
|
||||||||||||
Selling
|
9,673
|
9,944
|
23,567
|
23,707
|
||||||||||||
General
and administrative
|
798
|
1,024
|
2,911
|
2,354
|
||||||||||||
Total
operating expenses
|
16,942
|
16,300
|
44,291
|
38,389
|
||||||||||||
Income
from Operations
|
9,455
|
16,030
|
33,278
|
37,163
|
||||||||||||
Other
Income
|
||||||||||||||||
Interest
income
|
29
|
20
|
88
|
46
|
||||||||||||
Change
in fair value of derivative warrant liability
|
1,833
|
132
|
8,847
|
1,305
|
||||||||||||
Total
other income
|
1,862
|
152
|
8,935
|
1,351
|
||||||||||||
Net
Income Before Provision for Income Tax
|
11,317
|
16,182
|
42,213
|
38,514
|
||||||||||||
Provision
for Income Taxes
|
2,722
|
3,592
|
8,787
|
8,050
|
||||||||||||
Net
Income
|
$
|
8,595
|
$
|
12,590
|
$
|
33,426
|
$
|
30,464
|
||||||||
Basic
Earnings Per Share
|
$
|
0.51
|
$
|
0.76
|
$
|
1.99
|
$
|
1.84
|
||||||||
Basic
Weighted Average Shares Outstanding
|
16,790,851
|
16,655,697
|
16,786,240
|
16,535,924
|
||||||||||||
Diluted
Earnings Per Share
|
$
|
0.51
|
$
|
0.75
|
$
|
1.99
|
$
|
1.83
|
||||||||
Diluted
Weighted Average Shares Outstanding
|
16,790,851
|
16,741,745
|
16,825,294
|
16,606,576
|
||||||||||||
Other
Comprehensive Income
|
||||||||||||||||
Foreign
currency translation adjustment
|
$
|
2,538
|
$
|
122
|
$
|
3,094
|
$
|
245
|
||||||||
Net
Income
|
8,595
|
12,590
|
33,426
|
30,464
|
||||||||||||
Comprehensive
Income
|
$
|
11,133
|
$
|
12,712
|
$
|
36,520
|
$
|
30,709
|
See
accompanying summary of accounting policies and notes to the condensed
consolidated financial statements.
2
China
Sky One Medical, Inc. and Subsidiaries
Condensed
Consolidated Balance Sheets
($
in thousands, except share data)
|
September
30,
|
December 31,
|
||||||
2010
|
2009
|
|||||||
|
(Unaudited)
|
(Restated)
|
||||||
ASSETS
|
||||||||
Current
Assets
|
||||||||
Cash
and cash equivalents
|
$
|
71,971
|
$
|
52,756
|
||||
Accounts
receivable, net
|
23,036
|
21,146
|
||||||
Inventories
|
4,311
|
2,413
|
||||||
Prepaid
and other current assets
|
25
|
74
|
||||||
Total
current assets
|
99,343
|
76,389
|
||||||
Property
and equipment, net
|
15,505
|
15,491
|
||||||
Intangible
assets, net
|
23,551
|
25,114
|
||||||
Construction
in progress
|
13,214
|
12,932
|
||||||
Land
use rights, net
|
4,610
|
4,586
|
||||||
Construction
and land deposits
|
13,437
|
5,851
|
||||||
Total
Assets
|
$
|
169,660
|
$
|
140,363
|
||||
LIABILITIES
AND STOCKHOLDERS' EQUITY
|
||||||||
Current
Liabilities
|
||||||||
Accounts
payable and accrued expenses
|
$
|
5,233
|
$
|
4,186
|
||||
Taxes
payable
|
4,357
|
3,873
|
||||||
Derivative
warrant liability
|
1,716
|
11,435
|
||||||
Total
current liabilities
|
11,306
|
19,494
|
||||||
Commitments
and Contingencies
|
-
|
-
|
||||||
Stockholders'
Equity
|
||||||||
Preferred
stock ($0.001 par value, 5,000,000 shares authorized, none issued and
outstanding)
|
-
|
-
|
||||||
Common
stock ($0.001 par value, 50,000,000 shares authorized, 16,790,851 and
16,714,267 issued and outstanding, respectively)
|
17
|
17
|
||||||
Additional
paid-in capital
|
38,154
|
37,188
|
||||||
Retained
earnings
|
111,210
|
77,785
|
||||||
Accumulated
other comprehensive income
|
8,973
|
5,879
|
||||||
Total
stockholders' equity
|
158,354
|
120,869
|
||||||
Total
Liabilities and Stockholders' Equity
|
$
|
169,660
|
$
|
140,363
|
See
accompanying summary of accounting policies and notes to the condensed
consolidated financial statements.
3
China
Sky One Medical, Inc. and Subsidiaries
Condensed
Consolidated Statements of Cash Flows
(Unaudited,
$ in thousands)
|
|
Nine Months Ended September 30,
|
|
|||||
|
|
2010
|
|
|
2009
(restated)
|
|
||
Cash
flows from operating activities
|
||||||||
Net
Income
|
$
|
33,426
|
$
|
30,464
|
||||
Adjustments
to reconcile net cash provided by (used in) operating
activities:
|
||||||||
Depreciation
and amortization
|
2,895
|
1,753
|
||||||
Change
in fair value of derivative warrant liability
|
(8,847
|
)
|
(1,305
|
)
|
||||
Net
change in assets and liabilities
|
||||||||
Accounts
receivable
|
(1,363
|
)
|
(8,660
|
)
|
||||
Inventories
|
(1,816
|
)
|
(2,634
|
)
|
||||
Prepaid
and other current assets
|
(13
|
)
|
(15
|
)
|
||||
Accounts
payable and accrued expenses
|
880
|
3,938
|
||||||
Taxes
payable
|
397
|
2,391
|
||||||
Net
cash provided by operating activities
|
25,559
|
25,932
|
||||||
Cash
flows from investing activities
|
||||||||
Land
deposit
|
(7,335
|
)
|
-
|
|||||
Purchase
of fixed assets
|
(473
|
)
|
(122
|
)
|
||||
Purchase
of construction in progress
|
(14
|
)
|
(9,927
|
)
|
||||
Net
cash used in investing activities
|
(7,822
|
)
|
(10,049
|
)
|
||||
Cash
flows from financing activities
|
||||||||
Proceeds
from warrants conversion
|
94
|
29
|
||||||
Net
cash provided by financing activities
|
94
|
29
|
||||||
Effect
of exchange rate changes on cash and cash equivalents
|
1,384
|
103
|
||||||
Net
increase in cash and cash equivalents
|
19,215
|
16,015
|
||||||
Cash
and cash equivalents at beginning of period
|
52,756
|
40,288
|
||||||
Cash
and cash equivalents at end of period
|
$
|
71,971
|
$
|
56,303
|
||||
Supplemental
disclosure of cash flow information
|
||||||||
Interest
paid
|
$
|
-
|
$
|
-
|
||||
Taxes
paid
|
$
|
8,541
|
$
|
6,570
|
See
accompanying summary of accounting policies and notes to the condensed
consolidated financial statements.
4
China
Sky One Medical, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(Unaudited)
1. Description
of Business
China Sky
One Medical Inc. (“China Sky One” or the “Company”), a Nevada corporation, was
formed on February 7, 1986, and formerly known as Comet Technologies, Inc.
(“Comet”). On July 26, 2006, the Company changed the name of the
reporting company from "Comet Technologies, Inc." to "China Sky One Medical,
Inc."
China Sky
One is a holding company whose principal operations are conducted through its
wholly-owned subsidiaries. The Company has no revenues separate from
its subsidiaries, and has expenses related to its status as a public reporting
company and to its ownership interest in American California Pharmaceutical
Group, Inc. (“ACPG”) and Harbin City Tian Di Ren Medical Co.
(“TDR”).
ACPG, the
Company’s non operating United States holding company subsidiary, was
incorporated on December 16, 2003, in the State of California, under the name
“QQ Group, Inc.” QQ Group, Inc. changed its name to “American California
Pharmaceutical Group, Inc.” in anticipation of the Stock Exchange Agreement with
China Sky One (then known as “Comet Technologies, Inc.”) and TDR, described
herein. On December 8, 2005, ACPG completed a stock exchange transaction with
TDR a People’s Republic of China (“China” or “PRC”) based operating company
and TDR’s subsidiaries (the “TDR Acquisition”), each of which were fully
operating companies in the PRC. Under the terms of the agreement, ACPG exchanged
100% of its issued and outstanding common stock for 100% of the capital stock of
TDR and its subsidiaries, described below.
Thereafter,
on May 11, 2006, ACPG entered into a Stock Exchange Agreement (the “Exchange
Agreement”) with the shareholders of China Sky One. The terms of the Exchange
Agreement were consummated and the acquisition was completed on May 30, 2006. As
a result of the transaction, the Company issued a total of 10,193,377 shares of
its common voting stock to the stockholders of ACPG, in exchange for 100% of the
capital stock of ACPG resulting in ACPG becoming the Company’s wholly-owned
subsidiary. The transaction is treated as a reverse merger for accounting
purposes.
TDR,
formerly known as “Harbin City Tian Di Ren Medical Co.,” was originally formed
in 1994 and its principal executive office is located in Harbin City
of Heilongjiang Province, in the PRC. TDR was reorganized and incorporated as a
limited liability company on December 29, 2000, under the “Corporation Laws and
Regulations” of the PRC. At the time of the TDR Acquisition by ACPG in December
of 2005, TDR had two wholly-owned subsidiaries, Harbin First Bio-Engineering
Company Limited (“First”) and Kangxi Medical Care Product Factory, until July,
2006, when the two were merged, with First as the surviving subsidiary of TDR.
The principal activities of TDR and First are the research, manufacture and sale
of over-the-counter non-prescription health care products. TDR commenced its
business in the sale of branded nutritional supplements and over-the-counter
pharmaceutical products in the Heilongjiang Province. TDR has subsequently
evolved into an integrated manufacturer, marketer, and distributor of external
use natural Chinese medicine products sold primarily to and through independent
agents and China’s large pharmaceutical chains.
5
China
Sky One Medical, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(Unaudited)
As of
October 16, 2006, the Company organized Harbin Tian Qing Biotech Application
Company as a wholly-owned PRC subsidiary of TDR (“Tian Qing”), to conduct
research and development in the areas of tissue and stem cell banks. As of
September 30, 2010, Tian Qing had insignificant operations.
On April
3, 2008, TDR completed an acquisition pursuant to an Equity Transfer Agreement
dated February 22, 2008, between TDR and Heilongjiang Tianlong Pharmaceutical,
Inc., a corporation with a multitude of medicines approved by the PRC’s State
Food and Drug Administration (“SFDA”) and new medicine applications, organized
under the laws of the PRC (“Tianlong”), which is in the business of
manufacturing external-use pharmaceuticals. Pursuant to the Equity Transfer
Agreement, TDR acquired 100% of the issued and outstanding capital stock of
Tianlong from Tianlong’s sole stockholder, in consideration for an aggregate
purchase price of approximately $8,300,000, consisting of (i) $8,000,000 in
cash, and (ii) 23,850 shares of China Sky One (at $12 per share). The
acquisition received regulatory approval and closed on April 3,
2008.
The
following table summarizes the approximate estimated fair values of the assets
acquired in the Tianlong acquisition.
($ in thousands)
|
||||
Property
and equipment
|
$
|
6,315
|
||
Intangible
assets – SFDA licenses for drug batch numbers
|
1,787
|
|||
Other
|
170
|
|||
Net
assets acquired
|
$
|
8,272
|
On April
18, 2008, China Sky One through its subsidiary TDR consummated a share
acquisition pursuant to an Equity Transfer Agreement with the shareholders of
Heilongjiang Haina Pharmaceutical Inc., a recently formed corporation organized
under the laws of the PRC (“Haina”) licensed as a wholesaler of TCD,
bio-medicines, bio-products, medicinal devices, antibiotics and chemical
medicines. Haina does not have an established sales network and was acquired for
its primary asset, a Good Supply Practice (GSP) license (License No.
A-HLJ03-010) issued by the Heilongjiang office of the State Food and Drug
Administration (“SFDA”). The SFDA recently started issuing such licenses to
resellers of medicines that maintain certain quality controls. The GSP license
was issued as of December 21, 2006 and will expire on January 29, 2012 and will
enable the Company to expand its sales of medicinal products without having to
go through a lengthy license application process.
The
following table summarizes the approximate estimated fair values of the assets
acquired in the Haina acquisition.
($ in thousands)
|
||||
Cash
|
$
|
84
|
||
Intangible
assets – Goodwill
|
353
|
|||
Net
assets acquired
|
$
|
437
|
6
China
Sky One Medical, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(Unaudited)
Pursuant
to the Equity Transfer Agreement, TDR acquired 100% of the issued and
outstanding capital stock of Haina from its three stockholders in consideration
for payment of 3,000,000 RMB (approximately $437,000). TDR has been overseeing
the operations of Haina since January of 2008 as part of its due diligence prior
to closing of this acquisition.
On June
9, 2008, TDR entered into a Merger and Acquisition Agreement (the “Acquisition
Agreement”) with Peng Lai Jin Chuang Company, a corporation organized under the
laws of the People’s Republic of China (“Peng Lai”), which was organized to
develop, manufacture and distribute pharmaceutical, medicinal and diagnostic
products in the PRC. Pursuant to the Acquisition Agreement, TDR acquired all of
the assets of Peng Lai in consideration for an aggregate of approximately
(i) U.S.$2.5 million in cash, and (ii) 381,606 shares of the Company’s common
stock with a fair value of approximately $4.6 million (at $12 per share). The
acquisition of Peng Lai closed on September 5, 2008.
The
following table summarizes the approximate estimated fair values of the assets
acquired in the Peng Lai acquisition.
($ in thousands)
|
||||
Property
and equipment
|
$
|
4,177
|
||
Intangible
assets - SFDA licenses for drug batch numbers
|
2,917
|
|||
Net
assets acquired
|
$
|
7,094
|
All of
the Company’s significant operations and long lived assets are located in the
PRC.
2. Restatement
On May
11, 2010, the Company filed with the Securities and Exchange Commission (“SEC”)
a Current Report on Form 8-K, as amended on May 24, 2010, to report management’s
determination that the Company’s financial statements for the year ended
December 31, 2009, included in its Annual Report on Form 10-K filed with the SEC
on March 16, 2010, as amended on March 17, 2010 (the “2009 Form 10-K”), should
no longer be relied upon due to an error in such financial statements with
respect to the accounting for the 750,000 common stock purchase warrants the
Company issued in connection with its January 31, 2008 private placement (the
“Warrants”). The Company received comments from the staff of the SEC,
which led to the Company’s conclusion that the historical financial statements
for the year ended December 31, 2009 in the 2009 Form 10-K required restatement
to properly record the Warrants as a derivative liability.
On June
24, 2010, the Company filed with the SEC an additional Current Report on Form
8-K to report management’s determination that the Company’s financial
statements: (i) for the fiscal quarter ended March 31, 2009, included in its
Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 2010,
filed with the SEC on May 17, 2010 (the “March 2010 Form 10-Q”); (ii) for the
fiscal quarter ended June 30, 2009, included in its Quarterly Report on Form
10-Q filed with the SEC on August 14, 2009 (the “June 2009 Form 10-Q”); and
(iii) for the fiscal quarter ended September 30, 2009, included in its Quarterly
Report on Form 10-Q filed with the SEC on November 16, 2009 (the “September 2009
Form 10-Q” and, collectively with the March 2010 Form 10-Q and June 2009 Form
10-Q, the “Form 10-Qs”), should no longer be relied upon due to errors in such
financial statements with respect to the accounting for the
Warrants. The Company received comments from the staff of the SEC,
which led to the Company’s conclusion that the historical financial statements
in the Form 10-Qs required restatement to properly record the Warrants as a
derivative liability.
7
China
Sky One Medical, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(Unaudited)
The
Company has performed a complete assessment of the Warrants and has concluded
that the Warrants are within the scope of Accounting Standards Codification
815-40, “Derivatives and
Hedging – Contracts in Entity’s Own Equity” (“ASC 815-40”), formerly
Emerging Issues Task Force Issue No. 07-05, “Determining Whether an Instrument
(or Embedded Feature) Is Indexed to an Entity’s Own Stock” (“EITF
07-05”), due to the inclusion in the Warrants of a provision requiring a
weighted average adjustment to the exercise price of the Warrants in the event
the Company issues common stock, or securities convertible into or exercisable
for common stock, at a price per share lower than such exercise
price. Accordingly, ASC 815-40, formerly EITF 07-05, which was effective as
of January 1, 2009, should have been applied resulting in a reclassification of
the warrants as a liability, measured at fair value, with changes in fair value
recognized as part of other income or expense for each reporting period
thereafter.
On July
23, 2010, the Company filed amendments to the 2009 Form 10-K and March 2010 Form
10-Q with the SEC, reflecting the restatement. On August 9, 2010, the
Company filed June 2010 Form 10-Q, reflecting the restatement. The
corrections to the quarterly information in the amended March 31, 2010 Form 10-Q
and the June 2010 Form 10-Q had no impact on the Company’s previously reported
income from operations or cash flows for the periods being
restated.
This
quarterly report on Form 10-Q for the fiscal quarter ended September 30, 2010
incorporates corrections made in response to the accounting errors described
above by restating the Company’s financial statements presented herein for the
three and nine months ended September 30, 2009. The corrections to
the quarterly information in this Form 10-Q had no impact on the Company’s
previously reported income from operations or cash flows for the periods being
restated.
The
following tables ($ in thousands, except per share information) show the effects
of the restatement on the Company's consolidated statements of operations and
comprehensive income and consolidated statements of cash flows for the three and
nine month period ended September 30, 2009:
China
Sky One Medical, Inc. and Subsidiaries
Condensed
Consolidated Statements of Operations and Comprehensive Income
(Unaudited,
$ in thousands except per share data)
|
Three Months Ended
September 30, 2009
|
Nine Months Ended
September 30, 2009
|
||||||||||||||
|
As
Previously
Recorded
|
As
Restated
|
As
Previously
Recorded
|
As
Restated
|
||||||||||||
Change
in fair value of derivative warrant liability
|
$
|
-
|
$
|
132
|
$
|
-
|
$
|
1,305
|
||||||||
Total
other income
|
$
|
20
|
$
|
152
|
$
|
46
|
$
|
1,351
|
||||||||
Net
Income Before Provision for Income Tax
|
$
|
16,051
|
$
|
16,182
|
$
|
37,209
|
$
|
38,514
|
||||||||
Net
Income
|
$
|
12,459
|
$
|
12,590
|
$
|
29,159
|
$
|
30,464
|
||||||||
Basic
Earnings Per Share
|
$
|
0.75
|
$
|
0.76
|
$
|
1.76
|
$
|
1.84
|
||||||||
Diluted
Earnings Per Share
|
$
|
0.74
|
$
|
0.75
|
$
|
1.76
|
$
|
1.83
|
||||||||
Other
Comprehensive Income
|
||||||||||||||||
Foreign
currency translation adjustment
|
$
|
122
|
$
|
122
|
$
|
245
|
$
|
245
|
||||||||
Net
Income
|
12,459
|
12,590
|
29,159
|
30,464
|
||||||||||||
Comprehensive
Income
|
$
|
12,581
|
$
|
12,712
|
$
|
29,404
|
$
|
30,709
|
8
China
Sky One Medical, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(Unaudited)
The gain
resulting from the change in fair value of derivative warrant liability for the
three and nine month period ended September 30, 2009 was incurred at the
corporate level (a Nevada corporation). The Company did not recognize
any income tax benefits (expense) associated with the change in fair value in
the three and nine months ended September 30, 2009 (see Note
14). Therefore, the restatement did not have an effect on the Company’s
taxable income for the three and nine months ended September 30,
2009.
China
Sky One Medical, Inc. and Subsidiaries
Condensed
Consolidated Statements of Cash Flows
(Unaudited,
$ in thousands)
|
Nine Months Ended
September 30, 2009
|
|||||||
|
As
Previously
Recorded
|
As
Restated
|
||||||
Net
Income
|
$
|
29,159
|
$
|
30,464
|
||||
Change
in fair value of derivative liability
|
-
|
(1,305
|
)
|
|||||
Total:
|
$
|
29,159
|
$
|
29,159
|
3. Summary
of Significant Accounting Policies
The
Company has established various accounting policies that govern the application
of accounting principles generally accepted in the United States of America
(“U.S.”), which are utilized in the preparation of the Company’s financial
statements. Certain accounting policies involve significant judgments and
assumptions by management that have a material impact on the carrying value of
certain assets and liabilities. The judgments and assumptions used by
management are based on the Company’s historical experience and other factors,
which are believed to be reasonable under the circumstances. Because of the
nature of the judgments and assumptions made by management, actual results could
differ from these judgments and estimates, which could have a material impact on
the carrying values of assets and liabilities and the results of
operations.
9
China
Sky One Medical, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(Unaudited)
Principles of
Consolidation – The accompanying consolidated financial statements
include the accounts of the Company and its wholly-owned subsidiaries, ACPG,
TDR, First, Tian Qing, Tianlong, Haina and Peng Lai. All significant
inter-company transactions and balances were eliminated.
These
financial statements are stated in U.S. Dollars and have been prepared in
accordance with accounting principles generally accepted in the United States of
America (“U.S.”). This basis of accounting differs from that used under
applicable accounting requirements in the PRC. No material adjustment was
required.
Certain
items in the Company’s 2009 restated financial statements (see Note 2) have
been reclassified to conform with the 2010 financial statements
presentation.
Management
acknowledges its responsibility for the preparation of the accompanying interim
consolidated financial statements, which reflect all adjustments, consisting of
normal recurring adjustments, considered necessary, in its opinion, for a fair
presentation of its consolidated financial position and the results of its
operations for the interim period presented. These consolidated financial
statements should be read in conjunction with the summary of significant
accounting policies and notes to the consolidated financial statements
included in the Company’s Annual Report on Form 10-K for the year ended December
31, 2009, as amended.
The
accompanying unaudited condensed consolidated financial statements
for China Sky One Medical, Inc. and its subsidiaries have been prepared in
accordance with accounting principles generally accepted in the United States of
America for interim financial information and with the instructions to Form 10-Q
and Regulation S-X. Operating results for interim periods are not necessarily
indicative of results that may be expected for the fiscal year as a
whole.
Use of estimates – The
preparation of these financial statements in conformity with U.S. GAAP, requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities, disclosure of contingent assets and liabilities at the
dates of the financial statements, and the reported amounts of revenues and
expenses during the reported periods.
Significant
estimates include values and assigned lives to acquired tangible and intangible
assets, uncollectible accounts receivable, impairment testing of goodwill and
other long-lived assets, the valuation allowance for income taxes, and the
evaluation and estimate for contingencies. Actual results may differ
from these estimates.
Earnings per share - Basic
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. When applicable, diluted earnings per common share is
determined using the weighted-average number of common shares outstanding during
the period, adjusted for the dilutive effect of common stock equivalents,
consisting of shares that might be issued upon exercise of common stock options
and warrants.
10
China
Sky One Medical, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(Unaudited)
Potential
common shares issued are calculated using the treasury stock method, which
recognizes the use of proceeds that could be obtained upon the exercise of
options and warrants in computing diluted earnings per share. It assumes that
such proceeds would be used to purchase common stock at the average market price
of the common stock during the period.
Cash and cash equivalents –
The Company
considers all highly liquid instruments purchased with a maturity period of
three months or less to be cash equivalents. The carrying amounts reported in
the accompanying consolidated balance sheets for cash and cash equivalents
approximate their fair value.
A
significant amount of the Company’s cash and cash equivalents are held in
commercial bank checking accounts in the PRC and earn interest income
(annual yield of approximately 0.36% for the year ended December 31, 2009, and
the nine months ended September 30, 2010). For all the bank accounts in the PRC
and in the U.S., the Company earned interest income of
approximately $93,000 and $69,000 for the nine months ended September 30,
2010 and 2009, respectively. Management believes it is beneficial to retain
sufficient cash in checking accounts so it is readily available for working
capital and general corporate purposes, and to fund potential business and asset
acquisitions and other opportunities which may arise.
Accounts receivable
– Accounts receivable are stated at net realizable value, net of an
allowance for doubtful accounts. The allowance for estimated bad debts is based
upon the periodic analysis of individual customer balances including an
evaluation of days of sales outstanding, payment history, recent payment trends,
and perceived credit worthiness. As of September 30, 2010 and December 31, 2009,
the Company’s allowance for doubtful accounts was $56,000.
Inventories – Inventories
include finished goods, raw materials, freight-in, packing materials, labor, and
overhead costs and are valued at the lower of cost or market using the first-in,
first-out method. Inventory units are valued using the weighted average method.
Provisions are made for slow moving, obsolete and/or damaged inventory based
upon the periodic analysis of individual inventory items including an evaluation
of historical usage and/or movement, age, expiration date, and general
conditions. The Company recorded no inventory reserve position as of September
30, 2010 and December 31, 2009.
Property and equipment –
Property and equipment are stated at historical cost less accumulated
depreciation. Depreciation on property and equipment is provided using the
straight-line method over the estimated useful lives of the assets. The Company
uses an estimated residual value of 5% of cost, or valuation for both financial
and income tax reporting purposes. The estimated lengths of the useful lives of
the Company’s property and equipment are as follows:
Building
and Improvements
|
30
years
|
Land
use rights
|
50
years
|
Furniture
& Equipment
|
5
to 7 years
|
Transportation
Equipment
|
5
to 15 years
|
Machinery
and Equipment
|
7
to 14 years
|
11
China
Sky One Medical, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(Unaudited)
Expenditures
for renewals and betterments are capitalized while repairs and maintenance costs
are charged to the consolidated statement of operations in the year in which
they were incurred. In situations where it can be clearly demonstrated that the
expenditure has resulted in an increase in the future economic benefits expected
to be obtained from the use of the asset, the expenditure is capitalized as an
additional cost of the asset. Upon sale or disposal of an asset, the historical
cost and related accumulated depreciation or amortization of such asset is
removed from their respective accounts, and any gain or loss is recorded in the
consolidated statements of operations.
Property
and equipment are evaluated for impairment in value whenever an event or change
in circumstances indicates that the carrying values may not be recoverable. If
such an event or change in circumstances occurs and potential impairment is
indicated because the carrying value exceeds the estimated future undiscounted
cash flows of the asset, the Company will measure the impairment loss as the
amount by which the carrying value of the asset exceeds its fair value. The
Company did not record any impairment charges of property and equipment in the
three or nine months ended September 30, 2010 and 2009.
Construction-in-progress –
Properties currently under development are accounted for as
construction-in-progress. Construction-in-progress includes the acquisition and
land right costs, development expenditures, professional fees, and capitalized
interest costs during the period of construction.
Upon
completion and readiness for use of the project, the cost of
construction-in-progress is transferred as part of property and equipment. In
the case of construction-in-progress, management takes into consideration the
estimated cost to complete the project when making the lower of cost or market
calculation.
Intangible assets – Intangible
assets are accounted for in accordance with ASC topic 350, “Intangibles –
Goodwill and Other.” Intangible assets with finite useful lives are amortized
while intangible assets with indefinite useful lives are not amortized. The
Company reviews its long-lived assets and finite-lived intangible assets for
impairment on at least an annual basis or whenever events or changes in
circumstances indicate that the carrying amount of the assets may not be fully
recoverable. To determine recoverability of its long-lived assets, the Company
evaluates the probability that future undiscounted net cash flows will be less
than the carrying amount of the assets. Impairment costs, if any, are measured
by comparing the carrying amount of the related assets to their fair value. The
Company recognizes an impairment loss based on the excess of the carrying amount
of the assets over their respective fair values. Fair value is determined by the
use of undiscounted future cash flows, independent appraisals or other
appropriate methods. The Company did not record any impairment charges in the
three or nine months ended September 30, 2010 and 2009.
The
Company’s intangible assets consist of proprietary technologies, SFDA licenses
for drug batch numbers, and goodwill. Proprietary technologies are technologies
that the Company owns. The SFDA licenses for drug batch numbers and goodwill
were acquired in the business acquisitions of Tianlong, Peng Lai and Haina. The
Company has registered “Kang Xi” as the Company’s trademark, which is used for
all of the Company’s Tradition Chinese Medicine (“TCM”) products. The “Kang Xi”
trademark was developed internally and registered by TDR before the Company
became a public company. The Company’s cost basis in the trademark is
nominal. Therefore,
the Company did not have its “Kang Xi” trademark appraised, or recorded an
intangible asset for it. Additionally, none of the costs associated with the
trademark have been capitalized. As of September 30, 2010, the weighted average
amortization period for the Company’s intangible assets is approximately 7.5
years.
12
China
Sky One Medical, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(Unaudited)
Foreign Currency - The
Company’s principal country of operations is in the PRC. The financial position
and results of operations of the Company are recorded in Renminbi (“RMB”) 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 market rate of exchange at that date.
The registered equity capital denominated in the functional currency is
translated at the historical rate of exchange at the time of the capital
contribution. All translation adjustments resulting from the translation of the
financial statements into U.S. Dollars are recorded as accumulated other
comprehensive income, a component of stockholders’ equity. At September 30, 2010
the exchange rate was 6.70 RMB to one U.S. dollar compared to 6.84 RMB to one
U.S. dollar at December 31, 2009. For the nine months ended September 30, 2010,
the average exchange rate was 6.82 RMB to one U.S. dollar compared to 6.84 RMB
to one U.S. dollar for the same period of 2009.
Revenue recognition - Revenue
is recognized when the following criteria are met: (1) persuasive evidence
of an arrangement exists; (2) the product has been shipped and the customer
takes ownership and assumes the risk of loss; (3) the selling price is
fixed or determinable; and (4) collection of the resulting receivable is
reasonably assured. The Company believes that all of these criteria are
satisfied upon shipment from its facilities. Historically, the Company’s
estimated returns, allowances and claims have been deemed immaterial. The
Company’s sale agreements only allow a return if the product has quality related
issues. In such event, the Company accepts the return for equivalent product
exchange from inventory only. The Company’s revenues do not include multiple
deliverable arrangements.
The
Company occasionally applies to various government agencies for research grants.
Revenue from such research grants is recognized when earned. In situations where
the Company receives payment in advance for the performance of research and
development services, such amounts are deferred and recognized as revenue as the
related services are performed.
13
China
Sky One Medical, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(Unaudited)
Research and development -
Research and development expenses include the costs associated with the
Company’s internal research and development as well as research and development
conducted by third parties. These costs primarily consist of salaries, clinical
trials, outside consultants, and materials. All research and development costs
are expensed as incurred.
Third-party
expenses reimbursed under non-refundable research and development contracts are
recorded as a reduction to research and development expense in the consolidated
statement of operations.
The
Company recognizes in-process research and development in accordance with ASC
topic 730, “Research and Development.” Assets to be used in research and
development activities, specifically, compounds that have yet to receive new
drug approval and would have no alternative use, should approval not be given,
are immediately charged to expense when acquired. Certain assets and other
technologies acquired that has foreseeable future cash flows are capitalized as
intangible assets. Such intangible assets are amortized starting from the year
revenue is generated and amortized over the estimated stream of revenues derived
from the product sale. Should under any circumstances these capitalized
intangible assets have no future benefit; the Company will record an immediate
write-off for the remaining net carrying value within the consolidated statement
of operations.
The
Company incurred research and development expenses of approximately $5,592,000
and $4,885,000, for the three months ended September 30, 2010 and 2009,
respectively, and $15,266,000 and $10,980,000, for the nine months ended
September 30, 2010 and 2009, respectively.
Advertising – The Company signs contracts
with agents who then place its advertising in the mediums of television, radio
and internet. Advertising expense is incurred in the period the advertisements
take place. Thus, costs of advertising are expensed as incurred. Advertising
costs were approximately $6,084,000 and $5,031,000 for the three months
ended September 30, 2010 and 2009, respectively, and $12,480,000 and $11,245,000
for the nine months ended September 30, 2010 and 2009, respectively. An
immaterial amount of the Company’s advertisement expenses were related to
advertising production costs. Advertising costs are reported as part of selling
expenses in the consolidated statements of operations.
Taxation – The Company uses
the asset and liability method of accounting for deferred income taxes. The
Company’s provision for income taxes includes income taxes currently payable and
those deferred because of temporary differences between the financial statement
and tax bases of assets and liabilities. The Company records liabilities
for income tax contingencies based on the Company’s best estimate of the
underlying exposures.
The
Company periodically estimates its tax obligations using historical experience
in tax jurisdictions and informed judgments. There are inherent uncertainties
related to the interpretation of tax regulations in the jurisdictions in which
the Company transacts business. The judgments and estimates may change based on
the outcome of tax audits, as well as changes to, or further interpretations of,
regulations. The Company adjusts income tax expense in the period in which these
events occur.
Provision
for the PRC enterprise income tax is calculated at the prevailing rate based on
the estimated assessable profits less available tax relief for losses brought
forward. The
Company does not accrue taxes on unremitted earnings from foreign operations as
it is the Company’s intention to invest these earnings in the foreign operations
indefinitely.
14
China
Sky One Medical, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(Unaudited)
Enterprise income
tax
According
to “Enterprise Income Tax and Certain Preferential Policies Notice” published by
the Ministry of Finance and the National Tax Affairs Bureau, if the enterprise
is authorized by the State Council as a special entity, the enterprise income
tax rate is reduced to 15%. The following table sets forth the Company’s income
tax rate for TDR and its subsidiaries for the nine months ended September 30,
2010 and 2009:
Income Tax Rate
|
|
As of September 30,
|
|
|||||
for Subsidiaries
|
|
2010
|
|
|
2009
|
|
||
TDR
|
15
|
%
|
15
|
%
|
||||
First
|
15
|
%
|
15
|
%
|
||||
Tianlong
|
15
|
%
|
15
|
%
|
||||
Haina
|
25
|
%
|
25
|
%
|
||||
Peng
Lai
|
2%
of Revenue
|
*
|
2%
of Revenue
|
*
|
|
*
|
Reflects a 25% tax rate on 8% of
Peng Lai’s revenue, regardless of its taxable income. As authorized by
Peng Lai Municipal Tax Bureau, Peng Lai was not required to pay tax on the
remaining 92% of revenue.
|
Value added
tax
The
Provisional Regulations of PRC Concerning Value Added Tax promulgated by the
State Council came into effect on January 1, 1994. Under these regulations and
the Implementing Rules of the Provisional Regulations of the PRC Concerning
Value Added Tax, value added tax is imposed on goods sold in, or imported into,
the PRC and on processing, repair and replacement services provided within the
PRC.
Value
added tax payable in the PRC is charged on an aggregated basis at a rate of 13%
or 17% (depending on the type of goods involved) on the full price collected for
the goods sold or, in the case of taxable services provided, at a rate of 17% on
the charges for the taxable services provided, but excluding, in respect of both
goods and services, any amount paid in respect of value added tax included in
the price or charges, and less any deductible value added tax already paid by
the taxpayer on purchases of goods and services in the same financial
year.
According
to “Agriculture Product Value Added Tax Rate Adjustment and Certain Items’ Value
Added Tax Waiver” published by the Ministry of Finance and the National Tax
Affairs Bureau, the value added tax for agriculture related products is to be
taxed at 13%. Furthermore, traditional Chinese medicine and medicinal plant are
by definition agriculture related products.
The
Company may from time-to-time be assessed interest or penalties by major tax
jurisdictions, although such assessments historically have been minimal and
immaterial to the Company’s financial results. The Company’s policy is to
recognize interest and penalties accrued on any unrecognized tax benefits as a
component of income tax expense.
15
China
Sky One Medical, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(Unaudited)
The
Company files corporate income tax returns in the U.S. for China Sky One and
ACPG. ACPG wholly owns 100% of TDR and subsidiaries in the PRC. China Sky One
and ACPG are holding companies and do not generate business revenues and
management’s intent is not to distribute dividend income from TDR and
subsidiaries to either China Sky One or ACPG. As such, management has
established a full valuation allowance for the net operating losses incurred by
China Sky One and ACPG. The Company files income tax returns in the PRC for TDR
and its subsidiaries.
Comprehensive income –
Comprehensive income consists of net income and other gains and losses
affecting stockholders’ equity that, under generally accepted accounting
principles are excluded from net income. For the Company, such items consist
entirely of foreign currency translation gains and losses.
Retirement benefit costs –
According to the PRC regulations on pension plans, the Company contributes to a
defined contribution retirement plan organized by municipal government in the
province in which the Company is registered and all qualified employees as
defined by statutory regulations are eligible to participate in the
plan.
Contributions
to the pension or retirement plan are calculated at 22% of the employees’
salaries above a fixed threshold amount. The employees contribute between 2% to
8% to the pension plan, and the Company contributes the balance. The Company has
no other material obligations for the payment of retirement benefits beyond the
annual contributions under this plan. The Company paid retirement benefit costs
of $92,000 and $36,000 for the three months ended September 30, 2010 and
2009, respectively, and $208,000 and $126,000 for the nine months ended
September 30, 2010 and 2009, respectively.
Fair value of financial instruments
– The carrying amounts of certain financial instruments, including
cash and cash equivalents, accounts receivable, accounts payable and accrued
expenses, and other payables approximate their fair values at September 30,
2010 and December 31, 2009 because of the relatively short-term maturity of
these instruments.
Subsequent
Events
The
Company evaluated subsequent events through the date of filing of this Form 10-Q
in accordance with the Subsequent Events Topic of the FASB Accounting Standards
Codification under ASC topic 855.
Recent
accounting pronouncements
The
Financial Accounting Standards Board (“FASB”) has codified a single source of
authoritative nongovernmental U.S. GAAP, the “Accounting Standards
Codification” (the “Codification” or “ASC”). While the Codification does
not change U.S. GAAP, it introduces a new structure that is organized in an
easily accessible, user-friendly on-line research system. The Codification
supersedes all existing accounting standards documents. All other accounting
literature not included in the Codification will be considered
non-authoritative. Unless needed to clarify a point to readers, the Company will
refrain from citing specific section references when discussing application of
accounting principles or addressing new or pending accounting rule
changes.
16
China
Sky One Medical, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(Unaudited)
In April
2010, the FASB issued Accounting Standard Update (“ASU”) 2010-17, Revenue
Recognition – Milestone Method, which amended guidance on the criteria that
should be met for determining whether the milestone method of revenue
recognition is appropriate. A vendor can recognize consideration that is
contingent upon achievement of a milestone in its entirety as revenue in the
period in which the milestone is achieved only if the milestone meets all
criteria to be considered substantive.
The
consideration earned by achieving the milestone should:
1. Be
commensurate with either of the following:
a.
|
The
vendor’s performance to achieve the milestone; or
|
|
b.
|
The
enhancement of the value of the item delivered as a result of a specific
outcome resulting from the vendor’s performance to achieve the
milestone
|
2. Relate
solely to past performance
3. Be
reasonable relative to all deliverables and payment terms in the
arrangement.
A
milestone should be considered substantive in its entirety. An individual
milestone may not be bifurcated. An arrangement may include more than one
milestone, and each milestone should be evaluated separately to determine
whether the milestone is substantive. Accordingly, an arrangement may contain
both substantive and non-substantive milestones.
The
amendments in this ASU are effective on a prospective basis for milestones
achieved in fiscal years, and interim periods within those years, beginning on
or after June 15, 2010. Early adoption is permitted. The new
accounting guidance did not have a material impact on the Company’s consolidated
financial statements.
In
February 2010, the FASB issued ASU No. 2010-09, Subsequent Events (Topic 855);
Amendments to Certain Recognition and Disclosure Requirements. This ASU amended
the guidance on subsequent events and will no longer require that an SEC filer
disclose the date through which subsequent events have been evaluated. The
amendment is effective for interim and annual periods ending after June 15,
2010.
4. Revenue
By Product Category and Geographic Region
For the
nine months ended September 30, 2010 and 2009, overseas (non-PRC) sales were
approximately $5,928,000 and $8,956,000, respectively. For the three months
ended September 30, 2010 and 2009, overseas (non-PRC) sales were approximately
$2,202,000 and $4,530,000, respectively.
The
following table sets forth the Company’s principal product categories based on
application type and the approximate amount and percentage of revenue from each
of such product categories, during the nine months ended September 30, 2010 and
2009:
17
China
Sky One Medical, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(Unaudited)
For the Nine Months Ended September 30,
($ in thousands)
|
||||||||||||||||||||||||||||
# of
Products
|
2010
|
# of
Products
|
2009
|
Variance
|
||||||||||||||||||||||||
Product
Category
|
Sales
|
% of
Sales
|
Sales
|
% of
Sales
|
||||||||||||||||||||||||
Patches
|
5
|
$
|
24,470
|
23.1
|
%
|
5
|
$
|
30,842
|
30.8
|
%
|
$
|
(6,372
|
)
|
|||||||||||||||
Ointments
|
25
|
31,013
|
29.3
|
%
|
18
|
23,563
|
23.5
|
%
|
7,450
|
|||||||||||||||||||
Sprays
|
16
|
11,772
|
11.1
|
%
|
15
|
14,486
|
14.5
|
%
|
(2,714
|
)
|
||||||||||||||||||
Drops
|
10
|
8,569
|
8.1
|
%
|
4
|
4,925
|
4.9
|
%
|
3,644
|
|||||||||||||||||||
Diagnostic
Kits
|
3
|
4,446
|
4.2
|
%
|
3
|
9,411
|
9.4
|
%
|
(4,965
|
)
|
||||||||||||||||||
Others
|
59
|
25,586
|
24.2
|
%
|
44
|
17,015
|
16.9
|
%
|
8,571
|
|||||||||||||||||||
Total
|
118
|
$
|
105,856
|
100.0
|
%
|
89
|
$
|
100,242
|
100.0
|
%
|
$
|
5,614
|
Please
refer to “Part I, Item 2. Management’s Discussion and Analysis of Financial
Condition and Results of Operations” for an analysis on changes in revenue by
product category.
5. Concentrations
of Business and Credit Risk
Substantially
all of the Company's long-lived assets and business operations are located in
the PRC.
The
Company maintains certain bank accounts in the PRC which are not protected by
FDIC insurance or other insurance. As of September 30, 2010, the Company held
approximately $1,071,000 of cash and cash equivalent account balances within the
U.S. and all of the deposits were within the FDIC insurance limits.
As of September 30, 2010, the Company had approximately $70,888,000 in China
bank deposits, which are not insured.
A
significant amount of the Company’s sales are concentrated in China.
Accordingly, the Company is susceptible to fluctuations in its business caused
by adverse economic conditions in China. Difficult economic conditions in other
geographic areas into which the Company may expand may also adversely affect its
business, operations and finances.
The
Company provides credit in the normal course of business. The Company performs
ongoing credit evaluations of its customers and maintains allowances for
doubtful accounts based on factors surrounding the credit risk of specific
customers, historical trends, and other information.
The
Company does not require collateral for financial instruments subject to credit
risk.
The
Company is self-insured for all risks and carries no liability or property
insurance coverage of any kind. The Company does not set aside any reserves for
product liability risks or other potential claims. The Company’s policy is to
record losses associated with its lack of insurance coverage at such time as a
realized loss is incurred. Historically, the Company has not had any
material losses in connection with its lack of insurance coverage and was
not party to any material pending legal proceedings as of September 30, 2010.
Management’s intention is to use the Company’s working capital to fund any such
losses incurred due to the Company’s exposure to inadequate insurance
coverage.
18
China
Sky One Medical, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(Unaudited)
Payments
of dividends may be subject to some restrictions due to the Company’s operating
subsidiaries all being located in the PRC.
Major
Customers
For the
nine months ended September 30, 2010, no customer accounted for more than 10% of
the Company’s total revenues. For the nine months ended September 30, 2009,
Harbin Shiji Baolong and Shanxi Xintai accounted for 14% and 13% respectively of
sales revenues. At September 30, 2010, no customer accounted for 10% or
more of the Company’s accounts receivable. At September 30, 2009, Harbin Shiji
Baolong accounted for 25% of accounts receivable. No other customers accounted
for 10% or more of the Company’s total revenues or accounts receivable for the
nine months ended September 30, 2010 and 2009. During the third quarter of 2010,
Harbin Shiji Baolong, a domestic distributor, and Hangzhou Jiupin, an overseas
sales agent, terminated their business relationships with the Company. These two
customers accounted for 12% and 24% of the Company’s total revenue for the nine
months ended September 30, 2010 and 2009, respectively. For the three months
ended September 30, 2010, these two customers did not account for any of the
Company’s revenues. For the three months ended September 30, 2009, these two
customers accounted for 22% of the Company’s total revenue. The Company expects
to replace these customers with new relationships over time.
Major
Suppliers
For the
nine months ended September 30, 2010, Heilongjiang Kangda Medicine Company,
Shenzhen Hongyuan Plastic Packaging Company, and Harbin Zhongjia Chemical
Company accounted for approximately 45%, 11%, and 11% of the Company’s total
inventory purchases, respectively. For the nine months ended
September 30, 2009, Heilongjiang Kangda Medicine Co. and Harbin Zhongjia
Chemical Company accounted for approximately 40% and 16% respectively of the
Company’s inventory purchases. No other suppliers accounted for 10% or more
of the Company’s total inventory purchases for the nine months ended September
30, 2010 and 2009. The Company believes alternative local suppliers are
available to meet the Company’s fulfillment needs if necessary. Therefore, the
Company does not believe it is substantially dependent on any specific
supplier.
6. Earnings
Per Share
The
Company has applied SFAS No. 128, “Earnings Per Share” in the Company’s
calculation and presentation of earnings per share - “basic” and “diluted”.
Basic earnings per share are computed by dividing net
earnings available to common shareholders (the numerator) by the
weighted average number of common shares (the denominator) for the period
presented. The computation of diluted earnings per share is similar to basic
earnings per share, except that the denominator is increased to include the
number of additional common shares that would have been outstanding if the
potentially dilutive common shares had been issued.
Warrants
to purchase 593,800 shares of common stock and no stock options to purchase
shares of common stock were outstanding and exercisable as of September 30,
2010. Warrants to purchase 750,000 shares of common stock were exercisable
and outstanding as of September 30, 2009. These common stock equivalents were
included in the computation of diluted earnings per share only if the option
exercise prices were less than the average market price of the Company’s
common stock during these periods.
19
China
Sky One Medical, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(Unaudited)
The
dilutive potential common shares on warrants and options is calculated in
accordance with the treasury stock method, which assumes that proceeds from the
exercise of all warrants and options are used to repurchase common stock at the
average market price of the common stock during the relevant period. The amount
of shares remaining after the proceeds are exhausted represent s the potential
dilutive effect of the securities.
The
following table sets forth the Company’s computation of basic and diluted net
income per share for the three months ended September 30, 2010 and
2009:
|
|
For the three months ended
September 30,
($ in thousands, except share and per
share data)
|
|
|||||
|
|
2010
|
|
|
2009
(restated)
|
|
||
Numerator:
|
||||||||
Net
income used in calculation of basic and diluted earnings per
share
|
$
|
8,595
|
*
|
$
|
12,590
|
**
|
||
Denominator:
|
||||||||
Weighted-average
common shares outstanding used in calculation of basic earnings per
share
|
16,790,851
|
16,655,697
|
||||||
Effect
of dilutive securities:
|
||||||||
Warrants
and Options
|
-
|
86,048
|
||||||
Weighted-average
common shares used in calculation of diluted earnings per
share
|
16,790,851
|
16,741,745
|
||||||
Net
income per share:
|
||||||||
Basic
|
$
|
0.51
|
$
|
0.76
|
||||
Diluted
|
$
|
0.51
|
$
|
0.75
|
* Includes
a gain of $1,833 and $0.11 per share (basic and diluted) relating to the
change in fair value of the derivative warrant
liability relating to the Class A Warrants.
**
Includes a gain of $132 and $0.008 per share (basic and diluted) relating to the
change in fair value of the derivative warrant liability relating to the Class A
Warrants.
20
China
Sky One Medical, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(Unaudited)
The
following table sets forth the Company’s computation of basic and diluted net
income per share for the nine months ended September 30, 2010 and
2009:
|
|
For the nine months ended September 30,
($ in thousands, except share and per
share data)
|
|
|||||
|
|
2010
|
|
|
2009
(restated)
|
|
||
Numerator:
|
||||||||
Net
income used in calculation of basic and diluted earnings per
share
|
$
|
33,426
|
*
|
$
|
30,464
|
**
|
||
Denominator:
|
||||||||
Weighted-average
common shares outstanding used in calculation of basic earnings per
share
|
16,786,240
|
16,535,924
|
||||||
Effect
of dilutive securities:
|
||||||||
Warrants
and Options
|
39,054
|
70,652
|
||||||
Weighted-average
common shares used in calculation of diluted earnings per
share
|
16,825,294
|
16,606,576
|
||||||
Net
income per share:
|
||||||||
Basic
|
$
|
1.99
|
$
|
1.84
|
||||
Diluted
|
$
|
1.99
|
$
|
1.83
|
* Includes
a gain of $8,847 and $0.53 per share (basic and diluted) relating to the
change in fair value of the derivative warrant
liability relating to the Class A Warrants.
**
Includes a gain of $1,305 and $0.08 per share (basic and diluted) relating to
the change in fair value of the derivative warrant liability relating to the
Class A Warrants.
7. Equity
and Share-based Compensation
Compensation
cost for all stock-based compensation awards granted is based on the grant date
fair value estimated in accordance with the provisions of SFAS No. 123R. Under
the fair value recognition provisions of SFAS No. 123R, the Company recognizes
stock-based compensation net of an estimated forfeiture rate and only recognizes
compensation cost for those shares expected to vest on a straight-line prorated
basis over the requisite service period of the award.
In July
2006, the Company’s stockholders approved the 2006 Stock Incentive Plan (the
“2006 Plan”). The 2006 Plan, provides for the grant of stock options, restricted
stock awards, and performance shares to qualified employees, officers,
directors, consultants and other service providers. The 2006 Plan originally
authorized the Company to grant options and/or rights to purchase up to an
aggregate of 1,500,000 shares of common stock. As of September 30, 2010, awards
of an aggregate of 226,407 common shares have been granted pursuant to the 2006
Plan to Company’s employees and consultants.
21
China
Sky One Medical, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(Unaudited)
8. Securities
Purchase Agreement and Related Transaction
On
January 31, 2008 (the “Closing Date”), the Company entered into a Securities
Purchase Agreement (the “Purchase Agreement”) with certain accredited investors
(the “Investors”), for the purchase and sale of units consisting of an aggregate
of: (i) 2,500,000 shares of the Company’s common stock, and (ii) Class A
Warrants to purchase 750,000 additional shares of the Company’s common stock
exercisable at $12.50 per share, and expiring on July 31, 2011 (the “Class A
Warrants”), for a purchase price of $10.00 per unit (the “Unit Purchase Price”),
or gross offering proceeds of $25.0 million (the “2008 Offering”). The
Company received net proceeds of approximately $23.5 million in connection with
the 2008 Offering.
Pursuant
to the Purchase Agreement, among other things, if, and whenever, within twelve
(12) months of the Closing Date, the Company issued or sold, or was deemed to
have issued or sold, any shares of common stock, or securities convertible into
or exercisable for shares of common stock, or modified any of the foregoing
which may be outstanding (with the exception of certain excluded securities), to
any person or entity at a price per share, or conversion or exercise price per
share less than the Unit Purchase Price, then the Company would have been
required to issue, for each such occasion, additional shares of its common stock
to the Investors in such number so that the average per share purchase price of
the shares of common stock purchased by the Investors in the 2008 Offering would
have automatically been reduced to such other lower price per share. This
right expired on January 30, 2009.
In
addition, as of the Closing Date, the Company entered into a Make Good Agreement
(the “Make Good Agreement”) with Liu Yan-qing, its Chairman, Chief Executive
Officer and President, and a principal shareholder of the Company, (the
“Principal Shareholder”) and the Investors (collectively, the “Make Good
Parties”), pursuant to which the Principal Shareholder deposited 3,000,000
shares of his common stock of the Company (the “Escrow Shares”) into escrow, to
be released to the Investors in an amount pro rata pro to their initial
investments in the 2008 Offering, in the event the Company failed to attain
earnings per share, as adjusted, of at least (i) $1.05 per share for the fiscal
year ending December 31, 2007 (based on an aggregate of 13,907,696 shares
outstanding), and/or (ii) $1.63 per share for the fiscal year ending December
31, 2008 (based on 16,907,696 shares outstanding).
The
Company deemed the Escrow Shares arrangement as analogous to the issuance of a
fixed number of warrants in an equity transaction. Under the Make Good Agreement
these Escrow Shares would have been reallocated on a pro rata basis
to the Investors only if certain earnings targets were not achieved in years
2007 and 2008. If the earnings targets were met, the Escrow Shares would
automatically have been released to the Principal Shareholder. As of January 31,
2008, the date the common shares were placed into escrow, the Company achieved
the 2007 earnings target and, based upon internal forecasts, was confident the
2008 target would also be met. Based upon certain assumptions, including the low
probability that the Escrow Shares would be released to the Investors and not be
returned to the Principal Shareholder, the Company considered the fair value of
the right held by the Investors through the Escrow Shares provision under the
Make Good Agreement to be immaterial. As of December 31, 2008, the Company
satisfied the earnings per common share targets for each of fiscal 2007 and 2008
as defined under the Make Good Agreement and, as such, the Escrow Shares were
released to the Principal Shareholder in 2009.
In
connection with the 2008 Offering, the Company and the Investors entered into a
Put Agreement whereby the Investors were granted the right, but not the
obligation, to require the Company to repurchase certain common shares issued
under the Purchase Agreement at $10.00 per share (the Unit Purchase
Price). The Investors could only exercise their Put Right in the event that
either:
22
China
Sky One Medical, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(Unaudited)
|
1.
|
the Adjusted EPS of the Company
for the fiscal year ending December 31, 2007 was less than $0.80 per
share, as set forth in the fiscal year 2007 audited financial statements;
or
|
|
2.
|
the Company’s accounts receivable
exceeded $12.0 million at December 31, 2007, as set forth in the fiscal
year 2007 audited financial
statements.
|
As of the
Closing Date, based on preliminary financial results for the fiscal year ended
December 31, 2007, the Company determined that the events triggering the
Investors’ put right did not occur and that the put right would expire
unexercised on or prior to March 31, 2008 (the date the Company’s Form 10-KSB
was required to be filed with the SEC). Based upon these preliminary
results, the Company determined that the value of the put obligation was
immaterial and did not record it as a liability. Both of the targets were met
upon the filing of the Company’s Annual Report on Form 10-K for the
year ended December 31, 2007 on March 31, 2008, and the Investors’ rights under
the Put Agreement were terminated unexercised.
Additional
information relating to the Class A Warrants is provided in Note 9.
9. Outstanding
Warrants and Options
The
following table summarizes information about stock warrants outstanding and
exercisable as of September 30, 2010:
Weighted
|
Weighted
|
|||||||||||||||
average
|
average
|
|||||||||||||||
Shares
|
Exercise
|
Shares
|
Exercise
|
|||||||||||||
Underlying
|
Price
|
underlying
|
Price
|
|||||||||||||
Warrants
|
Warrants
|
Options
|
Options
|
|||||||||||||
Outstanding
as of September 30, 2009
|
750,000
|
$
|
12.50
|
-
|
$
|
-
|
||||||||||
Exercised
|
-
|
|
-
|
-
|
-
|
|||||||||||
Outstanding
as of December 31, 2009
|
750,000
|
12.50
|
-
|
-
|
||||||||||||
Exercised
|
(156,200
|
)
|
12.50
|
-
|
-
|
|||||||||||
Outstanding
as of September 30, 2010
|
593,800
|
$
|
12.50
|
-
|
$
|
-
|
As
of December 31, 2009, the Class A Warrants granted in connection the Securities
Purchase Agreement represented the right to purchase an aggregate of 750,000
shares of Common Stock of the Company, at an exercise price of $12.50 per
share. In addition, the Class A Warrants have the following
characteristics:
|
•
|
The Class A Warrants became
exercisable beginning on the six-month anniversary of the closing of the
January 2008 Offering and will expire July 31, 2011 (subject to extension
as described below).
|
23
China
Sky One Medical, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(Unaudited)
|
•
|
Commencing on the one-year
anniversary of the Closing Date, in the event the Warrant Shares are not
freely salable by the holders of the Class A Warrants due to the Company’s
failure to satisfy its registration requirements and an exemption for such
sale is not otherwise available to the Warrantholders under Rule 144, the
Class A Warrants will be exercisable on a cashless
basis.
|
|
•
|
The Exercise Price and number of
Warrant Shares are subject to adjustment for standard dilutive events,
such as dividends or distributions on the Company’s common stock paid in
shares of common stock, reclassifications or reorganizations of the common
stock, distributions of indebtedness or assets (other than cash) to all
holders of the common stock, a merger or consolidation with another
corporation in which the Company is not the survivor, or sale, transfer or
other distribution of all or substantially all of the Company’s assets to
another corporation to prevent dilution to the holders of the Class A
Warrants as a result of such event. The Exercise Price is also
subject to adjustment on a weighted-average basis for issuance of common
stock, or securities convertible into or exercisable for shares of common
stock, at a price per share, or conversion or exercise price per share
less than the Class A Warrant exercise price of $12.50 per share (a
“Trigger Issuance”). In the event of a Trigger Issuance, the
then-existing Exercise Price shall be reduced, as of the close of business
on the effective date of the Trigger Issuance, to a price determined as
follows:
|
Adjusted
Warrant Price = (A x
B) + D
A+C
where
“A”
equals the number of shares of the Company’s common stock outstanding, including
Additional Shares of Common Stock (as defined below) deemed to be issued
hereunder, immediately preceding such Trigger Issuance;
“B”
equals the Exercise Price in effect immediately preceding such Trigger
Issuance;
“C”
equals the number of Additional Shares of Common Stock issued or deemed issued
hereunder as a result of the Trigger Issuance; and
“D”
equals the aggregate consideration, if any, received or deemed to be received by
the Company upon such Trigger Issuance;
provided,
however, that in no event shall the Exercise Price after giving effect to such
Trigger Issuance be greater than the Warrant Price in effect prior to such
Trigger Issuance.
For
purposes of hereof, “Additional Shares of Common Stock” shall mean all shares of
common stock issued by the Company, or deemed to be issued in connection with a
the Trigger Issuance, other than certain excluded issuances (as defined in the
Class A Warrants).
24
China
Sky One Medical, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(Unaudited)
|
In
June 2008, the Emerging Issues Task Force issued EITF Consensus 07-05
(“Issue 07-05) “Determining Whether an
Instrument (for Embedded Feature) is Indexed to an Entity’s Own
Stock”. Under Issue 07-05, instruments which contain
anti-dilution provisions will no longer be considered indexed to a
company’s own stock for purposes of determining whether it meets the first
part of the scope exception in paragraph 11(a) of SFAS
133. Issue 07-05 provides new guidance for determining whether
equity instruments are indexed to a company’s own stock, and as a result,
whether those contracts should be marked-to-market. Issue 07-05
contains 20 examples illustrating its application. In
particular, Example 8 addresses an exercise price reset feature that is
common in many arrangements. Example 8, concludes that because
of the reset feature, the Class A Warrants will no longer be considered
indexed to a company’s own stock for purposes of determining whether it
meets the first part of the scope exception in paragraph 11(a) of SFAS
133. The adoption of Issue 07-05 required the Company to (1)
evaluate the Class A Warrants contingent exercise provisions and (2)
evaluate the instrument’s settlement provisions. The Company
determined that the Class A Warrants are akin to Example 8 of EITF 07-05
and not Example 16 of EITF 07-05, as the anti-dilution provision is
designed to protect the holder from issuances below the exercise price
(rather than below market price
issuances.).
|
|
•
|
At anytime following the date a
Registration Statement covering the Warrant Shares is declared effective,
the Company will have the ability to call the Class A Warrants at a price
of $0.01 per Class A Warrant, upon thirty (30) days prior written notice
to the holders of the Class A Warrants, provided (i) the closing price of
the Common stock exceeded $18.75 for each of the ten (10) consecutive
trading days immediately preceding the date that the call notice is given
by the Company, and (ii) the Company has attained an Adjusted EPS of at
least $1.75 per share for the fiscal year ending December 31, 2008, as set
forth in the Company’s audited financial statements of the
Company.
|
|
•
|
If, among other things, the
Company fails to cause a Registration Statement covering the Warrant
Shares to be declared effective prior to the applicable dates set forth in
the Registration Rights Agreement, the expiration date of the Class A
Warrants shall be extended one day for each day beyond the Effectiveness
Deadlines. The registration rights do not require a cash
settlement and the Class A Warrants can be settled in unregistered
shares. Therefore, paragraphs 14-18 of EITF 00-19 does not
apply to the registration rights associated with the Class A
Warrants. As a result, no liability accounting is
required.
|
During
the nine months ended September 30, 2010, the Warrant holders exercised 156,200
warrants including 148,700 warrants exercised on a cashless basis for a total of
69,084 shares of the Company’s common stock, and 7,500 warrants exercised for
cash proceeds of $93,750.
At
September 30, 2010, the Company had 593,800 Class A Warrants outstanding. The
Company used the Monte Carlo valuation model to estimate the fair value of the
Class A Warrants. Significant assumptions used at September 30, 2010
include a term of approximately 3.4 years; volatility of 69.0% and a risk free
interest rate of 0.84%. The outstanding Class A Warrants at September 30, 2010
had a fair value of approximately $1,716,000. For the nine months ended
September 30, 2010, the Company recorded income of $8,847,000 due to the
change in fair value of the related derivative warrant liability. For the
three months ended September 30, 2010, the Company recorded income of
$1,833,000 due to the change in fair value of the related derivative warrant
liability.
25
China
Sky One Medical, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(Unaudited)
At
September 30, 2009, the Company had 750,000 Class A Warrants outstanding. The
Company used the Monte Carlo valuation model to estimate the fair value of the
Class A Warrants. Significant assumptions used at September 30, 2009
include a term of approximately 3.7 years; volatility of 67.0% and a risk free
interest rate of 1.97%.The outstanding Class A Warrants at September 30, 2009
had a fair value of approximately $5,323,000. For the nine months ended
September 30, 2009, the Company recorded income of $1,305,000 due to the
change in fair value of the related derivative warrant liability. For the three
months ended September 30, 2009, the Company recorded income of $132,000
due to the change in fair value of the related derivative warrant
liability.
On
September 29, 2010, the Company filed a Form S-3 registration statement with the
SEC to register 1,004,009 issued and outstanding common shares and the 593,800
common shares underlying the Company’s outstanding Class A Warrants issued in
connection with the 2008 Offering.
10. Inventories
The
Company values its inventories at the lower of cost and market method.
Inventories are accounted for using the first-in, first-out method. Inventories
include packing materials, raw materials, supplemental materials,
work-in-process, and finished products.
As of
September 30, 2010 and December 31, 2009, inventories consisted of the
following:
|
|
($ in thousands)
|
|
|||||
|
|
September 30,
2010
(Unaudited)
|
|
|
December 31,
2009
|
|
||
Raw
Material
|
$
|
2,176
|
$
|
1,192
|
||||
Work-in-Process
|
693
|
578
|
||||||
Finished
Products
|
1,442
|
642
|
||||||
Total
Inventories
|
$
|
4,311
|
$
|
2,413
|
Historically,
the Company’s inventory is at its lowest levels at the end of each calendar year
and in the first fiscal quarter. The Company draws down the Company’s inventory
levels in December of each year for two main reasons. First, the Company’s
customers want to receive goods prior to the holiday season. In
addition, the first calendar quarter is traditionally the Company’s slowest
sales period. Since a lower volume of sales activity normally occurs during the
first quarter of each calendar year, the Company believes it is prudent to avoid
incurring unnecessary inventory carrying costs. At the appropriate time toward
the end of the first calendar quarter of each fiscal year, the Company begins to
ramp up the Company’s inventory levels to prepare for increased demand during
the coming stronger selling periods. Historically, the Company signed agreements
with suppliers that allow the Company to hold extra raw materials at the cost of
the suppliers. As a result, the Company could minimize the Company’s own
inventory carrying costs, and improve the Company’s cash management, by keeping
the inventory at the minimum level required to support the short-term sales.
However, due to anticipated future price increases of raw materials, in addition
to overhead costs for storing such raw materials, the Company started to
increase the inventory levels at the Company’s own cost from the end of
2009.
26
China
Sky One Medical, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(Unaudited)
Management
calculates its inventory turnover rate using total inventory rather than just
finished goods, because its production cycle is of an extremely short duration.
The inventory turnover rate is further discussed in the Liquidity section in
the Management’s Discussion and Analysis.
11. Property
and Equipment, net
As of
September 30, 2010 and December 31, 2009, Property and Equipment, net, consisted
of the following:
|
|
($ in thousands)
|
|
|||||
|
|
September 30,
|
|
|
|
|||
|
|
2010
(Unaudited)
|
|
|
December 31,
2009
|
|
||
Buildings
and improvements
|
$
|
11,326
|
$
|
10,570
|
||||
Machinery
and equipment
|
5,878
|
5,868
|
||||||
Transportation
equipment
|
979
|
955
|
||||||
Furniture
and equipment
|
385
|
325
|
||||||
Total
Property and Equipment
|
18,568
|
17,718
|
||||||
Less:
Accumulated Depreciation
|
(3,063
|
)
|
(2,227
|
)
|
||||
Property
and Equipment, Net
|
$
|
15,505
|
$
|
15,491
|
For the
nine months ended September 30, 2010 and 2009, depreciation expense totaled
$776,000 and $736,000, respectively.
Depreciation
expense included within Cost of Goods Sold for the nine months ended September
30, 2010 and 2009 amounted to $348,000 and $405,000, respectively.
12. Intangible
Assets, net
Intangible
assets consists of proprietary technologies that the Company purchased during
the Company’s normal course of business. The SFDA licenses for drug batch
numbers and goodwill were acquired in connection with the Company’s business
acquisitions of Tianlong and Peng Lai in 2008.
27
China
Sky One Medical, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(Unaudited)
A
breakdown of the Company’s intangible assets, net, by subsidiaries as of
September 30, 2010 is as follows:
Intangible
Assets as of September 30, 2010, net
($
in thousands) (Unaudited)
|
||||||||||||||||||||||||
Item
|
TDR
|
Haina
|
Tianlong
|
First
|
Peng
Lai
|
Total
|
||||||||||||||||||
Proprietary
Technologies
|
$
|
1,187
|
$
|
-
|
$
|
4,746
|
$
|
11,071
|
$
|
-
|
$
|
17,004
|
||||||||||||
SFDA
licenses for drug batch numbers
|
-
|
-
|
1,627
|
-
|
4,144
|
5,771
|
||||||||||||||||||
Goodwill
|
415
|
361
|
-
|
-
|
-
|
776
|
||||||||||||||||||
Total
|
$
|
1,602
|
$
|
361
|
$
|
6,373
|
$
|
11,071
|
$
|
4,144
|
$
|
23,551
|
A
breakdown of the Company’s intangible assets, net by subsidiaries as of December
31, 2009 is as follows:
Intangible
Assets as of December 31, 2009, net
($
in thousands)
|
||||||||||||||||||||||||
Item
|
TDR
|
Haina
|
Tianlong
|
First
|
Peng
Lai
|
Total
|
||||||||||||||||||
Proprietary
Technologies
|
$
|
1,275
|
$
|
-
|
$
|
5,034
|
$
|
11,854
|
$
|
-
|
$
|
18,163
|
||||||||||||
SFDA
licenses for drug batch numbers
|
-
|
-
|
1,751
|
-
|
4,441
|
6,192
|
||||||||||||||||||
Goodwill
|
406
|
353
|
-
|
-
|
-
|
759
|
||||||||||||||||||
Total
|
$
|
1,681
|
$
|
353
|
$
|
6,785
|
$
|
11,854
|
$
|
4,441
|
$
|
25,114
|
Historically,
the Company included its proprietary technologies and SFDA licenses for drug
batch numbers under the category of patents. The Company now believe
it is more accurate to categorize such intangible assets in separate
categories.
As of
September 30, 2010, the weighted average amortization period for the Company’s
proprietary technologies and SFDA licenses for drug batch numbers is
approximately 7.5 years.
Amortization
expense of the Company’s intangible assets with finite lives for each of the
nine months ended September 30, 2010 and 2009 was approximately $2,048,000
and $1,017,000, respectively.
13. Taxes
Payable
Taxes
payable as of September 30, 2010 and December 31, 2009 consisted of the
following:
|
|
($ in thousands)
|
|
|||||
|
|
September
30, 2010
(Unaudited)
|
|
|
December
31, 2009
|
|
||
Value
Added Tax, net
|
$
|
1,488
|
$
|
1,291
|
||||
Enterprise
Income Tax
|
2,754
|
2,452
|
||||||
City
Tax
|
64
|
43
|
||||||
Other
Taxes and additions
|
51
|
86
|
||||||
Total
Taxes Payable
|
$
|
4,357
|
$
|
3,873
|
28
China
Sky One Medical, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(Unaudited)
14. Income
Taxes
Under the
Provisional Regulations of PRC Concerning Income Tax on Enterprises promulgated
by the PRC, income tax is payable by enterprises at a rate of 25% 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.
According
to “Enterprise Income Tax and Certain Preferential Policies Notice” published by
the Ministry of Finance and the National Tax Affairs Bureau, if the enterprise
is authorized by the State Council as a special entity, the enterprise income
tax rate is reduced to 15%. The following table sets force the income tax rate
for TDR and its subsidiaries for the nine months ended September 30, 2010
and 2009:
|
|
As of September 30,
|
|
|||||
Income Tax
Rate
|
|
2010
|
|
|
2009
|
|
||
TDR
|
15
|
%
|
15
|
%
|
||||
First
|
15
|
%
|
15
|
%
|
||||
Tianlong
|
15
|
%
|
15
|
%
|
||||
Haina
|
25
|
%
|
25
|
%
|
||||
Peng
Lai
|
2%
of Revenue
|
* |
2%
of Revenue
|
*
|
|
*
|
Reflects a 25% Tax rate on 8% of
Peng Lai’s revenue, regardless of its taxable income. As authorized by
Peng Lai Municipal Tax Bureau, Peng Lai was not required to pay tax on the
remaining 92% of revenue.
|
All the
favorable tax rates for TDR, First, Tianlong and Peng Lai will expire by the end
of fiscal year 2010. The Company plans to seek renewal of these favorable
tax rates in the fourth quarter of 2010.
The
Company records a full valuation allowance to reduce the Company’s deferred tax
assets to the amount that is more likely than not to be realized. While the
Company has considered future taxable income and ongoing prudent and feasible
tax planning strategies in assessing the need for the valuation allowance, in
the event the Company were to determine that it would be able to realize the
Company’s deferred tax assets in the future in excess of its net recorded
amount, an adjustment to the deferred tax asset would increase income in the
period such determination was made.
Pursuant
to Sections 382 and 383 of the Internal Revenue Code (“IRC”), annual use of the
Company’s net operating losses and tax credit carryforwards may be limited
because of cumulative changes in ownership of more than 50% that have occurred.
Net operating loss (“NOL”) carryforwards only apply to the Company’s U.S.
holding companies because they incurred certain general and administrative costs
without generating any revenue and, therefore, suffered a loss. The Company has
no current intentions to distribute dividend income from its China-based
subsidiaries to the U.S. holding companies.
29
China
Sky One Medical, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(Unaudited)
Therefore,
the Company has established a full valuation allowance for the NOL carryforwards
incurred by the U.S. holding companies. Provision for the PRC
enterprise income tax is calculated at the prevailing rate based on the
estimated assessable profits less available tax relief for losses brought
forward. The Company does not accrue taxes on unremitted earnings from foreign
operations as it is the Company’s intention to invest these earnings in the
foreign operations indefinitely.
As of
September 30, 2010, the Company has U.S. net operating loss carryforwards of
approximately $10 million which will begin to expire in 2029. Accordingly, as
mentioned above, any deferred tax asset that would result from these
carryforwards have been fully reserved as of September 30, 2010.
During
the nine months ended September 30, 2010 and 2009, the Company’s U.S. holding
companies recorded income of approximately $8,847,000 and $1,305,000
respectively related to the change in fair value of its derivative warrant
liability with a full valuation allowance. Historically, the Company’s U.S.
holding companies have incurred ongoing operating losses, since the U.S. holding
companies do not generate any revenue. As such, Management has recorded a
full valuation allowance for its net operating loss carryforwards
since Management’s position it is more like than not that the future tax
benefits associated with the U.S. holding companies operating loss carryforwards
will not be realized. The net operating loss carryforwards at September 30,
2010 and 2009, for tax reporting purposes, exceed the income generated from the
change in fair value of the derivative warrant liability of $8,847,000 and
$1,305,000 for each of the respective periods. Accordingly, management did
not record any unrecognized income tax benefits due to the change in fair value
of the derivative warrant liability for each of the nine months ended September
30, 2010 and 2009.
The
Company’s effective tax rate was approximately 20.8% and 20.9% for the nine
month ended September 30, 2010 and 2009, respectively. A reconciliation
of the statutory tax provision to the Company’s tax provision for the
nine months ended September 30, 2010 and 2009 is as follows:
|
|
($ in thousands)
|
|
|||||||||
|
|
Nine Months Ended September 30,
2010
|
|
|||||||||
|
|
China
|
|
|
U.S.
|
|
|
Total
|
|
|||
Pre
tax income
|
$
|
34,336
|
$
|
7,877
|
$
|
42,213
|
||||||
Effective
statutory tax rate
|
25
|
%
|
34
|
%
|
||||||||
Provision
for statutory income tax
|
8,584
|
2,678
|
11,262
|
|||||||||
Other
(Special Entity, etc. )
|
203
|
-
|
203
|
|||||||||
Full
valuation allowance
|
-
|
(2,678
|
)
|
(2,678
|
)
|
|||||||
Provision
for income taxes
|
$
|
8,787
|
$
|
-
|
$
|
8,787
|
||||||
Effective
tax rate
|
25.6
|
%
|
-
|
20.8
|
%
|
30
China
Sky One Medical, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(Unaudited)
Pre-tax
income generated by business operations in China during the nine months ended
September 30, 2010 were derived from Haina’s business operations which are taxed
at a rate of 25%. During the nine months ended September 30, 2010, First
incurred an operating loss of approximately $4,351,000, which reduced China’s
consolidated Pre Tax Income, and in turn increased China’s effective tax
rate.
($ in thousands - Restated)
|
||||||||||||
Nine Months Ended September
30,
2009
|
||||||||||||
China
|
U.S.
|
Total
|
||||||||||
Pre
tax income
|
$
|
37,835
|
$
|
679
|
$
|
38,514
|
||||||
Effective
statutory tax rate
|
25
|
%
|
34
|
%
|
||||||||
Provision
for statutory income tax
|
9,459
|
230
|
9,689
|
|||||||||
Other
(Special Entity, etc. )
|
(1,409
|
)
|
-
|
(1,409
|
)
|
|||||||
Full
valuation allowance
|
-
|
(230
|
)
|
(230
|
)
|
|||||||
Provision
for income taxes
|
$
|
8,050
|
$
|
-
|
8,050
|
|||||||
Effective
tax rate
|
21.3
|
%
|
-
|
20.9
|
%
|
15. Land
Use Rights and Construction in Progress
The
Company considers the fact that, in the PRC, there is no land ownership but
rather land use rights and it is more appropriate to allocate land use
rights under a separate category and amortize land use rights based on 50 years
of the land use rights, or the term of the lease. Land use rights, net, are
approximately $4,610,000 and $4,586,000 at September 30, 2010 and December 31,
2009, respectively. Amortization expense for land use right were $71,000 and
$43,000 for the nine months ended September 30, 2010 and 2009,
respectively.
During
the second quarter in 2007 TDR entered into an agreement with the Development
and Construction Administration Committee of Harbin Song Bei New Development
district to purchase the land use rights for 50 years for the development
of a new corporate headquarters. The Company spent approximately $9.9
million, $730,000, and $2.1 million in the years of 2009, 2008, and 2007
respectively for this construction in progress. The majority of the construction
was completed in January 2010, and the Company moved into the new facilities in
January 2010. There was no expenditure for construction in progress during the
nine months ended September 30, 2010. Management estimates the additional cost
to complete the Company’s construction in progress in 2010 shall amount to
approximately $3.0 million, which should be completed within the fourth quarter
of 2010.
During
the second quarter of 2010, TDR submitted a bid deposit of approximately
$7,335,000 to Harbin High Technology Development Zone to participate in an
auction for a parcel of land of approximately 85,000 square meters in the Harbin
Song Bei District High Technology Zone. The auction is set to take place during
the fourth quarter of 2010. If the Company’s bid is accepted, the Company plans
to build a facility for the research and development and production of the
Company’s bio-engineering projects. If the Company’s bid is not accepted, the
deposit will be returned to TDR.
31
China
Sky One Medical, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(Unaudited)
16. Commitments
and Contingencies
The
formulation, manufacturing, processing, packaging, labeling, advertising,
distribution and sale of external use Chinese medicine such as those sold by the
Company are subject to regulations by one or more federal agencies. The
principal federal agencies include the State Food and Drug Administration of the
Government of the Peoples Republic of China, the Food and Drug Administration
(the “FDA”), Heilongjiang Provincial Food and Drug Administration of the
People's Republic of China (PFDA), National Biology Products Inspection
Institute (NBPI) and the National Food and Drug Administration (NFDA) of the
People's Republic of China and, to a lesser extent, the Consumer Product Safety
Commission. These activities are also regulated by various governmental agencies
for the countries, states and localities in which the Company’s products are
sold.
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 have
a material adverse effect on the Company’s financial position, results of
operations, or cash flows.
The
Company, like any other distributor or manufacturer of products is exposed to
the inherent risk of product liability claims in the events of possible injuries
caused by the use of its products. The Company does not have liability insurance
with respect to product liability claims; the insurance environment of China is
neither sufficient nor mature. Inadequate insurance or lack of contractual
indemnification from parties supplying raw materials or marketing its products,
and product liabilities related to defective products could have a material
adverse effect on the consolidated financial statements of the
Company.
The
Company is not involved in any legal matters arising in the normal course of
business at September 30, 2010. While incapable of estimation, in the opinion of
the management, the individual regulatory and legal matters in which the Company
might be involved in the future are not expected to have a material adverse
effect on the Company’s consolidated financial position, results of operations,
or cash flows.
On
September 4, 2009, the SEC issued a formal order of investigation relating to
certain of the Company’s accounting, record-keeping and disclosure practices.
The Company has received document and testimonial subpoenas from the SEC and has
complied, and intends to continue to comply, with all requests for
information.
17. Fair
Value Measurements
The FASB
Accounting Standards Codification Topic 820 clarifies the definition of fair
value, prescribes methods for measuring fair value, and establishes a fair value
hierarchy to classify the inputs used in measuring fair value as
follows:
Level 1 -
Inputs are unadjusted quoted prices in active markets for identical assets or
liabilities that are accessible at the measurement date.
Level 2 -
Inputs are unadjusted quoted prices for similar assets and liabilities in active
markets, quoted prices for identical or similar assets or liabilities in markets
that are not active and inputs other then quoted market prices that are
observable.
32
China
Sky One Medical, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(Unaudited)
Level 3 -
Inputs are unobservable inputs which reflect the reporting entity’s own
assumptions on what assumptions the market participants would use in pricing the
asset or liability based on the best available information.
As of
September 30, 2010, the Company had only financial liabilities which were
measured at fair value on a recurring basis using significant Level 3 inputs.
These financial liabilities as of September 30, 2010 and December 31, 2009 are
classified in the table below ($ in thousands):
September 30, 2010
|
||||||||||||||||
Level 1:
|
Level 2:
|
Level 3:
|
||||||||||||||
Quoted Prices
|
Significant Other
|
Significant
|
Total at
|
|||||||||||||
in Active Markets
|
Observable
|
Unobservable
|
September
|
|||||||||||||
Description
|
for Identical Assets
|
Inputs
|
Inputs
|
30, 2010 | ||||||||||||
Liabilities:
|
||||||||||||||||
Derivative
Class A Warrants
|
-
|
-
|
(1,716
|
) | (1,716 | ) | ||||||||||
Total
|
- | - | (1,716 | ) | (1,716 | ) |
December 31, 2009
|
||||||||||||||||
Level 1:
|
Level 2:
|
Level 3:
|
||||||||||||||
Quoted Prices
|
Significant Other
|
Significant
|
Total at
|
|||||||||||||
in Active Markets
|
Observable
|
Unobservable
|
September
|
|||||||||||||
Description
|
for Identical Assets
|
Inputs
|
Inputs
|
30, 2010 | ||||||||||||
Liabilities:
|
||||||||||||||||
Derivative
Class A Warrants
|
-
|
-
|
(11,435
|
) | (11,435 | ) | ||||||||||
Total
|
- | - | (11,435 | ) | (11,435 | ) |
The fair
value of derivative instruments is provided by the use of an independent third
party valuation expert. Certain derivatives with limited marketing activity are
valued using externally developed models that consider unobservable market
parameters (see Note 9).
The
following table provides a roll-forward reconciliation of the beginning balance
at December 31, 2009 and the ending balance at September 30, 2010 of the
derivative Class A Warrants liability measured at fair value using significant
Level 3 inputs ($ in thousands):
Derivative Liability
|
||||
Balance
at December 31, 2009
|
(11,435 | ) | ||
Unrealized
gains included in earnings
|
4,926 | |||
Settlements
|
873 | |||
Balance
at March 31, 2010
|
(5,636 | ) | ||
Unrealized
gains included in earnings
|
2,087 | |||
Balance
at June 30, 2010
|
(3,549 | ) | ||
Unrealized
gains Included in earnings
|
1,833 | |||
Balance
at September 30, 2010
|
(1,716 | ) |
33
Item 2. Management’s Discussion and Analysis
of Financial Condition and Results of Operations.
FORWARD
LOOKING STATEMENTS
The
following discussion should be read in conjunction with the information
contained in our consolidated financial statements and the notes thereto
appearing elsewhere herein and in the risk factors and “Forward Looking
Statements” summary set forth in the forepart of our Annual Report on Form 10-K
for the fiscal year ended December 31, 2009, as amended, as well as the “Risk
Factors” section above and are afforded the safe harbor provisions of Section
27A of the Securities Act and Section 21E of the Securities Exchange Act of
1934, as amended. Readers should carefully review the risk factors disclosed in
this Annual Report and other documents filed by us with the SEC.
DISCUSSION
General
We are
engaged, through our China-based indirect subsidiaries described below, in the
development, manufacture, marketing and sale of over-the-counter, branded
nutritional supplements and over-the-counter plant and herb-based pharmaceutical
and medicinal products. Our principal products are external use TCMs. We have
evolved into an integrated manufacturer, marketer and distributor of
external-use TCM products sold primarily in the PRC and through Chinese domestic
pharmaceutical chains. All of our business is conducted through our wholly-owned
subsidiary, ACPG which, in turn, wholly owns Harbin TDR, and TDR’s
subsidiaries.
We
achieved continuing growth on the sale of our own product line through our
sustained efforts to expand our distribution channels and promote our products.
However, during the third quarter of 2010, two of our major customers terminated
their business relationships with us negatively impacting our revenues and
income. We expect to replace these customers with new relationships over
time.
For the
nine months ended September 30, 2010, total revenues were $105,856,000, compared
to $100,242,000 for the nine months ended September 30, 2009. Net income was
$33,426,000, or $1.99 per share (basic and diluted) for the nine months ended
September 30, 2010, compared to net income of $30,464,000, or $1.83 per share
(basic and diluted) in the same period of 2009. For the three months ended
September 30, 2010, total revenues were $36,193,000, compared to $43,227,000 for
the three months ended September 30, 2009. Net income was $8,595,000, or $0.51
per share (basic and diluted) for the three months ended September 30, 2010,
compared to net income of $12,590,000, or $0.76 per share (basic) and $0.75 per
share (diluted) in the same period of 2009.
This
Quarterly Report on Form 10-Q for the fiscal quarter ended September 30, 2010
incorporates corrections made in response to the accounting errors described
elsewhere in this Form 10-Q and restates our financial statements for the three
and nine months ended September 30, 2009 (see Note 2 to the Notes to Condensed
Consolidated Financial Statements). The corrections to the quarterly
information in this Form 10-Q had no impact on our previously reported income
from operations or cash flows for the periods being restated.
34
Product
Line
During the
nine months ended September 30, 2010, we manufactured and marketed 118 products,
compared to 89 products for the nine months ended September 30, 2009. Our
manufacturing operations are conducted at our subsidiaries’ facilities located
in Heilongjiang Province and Shan Dong Province in the PRC. We sell our products
under five main categories:
Product Category
|
2010
|
2009
|
||||||
Patches
|
5 | 5 | ||||||
Ointments
|
25 | 18 | ||||||
Sprays
|
16 | 15 | ||||||
Drops
|
10 | 4 | ||||||
Diagnostic
Kits
|
3 | 3 | ||||||
Others
|
59 | 44 | ||||||
Total:
|
118 | 89 |
A
description of our principle products, which generated a majority of our sales
revenue for the nine months ended September 30, 2010 is as follows:
Patch
Category:
Sumei
Slim Patch
The Sumei
Slim Patch is marketed and sold within and outside the PRC as a more natural
treatment to lose weight. The Sumei Slim Patch uses Saponin as its
major ingredient, and is effective in regulating and restraining the excessive
secretion of certain hormones, while promoting others to foster weight loss as
well as prevent weight gain.
Pain
Relief Patch
A pain
relief patch is designed to apply to the area of neck, shoulder, and
waist. The patch is used for a number of ailments, including fever,
headache, heart dysentery, diarrhea, and stiffness and pain caused by
hypertension.
Anti-Hypertension
Patch
The
anti-hypertension patch is based on five thousand years of Chinese herbal vein
therapy that has been adapted to a modern transdermal therapeutic system
(“TTS”). The product utilizes a Body-Yong-Guan point technique, which
is believed to maximize the effectiveness of the medicinal
ingredients. The product is believed to stimulate blood capillaries
and to be effective in improving circulation and reducing blood
pressure.
QiXue
Asthma Patch
QiXue
asthma patch is designed for the treatment of chronic airways and lung
inflammation.
35
Ointment
Category:
Hemorrhoids
Ointment
This
product contains Acetate, Radix Notoginseng, and Rhizoma Coptidis. It
is made in soft ointment form that is effective in sterilizing and relieving
hemorrhoid symptoms, including itching, distending pain, burning, and
bleeding.
Compound
Camphor Cream
This
product is for the treatment of various pathogens on the skin surface and
subcutaneously, such as mycete, trichopytic, staphylococcal bacteria aureus,
bacillus coli, and candida albicans (thrush).
Kecuo
Yintong Ointment
This
product is designed to regulate sebum secretion and to prevent acne
outbreaks.
Spray
Category:
Stomatitis
Spray
This
spray is used for the treatment of dental ulcers, pharyngitis, and
faucitis. It is made with pure herbal medicines and, thus,
has minimum side effects to human bodies.
Drops
Category:
Naphazoline
Hydrochloride Eye Drops
Naphazoline
Hydrochloride Eye Drops are recommended for the temporary relief of eye redness
associated with minor irritations. This product can comfort the eyes
by lubricating them and relieving such irritations.
Lomefloxacin
Hydrochloride Eye Drops
Lomefloxacin
Hydrochloride Eye Drops are used for the treatment of acute and chronic
bacterial conjunctivitis, marginalis, meibomian gland, dacryocystisis and
keratitis.
Diagnostic
Kit Category:
Cardiac
Arrest Early Examination Kit
This
product is used for early stage diagnosis of myocardial infarction (heart
attacks).
36
Kidney
Disease Testing Kit
The
Urinate Micro Albumin Examination Testing Kit is used in connection with early
stage diagnosis for primary kidney disease, hypertension and
diabetes.
Other
Product Category:
We
include 59 of our products under the “Other” product category. No category of
products or individual product within the Other product category represents
10% or more of our revenues. The Other product category includes suppositories,
capsules, granules, injections, syrups, liniments, tablets and wash
fluids.
Naftopidil
Dispersible Tablet
This
tablet is designed to treat benign enlargement of the prostate among males in
their middle age. It is effective in its treatment because its
ingredients can be easily digested and absorbed by the human body.
Tinea
Liniment
Tinea
Liniment is an anti-fungal cream for the treatment of skin fungal infection and
yeast infection.
Metronidazole
and Chlorhexidine Washing Fluid
This is
an anti- pathogenic bacteria fluid for the treatment of Vaginal
inflammation.
Please
refer to “Sales by Product Line” hereunder for additional
information.
Summary
of Our Research and Development Activities
Research
and Development
We
conduct all of our research and development (“R&D”) activities either
internally or through collaborative arrangements with universities and research
institutions in the PRC. We have our own research, development and laboratory
facilities located in the facilities of First and Tianlong.
For the
nine months ended September 30, 2010, total research and development expense was
approximately $15,266,000. The major research and development projects that
accounted for the majority of our total research and development
expenses are as follows:
37
Major Research and Development Expenses during the Nine
Months Ended September 30, 2010
|
||||||||||||||||
($ in thousands)
|
||||||||||||||||
Projects
|
Expense
|
% of total
R&D
|
Aggregate
Expense Since
Commencement
of Project
|
Estimated
Additional Cost
to Complete
Research
|
||||||||||||
Diagnostic
Kits - 12 products
|
$ | 3,198 | 20.9 | % | $ | 5,928 | $ | 2,595 | ||||||||
Optimization
Experiments for Five Products
|
1,653 | 10.8 | % | 2,533 | - | |||||||||||
Monoclonal
Antibody
|
1,408 | 9.2 | % | 2,372 | 592 | |||||||||||
Endostatin
|
1,010 | 6.6 | % | 1,449 | 9,000 | |||||||||||
Antrodia
Cinnamomea Extract l
|
849 | 5.6 | % | 1,236 | 16,000 | |||||||||||
Tumor
Markers
|
775 | 5.1 | % | 775 | 210 | |||||||||||
Tiopronin
for Injection
|
644 | 4.2 | % | 1,170 | 150 | |||||||||||
Omeprazole
Sodium for Injection
|
686 | 4.5 | % | 1,691 | 314 | |||||||||||
Ozagrel
Sodium Injection
|
730 | 4.8 | % | 1,322 | 270 | |||||||||||
Aztreonam
For Injection
|
288 | 1.9 | % | 288 | 650 | |||||||||||
Voriconazole
for Injection
|
236 | 1.5 | % | 236 | 700 | |||||||||||
Cefmetazole
Sodium for Injection
|
229 | 1.5 | % | 229 | 650 | |||||||||||
Breast
Cancer Technology
|
497 | 3.3 | % | 2,767 | 8,300 | |||||||||||
Clindamycin
Phosphate for Injection
|
424 | 2.8 | % | 833 | 1,000 | |||||||||||
Levofloxacin
Hydrochloride Eye Drops
|
410 | 2.7 | % | 746 | 500 | |||||||||||
Compound
Allantoin VitaminB6-E and Aminoethylsulfonic Acid Eye
Drops
|
354 | 2.3 | % | 354 | 800 | |||||||||||
Glycosidic
Hydroxy Eye Drops
|
354 | 2.3 | % | 354 | 700 | |||||||||||
Nimesulide
Granules
|
439 | 2.9 | % | 967 | 800 | |||||||||||
Total
|
$ | 14,184 | 92.9 | % | $ | 25,250 | $ | 43,231 |
38
For the
nine months ended September 30, 2009, total research and development expense is
approximately $10,980,000. The major research and development projects that
accounted for the majority of our total research and development expenses
are as follows:
Major Research and Development Expenses during the Nine Months Ended September 30, 2009
|
||||||||||||||||
($ in thousands)
|
||||||||||||||||
Projects
|
Expense
|
% of total
R&D
|
Aggregate
Expense Since
Commencement
of Project
|
Estimated
Additional Cost
to Complete
Research
|
||||||||||||
Breast
Cancer Technology
|
$ | 1,507 | 13.7 | % | $ | 1,507 | $ | 9,300 | ||||||||
Monoclonal
Antibody
|
964 | 8.8 | % | 3,162 | 2,000 | |||||||||||
Diagnostic
Kits - 6 products
|
2,084 | 19.0 | % | 3,400 | 100 | |||||||||||
Change
Matrix for 4 Patch Products
|
1,820 | 16.6 | % | 1,820 | - | |||||||||||
Additional
experiments to apply 5 Products to the OTC
|
1,403 | 12.8 | % | 1,403 | - | |||||||||||
Naftopidil
Dispersible tablets
|
124 | 1.1 | % | 380 | 376 | |||||||||||
Sertraline
Hydrochloride capsules
|
124 | 1.1 | % | 373 | 376 | |||||||||||
Radix
Isatidis granule and syrup
|
95 | 0.9 | % | 377 | 405 | |||||||||||
Omeprazole
Sodium for Injection
|
540 | 4.9 | % | 540 | 1,000 | |||||||||||
Tiopronin
for Injection
|
526 | 4.8 | % | 526 | 800 | |||||||||||
Nimesulide
Granules
|
512 | 4.7 | % | 512 | 1,700 | |||||||||||
Clindamycin
Phosphate for Injection
|
410 | 3.7 | % | 410 | 1,800 | |||||||||||
Levofloxacin
Hydrochloride Eye Drops
|
336 | 3.1 | % | 336 | 1,300 | |||||||||||
Ozagrel
Sodium for Injection
|
183 | 1.7 | % | 183 | 1,000 | |||||||||||
Total
|
$ | 10,628 | 96.8 | % | $ | 14,929 | 20,157 |
39
Historically,
research and development expense fluctuates during each quarter. In general,
different project has different requirements and different time span associated
with different costs and different payment terms. Some main factors for the
R&D expense fluctuation are listed as the following:
|
•
|
Each project will go through
multi stages before being submitted to the
SFDA.
|
|
•
|
Different drugs require for
different amount of testing samples or trials which will result in
different time span for the testing and approval
process.
|
|
•
|
R&D expense is incurred at
different stages of the process based on our agreement signed with the
third party (qualified hospitals or professional research
institutions).
|
|
•
|
Since different drugs require
different stages of process or different amount of samples to be
collected, the same R&D stage for different drugs result in different
time span and different
expense.
|
|
•
|
In some cases, after we submit
the completed document to the SFDA, we may be required to supply
additional testing or document, which will result in longer time span and
increased expense.
|
|
•
|
For the R&D projects that are
conducted internally, we only record the related personnel and material
costs.
|
Significant
Accounting Estimates and Policies
The
discussion and analysis of our financial condition and results of operations is
based upon our financial statements which have been prepared in accordance with
accounting principles generally accepted in the United States of America
(“GAAP”). The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amounts of assets and
liabilities. On an on-going basis, we evaluate our methodologies and assumptions
used to derive these estimates. Significant estimates include the reserve
allowance for doubtful accounts and inventories, our impairment test for
long-lived assets and goodwill, the valuation allowance for income taxes, the
remaining useful lives of our long-lived assets and our evaluation and recording
contingencies. We base our estimates on historical experience and on other
assumptions that we believes to be reasonable under the circumstances, the
results of which form our basis for making judgments about the carrying values
of assets and liabilities that are not readily apparent from other sources.
Actual results may differ from these estimates. Our significant estimates
include the following:
Long-lived
assets are evaluated for impairment whenever indicators of impairment exist.
Accounting standards require that if an impairment indicator is present, we must
assess whether the carrying amount of the asset is unrecoverable by estimating
the sum of the future cash flows expected to result from the asset, undiscounted
and without interest charges. If the recoverable amount is less than the
carrying amount, an impairment charge must be recognized based on the fair value
of the asset.
40
As part
of the process of preparing our financial statements, we are required to
estimate our income taxes. This process involves estimating our current tax
exposure together with assessing temporary differences resulting from differing
treatment of items for tax and accounting purposes. These differences result in
deferred tax assets and liabilities. We have deemed our temporary tax
differences related to our principal business operations in the PRC to be
immaterial. We must then assess the likelihood that our deferred tax assets will
be recovered from future taxable income, and, to the extent we believe that
recovery is not likely, we must establish a valuation allowance. To the extent
that we establish a valuation allowance or increase this allowance in a period,
we must include a tax provision or reduce our tax benefit in the statements of
operations. We use our judgment to determine our provision or benefit for income
taxes, deferred tax assets and liabilities and any valuation allowance recorded
against our net deferred tax assets. We believe, based on a number of factors
including the continued historical operating losses of China Sky and ACPG, that
we will not realize the future benefits of a significant portion of our net
deferred tax assets and we have accordingly provided a full valuation allowance
against our deferred tax assets. China Sky and ACPG do not generate revenues and
were established as the Holding Companies of our foreign operations. Management
has no intention to remit to either China Sky or ACPG any undistributed earnings
of business operations in China. However, various factors may cause those
assumptions to change in the near term.
We cannot
predict what future laws and regulations might be passed that could have a
material effect on our results of operations. We assess the impact of
significant changes in laws and regulations on a regular basis and update the
assumptions and estimates used to prepare our financial statements when we deem
it necessary.
We review
our accounting policies on a periodic basis to ensure compliance with GAAP. Our
most significant accounting policies are those related to intangible assets and
research and development.
Derivative liabilities - The
Class A Warrants (“the Warrants”) issued in connection with the private
placement we consummated on January 31, 2008 private placement include a reset
provision triggered if the Company issues common shares below the exercise price
of $12.50 as defined under the Warrant Agreement. Effective January 1, 2009 the
reset provision of these Warrants preclude equity accounting treatment under ASC
815 (formerly EITF 07-5). Accordingly, effective January 31, 2009, the
Company is required to reclassify the Warrants at their fair value to
liabilities each reporting period under ASC 815-40. At September 30, 2010, we
had 593,800 Warrants outstanding. The Company used the Monte Carlo
valuation model to estimate the fair value of the Warrants. Significant
assumptions used at September 30, 2010 include a term of approximately 3.4
years; volatility of 69.0% and a risk free interest rate of 0.84%. At
September 30, 2009, the Company had 750,000 Warrants outstanding. The Company
used the Monte Carlo valuation model to estimate the fair value of the
Warrants. Significant assumptions used at September 30, 2009 include
a term of approximately 3.7 years; volatility of 67.0% and a risk free interest
rate of 1.97%. The outstanding Warrants at September 30, 2010 and 2009 had a
fair value of approximately $1,716,000 and $5,323,000, respectively. Due to the
change in fair value of derivative warrant liability the Company realized income
of $8,847,000 and $1,305,000 for the nine months ended September 30, 2010
and 2009, respectively. Due to the change in fair value of derivative
warrant liability the Company realized income of $1,833,000 and
$132,000 for the three months ended September 30, 2010 and 2009,
respectively.
41
Intangible assets – Our
intangible assets consists of proprietary technologies, SFDA licenses for drug
batch numbers, and goodwill. Proprietary technologies are technologies that we
own. The SFDA licenses for drug batch numbers and goodwill were acquired in the
business acquisitions of Tianlong, Peng Lai and Haina. We have registered “Kang
Xi” as our trademark, which is used for all of the Company’s Tradition Chinese
Medicine (“TCM”) products. The “Kang Xi” trademark was developed internally and
registered by TDR before the Company became a public company. The Company’s cost
basis in the trademark is nominal. Therefore, the Company did
not have its “Kang Xi” trademark appraised, or recorded an intangible asset for
it. Additionally, none of the costs associated with the trademark have been
capitalized.
Intangible
assets with finite useful lives are amortized while intangible assets with
indefinite useful lives are not amortized. Goodwill and intangible assets are
tested periodically for impairment. Accordingly, the Company reviews its
long-lived assets, including property and equipment and finite-lived intangible
assets for impairment whenever events or changes in circumstances indicate that
the carrying amount of the assets may not be fully recoverable. To determine
recoverability of its long-lived assets, we evaluate the probability that future
undiscounted net cash flows will be less than the carrying amount of the assets.
Impairment costs, if any, are measured by comparing the carrying amount of the
related assets to their fair value. The Company did not record any impairment
charges related to its tangible and intangible assets held during the three and
nine months ended September 30, 2010 and 2009. As of September 30, 2010, the
weighted average amortization period of our intangible assets
approximated 7.5 years.
Research and
development—Research and development expenses include the costs
associated with the Company’s internal research and development as well as
research and development conducted by third parties. These costs primarily
consist of salaries, clinical trials, outside consultants, and materials. All
research and development costs are expensed as incurred.
Third-party
expenses reimbursed under non-refundable research and development contracts are
recorded as a reduction to research and development costs in the statement of
operations.
Assets to
be used in research and development activities, specifically, compounds that
have yet to receive new drug approval and would have no alternative use, should
approval not be given, are immediately charged to expense when acquired. Certain
assets and high technologies acquired that has a foreseeable future cash flows
are capitalized as intangible assets. Such intangible assets are amortized
starting from the year revenue is generated and amortized over its estimated
life. If a capitalized intangible asset is deemed to have no future benefit, the
unamortized carrying value will be expensed.
For the
nine months ended September 30, 2010 and 2009, we incurred $15,266,000 and
$10,980,000, respectively, in research and development expenditures. For the
three months ended September 30, 2010 and 2009, we incurred $5,592,000 and
$4,885,000, respectively, in research and development expenditures.
42
Trends
and Uncertainties
In 2008,
general worldwide economic conditions declined due to sequential effects of the
sub-prime lending crisis, general credit market crisis, collateral effects on
the finance and banking industries, concerns about inflation, slower economic
activity, decreased consumer confidence, reduced corporate profits and capital
spending, adverse business conditions and liquidity concerns. However,
since all of our business operations, and most of our sales, are currently
conducted in the PRC, we have not been greatly affected by the economic
downtown. 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.
We have
benefited from the overall economic development in the PRC in recent years and
the increase in the number of elderly people in China, which together have
resulted in increased expenditures on medicine in the PRC, including
TCMs. 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.
Historically,
we signed agreements with suppliers that allowed us to hold extra raw materials
at the cost of the suppliers. As a result, we were able to minimize our own
inventory carrying costs, and improve our cash management, by keeping the
inventory at the minimum level required to support the short-term sales.
However, due to our forecasts for certain cost increases of raw
materials and the overhead costs for storing such raw materials in fiscal 2010,
we began to increase our inventory levels toward the second half of
2009. We expect this practice to continue for the foreseeable
future.
During
the third quarter of 2010, Harbin Shiji Baolong, a domestic distributor, and
Hangzhou Jiupin, and overseas sales agent, terminated their business
relationship with us. These two customers accounted for an aggregate of 12% and
24% of our total revenue for the nine months ended September 30, 2010 and 2009,
respectively. These two customers did not account for any of our revenues during
the three months ended September 30, 2010. For the three months ended September
30, 2009, these two customers accounted for an aggregate of 22% of our total
revenue. We expect to replace these customers with new relationships over time
and that our revenues and income will be negatively impacted by this disruption
to our distribution channels at least through the end of 2010. We also expect to
incur higher selling and marketing costs through the end of 2010 in connection
with developing new customer relationships.
Historically,
our Slim Patch products have been one of our best selling products both
domestically and outside of the PRC. Beginning in the fourth quarter of 2009,
China domestic sales of Slim Patch products began to decline. The
regulations and restrictions launched at that time by the Chinese government
prohibiting television advertisement of weight loss products in the
PRC have negatively impacted the Slim Patch distribution channel in the PRC. The
revenue generated from the China domestic market of Slim Patch products was
$4,193,000 and $9,879,000 for the nine months ended September 30, 2010 and 2009,
respectively. In addition, following Hangzhou Jiupin’s termination of its
business relationship with us, our overseas sales of Slim Patch products also
decreased. Revenues generated from the Slim Patch overseas sales were
$5,928,000 and $8,956,000 for the nine months ended September 30, 2010 and 2009,
respectively. We expect sales of our Slim Patch products in the PRC to remain
lower for the foreseeable future due to the Chinese government’s restrictions,
and to remain lower overseas until we are able to locate a new overseas sales
agent to handle sales in the affected or new markets.
43
For the
remainder of fiscal year 2010, we anticipate price increases of certain raw
materials due to unforeseen natural disasters and inflation that will result in
the increase of our cost of goods sold. In addition, our sales and marketing
strategy to promote certain of our products which have less market competition
by coordinating with reputable distributors who have extensive market channel
and will launch these products at lower margins. These factors will have
negative impact on our overall gross product margins as discussed
below.
Results
of Operations
Restatement
of Financial Statements
As
discussed in Note 2 to the Financial Statements, we have restated our financial
statements for the three and nine month periods ended September 30,
2009.
For
the three months ended September 30, 2010 and 2009
Revenue,
Cost of Goods Sold, Gross Profit and Gross Profit Margin
The
following table sets forth our revenues, cost of goods sold, gross profit and
gross profit margin during the three months ended September 30, 2010 and
2009:
|
|
For the Three Months Ended
|
|
|||||||||
September 30,
|
||||||||||||
($ in thousands)
|
||||||||||||
|
|
2010
|
|
|
2009
|
|
|
Variance
|
|
|||
Revenues
|
|
$
|
36,193
|
|
|
$
|
43,227
|
|
|
$
|
(7,034
|
) |
Cost of Goods Sold
|
|
|
9,796
|
|
|
|
10,897
|
|
|
|
(1,101
|
) |
Gross
Profit
|
$
|
26,397
|
$
|
32,330
|
$
|
(5,933
|
) | |||||
Gross
Profit Margin
|
72.9
|
%
|
74.8
|
%
|
1.9
|
% |
For the
three months ended September 30, 2010, total revenues decreased by approximately
$7,034,000, or 16.3%, as compared to the same period of 2009. The decrease is
primarily due to weaker sales from products in our Patches, Sprays and
Diagnostic Kits product categories, due in part to the termination of two major
customer relationships during the third quarter of 2010 (see “Sales by Product
Line” below).
Cost of
goods sold decreased by $1,101,000, or 10.1%, compared to the same period in the
prior year. The lower cost of goods sold is principally attributable to our
lower sales volume. However, the ratio of cost of goods sold to revenues
increased to 27.1%, compared to 25.2% in the prior year, due to inflation and
unforeseen natural disasters which caused an increase in the price of raw
materials we use to produce certain of our products, including Honey Suckle
Flower and Notoginseng. For the remainder of fiscal year 2010, we
anticipate price increases of certain raw materials due to inflation, and the
overhead costs for storing raw materials, that will result in the increase of
our cost of goods sold.
44
Our sales
and marketing strategy is to promote certain of our products which have less
market competition by coordinating with reputable distributors who have
extensive market channels. However, these distributors seek lower sales prices
which will have a negative impact on our overall gross product
margins.
Sales
by Product Line
We
believe that the most meaningful presentation of our products is by categories
of method of delivery. The following table sets forth our principal product
categories based on application type, and the approximate amount and percentage
of revenue from each of such product categories, during each of the three months
ended September 30, 2010 and 2009:
For the Three Months Ended September 30,
($ in thousands)
|
||||||||||||||||||||||||||||
2010
|
2009
|
Variance
|
||||||||||||||||||||||||||
Product
Category
|
# of
Products
|
Sales
|
% of
Sales
|
# of
Products
|
Sales
|
% of
Sales
|
||||||||||||||||||||||
Patches
|
5
|
$
|
6,529
|
18.0
|
%
|
5
|
$
|
11,783
|
27.3
|
%
|
$
|
(5,254
|
)
|
|||||||||||||||
Ointments
|
24
|
11,602
|
32.1
|
%
|
18
|
10,823
|
25.0
|
%
|
779
|
|||||||||||||||||||
Sprays
|
15
|
3,645
|
10.1
|
%
|
15
|
6,775
|
15.7
|
%
|
(3,130
|
)
|
||||||||||||||||||
Drops
|
10
|
3,877
|
10.7
|
%
|
4
|
3,074
|
7.1
|
%
|
803
|
|||||||||||||||||||
Diagnostic
Kits
|
3
|
661
|
1.8
|
%
|
3
|
2,623
|
6.1
|
%
|
(1,962
|
)
|
||||||||||||||||||
Others
|
58
|
9,879
|
27.3
|
%
|
44
|
8,149
|
18.8
|
%
|
1,730
|
|||||||||||||||||||
Total
|
115
|
*
|
$
|
36,193
|
100.0
|
%
|
89
|
$
|
43,227
|
100.0
|
%
|
$
|
(7,034
|
)
|
*
We discontinued sales of 3 products during the third quarter of 2010 due to
their low sales volume (one each from our Ointments, Sprays and Others
categories).
We
marketed 115 products during the three months ended September 30, 2010, compared
with 89 products during the three months ended September 30, 2009. The
Company’s total revenue decreased by $7,034,000, or 16.3%, as compared to the
same period of 2009. The revenue decrease is primarily due to the decreased
sales from our Patch, Spray and Diagnostic Kits product categories.
For the
three months ended September 30, 2010, revenues from Patch products decreased by
$5,254,000, or 44.6%, as compared to the same period of 2009. The decrease is
primarily due to the decreased sales of our Slim Patch products both within
China and the overseas. Beginning in the fourth quarter of 2009, Chinese
domestic sales of our Slim Patch products began to decline. The regulations
and restrictions launched at that time by the Chinese government prohibiting
television advertisement of weight loss products in the PRC have
negatively impacted the Slim Patch distribution channel. The revenue generated
from the China domestic market of our Slim Patch products was $1,571,000 and
$2,761,000 for the three months ended September 30, 2010 and 2009, respectively.
Sales of the Slim Patch products also accounted for all of our overseas sales
during the three months ended September 30, 2009 and 2010. Our overseas sales
are realized through Chinese domestic agents whom are appointed by overseas
importers. During the third quarter of 2010, Hangzhou Jiupin, an overseas sales
agent, terminated its business relationship with us which had a negative impact
to the overseas sales of our Slim Patch products. The revenue generated from
overseas market of Slim Patch products was $2,202,000 and $4,530,000 for the
three months ended September 30, 2010 and 2009, respectively. For the three
months ended September 30, 2010, revenues from Pain Relief Patch products
decreased by $1,361,000, or 70.5%, as compared to the same period of 2009. The
decrease is primarily due to the termination by Hangzhou Jiupin during the third
quarter of 2010. Management is currently seeking a new overseas sales agent to
replace this customer.
45
For the
three months ended September 30, 2010, revenues from Ointments increased by
$779,000, or 7.2%, as compared to the same period of 2009. The increase is
primarily due to the increased sales from our Compound Camphor Cream.
Revenue generated from Compound Camphor Cream was $6,183,000 and
$5,484,000 for the three months ended September 30, 2010 and 2009,
respectively. This increase is primarily due to our continued efforts to promote
and advertise this product during the third quarter of 2010. There are
additional 7 new Ointment products launched during the three months ended
September 30, 2010 as compared to the same period of 2009. Revenue generated
from these 7 new Ointment products was $655,000 for the three months ended
September 30, 2010.
For the
three months ended September 30, 2010, revenue generated from our Spray products
decreased by $3,130,000, or 46.2%, as compared to the same period of 2009,
primarily due to the decreased sales of our Stomatitis spray, FuShuang Spray,
JiaoShuang Spray, and JieYin Spray. The revenue decrease is primarily due to the
termination of our business relationship with Harbin Shiji Baolong during the
third quarter of 2010. Management is currently seeking new domestic distributors
to replace this customer.
For the
three months ended September 30, 2010, revenue from our Drops products increased
by $803,000, or 26.1%, as compared to the same period of 2009, primarily due to
$532,000 of sales of the 6 Drops products we introduced during the three months
ended September 30, 2010.
For the
three months ended September 30, 2010, revenue generated from our Diagnostic
Kits decreased by $1,962,000, or 74.8%, as compared to the same period of 2009,
primarily due to decreased sales of our Cardiac Arrest Early Examination Kits
which was promoted by Harbin Shiji Baolong, a distributor which terminated its
business relationship with us. Revenue generated from Cardiac Arrest Early
Examination Kits was $206,000 and $2,165,000 for the three months ended
September 30, 2010 and 2009, respectively. Management is currently seeking a
replacement for this distributor.
For the
three months ended September 30, 2010, revenues from our Other products category
increased by $1,730,000, or 21.2%, as compared to the same period of 2009. The
revenue increase is primarily due to the increases sales of our Metronidazole
and Chlorhexidine Washing Fluid, as well as sales of the additional 14 products
we introduced during the three months ended September 30, 2010. The revenue
generated from the Metronidazole and Chlorhexidine Washing Fluid increased by
$425,000 as compared to the same period of 2009. The sales increase from the
Metronidazole and Chlorhexidine Washing Fluid is primarily due to sales to a new
distributor we engaged in the second quarter of 2010. The revenue generated from
the additional 14 products was $1,482,000 for the three months ended September
30, 2010.
46
Operating
Expenses
The
following table summarizes the changes in our operating expenses for the three
months ended September 30, 2010 and 2009:
For the Three Months Ended September 30,
($ in thousands)
|
|
|||||||||||
Operating Expenses
|
|
2010
|
|
|
2009
|
|
|
Variance
|
|
|||
Selling expense
|
|
$
|
9,673
|
|
|
$
|
9,944
|
|
|
|
(2.7
|
)%
|
General
and administrative expense
|
798
|
1,024
|
(22.1
|
)%
|
||||||||
Depreciation
and amortization
|
879
|
447
|
96.6
|
%
|
||||||||
Research
and development
|
5,592
|
4,885
|
14.5
|
%
|
||||||||
Total
operating expenses
|
16,942
|
16,300
|
3.9
|
%
|
||||||||
Total
revenue
|
$
|
36,193
|
$
|
43,227
|
(16.3
|
)%
|
||||||
%
of operating expenses to revenue
|
46.8
|
%
|
37.7
|
%
|
9.1
|
%
|
For the
three months ended September 30, 2010, selling expense decreased compared to the
same period of 2009, primarily due to our decreased sales volume. For the three
months ended September 30, 2010, our advertising costs increased by $1,053,000,
or 20.9% as compared to the same period of 2009.
General
and administrative expense for the three months ended September 30, 2010
decreased by 22.1% compared to the same period in the prior year, primarily due
to the decreased sales volume and a decrease in our professional
fees.
Depreciation
and amortization expense amounted to $879,000 compared to $447,000 for
the three months ended September 30, 2010 and 2009,
respectively. This increase of $432,000 was primarily due to the
amortization expense of our proprietary technologies, Antroquinonol and Small
RNAs Technology, that we acquired during the fourth quarter of 2009. These two
proprietary technologies were acquired for approximately $10,969,000 and are
being amortized over an estimated useful life of 10 years.
For the
three months ended September 30, 2010, total research and development expense
was approximately $5,592,000 as compared to $4,885,000 for the same period in
2009. Refer to detailed analysis of research and development expenses for a
table of costs by project.
The major
research and development projects that accounted for the majority of
our total research and development expense are as follows:
47
Major Research and Development Expense during the Three Months Ended
September 30, 2010
|
||||||||
($ in thousands)
|
||||||||
Projects
|
Expense
|
% of total R&D
|
||||||
Monoclonal
Antibody
|
$ | 1,408 | 25.2 | % | ||||
Diagnostic
Kits - 4 products
|
1,305 | 23.3 | % | |||||
Omeprazole
Sodium for Injection
|
686 | 12.3 | % | |||||
Ozagrel
Sodium Injection
|
730 | 13.1 | % | |||||
Aztreonam
For Injection
|
288 | 5.2 | % | |||||
Voriconazole
for Injection
|
236 | 4.2 | % | |||||
Cefmetazole
Sodium for Injection
|
229 | 4.1 | % | |||||
Compound
Allantoin VitaminB6-E and Aminoethylsulfonic Acid Eye
Drops
|
354 | 6.3 | % | |||||
Glycosidic
Hydroxy Eye Drops
|
354 | 6.3 | % | |||||
Total
|
$ | 5,590 | 99.9 | % |
For the
three months ended September 30, 2009, total research and development expense is
approximately $4,885,000. The major research and development projects that
accounted for the majority of our total research and development expense is
listed are as follows:
Major
Research and Development Expense During the Three Months
|
||||||||
Ended September
30, 2009
|
||||||||
($
in thousands)
|
||||||||
Projects
|
Expense
|
% of total R&D
|
||||||
Additional
experiments to apply 5 Products to the OTC
|
$ | 1,403 | 28.7 | % | ||||
Diagnostic
Kits - 3 products
|
1,228 | 25.1 | % | |||||
Change
Matrix for 4 Patch Products
|
1,820 | 37.3 | % | |||||
Naftopidil
Dispersible tablets
|
124 | 2.5 | % | |||||
Sertraline
Hydrochloride capsules
|
124 | 2.5 | % | |||||
Radix
Isatidis granule and syrup
|
95 | 1.9 | % | |||||
Total
|
$ | 4,794 | 98.1 | % |
Other
Income
For the
three months ended September 30, 2010 and 2009, we recorded unrealized gains of
$1,833,000 and $132,000 (restated), respectively, due to changes in fair value
of our derivative warrant liability resulting from the decreases in the
estimated fair value of the warrants issued in our January 2008 private
placement (as described in Note 8 to the Notes to the financial statements
appearing elsewhere in this report).
For
the nine months ended September 30, 2010 and 2009
Revenue,
Cost of Goods Sold, Gross Profit and Gross Profit Margin
The
following table sets forth our revenues, cost of goods sold, gross profit and
gross profit margin during the nine months ended September 30, 2010 and
2009:
48
For
the Nine Months Ended
|
||||||||||||
September
30,
|
||||||||||||
($
in thousands)
|
||||||||||||
2010
|
2009
|
Variance
|
||||||||||
Revenues
|
$
|
105,856
|
$
|
100,242
|
5.6
|
%
|
||||||
Cost
of Goods Sold
|
28,287
|
24,690
|
14.6
|
%
|
||||||||
Gross
Profit
|
$
|
77,569
|
$
|
75,552
|
2.7
|
%
|
||||||
Gross
Profit Margin
|
73.3
|
%
|
75.4
|
%
|
(2.1
|
)%
|
For the
nine months ended September 30, 2010, total revenues increased by approximately
$5,614,000, or 5.6%, as compared to the same period of 2009. The revenue
increase is primarily due to the strong sales from Ointment, Drops and Others
product categories. The positive variance is partially offset by the decreased
revenue from the sales of our Patch and Diagnostic Kits categories ,
due in part to the termination of two major customer relationships during the
third quarter of 2010 (see “Sales by Product Line” below).
Cost of
goods sold increased by $3,597,000, or 14.6%, compared to the same period of the
prior year. The higher cost of goods sold is principally attributable to our
higher sales volume. However, the ratio of cost of goods sold to revenues
increased to 26.7%, compared to 24.6% in the prior year, due to inflation and
unforeseen natural disasters which caused an increase in the price of raw
materials we use to produce certain of our products, including Honey Suckle
Flower and Notoginseng. For the remainder of fiscal year 2010, we
anticipate price increases of certain raw materials due to inflation, and the
overhead costs for storing such raw materials, that will result in the increase
of our cost of goods sold.
Our sales
and marketing strategy is to promote certain of our products which have less
market competition by coordinating with reputable distributors who have
extensive market channels and will resell these products at lower margins. We
expect these factors will continue to have a negative impact on our overall
gross product margins.
Sales
by Product Line
We
believe that the most meaningful presentation of our products is by categories
of method of delivery. The following table sets forth our principal product
categories based on application type, and the approximate amount and percentage
of revenue from each of such product categories, during each of the nine months
ended September 30, 2010 and 2009:
For the Nine Months Ended September 30,
|
||||||||||||||||||||||||||||
($ in thousands)
|
||||||||||||||||||||||||||||
# of
Products
|
2010
|
# of
Products
|
2009
|
Variance
|
||||||||||||||||||||||||
Product
Category
|
Sales
|
%
of
Sales
|
Sales
|
%
of
Sales
|
||||||||||||||||||||||||
Patches
|
5
|
$
|
24,470
|
23.1
|
%
|
5
|
$
|
30,842
|
30.8
|
%
|
$
|
(6,372
|
)
|
|||||||||||||||
Ointments
|
25
|
31,013
|
29.3
|
%
|
18
|
23,563
|
23.5
|
%
|
7,450
|
|||||||||||||||||||
Sprays
|
16
|
11,772
|
11.1
|
%
|
15
|
14,486
|
14.5
|
%
|
(2,714
|
)
|
||||||||||||||||||
Drops
|
10
|
8,569
|
8.1
|
%
|
4
|
4,925
|
4.9
|
%
|
3,644
|
|||||||||||||||||||
Diagnostic
Kits
|
3
|
4,446
|
4.2
|
%
|
3
|
9,411
|
9.4
|
%
|
(4,965
|
)
|
||||||||||||||||||
Others
|
59
|
25,586
|
24.2
|
%
|
44
|
17,015
|
16.9
|
%
|
8,571
|
|||||||||||||||||||
Total
|
118
|
$
|
105,856
|
100.0
|
%
|
89
|
$
|
100,242
|
100.0
|
%
|
$
|
5,614
|
49
We
marketed 118 products during the nine months ended September 30, 2010, compared
to 89 products during the nine months ended September 30, 2009. The
Company’s total revenue increased by $5,614,000, or 5.6%, as compared to the
same period of 2009. The increase is primarily due to the strong sales from
our Ointment, Drops and Others product categories, which was partially offset by
the decreased sales generated from our Patches, Spray and Diagnostic
Kits.
For the
nine months ended September 30, 2010, revenues from Patch products decreased by
$6,372,000, or 20.7%, as compared to the same period of 2009. The decrease is
primarily due to the decreased sales of our Slim Patch products both within
China and overseas. From the fourth quarter of 2009, China domestic sales of
Slim Patch products began to decline. The regulations and restrictions
launched at that time by the Chinese government prohibiting television
advertisement of weight loss products in the PRC have negatively
impacted the Slim Patch distribution channel in the PRC. The revenue generated
from the China domestic market of Slim Patch products was $4,193,000 and
$9,879,000 for the nine months ended September 30, 2010 and 2009, respectively.
The decrease in overseas sales of our Slim Patch products was primarily due to
the termination by Hangzhou Jiupin, a key overseas sales agent, of its business
relationship with us during the third quarter of 2010. Revenues generated from
the Slim Patch overseas sales were $5,928,000 and $8,956,000 for the nine months
ended September 30, 2010 and 2009, respectively. For the nine months ended
September 30, 2010, revenues from Anti-Hypertension Patch increased by
$1,580,000 or 42.9% as compared to the same period of 2009. The increase is
primarily due to the strong revenue generated during the six months ended June
30, 2010. For the three months ended September, 2010, revenue from sales of our
Anti-Hypertension Patch decreased by $350,000, or 15.3% as compared to the same
period of 2009.
For the
nine months ended September 30, 2010, revenues from Ointments increased by
$7,450,000, or 31.6%, as compared to the same period of 2009. The increase was
primarily due to the increased sales from our Compound Camphor Cream
and additional 7 new Ointment products launched during the nine months ended
September 30, 2010 as compared to the same period of 2009. Revenue generated
from Compound Camphor Cream was $15,314,000 and $10,203,000 for the nine
months ended September 30, 2010 and 2009, respectively. This increase is
primarily due to our continued efforts to promote and advertise this
product. Revenue generated from the 7 new Ointment products was $781,000 for the
nine months ended September 30, 2010.
For the
nine months ended September 30, 2010, revenue generated from our Spray products
decreased by $2,714,000, or 18.7%, as compared to the same period of 2009,
primarily due to the decreased sales of our FuShuang Spray, JiaoShuang Spray,
and JieYin Spray. The revenue decrease is primarily due to the termination of
business relationship by Harbin Shiji Baolong during the third quarter of 2010.
Management is currently seeking new channel distributors to replace this
relationship.
For the
nine months ended September 30, 2010, revenues from our Drops products increased
by $3,644,000, or 74.0%, as compared to the same period of 2009, primarily due
to the increase sales of our Naphazoline Hydrochloride Eye Drops and an
additional 6 Drops products launched during the nine months ended September 30,
2010. Revenue generated from Naphazoline Hydrochloride Eye Drops was $5,569,000
and $3,118,000 for the nine months ended September 30, 2010 and 2009,
respectively. The increase is primarily due to the strong sales revenue
generated during the first six months of 2010. For the three months ended
September 30, 2010, revenue from Naphazoline Hydrochloride Eye Drops increased
by $156,000, or 6.9% as compared to the same period of 2009. Revenue generated
from the additional 6 new Drops products was $776,000 for the nine months ended
September 30, 2010.
50
For the
nine months ended September 30, 2010, revenue generated from our Diagnostic Kits
decreased by $4,965,000, or 52.8%, as compared to the same period of 2009,
primarily due to decreased sales of our Cardiac Arrest Early Examination Kits
which was promoted by Harbin Shiji Baolong, a domestic distributor, which
terminated its business relationship with us during the third quarter of 2010.
Revenue generated from Cardiac Arrest Early Examination Kits was $2,637,000 and
$7,468,000 for the nine months ended September 30, 2010 and 2009,
respectively. Management is currently seeking a new channel distributor to
replace Harbin Shiji Baolong.
For the
nine months ended September 30, 2010, revenues from our Other products category
increased by $8,571,000, or 50.4%, as compared to the same period of 2009. The
revenue increase is primarily due to the sales increase of our Metronidazole and
Chlorhexidine Washing Fluid, as well as of 14 additional products we introduced
during the nine months ended September 30, 2010. Revenue generated from the
Metronidazole and Chlorhexidine Washing Fluid increased by 194.8%, or $1,242,000
as compared to the same period of 2009, primarily due to sales to a new
distributor we engaged in the second quarter of 2010. Revenue generated from the
additional 14 products was $2,235,000 for the nine months ended September 30,
2010.
Operating
Expenses
The
following table summarizes the changes in our operating expenses for the nine
months ended September 30, 2010 and 2009:
For the Nine Months Ended September 30,
|
|
|||||||||||
($ in thousands)
|
||||||||||||
Operating Expenses
|
|
2010
|
|
|
2009
|
|
|
Variance
|
|
|||
Selling
expense
|
$
|
23,567
|
$
|
23,707
|
(0.6
|
)%
|
||||||
General
and administrative expense
|
2,911
|
2,354
|
23.7
|
%
|
||||||||
Depreciation
and amortization
|
2,547
|
1,348
|
88.9
|
%
|
||||||||
Research
and development
|
15,266
|
10,980
|
39.0
|
%
|
||||||||
Total
operating expenses
|
44,291
|
38,389
|
15.4
|
%
|
||||||||
Total
revenue
|
$
|
105,856
|
$
|
100,242
|
5.6
|
%
|
||||||
%
of operating expenses to revenue
|
41.8
|
%
|
38.3
|
%
|
3.5
|
%
|
For the
nine months ended September 30, 2010, selling expense remained constant with the
same period of 2009, primarily due to the increased advertisement expense and
partially offset by the decreased cost associated with transferring of certain
logistic expenses to our distributors. For the nine months ended September 2010,
advertising costs increased by 1,235,000, or 11.0% as compared to the same
period of 2009.
General
and administrative expense for the nine months ended September 30, 2010
increased by 23.7% compared to the same period of the prior year, primarily due
to increased sales volume and our increased professional fees.
51
Depreciation
and amortization expense amounted to $2,547,000 compared to
$1,348,000 for the nine months ended September 30,
2010 and 2009, respectively. This increase of
$1,199,000 is primarily due to the amortization expense of our proprietary
technologies, Antroquinonol and Small RNAs Technology, that we acquired during
the fourth quarter of 2009. These two proprietary technologies were acquired for
approximately $10,969,000 and are being amortized over an estimated useful life
of 10 years.
For the
nine months ended September 30, 2010, total research and development expense was
approximately $15,266,000. The major research and development projects that
accounted for the majority of our total research and development expense
are as follows:
Major Research and Development Expenses during the Nine Months Ended September 30, 2010
|
||||||||||||||||
($ in thousands)
|
||||||||||||||||
Projects
|
Expense
|
% of total
R&D
|
Aggregate
Expense Since
Commencement
of Project
|
Estimated
Additional Cost
to Complete
Research
|
||||||||||||
Diagnostic
Kits - 12 products
|
$ | 3,198 | 20.9 | % | $ | 5,928 | $ | 2,595 | ||||||||
Optimization
Experiments for Five Products
|
1,653 | 10.8 | % | 2,533 | - | |||||||||||
Monoclonal
Antibody
|
1,408 | 9.2 | % | 2,372 | 592 | |||||||||||
Endostatin
|
1,010 | 6.6 | % | 1,449 | 9,000 | |||||||||||
Antrodia
Cinnamomea Extract l
|
849 | 5.6 | % | 1,236 | 16,000 | |||||||||||
Tumor
Markers
|
775 | 5.1 | % | 775 | 210 | |||||||||||
Tiopronin
for Injection
|
644 | 4.2 | % | 1,170 | 150 | |||||||||||
Omeprazole
Sodium for Injection
|
686 | 4.5 | % | 1,691 | 314 | |||||||||||
Ozagrel
Sodium Injection
|
730 | 4.8 | % | 1,322 | 270 | |||||||||||
Aztreonam
For Injection
|
288 | 1.9 | % | 288 | 650 | |||||||||||
Voriconazole
for Injection
|
236 | 1.5 | % | 236 | 700 | |||||||||||
Cefmetazole
Sodium for Injection
|
229 | 1.5 | % | 229 | 650 | |||||||||||
Breast
Cancer Technology
|
497 | 3.3 | % | 2,767 | 8,300 | |||||||||||
Clindamycin
Phosphate for Injection
|
424 | 2.8 | % | 833 | 1,000 | |||||||||||
Levofloxacin
Hydrochloride Eye Drops
|
410 | 2.7 | % | 746 | 500 | |||||||||||
Compound
Allantoin VitaminB6-E and Aminoethylsulfonic Acid Eye
Drops
|
354 | 2.3 | % | 354 | 800 | |||||||||||
Glycosidic
Hydroxy Eye Drops
|
354 | 2.3 | % | 354 | 700 | |||||||||||
Nimesulide
Granules
|
439 | 2.9 | % | 967 | 800 | |||||||||||
Total
|
$ | 14,184 | 92.9 | % | $ | 25,250 | $ | 43,231 |
52
For the
nine months ended September 30, 2009, total research and development expense was
approximately $10,980,000. The major research and development projects that
accounted for the majority of our total research and development expenses
are as follows:
Major Research and Development Expenses during the Nine Months Ended September 30, 2009
|
||||||||||||||||
($ in thousands)
|
||||||||||||||||
Projects
|
Expense
|
% of total
R&D
|
Aggregate
Expense Since
Commencement
of Project
|
Estimated
Additional Cost
to Complete
Research
|
||||||||||||
Breast
Cancer Technology
|
$ | 1,507 | 13.7 | % | $ | 1,507 | $ | 9,300 | ||||||||
Monoclonal
Antibody
|
964 | 8.8 | % | 3,162 | 2,000 | |||||||||||
Diagnostic
Kits - 6 products
|
2,084 | 19.0 | % | 3,400 | 100 | |||||||||||
Change
Matrix for 4 Patch Products
|
1,820 | 16.6 | % | 1,820 | - | |||||||||||
Additional
experiments to apply 5 Products to the OTC
|
1,403 | 12.8 | % | 1,403 | - | |||||||||||
Naftopidil
Dispersible tablets
|
124 | 1.1 | % | 380 | 376 | |||||||||||
Sertraline
Hydrochloride capsules
|
124 | 1.1 | % | 373 | 376 | |||||||||||
Radix
Isatidis granule and syrup
|
95 | 0.9 | % | 377 | 405 | |||||||||||
Omeprazole
Sodium for Injection
|
540 | 4.9 | % | 540 | 1,000 | |||||||||||
Tiopronin
for Injection
|
526 | 4.8 | % | 526 | 800 | |||||||||||
Nimesulide
Granules
|
512 | 4.7 | % | 512 | 1,700 | |||||||||||
Clindamycin
Phosphate for Injection
|
410 | 3.7 | % | 410 | 1,800 | |||||||||||
Levofloxacin
Hydrochloride Eye Drops
|
336 | 3.1 | % | 336 | 1,300 | |||||||||||
Ozagrel
Sodium for Injection
|
183 | 1.7 | % | 183 | 1,000 | |||||||||||
Total
|
$ | 10,628 | 96.8 | % | $ | 14,929 | 20,157 |
53
Other
Income
For the
nine months ended September 30, 2010 and 2009, we recorded unrealized gains of
$8,847,000 and $1,305,000 (restated), respectively, due to changes in fair value
of our derivative warrant liability resulting from decreases in the
fair value of the warrants issued in our January 2008 private placement (as
described in Note 8 to the Notes to the financial statements appearing elsewhere
in this report).
Liquidity
and Capital Resources
The
following table summarizes our cash and cash equivalents position, our working
capital, and our cash flow activity as of September 30, 2010 and
2009:
|
|
As of September 30,
|
|
|||||
($ in thousands, except
|
||||||||
ratio and days)
|
||||||||
|
|
2010
|
|
|
2009
(restated)
|
|
||
Cash
and cash equivalents
|
$
|
71,971
|
$
|
56,303
|
||||
Current
ratio
|
8.8
|
5.1
|
||||||
Quick
ratio
|
8.4
|
4.5
|
||||||
Average
accounts receivable turnover days
|
55.7
|
45.2
|
||||||
Average
inventory turnover days
|
35.7
|
17.3
|
||||||
Working
capital
|
$
|
88,037
|
$
|
73,741
|
||||
Inventories
|
$
|
4,311
|
$
|
3,099
|
||||
Cash
provided by (used in):
|
||||||||
Operating
activities
|
$
|
25,559
|
$
|
25,932
|
||||
Investing
activities
|
$
|
(7,822
|
) |
$
|
(10,049
|
) | ||
Financing
activities
|
$
|
94
|
$
|
29
|
54
As of
September 30, 2010, cash and cash equivalents were approximately $71,971,000 as
compared to $56,303,000 at September 30, 2009.
We had
working capital at September 30, 2010 of approximately $88,037,000, compared to
$73,741,000 at September 30, 2009 (restated). Our increase in working capital in
2010 was primarily due to the increased cash flows generated from our operating
activities, offset in part by cash used in investing activities. We consider
current working capital and borrowing capabilities are adequate to cover our
current operating and capital requirements in the near future.
Cash
flows provided by operating activities was approximately $25,559,000 for the
nine months ended September 30, 2010. Our cash flows from operating activities
resulted from net income of $33,426,000 (including a non-cash gain of $8,847,000
from the change in fair value of our warrant derivative liability), further
increased by depreciation and amortization of $2,895,000, partially offset by
accounts receivable of $1,363,000 and inventories of $1,816,000.
Cash
flows used in investing activities was approximately $7,822,000 for the nine
months ended September 30, 2010 compared to $10,049,000 in the same period of
2009. Cash flows used in investing activities in 2010 were primarily related to
a bid deposit of approximately $7,335,000 we submitted to Harbin High Technology
Development Zone to participate in an auction to a parcel of land of
approximately 85,000 square meters in the Harbin Song Bei District High
Technology Zone. Cash flows used in investing activities in 2009 were
primarily related to the construction costs of our new corporate
headquarters in Harbin Song Bei District.
Cash
flows provided from financing activities was approximately $94,000 for the nine
months ended September 30, 2010 compared to approximately $29,000 for the same
period in 2009. Cash flows provided from financing activities in 2010 and 2009
were primarily related to warrants exercised for cash by certain warrant holders
of ours.
In
January 2010, we completed the construction of two office buildings and moved
into these new facilities. It is anticipated that residual work, including road
construction, fire control equipment, amenity improvement, and final
acceptance, will be completed on these facilities during the fourth quarter of
2010, at an additional cost of approximately $3.0 million.
Our
current ratio was 8.8 at September 30, 2010 compared to 5.1 at September 30,
2009 and the quick ratio was 8.4 at September 30, 2010 compared to 4.5 at
September 30, 2009. We endeavor to ensure that funds are available to take
advantage of new investment opportunities and that funds are sufficient to meet
future liquidity and capital needs.
55
We
calculate accounts receivable turnover by averaging the opening and closing
balances of out accounts receivable during that period and dividing that amount
by our average daily sales during that period. Since accounts
receivables fluctuate over the course of each quarter, in order to determine a
more representative accountant receivables collection days, management
calculates the turnover rate on a quarter-by-quarter basis.
Our
average daily sales, average accounts receivable, and accounts receivable
turnover days for each of the nine months ended September 30, 2010 and 2009 were
as follows:
Nine Months Ended
September 30,
|
|
Average Daily
Sales
($ in
thousands)
|
|
|
Average A/R
($ in
thousands)
|
|
|
Turnover
Days
|
|
|||
2010
|
$
|
387
|
$
|
21,546
|
55.7
|
|||||||
2009
|
$
|
366
|
$
|
16,525
|
45.2
|
Account
receivable turnover days increased to 55.7 in the nine months ended September
30, 2010 comparing to 45.2 in the same period of 2009. The increase is primarily
due to the average account receivable increase outpaced the increase of average
daily sales. Accounts receivable collections are generally slower during the
fourth fiscal quarter and the first fiscal quarter, partly due to the Chinese
public holidays within that period (about three weeks in total). During the
second and third quarter of each year, due to stronger sales volume, the product
turnover rate at our distributors and agents is higher, resulting in their
shorter accounts payable periods.
Our
inventory turnover days for the nine months ended September 30, 2010 and 2009
calculated by using average daily costs of goods sold and average inventory for
each quarter were as follows:
Nine Months Ended
September 30,
|
|
Average Daily
COGS
($ in
thousands)
|
|
|
Average
Inventory
($ in
thousands)
|
|
|
Turnover
Days
|
|
|||
2010
|
$
|
104
|
$
|
3,715
|
35.7
|
|||||||
2009
|
$
|
90
|
$
|
1,558
|
17.3
|
Historically,
we signed agreements with suppliers that allowed us to hold extra raw materials
at the cost of the suppliers. As a result, we could minimize our own inventory
carrying costs, and improve our cash management, by keeping the inventory at the
minimum level required to support the short-term sales. However, due to the
forecast of certain cost increases of raw materials in 2010, management began to
increase the inventory levels toward the second half of 2009. The inventory
turnover days increased to 35.7 days for the nine months ended September 30,
2010 compared to 17.3 days in the same period of 2009. This increase is
primarily due to the increased inventory level by the end of fiscal year 2009 to
support our expected sales growth.
56
Contractual
Obligations and Commercial Commitments
As of
September 30, 2010, we have commitments and contractual obligations as
follows:
In
January 2010, we completed the construction of two office buildings and moved
into the new facilities located in Song Bei District of Harbin city, PRC. It is
anticipated that residual work, including road construction, fire control
equipment, amenity improvement, and final acceptance, will be completed on these
facilities during the fourth quarter of 2010, at an additional cost of
approximately $3.0 million.
We do not
have any long-term debt obligations, capital lease obligations, operating lease
obligations, purchase obligations, and other long term liabilities reflected on
our balance sheet under GAAP.
Currency
Exchange Fluctuations
All of
our revenue and majority of the expenses during the nine months ended September
30, 2010 were denominated primarily in RMB, the currency of China, and were
converted into U.S. dollars at the exchange rate of 6.81640 RMB to 1 U.S. Dollar
at September 30, 2010 from 6.84251 RMB to 1 U.S. Dollar at September 30, 2009.
There can be no assurance that RMB-to-U.S. dollar exchange rates will remain
stable. A devaluation of RMB relative to the U.S. dollar would adversely affect
our business, financial condition and results of operations. We do not engage in
currency hedging.
Off-Balance
Sheet Arrangements
We do not
have any off-balance sheet arrangements that are currently material or
reasonably likely to be material to our financial position or results of
operations.
57
Item
3. Quantitative and Qualitative Disclosures About
Market Risk.
We
are subject to certain risks and uncertainties as described
below. These risks and uncertainties may not be the only ones we
face. There may be additional risks that we do not presently know of,
or that we currently consider immaterial. All of these risks could
adversely affect our business, financial condition, results of operations and
cash flows. Our business and operations may be adversely affected if any of
such risks are realized. All investors should consider the following
risks before deciding to purchase or sell our securities.
As of
September 30, 2010, we do not invest or trade market risk sensitive instrument
or have any debt subject to interest rate fluctuations.
Substantially
all of our revenues and expenses are denominated in RMB. Since 1994, the
exchange rate for the RMB against the U.S. dollar has remained relatively
stable, most of the time in the region of approximately RMB8.00 to U.S.$1.00.
However, in 2005, the Chinese government announced that would begin pegging the
exchange rate of the RMB against a number of currencies, rather than just the
U.S. dollar. Currently, exchange rates are approximately RMB6.8 to U.S.$1.00
resulting in the increase in price of Chinese products to U.S.
purchasers. As our operations are primarily in China, any significant
revaluation of the Chinese RMB may materially and adversely affect cash flows,
revenues and financial condition. If we decide to convert RMB into U.S.
dollars and the U.S. dollar appreciates against the RMB, the U.S. dollar
equivalent of the RMB that we convert would be reduced.
Inflation
in China has not materially impacted our results of operations in recent years,
but we can provide no assurance that we will not be affected in the
future. According to the PRC National Bureau of Statistics, the inflation
rate in the consumer price index in China was 5.9%, 4.8%, and 1.9% in 2009,
2008, and 2007, respectively.
A
significant amount of our cash and cash equivalents are held in commercial bank
checking accounts in the PRC and earned an annual interest income yield of
approximately 0.36% for the nine months ended September 30, 2010. For all
the bank accounts in the PRC, we earned interest income of approximately $93,000
and $69,000 for the nine months ended September 30, 2010 and 2009,
respectively.
Item
4. Controls and Procedures.
Disclosure
Controls and Procedures (Revised)
Our
management, with the participation of our chief executive officer (principal
executive officer) and chief accounting officer (principal financial and
accounting officer), evaluated the effectiveness of our disclosure controls and
procedures as of September 30, 2010. The term “disclosure controls and
procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Securities
Exchange Act, means controls and other procedures of a company that are designed
to ensure that information required to be disclosed by a company in the reports
that it files or submits under the Securities Exchange Act are recorded,
processed, summarized and reported within the time periods specified in the
SEC’s rules and forms. Disclosure controls and procedures include, without
limitation, controls and procedures designed to ensure that information required
to be disclosed by a company in the reports that it files or submits under the
Exchange Act are accumulated and communicated to the company’s management,
including its principal executive and principal financial officers, as
appropriate to allow timely decisions regarding required disclosure. Our
management recognizes that any controls and procedures, no matter how well
designed and operated, can provide only reasonable assurance of achieving their
objectives and management necessarily applies its judgment in evaluating the
cost-benefit relationship of possible controls and procedures. Our
disclosure controls and procedures are designed to provide reasonable assurance
of achieving their objectives as described above.
58
We
received comments from the SEC which, for the reasons set forth in our Annual
Report on Form 10-K for the year ended December 31, 2009, as amended, under Item
9A. “Management’s Annual Report on Internal Control over Financial Reporting,”
led our management to determine that restatements were required for our
financial statements for the three month periods ended March 31, 2009, June 30,
2009 and September 30, 2009. As a result of the foregoing and additional
comments received from the SEC, on June 18, 2010, management determined that a
material weakness existed with respect to our reporting of complex, non-routine
transactions. This weakness was a result of our incorrect interpretation of
the guidance in ASC 815-40, “Derivative and Hedging – Contracts
in an Entity’s own Equity”, and incorrect conclusion regarding its
application, which required the restatement of our financial statements as of
and for the three months ended March 31, 2009, June 30, 2009, and September 30,
2009.
As result
of our remediation of the material weakness identified with respect to
our reporting of non-routine complex transactions, our chief executive officer
and principle accounting officer have concluded that, as of September 30, 2010,
our disclosure controls and procedures were effective to ensure that the
information required to be disclosed by us in the reports that we file or submit
under the Exchange Act was recorded, processed, summarized and reported within
the time periods specified in the SEC’s rules and forms and that such
information required to be disclosed is accumulated and communicated to
management, including our chief executive officer and principle accounting
officer, to allow timely decisions regarding required disclosures.
Changes
in Internal Control Over Financial Reporting
During
the three months ended September 30, 2010, to remediate the weakness in our
disclosure controls and procedures, we hired third party consultants to assist
us in identifying and analyzing complex non-routine transactions and with
valuing and determining the appropriate accounting treatment for any such
complex non-routine transactions. These are the only changes which have
materially affected, or are reasonably likely to materially affect, our internal
control over financial reporting.
59
PART
II - OTHER INFORMATION
Item
1. Legal Proceedings.
On
September 4, 2009, the SEC issued a formal order of investigation relating to
certain of our accounting, record-keeping and disclosure
practices. At such
time, we received document and testimonial subpoenas from the SEC and have
complied with those requests for information. In September 2010, we
received a supplemental document subpoena from the SEC. To date, we have
produced documents and remain in the process of evaluating the supplemental
request and whether additional productions are appropriate.
Item
1A. Risk Factors.
We are dependent
on a limited number of customers for a significant portion of our revenues and
accounts receivable and this dependence is likely to
continue.
We have
been dependent on a limited number of customers for a significant portion of our
revenue. For the nine months ended September 30, 2010, no customer
accounted for more than 10% of the Company’s total revenues. For the nine
months ended September 30, 2009, Harbin Shiji Baolong and Shanxi Xintai
accounted for 14% and 13% respectively of sales revenues. Dependence
on a few customers could make it difficult to negotiate attractive prices for
our products and could expose us to the risk of substantial losses if any such
customer stops purchasing our products. During the third quarter of
2010, two of our largest customers terminated their business relationships with
us. As a result, we expect declines in our revenues and income for
the remainder of 2010, consistent with those experienced in the three month
period ended September 30, 2010. If we are unable to replace these
customers our results of operations will be materially adversely
affected.
We expect
that a limited number of customers will continue to contribute to a significant
portion of our sales in the near future. Our ability to maintain close
relationships with these top customers is essential to the growth and
profitability of our business. If we fail to sell our products
to our other large customers in any particular period, or
if other large customers purchase fewer of our products, defer orders or
fail to place additional orders with us, or if we fail to develop additional
major customers, our revenue would likely decline and our results of operations
would be adversely affected.
In
addition, our accounts receivable are concentrated among a small number of our
customers. At September 30, 2010, no customer accounted for 10%
or more of the Company’s accounts receivable. At September 30, 2009, Harbin
Shiji Baolong accounted for 25% of accounts receivable. If any our customers
fail to pay us on a timely basis, or do not pay us at all, our business, cash
flow, financial condition and results of operations may be materially and
adversely affected.
We
are the subject of a formal SEC order of investigation which, if not favorably
resolved, could have material adverse consequences to us.
On
September 4, 2009, the SEC issued a formal order of investigation relating to,
among other things, certain of our accounting, record-keeping and disclosure
practices. At such
time, we received document and testimonial subpoenas from the SEC and have
complied with those requests for information. In September 2010, we
received a supplemental document subpoena from the SEC. To date, we have
produced documents and remain in the process of evaluating the supplemental
request and whether additional productions are appropriate. We
cannot assure you that we will be able to resolve this investigation favorably,
or that we will not be materially adversely effected by this
investigation or its outcome.
60
Item 2. Unregistered Sales of Equity
Securities and Use of Proceeds.
In the
three month period ended September 30, 2010, we did not engage in any
unregistered sales of equity securities.
Item
3. Defaults Upon Senior Securities.
In the
three month period ended September 30, 2010, we did not default upon any senior
securities.
Item
4. Removed and Reserved.
Item
5. Other Information.
None.
Item
6. Exhibits
Exhibit No.
|
|
Description of Exhibit
|
31.1
|
Certification
of Principal Executive Officer pursuant to Rule 13a-14 and Rule 15d-14(a),
promulgated under the Securities and Exchange Act of 1934, as
amended*
|
|
31.2
|
Certification
of Principal Financial and Accounting Officer pursuant to Rule 13a-14 and
Rule 15d-14(a), promulgated under the Securities and Exchange Act of 1934,
as amended*
|
|
32.1
|
Certification
pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002 (Principal Executive
Officer)*
|
|
32.2
|
Certification
pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002 (Principal Financial and Accounting
Officer)*
|
* Filed
herewith
61
SIGNATURES
Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
CHINA
SKY ONE MEDICAL, INC.
|
||
Dated:
November 8, 2010
|
By:
|
/s/ Liu Yan-qing |
Liu
Yan-qing
|
||
Chairman,
Chief Executive Officer and President
|
||
Dated:
November 8, 2010
|
By:
|
/s/ Zhang Yu-kun |
Zhang
Yu-kun
|
||
Chief
Accounting
Officer
|
62