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EX-32.2 - EX-32.2 - EMERALD DAIRY INCv218772_ex32-2.htm
EX-14.1 - EX-14.1 - EMERALD DAIRY INCv218772_ex14-1.htm
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K
 
(Mark One)

x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 
For the fiscal year ended:  
 
December 31, 2010
 
or
 
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 
For the transition period from _____________________ to _____________________ 
 
 
Commission file number:  
000-52174
   
 
EMERALD DAIRY INC.
(Exact name of registrant as specified in its charter)

Nevada
 
80-0137632
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
     
11990 Market Street, Suite 205
Reston, Virginia
 
 
20190
(Address of principal executive offices)
 
(Zip Code)
 
Registrant’s telephone number, including area code: (703) 867-9247                                      
 
Securities registered pursuant to Section 12(b) of the Act:
 
   
Title of each class
 
Name of each exchange on which registered
None
 
Not Applicable
 
Securities registered pursuant to Section 12(g) of the Act:
 
Common Stock
(Title of Class)

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

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
¨ Yes      x No

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

Indicate by check mark whether the registrant 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.
¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer ¨
Accelerated filer o
   
Non-accelerated filer ¨ (do not check if a smaller reporting company)
Smaller reporting company x

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

As of June 30, 2010, the aggregate market value of the voting and non-voting common equity held by non-affiliates was approximately $27,784,647, based on the last closing price of $1.38 per share, as quoted on the Over-the-Counter Bulletin Board maintained by the Financial Industry Regulatory Authority.

As of April 13, 2011, the registrant had 34,207,379 shares of common stock issued and outstanding (not including an additional 1,944,444 shares of common stock currently being held in treasury).

DOCUMENTS INCORPORATED BY REFERENCE

None

 
 

 

EMERALD DAIRY INC.

FORM 10-K

TABLE OF CONTENTS

     
PAGE
PART I
     
       
Item 1.
 
Business
2
Item 1A.
 
Risk Factors
16
Item 1B.
 
Unresolved Staff Comments
29
Item 2.
 
Properties
29
Item 3.
 
Legal Proceedings
30
Item 4.
 
(Removed and Reserved)
30
       
PART II
     
       
Item 5.
 
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
31
Item 6.
 
Selected Financial Data
32
Item 7.
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations
33
Item 7A.
 
Quantitative and Qualitative Disclosures About Market Risk
50
Item 8.
 
Financial Statements and Supplementary Data
50
Item 9.
 
Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
51
Item 9A.
 
Controls and Procedures
51
Item 9B.
 
Other Information
55
       
PART III
     
       
Item 10.
 
Directors, Executive Officers and Corporate Governance
56
Item 11.
 
Executive Compensation
59
Item 12.
 
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
65
Item 13.
 
Certain Relationships and Related Transactions, and Director Independence
68
Item 14.
 
Principal Accounting Fees and Services
69
Item 15.
 
Exhibits, Financial Statement Schedules
70
       
Signatures
73
 
 
- i -

 

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K, contains certain “forward-looking statements” within the meaning of Section 27A of the Securities Act, and Section 21E of the Exchange Act.  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.

These forward-looking statements are based on our current expectations.  They include, among other things, statements relating to:

·           future sales and financings;

·           the future development of our business;

·           our ability to execute our business strategy;

·           projected expenditures; and

·           the market for our products.

You can identify forward-looking statements by terminology such as “may,” “will,” “should,” “could,” “expects,” ‘intends,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of these terms or other comparable terminology.  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 and such statements speak only as of the date they were made.  Actual events or results may differ materially from those suggested by these forward-looking statements.  All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these cautionary factors and to others contained throughout this report.  We are under no duty to update any of the forward-looking statements after the date of this report or to conform these statements to actual results, except as otherwise required by law.

Although it is not possible to create a comprehensive list of all factors that may cause actual results to differ from the results expressed or implied by our forward-looking statements or that may affect our future results, some of these factors are set forth under “Risk Factors” discussed in Part 1, Item 1A of this Annual Report on Form 10-K.  We do not intend to update publicly any forward-looking statement contained herein to reflect any change our expectations with regard thereto, or any change in events, conditions or circumstances on which any such statement is based.

Unless the context otherwise requires, the terms “the Company,” “we,” “us” and “our” refer to Emerald Dairy Inc., together with our consolidated subsidiaries.

 
- 1 -

 

PART I

Item 1.  Business.

Company Background

We are engaged, through our China-based indirect subsidiaries (described below) in the manufacture and sale of milk powder, soybean powder and rice powder in the People’s Republic of China (the “PRC”).

Our predecessor filer, Micro-Tech Identification Systems, Inc. (“Micro-Tech”), was incorporated pursuant to the laws of the State of Nevada on September 24, 1986. For several years prior to the Reverse Merger (described below), Micro-Tech was a “shell company,” as defined by Rule 405 of the Securities Act of 1933, as amended (the “Securities Act”), and its primary business operations involved seeking the acquisition of assets, property, or businesses that would be beneficial to it and its shareholders.

On October 9, 2007, American International Dairy Holding Co., Inc. (“AIDH”), a Nevada corporation, became a wholly-owned subsidiary of Micro-Tech, when it merged with Micro-Tech’s wholly-owned subsidiary, which was organized for that purpose (the “Reverse Merger”). Immediately following the Reverse Merger, Micro-Tech succeeded to the business of AIDH as its sole line of business, and changed its name to Amnutria Dairy Inc.  On January 25, 2008, we changed our name from Amnutria Dairy Inc. to Emerald Dairy Inc.

AIDH was organized pursuant to the laws of the State of Nevada on April 18, 2005, for the purpose of acquiring the stock of Heilongjiang Xing An Ling Dairy, Co. Limited (“XAL”), a company formed on September 8, 2003 pursuant to the laws of the PRC.  On May 30, 2005, AIDH acquired XAL. This transaction was treated as a recapitalization of XAL for financial reporting purposes. The effect of this recapitalization was rolled back to the inception of XAL for financial reporting purposes.

Prior to September 23, 2006, XAL owned approximately 57.7% of Heilongjiang Beian Nongken Changxing Lvbao Dairy Limited Liability Company, a PRC company (“LvBao”), with the remaining balance being held by AIDH’s sole shareholder. On September 23, 2006, the remaining 42.3% ownership in LvBao was transferred to XAL and was treated as an additional capital contribution. The effect of this contribution by the sole shareholder was rolled back to September 8, 2003 for financial reporting purposes.

On May 22, 2008, AIDH formed a new wholly-owned subsidiary, Hailun Xinganling Dairy Co., Ltd. (“HXD”), under the laws of the PRC.

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

 
·
XAL handles our promotion, sales and administrative functions;
 
 
·
LvBao handles production of our products at our production facility located in Beian City, Heilongjiang Province, PRC; and
 
 
·
HXD handles production of our products at our production facility located in Hailun City, Heilongjiang Province, PRC.
 
 
- 2 -

 

Our U.S. offices are located at 11990 Market Street, Suite 205, Reston, Virginia 20190, telephone number (703) 867-9247.  Our corporate headquarters are located at 10 Huashan-lu, Xiangfang-qu, 9th Floor, Wanda Building, Harbin City, Heilongjiang Province, PRC 150001.
 
Below is a chart depicting our corporate organization:
 

Industry

The Chinese government has recognized that the dairy industry is not only crucial to reform the structure of agriculture in the country and increase the income of farmers, but also that it is important to improve the diet, health, and overall welfare of the Chinese people.  In recent years, milk and dairy products have gradually become an accepted daily necessity in the life of Chinese people.  As a result, the dairy market is one of the fastest growing markets in the PRC, growing at a rate of 14% per year over the past six years according to the National Bureau of Statistics of China.
 
 
- 3 -

 

Products

We are a producer of milk powder, soybean powder and rice powder in the PRC.  Through our network of over 1,200 salespeople, our products are distributed throughout 20 provinces in Mainland China, and sold in over 6,500 retail outlets.

Our 30 products are marketed under two brands:

 
·
“Xing An Ling,” which is designed for high-end customers; and
 
 
·
“Yi Bai,” which is designed for middle and low-end customers.
 
We also produce milk powder products on a contract basis for third parties, which then resell such products under their own brand names (hereinafter referred to as “subcontracting”).

Our total sales were approximately $55.3 million, $44.7 million and $44.3 million in the fiscal years ended December 31, 2010, 2009 and 2008, respectively.  Milk powder sales, including subcontracting, accounted for 94.4%, 94.4% and 95.5% of our total sales in the fiscal years ended December 31, 2010, 2009 and 2008, respectively.  Soybean powder sales accounted for 2.6%, 2.6% and 2.0% of total sales in the fiscal years ended December 31, 2010, 2009 and 2008, respectively.  Rice powder sales accounted for 3.0%, 3.0% and 2.5% of total sales in the fiscal years ended December 31, 2010, 2009 and 2008, respectively.  No single customer accounted for more than 5% of our total sales in the fiscal years ended December 31, 2010, 2009 and 2008.

Milk Powder Products

We target one of the most attractive segments in the dairy market - milk powder.  We have milk powder products specifically geared towards different age groups and demographics, as follows:

 
·
Formula milk powder for infants aged 0-6 months old - Specifically designed to provide babies with necessary nutrients such as calcium, selenium, bioactive substance, and more than 20 vitamins and minerals essential for an infant’s growth.
 
 
·
Formula milk powder for babies 6-12 months old - Specifically designed to help with the development of the brain, intestines, and body’s immunity.
 
 
·
Formula milk powder for young children from 1-3 years old - Provides children with comprehensive nutritional support at the critical period of their brains’ development, and, with nucleotide contents close to breast milk’s level, to help boost children’s immunity.
 
 
·
Formula for 3-7 years old pre-schoolers - Geared toward children in the growth acceleration period, when breast milk or infant food is gradually substituted with adult foods.
 
 
·
Multi-dimensional formula for pregnant women and breast-feeding mothers - Designed for pregnant women who need to supplement themselves with maternal and infant nutrition needed to ensure the health of both mother and infant.
 
 
·
High calcium milk powder for those 7-22 years old - Designed for the years one spends as a student, it meets the daily nourishment supply standard set by the Chinese Nourishment Academic Association.
 
 
- 4 -

 

 
·
Zinc, Ferrum and Calcium milk powder for the whole family - Produced in accordance with scientific processes and test standards to supply the body with much needed calcium, ferrum and zinc.
 
 
·
High calcium and sugar-free milk powder for the middle-aged and old-aged - Based on the daily dietary nutrient supply standards of the middle-aged and the physiological characteristics of the elderly, as recommended by the Chinese Nutrition Institute.
 
 
·
Low fat and high calcium milk powder for women - This product was developed in accordance with a woman’s physiological characteristics and nutritional needs, to keep woman body fit and healthy.
 
In February 2008, we obtained organic label certification from Guangdong Zhongjian Certification Co., Ltd. We recently began commercializing an organic product line.
 
Soy Powder Products
 
We began selling soybean powder products in fiscal 2006 as a substitute for milk powder, for consumers who do not like milk powder, or are allergic to milk powder.  We began as a reseller of soybean powder products in fiscal 2006, but began producing soybean powder in-house in fiscal 2007.

Rice Powder Products

We began selling rice powder products in fiscal 2006 as a substitute for milk powder.  Prior to October 2007, we used a third party to produce rice powder products, which were then resold by us under the “Xing An Ling” brand name.  Commencing in October 2007, we began producing rice powder in-house.

Production, Supply and Distribution

Production

We believe that a lack of adequate production capacity had been a significant impediment to our ability to increase our revenue in recent years.  Production capacity at our facility in Beian City reached approximately 7,000 tons in 2007, with annual revenue of approximately $29.6 million and net income of approximately $3.6 million. In 2008, by adding a third shift to the existing two shifts working schedule at our facility in Beian City, our production capacity reached approximately 9,000 tons, with revenue of approximately $44.3 million and net income of approximately $2.3 million.  In 2009, while our new production facility was being constructed in Hailun City, our annual production capacity continued at approximately 9,000 tons, with revenue of approximately $44.7 million and net income of approximately $4.2 million.

In November 2010, we commenced production at our new production facility in Hailun City.  This new facility currently has one production line, which has the capacity to produce over 9,000 tons of milk powder annually, giving us a total annual production capacity of over 18,000 tons.  In 2010, we had revenue of approximately $55.3 million and net income of approximately $3.2 million.  A second production line can be added at this new facility, which, when completed, would enable us to produce in excess of an additional 9,000 tons of milk powder per year. Although there can be no assurance that we will add a second production line to our new facility, we currently intend to do so. If we were to add a second production line at this new facility it would enable us to produce over 9,000 additional tons of milk powder per year, giving us a total annual production capacity of over 27,000 tons of milk powder.
 
 
- 5 -

 

Local farmers we purchase milk from deposit fresh milk at the third-party milking stations we utilize. The fresh milk is stored in refrigerated tanks, and then trucked by the supplier’s trucking service to one of our production facilities. When the refrigerated fresh milk arrives at our production facility a sample is taken to be sure it meets our product standards.  If the sample passes inspection it goes to production, where the necessary ingredients are added to the fresh milk to make formula.  If the sample fails inspection, it is rejected.  The formula passes through a high pressure gauge, which sprays the formula out in a fine spray.  A high temperature fan instantly dries the formula turning it into milk powder.  The milk powder is first placed in large containers, and then packaged into customer friendly bags or tins. After it has been packaged, the finished product gets trucked to retail outlets for sale.  Since we are located close to the milking stations, the entire production process can be completed in approximately 30-35 hours.  The time it takes to go from processing the milk to retail sale of the finished product is only an average of 45 days.  Therefore, we are able to keep our warehousing costs low.

We strictly supervise resources allotment, purchasing inspection, raw materials check, sales, and customer service, and believe we have established an effective quality control process.  Five approved dairy experts supervise the whole production process to ensure that the products comply with national standards. These experts are selected by us based on their education and experience in the industry.  We have established an advanced bacteria-free laboratory to asses our products throughout the production process.  We established a professional sanitation, quality control and quality management group to make the production comply with national food and sanitation regulations.  We also established sanitation, quality, operation, management systems to improve the production and enforce our workers’ awareness of sanitation and quality.  Each of our workers needs to go through a physical check-up periodically and obtain a clean “health certificate.”

In 2004, we adopted a method to that enables us to assess our inventory each month, allowing us to control our inventories in real time.  As a result, we believe our inventories and the efficiency of our supply chain are at the appropriate levels for our business.

We established a cost-control center, and formed cost-control systems on working procedure and on each cost-control point.  With an established original date for each batch of our product on record, we request that each department control production expenses and time, and take responsibility.  Through cost calculation, we make quantity difference analysis and price difference analysis, and compare and analyze each month’s cost budgets with the prior month’s, so we can gradually cut costs.

Our packaging facility is designed based on the GMP 600,000 level standard of the pharmacy industry.  “GMP” refers to the Good Manufacturing Practice Regulations promulgated by the United States Food and Drug Administration under the authority of the Federal Food, Drug, and Cosmetic Act.  GMP regulations address issues including recordkeeping, personnel qualifications, sanitation, cleanliness, equipment verification, process validation, and complaint handling.  Management believes our laboratory, which is 300 square meters in size, is constructed in accordance with GMP standards.

In addition, the facility complies with all HACCP standards.  “HACCP,” or Hazard Analysis and Critical Central Point (HACCP) (ISO 22000 Food Safety Management System), is a process control system designed to identify and prevent microbial and other hazards in food production and entire food chain.  HACCP includes steps designed to prevent problems before they occur and to correct deviations through a systematic way as soon as they are detected.  As a result, we believe we have achieved an ideal environment for productions and packaging.  Our automated intelligent program-controlled packaging line, which consists of some of the most advanced packaging equipment in the Chinese dairy industry, is capable of tinned milk powder packaging.  It effectively reduces the touch of workers and avoids second-time contamination.

In February 2008, we obtained organic label certification from Guangdong Zhongjian Certification Co., Ltd.  In June 2009, we started to develop an organic baby formula line for the high-end market. To meet the standards for an organic product, we were required to maintain a herd of 527 organic-fed cows that were closely monitored by certification authorities to ensure they met the rigid organic farming standards. After 16 months of monitoring and subsequent product testing, our organic farming operation and production line were approved by China's Guangdong Zhongjiang Certification Co.  We now use the “China Organic Product” seal on our organic formula packaging and in associated marketing materials.
 
 
- 6 -

 

Supply

Our supply of raw milk for both of our production facilities comes from farms along the Beian Long River in Heilongjiang Province, located in the southwest of Xiaoing’anling, 47 degrees north latitude.  The land sits on one of the only three black plates in the world, giving it the unique soil, vegetation, climate and ecological environment best for the growth of cows.  As a result, it is recognized as one of the premium cow raising belts internationally.  Beian’s grassland area amounts to 285 acres, raising more than 41,000 cows, with the milk production of 72,000 tons annually.  By using such high-quality fresh milk as a raw material, we are able to maintain our product as a natural, clean and green food.

We currently have signed contracts with over 3,700 local farmers, giving us access to the milk of approximately 41,000 cows. We expect that, as our output increases at our new production facility in Hailun City, we will need to increase the number of local farmers we contract with.  Pursuant to the standard raw milk purchase agreements we enter into with local farmers:

 
·
The term of raw milk purchase agreements is one year.
 
 
·
Farmers have the option to discontinue the agreements any time during the one-year term by giving one-week notice.
 
 
·
We are obligated to purchase from farmers the whole raw milk meeting certain quality standards.
 
 
·
The purchase price of raw milk is approximately $0.17 per lb., which fluctuates depending on the market price of raw milk.
 
 
·
If there is a change in price, we must notify farmers within one week, or risk losing them as suppliers.
 
The terms set forth above are the standard terms within the Chinese dairy industry, which is regulated by the Office of Milk Source (a department of city government).  The price of raw milk is market driven and is most-closely linked to the Heilongjiang Province regional market.  The price of raw milk is also closely monitored by the Office of Milk Source.  We settle our accounts with the farmers once a month.

The entire milking process is done automatically, without any human contact.  The farmers raise their own cattle, however, we share certain know how and technical support with the farmers to help them increase the quality and capacity of their milk.  This model not only enhances the milk farmers’ enthusiasm and breeding capability, and stimulates local economic development, but it also assures the milk volume, quality and the stability of the supply.  In addition, by working closely with the local farmers in this way, we are better able to track each cow’s health and milking capacity.

Since no other large-scaled dairy enterprise is located nearby, our milk source is relatively plentiful and readily available.

We have approximately 100 cows of our own, to meet a small amount of the total supply.  However, these cows are mainly used to provide scientific and quality service for dairy farmers including disease control and treatment or other experiments. We provide certain services to the local farmers including help with improving farming methods, information and assistance with increasing milk yield, appointing experts to lectures, sharing of scientific knowledge, and strengthening disease surveillance and control.
 
 
- 7 -

 

We currently utilize 66 milking stations, all of which are owned and operated by third parties.  We pay market price for using the milking stations.  For administrative purposes, we group these milking stations into several service districts. We expect that as our output increases at our new production facility in Hailun City we will need to increase the number of milking stations we utilize.

The major raw materials we use to produce our products include fresh milk, whey, degrease powder, vegetable protein, and vegetable oil esters.  After years of development, we have formed steady, complementary and cooperative relationships with our suppliers.  As our sales increase, more capital will be obtained to strengthen our negotiation leverage, allowing us to acquire less expensive and quality raw materials more easily.  The procurement of raw materials is mainly done through bidding and other forms of network transactions.

Our product packages, packaging boxes, packing cans, and other packaging materials are also supplied by parties with which we have long-term relationships.

We have found it relatively easy to purchase all major raw materials we need from these suppliers, and have been able to sell all the products we have produced.  We believe the suppliers of our raw materials and packaging materials will be able to keep up with our growth for the foreseeable future.

In 2010 and 2009, Yu Ya Wei Ye Trading Company, which supplies us with whey used in production of our products, supplied us with approximately 10.1% and 11.0% of our raw materials, respectively.  In 2008, no single supplier accounted for more than 10% of our raw materials.

Distribution

We have a sales network consisting of over 1,200 people, across 20 provinces in the PRC.  Orders are initiated by sales people depending on their customers’ needs, and are approved by their province (regional) manager.  Regional managers combine orders from various sales teams and send orders to headquarters.  After confirmation of the orders from the regional managers, headquarters gives instructions to third party trucking companies to distribute products, according to the combined orders, to regional hub offices.  We distribute our products from our headquarters to distributors in large combined orders based on region, as compiled by the regional manager.

We use three independent trucking contractors to distribute our products to the 20 provinces in the PRC in which we sell our products. We selected these trucking companies based on cost and efficiency.  There are many trucking companies available so that, if necessary, any of the independent trucking contractors we currently use could easily be replaced.

Railway transportation is also a major means for the distribution of our products. It is usually used when the products need to travel a long distance, because of the relatively low cost.  However, its speed is slower than that of the trucks, since the products first need to get to Beian Station, before being distributed to their ultimate destination.

Market Opportunity

There are a total of 30 provinces in mainland China.  Our products are generally sold in 20 of the provinces, through our 1,200-plus person sales network.  Our sales are spread out, with no single province accounting for more than 10% of our total sales.  The 20 provinces in which we sell our products are the major provinces along the Pacific Ocean and in central China.  The 10 provinces in which our products are not sold, are those where the competition is too intense, or the potential customers are either too poor or too disbursed to make it economically feasible.
 
 
- 8 -

 

The PRC’s population of 1.3 billion offers a huge market for the developing dairy industry in the PRC. The dairy industry is increasing much faster than the growth of the PRC’s gross domestic product (GDP).  According to the statistics from the Food and Agriculture Organization of the United Nations (FAO), total Chinese milk production is the seventh largest in the world.  The dairy market is one of the fastest growing markets in the PRC, growing at a rate of 14% per year over the past six years, according to the National Bureau of Statistics of China.  It is widely predicted that the dairy industry in the PRC will continue at a growth rate of 15% per year.  The “11th Five Years Plan” urged that the average annual dairy consumption should reach 10 kg per person and should reach 16 kg in 2015.

The average consumption of dairy per person in the PRC is much lower than the world average.  As a result, we believe the Chinese dairy market has considerable potential for growth, especially if the Chinese economy continues to experience significant growth.

According to the “China Food and Nutrition Development outline (2001-2010)” approved by the Chinese State Council, the dairy industry is one of the three food industries that should be developed first.  The outline suggests that by 2010, average consumption of dairy per person should reach 16 kg, in which the average consumption of dairy per person for rural habitants and those who live in cities and towns are 32kg and 7kg, respectively.  Experts predict that the annual dairy output in the PRC will be 20 million tons and 70 million tons in 2015 and 2030, respectively. Based upon these predictions, we believe that over the next few years, the Chinese dairy industry should continue to grow at a rapid pace and the consumption of dairy will continue to increase as a result of the anticipated rise in living standards and change in consumption behavior by the average Chinese consumer.

According to the National Bureau of Statistics of the PRC, about 15 million infants are born in the PRC each year. Each 0-6 month old baby will need 27.2 kg. milk powder, for an annual total demand of 90,000 tons. Each 6-12 month old baby will need 31 kg. milk powder, for an annual total demand of 110,000 tons.  But the current supply is just 80,000-100,000 tons, leaving much room for growth.  According to the Dairy Association of China, the infant formula market in the PRC, which is the market we target, has grown even faster in recent years, at a rate of 20%-30% per year, and has surpassed Japan, becoming the second largest infant formula dairy market in the world, behind the U.S.

In mid-2008, a number of milk powder products produced within the PRC were found to contain unsafe levels of tripolycyanamide, also known as melamine, sickening thousands of infants.  This prompted the Chinese government to conduct a nationwide investigation into how the milk powder was contaminated, and caused a worldwide recall of certain milk powder products produced within the PRC.  On September 16, 2008, the PRC’s Administration of Quality Supervision, Inspection and Quarantine (“AQSIQ”) revealed that it had tested samples from 175 dairy manufacturers, and published a list of 22 companies whose products contained melamine.  We passed the emergency inspection and were not included on AQSIQ’s list.  We believe the contraction in the Chinese milk powder industry caused by this crisis has lead to increased demand for our products.  However, until we recently completed construction and equipping of a first production line at our new production facility in Hailun City, we were not able to increase our supply to meet this demand.

Company Strategy

As part of our plan to pursue the market opportunities discussed above, we intend to enact the following strategies:
 
 
- 9 -

 

Production Strategy

Through a combination of internal growth in production capacity and strategic acquisitions we believe we will be capable of producing over 27,000 tons of milk powder annually by the end of fiscal 2012.  Our growth strategy for the next three years will be primarily focused on internal growth by expanding production capacity and strengthening sales efforts.

As a step toward implementing this strategy, in November 2010, we commenced production at our new production facility in Hailun City, Heilongjiang Province, PRC. Currently, this new facility has one production line, with the capacity to produce over 9,000 tons of milk powder annually. This first phase of this project has cost us an aggregate of approximately $22.0 million, including land use rights, construction expenses and equipment costs. A second production line can be added at this new facility, which, when completed, would enable us to produce in excess of an additional 9,000 tons of milk powder per year. Although there can be no assurance that we will add a second production line to our new facility, we currently intend to do so.  If we were to add a second production line at this new facility it would enable us to produce over 9,000 additional tons of milk powder per year, giving us a total annual production capacity of over 27,000 tons of milk powder. We expect the cost to add a second production line at our Hailun City production facility to be approximately $15.0 million. We plan to fund the second production line with a combination of retained earnings and, to the extent necessary, funds raised from the capital market through private or public equity offerings, private or public debt offerings and/or equipment lease transactions. There can be no assurance that that any additional financing will become available to us, and if available, on terms acceptable to us.

In addition, management will consider making strategic acquisitions if opportunities become available.  We have no current agreements or plans for proposed acquisitions, and there can be no assurance we will consummate any acquisitions in the future.

Prior to October 2007, we used a third party to produce rice powder products which were then resold under the “Xing An Ling” brand name.  Commencing in October 2007, we began producing rice powder in-house.  Rice powder products accounted for approximately 3.0% of our total revenue in each of 2010 and 2009.  We expect that rice powder products will continue to comprise approximately 3.0% of our total sales.

Similarly, we began reselling soy powder products in fiscal 2006, and producing soy powder in-house in fiscal 2007.  Soy powder products accounted for approximately 2.6% of our total revenue in each of 2010 and 2009.  We expect that soy milk powder products will continue to comprise approximately 2.6% of our total sales.

In February 2008, we obtained organic label certification from Guangdong Zhongjian Certification Co., Ltd.  In June 2009, we started to develop an organic baby formula line for the high-end market. To meet the standards for an organic product, we were required to maintain a herd of 527 organic-fed cows that were closely monitored by certification authorities to ensure they met the rigid organic farming standards.  After 16 months of monitoring and subsequent product testing, our organic farming operation and production line were approved by China's Guangdong Zhongjiang Certification Co.  We recently began commercializing an organic product line.  We use the “China Organic Product” seal on our organic formula packaging and in associated marketing materials.  We believe that, similar to the growth of the organic milk market in the U.S., organic milk products will be popular in the PRC.  Over time, we believe our organic product line will help increase our revenues.

Market Strategy

Brand

In the Chinese milk powder market, positive brand image helps establish high customer recognition, strong customer loyalty, and good product reputation, which we believe are key elements to increase our sales revenue.  Therefore, we have focused on establishing a positive brand image. Our 30 products are marketed under two brands:
 
 
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·
“Xing An Ling,” which is designed for high-end customers; and
 
 
·
“Yi Bai,” which is designed for middle and low-end customers.
 
Price

In the Chinese dairy market similar products are often sold at widely differing prices.  The gap between prices of similar products could be as much as 10 times.  At present, the consumers who have the highest income often choose high-end dairy brands from foreign companies, such as Nestle, Mead Johnson, and Dumex.  Those customers who earn less tend to choose lower-price brands such as Shengyuan and Nanshan.  Historically, our products were not as popular as some of our competitors’ because they were less expensive than similar competing products and, therefore, perceived to be of a lesser quality.  To address this, our new products are aimed at middle-end and high-end infant milk powder market.

Sales Channel

We have over 1,200 people in our sales network across 20 provinces covering more than 6,500 retail outlets (i.e., supermarkets) in the PRC.  Over the past three years, no single customer accounted for 5% or more of our total sales.

There are no limitations on the geographic areas in China in which we can sell our products.  There are a total of 30 provinces in the PRC.  The 20 provinces in which we sell our products are the major provinces along the Pacific Ocean and in central China.  The 10 provinces in which our products are not sold, are those where either, we would not be able to compete due to intense competition, or the potential customers are either too poor or too disbursed to make it economically feasible.

Rather than using a wholesaler, our sales people deal directly with the retail outlets.  This business model has higher sales expenses compared to traditional business model, where a wholesaler is used.  The reason for this is that each of our sales people can cover only so many retail outlets and, therefore, we have to employ more sales people to achieve the same sales volume. On the other hand, by selling directly to retail, we can sell products at a higher margin than if we sold our products to a wholesaler.  We believe that the increased margins resulting from our direct to retail market strategy more than offsets the additional sales expense we incur by not using wholesalers.  In addition, our sales people know the customers, so they obtain better information on sales, demand, and other important factors.  We will continue to use our current business model of selling directly to the retail outlets, without use of a wholesaler, for the foreseeable future.

Promotion

We plan to:

 
·
Advertise our products on the leading TV stations in important markets, publicize product information and ideas by advertising in national or local newspapers and magazines, and use our website and webpage advertisement to attract internet users to introduce our products and business;
 
 
·
Promote our products by attending and holding exhibitions and seminars, presenting promotional items and hand out leaflets;
 
 
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·
Teach our “shopping guides,” who are generally women that give out free samples of products in supermarkets and provide information on products, about our products and how to promote our products by face to face communication and illustration to end users; and
 
 
·
Invite famous pediatricians to hold seminars on knowledge of nutrients and baby tending for pregnant women, so as to promote our brand and attract customers.
 
Currently, we spend approximately 8%-12% of total revenues on advertising and promotional efforts throughout the year.  We spent approximately $6.1 million, $4.5 million and $5.4 million on advertising and promotion in fiscal 2010, 2009 and 2008, respectively.  We currently expect to spend an aggregate of approximately $8.0 million on advertising and promotion in fiscal 2011.  The funds for advertising and promotion generally come out of our earnings.

Our English-language website is located at www.emeralddairy.com.  The English-language website went live in May 2008.  The website includes a link to our Chinese-language website.  The information on our websites does not constitute part of this report.

Human Resources Strategy

We believe employing talented people is the best competitive advantage we can have, so we strive to hire the most qualified employees at every level.  Besides seeking to attract quality employees from outside of our company, we will also continue to develop and train our own sales team.

Competition

Currently, five state-owned dairy groups control more than half of the dairy market in the PRC.  They are Mengniu (in Inner Mongolia), Yili Industrial Group (in Inner Mongolia), Bright Dairy & Food (in Shanghai), Sanyuan (in Beijing) and Wandashan (in Heilongjiang).  Over half of the top 20 dairy manufacturers have entered China.  Most of the dairy producers provide infant milk powder.  However, the high-end infant milk powder is less than one-third of the total output.  In the past, the dairy producers mainly gave discounts as the major competition tactic.  Now, however, the producers are beginning to focus on the raw milk source, brand, and sales network.

Our competitors are divided into three major categories:

 
·
Domestic large-scale producers;
 
 
·
Foreign producers; and
 
 
·
Domestic middle & small-scale producers.
 
Most of the larger players in the Chinese dairy industry have been concentrating in the first-tier cities such as Beijing and Shanghai with high end milk powder products.  We focus on penetrating less-competitive second and third tier cities.  We have a 1,200-plus person sales network across 20 provinces in China, covering more than 6,500 retail outlets.  Our closest competitors are American Dairy, Inc. and Wondersun Dairy in terms of products, price range and geographic coverage.

We believe that we have a competitive advantage over our competitors because:
 
 
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·
Our production facilities are located close to the milking stations from which we obtain fresh milk and, therefore, the entire production process can be completed in approximately 30-35 hours.  The production facilities of other multi-regional dairy enterprises are located up to two days’ drive away from the milking stations they use.  Therefore, it may take them up to four days to process their milk products.
 
 
·
Our business model of selling directly to the retail outlets, as opposed to selling to a wholesaler, allows us to sell our products at a higher margin at retail.  Our sales people know the customers, so they obtain better information on sales trends and customer demands and requirements than our competitors who sell their product to wholesalers.
 
 
·
We recently began commercializing an organic baby formula line for the high-end market.  Over the long term, we believe that, similar to the growth of the organic milk market in the U.S., organic milk products will be popular in the PRC.
 
On the other hand, we are at a competitive disadvantage because many of our current and potential competitors have longer operating histories and greater name recognition, and possess substantially greater financial, marketing and other competitive resources than we do.

Intellectual Property

We have obtained trademark registrations for the use of our tradenames “Xing An Ling” and “Yi Bai”, which have been registered with the Trademark Bureau of the State Administration for Industry and Commerce with respect to our milk powder products.  We believe our trademarks are important to the establishment of consumer recognition of our products.  However, due to uncertainties in Chinese trademark law, the protection afforded by our trademarks is uncertain and they may not provide adequate protection.  Moreover even if it is sufficient, in the event our trademarks or trade names are challenged or infringed, we may not have the financial resources to defend it against any challenge or infringement and such defense could in any event be unsuccessful.  Moreover, any events or conditions that negatively impact our trademarks could have a material adverse effect on our business, operations and finances.

Regulatory Matters

We are regulated under national, provincial and local laws in China.  The following information summarizes certain aspects of those regulations applicable to us and is qualified in its entirety by reference to all particular statutory or regulatory provisions.

Regulations at the national, province and local levels are subject to change.  To date, compliance with governmental regulations has not had a material impact on our level of capital expenditures, earnings or competitive position, but, because of the evolving nature of such regulations, we are unable to predict the impact such regulation may have in the future.

As a manufacturer and distributor of food products, we are subject to regulations of the PRC’s Agricultural Ministry.  This regulatory scheme governs the manufacture (including composition and ingredients), labeling, packaging and safety of food.  It also regulates manufacturing practices, including quality assurance programs, for foods through its current good manufacturing practices regulations, and specifies the quality standards for certain foods, including the products we sell, and prescribes the format and content of many of the products we sell, prescribes the format and content of certain nutritional information required to appear on food products labels and approves and regulates claims of health benefits of food products.
 
 
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In addition, the PRC’s Agricultural Ministry authorizes regulatory activity necessary to prevent the introduction, transmission or spread of communicable diseases.  These regulations require, for example, pasteurization of milk and milk products.  We and our products are also subject to provincial and local regulations through such measures as the licensing of dairy manufacturing facilities, enforcement of standards for our products, inspection of our facilities and regulation of our trade practices in connection with our sale of dairy products.

To date, we have received the following licenses to produce our products, which are significant for the reasons set forth below:

License
 
Issuer
 
Effective Period
 
Significance
Infant & Baby Formula Milk Powder Production Permit
 
State General Administration of Quality Supervision and Inspection and Quarantine of the People’s Republic of China
 
 
Beian Facility
April 2005 -
May 2010 (1)
 
Hailun Facility
March 2011 -
March 2014
 
Only current license holders are permitted to produce formula milk powder in the PRC.
 
             
Organic Production Certification
 
Guangdong Zhongjian Certification Co., Ltd.
 
October 2010 – October 2011
 
This certification allows us to produce and sell organic milk powder products.
 
             
ISO 22000 / HACCP Certification
 
Beijing New Century Certification Co. Ltd.
 
Beian Facility
September 2007 - September 2010 (1)
 
Hailun Facility
New issuance in process (2)
 
The ISO 22000 international standard specifies the requirements for a food safety management system. ISO 22000 integrates the principles of the Hazard Analysis and Critical Control Point (HACCP) system and application steps developed by the Codex Alimentarius Commission. Hazard analysis is the key to an effective food safety management system.
 
             
ISO 9001 Certification
 
Beijing New Century Certification Co. Ltd.
 
Beian Facility
September 2007 - September 2010 (1)
 
Hailun Facility
New issuance in process (2)
 
ISO 9000 is a family of standards for quality management systems. ISO 9000 is maintained by ISO, the International Organization for Standardization and is administered by accreditation and certification bodies. ISO 9001 (which is one of the standards in the ISO 9000 family) includes a set of procedures that cover the establishment and monitoring all key processes in a business.  Only a company or organization that has been independently audited and certified to be in conformance with ISO 9001 may publicly state that it is “ISO 9001 certified.”
             
Certificate of Conformity of Quality System Certification
 
Standardization Administration of the People's Republic of China
 
Beian Facility
September 2005 - September 2010 (1)
 
Hailun Facility
New issuance in process (2)
 
This certification is only given to companies that meet an international standard of quality control and production. Consumers in the PRC give a more positive reception to products that meet international standards.
 
 
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(1)
We have applied for renewal of these permits and certifications.  We have no reason to believe these permits and certifications will not be renewed.
 
 
(2)
We have applied for these certifications for our new production facility.  We have no reason to believe these certifications will not be issued.
 
Employees
 
As of the date hereof, we have 1,449 employees. Of these, 1,191 are in sales, 214 are in manufacturing and 43 are in management and administration.  None of our employees are subject to a collective bargaining agreement.  We consider our relationship with our employees to be good.

Available Information

We file various reports with the Securities and Exchange Commission (“SEC”), including Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, which are available though the SEC's electronic data gathering, analysis and retrieval system (“EDGAR”) by accessing the SEC's home page (http://www.sec.gov).  The documents are also available to be read or copied at the SEC’s Public Reference Room located at 100 F Street, NE, Washington, D.C., 20549.  Information on the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330.

We also make available free of charge through our website (www.emeralddairy.com) our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and, if applicable, amendments to those reports filed or furnished pursuant to the Securities Exchange Act of 1934, as amended (the “Exchange Act”) as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.

 
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Item 1A.  Risk Factors.

Risk Factors

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 risk factors before deciding to purchase or sell our securities.

Risks Related to Our Business
 
Unstable market conditions may have serious adverse consequences on our business.
 
In 2008 and 2009, general worldwide economic conditions declined resulting in a more volatile and costly business climate.  Although all of our business operations are currently conducted in the PRC, our general business strategy, as well as our results of operations and financial condition, may be adversely affected by unpredictable and unstable market conditions.  If the current equity and credit markets deteriorate, or do not improve from current levels, it may make it difficult, if not impossible, for us to obtain debt or equity financing on acceptable terms at a time when we wish to do so.  While we believe we have adequate capital resources to meet current working capital requirements for the next twelve months, a radical economic downturn or increase in our expenses could require additional financing on less than attractive rates or on terms that are excessively dilutive to existing stockholders.  In addition, we will need to raise funds to equip the second production line at our new facility in Hailun City.  Therefore, failure to secure any necessary financing in a timely manner and on favorable terms could have a material adverse effect on our growth strategy, financial performance and stock price and could require us to delay or abandon our expansion plans.  These factors may have a material adverse effect on our results of operations, financial condition or cash flows and could cause the price of our common stock to decline significantly.
 
Our products may not achieve or maintain market acceptance.
 
We market our products in the PRC.  Dairy product consumption in the PRC has historically been lower than in many other countries in the world.  Growing interest in milk products in the PRC is a relatively recent phenomenon which makes the market for our products less predictable.  Consumers may lose interest in our products.  As a result, achieving and maintaining market acceptance for our products will require substantial marketing efforts and the expenditure of significant funds to encourage dairy consumption in general, and the purchase of our products in particular.  There is substantial risk that the market may not accept or be receptive to our products.  Market acceptance of our current and future products will depend, in large part, upon our ability to inform potential customers that the distinctive characteristics of our products make them superior to competitive products and justify their pricing.  Our current and future products may not be accepted by consumers or able to compete effectively against other premium or non-premium dairy products.  Lack of market acceptance would limit our revenues and profitability.
 
In addition, we market our products, in part, as a healthy and good source of nutrition, however, periodically, medical and other studies are released and announcements by medical and other groups are made which raise concerns over the healthfulness of cow’s milk in the human diet.  An unfavorable study or medical finding could erode the popularity of milk in the Chinese diet and negatively affect the marketing of our product causing sales and revenues to decline.
 
 
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Contamination of milk powder products produced in the PRC could result in negative publicity and have a material adverse effect on our business.
 
In mid-2008, a number of milk powder products produced within the PRC were found to contain unsafe levels of tripolycyanamide, also known as melamine, sickening thousands of infants.  This prompted the Chinese government to conduct a nationwide investigation into how the milk powder was contaminated, and caused a worldwide recall of certain milk powder products produced within the PRC. On September 16, 2008, the PRC’s AQSIQ revealed that it had tested samples from 175 dairy manufacturers, and published a list of 22 companies whose products contained melamine.  We passed the emergency inspection and were not included on AQSIQ’s list.  Although we believe that the inevitable contraction in the Chinese milk powder industry caused by this crisis may lead to increased demand for our products, we can not be certain that the illnesses caused by contamination in the milk powder industry, whether or not related to our products, will not lead to a sustained decrease in demand for milk powder products produced within the PRC, thereby having a material adverse effect on our business.
 
As we increase the scale of our operations, we may be unable to maintain the level of quality we currently attain by producing our products in small batches.  If quality of our product declines, our sales may decline.
 
Our products are manufactured in small batches.  If we are able to increase our sales, we will be required to increase our production.  Increased production levels may force us to modify our current manufacturing methods in order to meet demand.  We may be unable to maintain the quality of our dairy products at increased levels of production.  If quality declines, consumers may not wish to purchase our products and a decline in the quality of our products could damage our reputation, business, operations and finances.
 
We depend on supplies of raw milk and other raw materials, a shortage of which could result in reduced production and sales revenues and/or increased production costs.
 
Raw milk is the primary raw material we use to produce our products.  As we pursue our growth strategy, we expect raw milk demands to continue to grow.  Because we own only a small number of dairy cows, we depend on dairy farms and dairy farmers for our supply of fresh milk.  We expect that we will need to continue to increase the number of dairy farmers from which we source raw milk.  If we are not able to renew our contracts with suppliers or find new suppliers to provide raw milk we will not be able to meet our production goals and our sales revenues will fall.  If we are forced to expand our sources for raw milk, it may be more and more difficult for us to maintain our quality control over the handling of the product in our supply and manufacturing chain.  A decrease in the quality of our raw materials would cause a decrease in the quality of our products and could damage our reputation and cause sales to decrease.
 
Raw milk production is, in turn, influenced by a number of factors that are beyond our control including, but not limited to, the following:
 
 
·
seasonal factors: dairy cows generally produce more milk in temperate weather than in cold or hot weather and extended unseasonably cold or hot weather could lead to lower than expected production;
 
 
·
environmental factors: the volume and quality of milk produced by dairy cows is closely linked to the quality of the nourishment provided by the environment around them, and, therefore, if environmental factors cause the quality of nourishment to decline, milk production could decline and we may have difficulty finding sufficient raw milk; and
 
 
·
governmental agricultural and environmental policy: declines in government grants, subsidies, provision of land, technical assistance and other changes in agricultural and environmental policies may have a negative effect on the viability of individual dairy farms, and the numbers of dairy cows and quantities of milk they are able to produce.
 
 
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We also source large volumes of soy beans, rice, and other raw materials from suppliers. Interruption of or a shortage in the supply of raw milk or any of our other raw materials could result in our being unable to operate our production facilities at full capacity or, if the shortage is severe, at any production level at all, thereby leading to reduced production output and sales and reduced revenues.  In 2010 and 2009, Yu Ya Wei Ye Trading Company, which supplies us with whey used in production of our products, supplied us with approximately 10.1% and 11.0% of our raw materials, respectively.  In 2008, no single supplier accounted for more than 10% of our raw materials.
 
Even if we are able to source sufficient quantities of raw milk or our other raw materials to meet our needs, downturns in the supply of such raw materials caused by one or more of these factors could lead to increased raw material costs which we may not be able to pass on to the consumers of our products, causing our profit margins to decrease.
 
Volatility of raw milk costs makes our operating results difficult to predict, and a steep cost increase could cause our profits to diminish significantly.
 
The policy of the PRC since the mid-1990s has focused on moving the Chinese dairy industry in a more market-oriented direction. These reforms have resulted in the potential for greater price volatility relative to past periods, as prices are more responsive to the fundamental supply and demand aspects of the market. These changes in the PRC’s dairy policy could increase the risk of price volatility in the dairy industry, making our net income difficult to predict. Also, if prices are allowed to escalate sharply, our costs will rise and we may not be able to pass them on to consumers of our products, which will lead to a decrease in our profits.
 
The milk business is highly competitive and, therefore, we face substantial competition in connection with the marketing and sale of our products.
 
We face competition from non-premium milk producers distributing milk in our marketing area and other milk producers packaging their milk in glass bottles, and other special packaging, which serve portions of our marketing area. Most of our competitors are well established, have greater financial, marketing, personnel and other resources, have been in business for longer periods of time than we have, and have products that have gained wide customer acceptance in the marketplace. Our largest competitors are state-owned dairies owned by the government of the PRC. Large foreign milk companies have also entered the milk industry in the PRC. The greater financial resources of such competitors will permit them to procure retail store shelf space and to implement extensive marketing and promotional programs, both generally and in direct response to our advertising claims. The milk industry is also characterized by the frequent introduction of new products, accompanied by substantial promotional campaigns. We may be unable to compete successfully or our competitors may develop products which have superior qualities or gain wider market acceptance than ours.
 
We face the potential risk of product liability associated with food products; Lack of general liability insurance exposes us to liability risks in the event of litigation against us.
 
We sell products for human consumption, which involves risks such as product contamination or spoilage, product tampering and other adulteration of our products. We may be subject to liability if the consumption of any of our products causes injury, illness or death. In addition, we may recall products in the event of contamination or damage. A significant product liability judgment or a widespread product recall may negatively impact our profitability for a period of time depending on product availability, competitive reaction and consumer attitudes. Even if a product liability claim is unsuccessful or is not fully pursued, the negative publicity surrounding any assertion that our products caused illness or injury could adversely affect our reputation with existing and potential customers and our corporate and brand image. We would also have to incur defense costs, including attorneys’ fees, even if a claim is unsuccessful. We do not have liability insurance with respect to product liability claims. Any product liabilities claims could have a material adverse effect on its business, operating results and financial condition.
 
 
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The loss of any of our key executives could cause an interruption of our business and an increase in our expenses if we are forced to recruit a replacement. We have no key-man life insurance covering these executives.
 
We are highly dependent on the services of Yang Yong Shan, our Chairman, Chief Executive Officer and President.  He has been primarily responsible for the development and marketing of our products and the loss of his services would have a material adverse impact on our operations.  We have not applied for key-man life insurance on his life and have no current plans to do so.
 
We do not have any independent directors serving on our board of directors, which could present the potential for conflicts of interest and prevent our common stock from being listed on a national securities exchange.
 
We currently do not have any independent directors serving on our board of directors and we cannot guarantee that our board of directors will have any independent directors in the future.  In the absence of a majority of independent directors, our executive officers could establish policies and enter into transactions without independent review and approval thereof.  This could present the potential for a conflict of interest between us and our stockholders, generally, and the controlling officers, stockholders or directors.
 
In addition, since none of the directors currently on our board of would qualify as an independent director under the rules of the New York Stock Exchange, NYSE Amex Equities or The Nasdaq Stock Market, we would fail to satisfy at least one of the necessary initial listing requirements for any of these national securities exchanges.  Therefore, until we appoint a majority of independent directors to our board we expect that our common stock will continue to be listed on Over-the-Counter Bulletin Board (“OTCBB”) maintained by the Financial Industry Regulatory Authority (“FINRA”), which might make our common stock less attractive to potential investors than if it had been listed on a national securities exchange.
 
Our management has identified certain material weaknesses in our internal control over financial reporting, which if not properly remediated could result in material misstatements in our future interim and annual financial statements and have a material adverse effect on our business, financial condition and results of operations and the price of our common stock.
 
Our management is responsible for establishing and maintaining adequate internal control over financial reporting.  Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with U.S. generally accepted accounting principles.
 
As further described in “Item 9A. Controls and Procedures,” our management has identified certain material weaknesses in our internal control over financial reporting.  A material weakness, as defined in the standards established by the Public Company Accounting Oversight Board (“PCAOB”), is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis.
 
Although we are in the process of implementing initiatives aimed at addressing these material weaknesses, these initiatives may not remediate the identified material weakness.  Failure to achieve and maintain an effective internal control environment could result in us not being able to accurately report our financial results, prevent or detect fraud or provide timely and reliable financial information pursuant to the reporting obligations we have as a public company, which could have a material adverse effect on our business, financial condition and results of operations. Further, it could cause our investors to lose confidence in the financial information we report, which could adversely affect the price of our common stock.
 
 
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Ensuring that we have adequate internal financial and accounting controls and procedures in place might entail substantial costs, may take a significant period of time, and may distract our officers and employees from the operation of our business, which could adversely affect our operating results and our ability to operate our business.
 
Ensuring that we have adequate internal financial and accounting controls and procedures in place to help ensure that we can produce accurate financial statements on a timely basis is a costly and time-consuming effort that needs to be re-evaluated frequently. We became a public company on October 2007, by virtue of the Reverse Merger.  As a public company, we need to document, review, and test and, if appropriate, improve our internal controls and procedures in connection with Section 404 of the Sarbanes-Oxley Act, which requires annual management assessments of the effectiveness of our internal control over financial reporting and, in the future, will also require a report by our independent auditors on our assessment.  Both the Company and its independent auditors will be testing our internal controls in connection with the Section 404 requirements and, as part of that documentation and testing, will identify areas for further attention and improvement.
 
Implementing any appropriate changes to our internal controls might entail substantial costs in order to add personnel and modify our existing accounting systems, take a significant period of time to complete, and distract our officers and employees from the operation of our business.  These changes might not, however, be effective in maintaining the adequacy of our internal controls, and could adversely affect our operating results and our ability to operate our business.
 
We have a significant amount of debt outstanding, including promissory notes in the aggregate principal amount of $3,466,411 for which the maturity date has passed, which could materially and adversely affect our business and financial condition.
 
We have incurred substantial indebtedness through loans made to us during the past 36 months by certain investors and lenders.  Our agreements with these investors and lenders, and the promissory notes we issued in connection with such agreements, contain various covenants, including, in certain instances, cross-default provisions.  These loan covenants may negatively affect our business, financial condition, operating results and cash flows in many ways, including:
 
 
·
increasing the cost, or limiting the availability of, additional financing for working capital, acquisitions or other purposes, including our plans to install a second production line at our new facility in Hailun City;
 
 
·
limiting the ways in which we can use our cash flow, much of which may have to be used to satisfy debt; and
 
 
·
adversely affecting our ability to respond to changing business or economic conditions.
 
The occurrence of any one of these events could have a material adverse effect on our business, financial condition, results of operations, prospects and ability to satisfy our obligations under our short and long term indebtedness.
 
Historically, we have not been able to repay certain of our loans as they have come due.  In fact, outstanding promissory notes in the aggregate principal amount of $3,466,411 are currently past due.  We are currently negotiating with the lenders for extensions of the maturity dates of the applicable promissory notes, and expect to have the executed modification agreements and extensions shortly.  However, there can be no assurance that we will be able to extend the maturity dates of these notes on terms acceptable to us.  Our failure to cure these events of default, or to obtain waivers from the noteholders, could materially and adversely affect our business.
 
 
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We may have difficulty raising necessary capital to fund our expansion plans, which may require us to curtail such plans. In addition, we may be required to issue equity or equity-linked securities in connection with capital raising activities, which may cause dilution in the value of our common stock.
 
In November 2010, we commenced production at our new production facility in Hailun City, Heilongjiang Province, PRC, which currently has one production line.  Although there can be no assurance that we will add a second production line to our new facility, we currently intend to do so.  We expect the cost to add a second production line at our Hailun City production facility to be approximately $15.0 million. We plan to fund the second production line with a combination of retained earnings and, to the extent necessary, funds raised from the capital markets. There can be no assurance that any additional financing will become available to us, and if available, on terms acceptable to us.  If we are not able to raise necessary capital to fund our expansion plans, we may be forced to curtail such plans, which may adversely affect our business. The inability to secure additional financing would force us to curtail our expansion plans, which may adversely affect our business and financial condition.
 
In addition, we may be required to sell additional equity or equity-linked securities in connection with any capital raising activities.  If additional funds are raised through the issuance of equity or equity-linked securities, there may be a significant dilution in the value of our outstanding common stock.
 
Risks Related to Doing Business in the PRC
 
Changes in the PRC’s political or economic situation could harm us and our operational results.
 
Economic reforms which have been adopted by the Chinese government could change at any time.  Because many reforms are unprecedented or experimental, they are expected to be refined and adjusted. Other political, economic and social factors, such as political changes, changes in the rates of economic growth, unemployment or inflation, or in the disparities in per capita wealth between regions within the PRC, could lead to further readjustment of the reform measures. This refining and readjustment process may negatively affect our operations. This could damage our operations and profitability. Some of the things that could have this effect are:
 
 
·
level of government involvement in the economy;
 
 
·
control of foreign exchange;
 
 
·
methods of allocating resources;
 
 
·
balance of payments position;
 
 
·
international trade restrictions; or
 
 
·
international conflict.
 
The Chinese economy differs from the economies of most countries belonging to the Organization for Economic Cooperation and Development, or OECD, in many ways. As a result of these differences, we may not develop in the same way or at the same rate as might be expected if the Chinese economy were similar to those of the OECD member countries.  It is possible that the Chinese government may abandon its reforms and return to a more nationalized economy. Negative impact upon economic reform policies or nationalization could result in a total investment loss in our common stock.
 
 
- 21 -

 

Changes in the interpretations of existing laws and the enactment of new laws may negatively impact our business and results of operation.
 
There are substantial uncertainties regarding the application of Chinese laws, especially with respect to existing and future foreign investments in the PRC. The Chinese legal system is a civil law system based on written statutes. Unlike common law systems, it is a system in which precedents set in earlier legal cases are not generally used. Laws and regulations affecting foreign invested enterprises in the PRC have only recently been enacted and are evolving rapidly, and their interpretation and enforcement involve uncertainties. Changes in existing laws or new interpretations of such laws may have a significant impact on our methods and costs of doing business. For example, new legislative proposals for product pricing, approval criteria and manufacturing requirements may be proposed and adopted. Such new legislation or regulatory requirements may have a material adverse effect on our financial condition, results of operations or cash flows. In addition, we will be subject to varying degrees of regulation and licensing by governmental agencies in the PRC. Future regulatory, judicial and legislative changes could have a material adverse effect on our Chinese operating subsidiaries.  Regulators or third parties may raise material issues with regard to our Chinese subsidiaries or our compliance or non-compliance with applicable laws or regulations or changes in applicable laws or regulations may have a material adverse effect on our operations. Because of the evolving nature in the law, it will be difficult for us to manage and plan for changes that may arise.
 
It will be difficult for any shareholder of ours to commence a legal action against our executives.  Enforcing judgments won against them or the Company will be difficult.
 
Most of our officers and directors reside outside of the United States. As a result, it will be difficult, if not impossible, to acquire jurisdiction over those persons in a lawsuit against any of them, including with respect to matters arising under U.S. federal securities laws or applicable state securities laws.  Because the majority of our assets are located in the PRC, it would also be extremely difficult to access those assets to satisfy an award entered against us in United States court. Moreover, we have been advised that the PRC does not have treaties with the United States providing for the reciprocal recognition and enforcement of judgments of courts.
 
Recent PRC regulations relating to mergers and acquisitions of domestic enterprises by foreign investors may increase the administrative burden we face and create regulatory uncertainties.
 
On August 8, 2006, six PRC regulatory agencies, namely, the PRC Ministry of Commerce (“MOFCOM”), the State Assets Supervision and Administration Commission (“SASAC”), the State Administration for Taxation, the State Administration for Industry and Commerce, the China Securities Regulatory Commission (“CSRC”), and the State Administration of Foreign Exchange (“SAFE”), jointly adopted the Regulations on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors (the “New M&A Rule”), which became effective on September 8, 2006. The New M&A Rule purports, among other things, to require offshore special purpose vehicles (“SPVs”), formed for overseas listing purposes through acquisitions of PRC domestic companies and controlled by PRC companies or individuals, to obtain the approval of the CSRC prior to publicly listing their securities on an overseas stock exchange.
 
On September 21, 2006, pursuant to the New M&A Rule and other laws and regulations of the PRC (“PRC Laws”), the CSRC, on its official website, promulgated relevant guidance with respect to the issues of listing and trading of domestic enterprises’ securities on overseas stock exchanges (the “Administrative Permits”), including a list of application materials with respect to the listing on overseas stock exchanges by SPVs.
 
 
- 22 -

 

On October 9, 2007, AIDH, parent company of the Chinese corporations through which we do all of our business, became a subsidiary through a Reverse Merger, as further described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Recent Developments — Reverse Merger, Private Placements and Related Transactions.”
 
Based on our understanding of current PRC Laws, we believe that the New M&A Rule does not require us or our Chinese shareholders or our entities in China to obtain the CSRC approval in connection with the Reverse Merger because AIDH completed the approval procedures of the acquisition of a majority equity interest in its PRC subsidiary before September 8, 2006 when the New M&A Rule became effective.
 
There are, however, substantial uncertainties regarding the interpretation and application of current or future PRC Laws, including the New M&A Rule. PRC government authorities may take a view contrary to our understanding that we do not need the CSRC approval, and Chinese government authorities may impose additional approvals and requirements.
 
Further, if the PRC government finds that we or our Chinese shareholders did not obtain the CSRC approval, which should have been obtained before consummating the Reverse Merger, we could be subject to severe penalties. The New M&A Rule does not specify penalty terms, so we are not able to predict what penalties we may face, but they could be materially adverse to our business and operations.
 
Future inflation in the PRC may inhibit our ability to conduct business in the PRC.
 
In recent years, the Chinese economy has experienced periods of rapid expansion and high rates of inflation. During the past ten years, the annual rate of inflation in the PRC has been as high as 20.7% and as low as 2.2%. These factors have led to the adoption by the Chinese government, from time to time, of various corrective measures designed to restrict the availability of credit or regulate growth and contain inflation. High inflation may in the future cause the Chinese government to impose controls on credit and/or prices, or to take other action, which may inhibit economic activity in the PRC, which may harm the market for our products and adversely affect our operations and business.
 
We may have difficulty establishing adequate management, legal and financial controls in the PRC.
 
The PRC historically has been deficient in western-style management and financial reporting concepts and practices, as well as in modern banking, computer and other control systems. We may have difficulty in hiring and retaining a sufficient number of qualified employees to work in the PRC. As a result of these factors, we may experience difficulty in establishing management, legal and financial controls, collecting financial data and preparing financial statements, books of account and corporate records and instituting business practices that meet western standards.  If we are not able to maintain adequate controls our financial statements may not properly represent our financial condition, results of operation or cash flows.  Weakness in our controls could also delay disclosure of information to the public which is material to an investment decision with respect to our stock.
 
Fluctuations in the exchange rate between the Chinese currency and the United States dollar could adversely affect our operating results.
 
The functional currency of our operations in China is “Renminbi,” or “RMB.” However, results of our operations are translated at average exchange rates into United States dollars for purposes of reporting results. As a result, fluctuations in exchange rates may adversely affect our expenses and results of operations as well as the value of our assets and liabilities. Fluctuations may adversely affect the comparability of period-to-period results.  We currently do not use hedging techniques, and even if in the future we do, we may not be able to eliminate the effects of currency fluctuations. Thus, exchange rate fluctuations could cause our profits to decline, which, in turn, may cause our stock prices, to decline.
 
 
- 23 -

 

Changes in foreign exchange regulations in the PRC may affect our ability to pay dividends in foreign currency or conduct other foreign exchange business.
 
The Renminbi is currently not a freely convertible currency, and the restrictions on currency exchange may limit our ability to use revenues generated in RMB to fund our business activities outside the PRC, or to make dividends or other payments in United States dollars. The PRC government strictly regulates conversion of RMB into foreign currencies. Over the years, foreign exchange regulations in the PRC have significantly reduced the government’s control over routine foreign exchange transactions under current accounts. In the PRC, SAFE regulates the conversion of the RMB into foreign currencies. Pursuant to applicable PRC laws and regulations, foreign invested enterprises incorporated in the PRC are required to apply for “Foreign Exchange Registration Certificates.” Currently, conversion within the scope of the “current account” (e.g. remittance of foreign currencies for payment of dividends, etc.) can be effected without requiring the approval of SAFE. However, conversion of currency in the “capital account” (e.g. for capital items such as direct investments, loans, securities, etc.) still requires the approval of SAFE.
 
In addition, on October 21, 2005, SAFE issued the Notice on Issues Relating to the Administration of Foreign Exchange in Fundraising and Reverse Investment Activities of Domestic Residents Conducted via Offshore Special Purpose Companies (“Notice 75”), which became effective as of November 1, 2005. Notice 75 replaced the two rules issued by SAFE in January and April 2005.
 
According to Notice 75:
 
 
·
prior to establishing or assuming control of an offshore company for the purpose of obtaining overseas equity financing with assets or equity interests in an onshore enterprise in the PRC, each PRC resident, whether a natural or legal person, must complete the overseas investment foreign exchange registration procedures with the relevant local SAFE branch;
 
 
·
an amendment to the registration with the local SAFE branch is required to be filed by any PRC resident that directly or indirectly holds interests in that offshore company upon either (1) the injection of equity interests or assets of an onshore enterprise to the offshore company, or (2) the completion of any overseas fund raising by such offshore company; and
 
 
·
an amendment to the registration with the local SAFE branch is also required to be filed by such PRC resident when there is any material change in the capital of the offshore company that does not involve any return investment, such as (1) an increase or decrease in its capital, (2) a transfer or swap of shares, (3) a merger or division, (4) a long term equity or debt investment, or (5) the creation of any security interests.
 
Moreover, Notice 75 applies retroactively. As a result, PRC residents who have established or acquired control of offshore companies that have made onshore investments in the PRC in the past were required to complete the relevant overseas investment foreign exchange registration procedures by March 31, 2006. Under the relevant rules, failure to comply with the registration procedures set forth in Notice 75 may result in restrictions being imposed on the foreign exchange activities of the relevant onshore company, including the payment of dividends and other distributions to its offshore parent or affiliate and the capital inflow from the offshore entity, and may also subject relevant PRC residents to penalties under PRC foreign exchange administration regulations.
 
In addition, SAFE issued updated internal implementing rules (“Implementing Rules”) in relation to Notice 75. The Implementing Rules were promulgated and became effective on May 29, 2007. Such Implementing Rules provide more detailed provisions and requirements regarding the overseas investment foreign exchange registration procedures. However, even after the promulgation of Implementing Rules there still exist uncertainties regarding the SAFE registration for PRC residents’ interests in overseas companies. It remains uncertain whether PRC residents shall go through the overseas investment foreign exchange registration procedures under Notice 75 or Implementing Rules.
 
 
- 24 -

 

Penalties for non-compliance which may be issued by SAFE can impact the PRC resident investors as well as the onshore subsidiary. However, certain matters related to implementation of Circular No. 75 remain unclear or untested. As a result, we may be impacted by potential penalties which may be issued by SAFE. For instance, remedial action for violation of the SAFE requirements may be to restrict the ability of our Chinese subsidiaries to repatriate and distribute its profits to us in the United States. The results of non-compliance are uncertain, and penalties and other remedial measures may have a material adverse impact upon our financial condition and results of operations.
 
Extensive regulation of the food processing and distribution industry in the PRC could increase our expenses resulting in reduced profits.
 
We are subject to extensive regulation by the PRC's Agricultural Ministry, and by other county and local authorities in jurisdictions in which our products are processed or sold, regarding the processing, packaging, storage, distribution and labeling of our products. Applicable laws and regulations governing our products may include nutritional labeling and serving size requirements. Our processing facilities and products are subject to periodic inspection by national, county and local authorities. To the extent that new regulations are adopted, we will be required to conform our activities in order to comply with such regulations. Our failure to comply with applicable laws and regulations could subject us to civil remedies, including fines, injunctions, recalls or seizures, as well as potential criminal sanctions, which could have a material adverse effect on our business, operations and finances.
 
Limited and uncertain trademark protection in the PRC makes the ownership and use of our trademarks uncertain.
 
We have obtained trademark registrations for the use of our tradenames “Xing An Ling” and “Yi Bai”, which have been registered with the PRC’s Trademark Bureau of the State Administration for Industry and Commerce with respect to our milk products. We believe our trademarks are important to the establishment of consumer recognition of our products. However, due to uncertainties in Chinese trademark law, the protection afforded by our trademarks may be less than we currently expect and may, in fact, be inadequate. Moreover, in the event our trademarks or trade names are challenged or infringed, we may not have the financial resources to defend against any challenge or infringement and such defense could in any event be unsuccessful. Moreover, any events or conditions that negatively impact our trademarks could have a material adverse effect on our business, operations and finances.
 
Risks Relating to the Market for Our Common Stock
 
Because we became public by means of a reverse merger, we may not be able to attract the attention of major brokerage firms.
 
On October 9, 2007, we became public by virtue of the Reverse Merger, as defined in “Item 1. Business – Company Background”.  There may be risks associated with our becoming public through a reverse merger.  Because of the Reverse Merger, we could be exposed to undisclosed liabilities resulting from our operations prior to the merger and we could incur losses, damages or other costs as a result.  In addition, securities analysts of major brokerage firms may not provide coverage of us since there is no incentive to brokerage firms to recommend the purchase of our common stock. Further, brokerage firms may not want to conduct any secondary offerings on our behalf in the future.  These factors may negatively affect the market price and liquidity of our common stock.
 
 
- 25 -

 

There is currently a limited trading market for our common stock and a more liquid trading market may never develop or be sustained and stockholders may not be able to liquidate their investment at all, or may only be able to liquidate the investment at a price less than the Company’s value.
 
There is currently a limited trading market for our common stock and a more liquid trading market may never develop.  As a result, the price of our shares may not reflect the value of the Company.  Consequently, investors may not be able to liquidate their investment at all, or if they are able to liquidate it may only be at a price that does not reflect the value of our business.  Because the price for our stock is low, many brokerage firms may not be willing to effect transactions in the securities. Even if an investor finds a broker willing to effect a transaction in our stock, the combination of brokerage commissions, transfer fees, taxes, if any, and any other selling costs may exceed the selling price. Further, many lending institutions will not permit the use of common stock like ours as collateral for any loans.  Even if a more active market should develop, the price may be highly volatile.
 
Our common stock is currently approved for quotation on the OTCBB.  We do not satisfy the initial listing standards of the New York Stock Exchange, NYSE Amex Equities or The Nasdaq Stock Market.  If we never are able to satisfy any of those listing standards our common stock will never be listed on an exchange, or we may choose not to apply for any such listing.  As a result, the trading price of our stock may be lower than if we were listed on an exchange. Our stock may be subject to increased volatility.  When a stock is thinly traded, a trade of a large block of shares can lead to a dramatic fluctuation in the share price.  These factors may make it more difficult for our shareholders to sell their shares.
 
Our stock price may be volatile in response to market and other factors.
 
The market price for our stock may be volatile and subject to price and volume fluctuations in response to market and other factors, including the following, some of which are beyond our control:
 
 
·
the increased concentration of the ownership of our shares by a limited number of affiliated stockholders following the Reverse Merger may limit interest in our securities;
 
 
·
variations in quarterly operating results from the expectations of securities analysts or investors;
 
 
·
announcements of technological innovations or new products or services by us or our competitors;
 
 
·
reductions in the market share of our products;
 
 
·
announcements by us or our competitors of significant acquisitions, strategic partnerships, joint ventures or capital commitments;
 
 
·
general technological, market or economic trends;
 
 
·
volatility in our results of operations;
 
 
·
investor perception of our industry or prospects;
 
 
·
insider selling or buying;
 
 
·
investors entering into short sale contracts;
 
 
·
regulatory developments affecting our industry; and

 
·
additions or departures of key personnel.
 
These factors may negatively affect the market price and liquidity of our common stock.
 
 
 
- 26 -

 
 
“Penny Stock” rules may make buying or selling our common stock difficult.
 
Trading in our common stock is subject to the “penny stock” rules. The SEC has adopted regulations that generally define a penny stock to be any equity security that has a market price of less than $5.00 per share, subject to certain exceptions. These rules require that any broker-dealer that recommends our common stock to persons other than prior customers and accredited investors, must, prior to the sale, make a special written suitability determination for the purchaser and receive the purchaser’s written agreement to execute the transaction. Unless an exception is available, the regulations require the delivery, prior to any transaction involving a penny stock, of a disclosure schedule explaining the penny stock market and the risks associated with trading in the penny stock market. In addition, broker-dealers must disclose commissions payable to both the broker-dealer and the registered representative and current quotations for the securities they offer. The additional burdens imposed upon broker-dealers by such requirements may discourage broker-dealers from effecting transactions in our common stock, which could severely limit the market price and liquidity of our common stock.
 
Restrictions on the use of Rule 144 by shell companies or former shell companies could affect your ability to resale our shares.
 
Historically, the SEC has taken the position that Rule 144 under the Securities Act, as amended, is not available for the resale of securities initially issued by companies that are, or previously were, blank check companies like us, to their promoters or affiliates despite technical compliance with the requirements of Rule 144. The SEC has codified and expanded this position in its amendments to Rule 144, effective on February 15, 2008, and which apply to securities acquired both before and after that date by prohibiting the use of Rule 144 for resale of securities issued by shell companies (other than business transaction related shell companies) or issuers that have been at any time previously a shell company. The SEC has provided an important exception to this prohibition, however, if the following conditions are met: the issuer of the securities that was formerly a shell company has ceased to be a shell company; the issuer of the securities is subject to the reporting requirements of Section 13 or 15(d) of the Exchange Act; the issuer of the securities has filed all Exchange Act reports and material required to be filed, as applicable, during the preceding 12 months (or such shorter period that the issuer was required to file such reports and materials), other than Form 8-K reports; and at least one year has elapsed from the time that the issuer filed current Form 10 type information with the SEC reflecting its status as an entity that is not a shell company. As such, due to the fact that we had been a shell company prior to October 2007, holders of "restricted securities" within the meaning of Rule 144, when they resell their shares pursuant to Rule 144, shall be subject to the conditions set forth in Rule 144.
 
We have a concentration of stock ownership and control, which may have the effect of delaying, preventing, or deterring certain corporate actions and may lead to a sudden change in our stock price.
 
Our common stock ownership is highly concentrated. As of the date hereof, our Chairman, Chief Executive Officer and President, Yang Yong Shan, beneficially owns 14,348,329 shares, or approximately 41.2% of our total outstanding common stock.  His interests may differ significantly from your interests.  As a result of the concentrated ownership of our stock, a relatively small number of stockholders, acting together, will be able to control all matters requiring stockholder approval, including the election of directors and approval of mergers and other significant corporate transactions.  In addition, because our stock is so thinly traded, the sale by any of our large stockholders of a significant portion of that stockholder’s holdings could cause a sharp decline in the market price of our common stock.
 
 
- 27 -

 

We have the right to issue up to 10,000,000 shares of "blank check" preferred stock, which may adversely affect the voting power of the holders of other of our securities and may deter hostile takeovers or delay changes in management control.
 
Our certificate of incorporation provides that we may issue up to 10,000,000 shares of preferred stock from time to time in one or more series, and with such rights, preferences and designations as our board of directors may determine from time to time. While none of our preferred stock has yet been issued, our board of directors, without further approval of our common stockholders, is authorized to fix the dividend rights and terms, conversion rights, voting rights, redemption rights, liquidation preferences and other rights and restrictions relating to any series of our preferred stock. Issuances of shares of preferred stock could, among other things, adversely affect the voting power of the holders of other of our securities and may, under certain circumstances, have the effect of deterring hostile takeovers or delaying changes in management control.  Such an issuance would dilute existing stockholders, and the securities issued could have rights, preferences and designations superior to our common stock.
 
A substantial number of shares of our common stock are issuable upon exercise of outstanding warrants, the exercise of which will substantially reduce the percentage ownership of holders of our currently outstanding shares of common stock, and the sale of which may cause a decline in the price at which shares of our common stock can be sold.
 
As of the date hereof, we have outstanding exercisable warrants to purchase an aggregate of 8,108,651 shares of our common stock, of which:
 
 
·
833,811 are exercisable at a price of $1.50 per share;
 
 
·
2,233,891 are exercisable at a price of $1.63 per share;
 
 
·
1,717,600 are exercisable at a price of $1.65 per share;
 
 
·
875,515 are exercisable at a price of $2.04 per share;
 
 
·
75,000 are exercisable at a price of $2.61 per share; and
 
 
·
2,372,834 are exercisable at a price of $3.26 per share.
 
The issuance of all or substantially all additional shares of common stock that are issuable upon exercise of our outstanding warrants will substantially reduce the percentage equity ownership of holders of shares of our common stock.  In addition, the exercise of a significant number of warrants, and subsequent sale of shares of common stock received upon such exercise, could cause a sharp decline in the market price of our common stock. The rights and obligations under the warrants are further described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources – Warrants.”
 
A substantial number of shares of our common stock owned by our Chief Executive Officer are pledged to secure our repayment of outstanding debt.  The sale of these shares following an event of default under the applicable loan documents may cause a decline in the price at which shares of our common stock can be sold.
 
In connection with our issuance of promissory notes in the aggregate principal amount of $3,446,411, Yang Yong Shan, our Chief Executive Officer, entered into pledge agreements pursuant to which he transferred 7,988,279 shares of our common stock owned by him into escrow accounts to secure our repayment of such promissory notes.  Pursuant to the pledge agreements, Mr. Yang agreed to transfer all of the escrowed shares to the holders of the promissory notes if we default on the notes.  The maturity dates on all of these promissory notes has passed.  We are currently negotiating extensions of the overdue promissory notes.  However there can be no assurance that we will be able to extend the maturity dates of these notes on terms acceptable to us.  Until we have reached agreements with the noteholders for the extension of the maturity dates of these promissory notes, any of the noteholders may obtain their pro rata share of the escrowed shares by delivering a notice of default to us, and may seek to sell such shares.  This could adversely affect the price at which shares of our common stock can be sold.
 
 
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We have not paid, and do not intend to pay, cash dividends in the foreseeable future.
 
We have not paid any cash dividends on our common stock and do not intend to pay cash dividends in the foreseeable future. We intend to retain future earnings, if any, for reinvestment in the development and expansion of our business. Dividend payments in the future may also be limited by other loan agreements or covenants contained in other securities which we may issue. Any future determination to pay cash dividends will be at the discretion of our board of directors and depend on our financial condition, results of operations, capital and legal requirements and such other factors as our board of directors deems relevant.  In addition, the promissory notes we issued in the June 2008 Note Offering, as amended, and November 2008 Note Offering, further described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources – Promissory Notes,” contain restrictive covenants on our payment of dividends.

Item. 1B.  Unresolved Staff Comments

None.

Item 2.  Properties.

Under Chinese law, the government owns all of the land in the PRC and companies and individuals are authorized to use the land only through land use rights granted by the PRC government.

Our manufacturing facility in Beian City, Heilongjiang Province, PRC, occupies approximately 38,600 square meters of land and has approximately 4,600 square meters for production.  Currently there are two production lines with daily capacity to process an aggregate of 200 tons of fresh milk.

Our manufacturing facility in Hailun City, Heilongjiang Province, PRC, occupies approximately 60,000 square meters of land and has approximately 21,800 square meters for production.  Currently there is currently one production line with daily capacity to process 250 tons of fresh milk.

We also have sales offices in each of the 20 provinces in the PRC in which our products are sold.  All leases are on an annual basis and commence on January 1, of each year.  For the years ended December 31, 2010 and 2009, we incurred aggregate rental expenses of $76,447 and $76,098, respectively.  As of December 31, 2010, we had outstanding lease commitments totaling $158,356 is due in 2011.

In the opinion of our management, each of our properties is adequately covered by insurance.

In addition, in fiscal 2008 we purchased and paid for an office building, located in Harbin City, Heilongjiang Province, PRC, for approximately $1.8 million.  This office building, which contains approximately 6,900 square feet of space, serves as our corporate headquarters.
 
 
- 29 -

 

Item 3.  Legal Proceedings.

There are no legal proceedings pending or threatened against us, and we are not aware of any proceedings that a governmental authority is contemplating against us.

Item 4.  (Removed and Reserved).

 
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PART II

Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

Market Information
 
Our common stock was approved for quotation on the OTCBB in the first quarter of 2007. Through October 9, 2007, our trading symbol was “MCTC.OB.”  As of October 9, 2007, we changed our name to Amnutria Dairy Inc. and were assigned a new trading symbol of “AUDY.OB.”  On January 25, 2008, we changed our name to Emerald Dairy Inc. and received a new trading symbol of “EMDY.OB”
 
There is currently only a limited trading market for our common stock and no assurance can be given that a more liquid trading market for our common stock will develop or be maintained.
 
The high and low sales prices for our common stock for the fiscal years ended December 31, 2009 and 2010, and the subsequent interim period, were as follows:
 
Quarter Ended
 
High
   
Low
 
             
2009
           
March 31, 2009
  $ 1.00     $ 0.26  
June 30, 2009
  $ 2.11     $ 0.60  
September 30, 2009
  $ 1.90     $ 1.30  
December 31, 2009
  $ 2.00     $ 1.50  
                 
2010
               
March 31, 2010
  $ 1.80     $ 1.20  
June 30, 2010
  $ 1.44     $ 1.11  
September 30, 2010
  $ 1.40     $ 0.80  
December 31, 2010
  $ 1.52     $ 0.95  
                 
2011
               
March 31, 2011
  $ 1.25     $ 0.77  
June 30, 2011 (through April 13, 2011)
  $ 0.90     $ 0.60  
 
Trading in our common stock has been sporadic and the quotations set forth above are not necessarily indicative of actual market conditions.  All prices reflect inter-dealer prices without retail mark-up, mark-down, or commission and may not necessarily reflect actual transactions.
 
Holders
 
As of April 13, 2011, there were 152 holders of record of our common stock.  Such number of record owners was determined from our shareholder records and does not include beneficial owners whose shares are held in nominee accounts with brokers, dealers, banks and clearing agencies.
 
 
- 31 -

 

Dividends
 
We have not paid any dividends since inception and do not anticipate paying any dividends in the foreseeable future.  We currently intend to retain all available funds and any future earnings of our business for use in the operation of our business.  The declaration, payment and amount of future dividends, if any, will depend upon our future earnings, results of operations, financial position and capital requirements, among other factors, and will be at the sole discretion of our Board of Directors.  Certain promissory notes we have issued, as further described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources – Promissory Notes,” contain restrictive covenants related to our payment of dividends.
 
Securities Authorized For Issuance Under Equity Compensation Plan

See Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters” for certain information with respect to our equity compensation plans as of December 31, 2010.

Recent Sales of Unregistered Securities

In the three month period ended December 31, 2010, we did not issue any unregistered securities.

Item 6.  Selected Financial Data.

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

 
- 32 -

 

Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of Operation.

The financial and business analysis in this Annual Report on Form 10-K (the “Report”) provides information we believe is relevant to an assessment and understanding of our financial condition and results of operations. The following discussion should be read in conjunction with our consolidated financial statements and related notes included in Part II, Item 8 of this Report.

Overview

We are a producer of milk powder, rice powder and soybean milk powder, which currently comprise approximately 94.4%, 3.0% and 2.6% of our sales, respectively. Through our network of over 1,200 salespeople, our products are distributed throughout 20 provinces in the PRC, and sold in over 6,500 retail outlets.

Our 30 products are marketed under two brand names:

 
·
“Xing An Ling,” which is designed for high-end customers; and

 
·
“Yi Bai,” which is designed for middle and low-end customers.

The Chinese government has initiated programs to promote milk consumption and is providing incentives to increase dairy production. The dairy market is one of the fastest growing markets in the PRC. It has been growing at a rate of 14% per year over the past six years, according to the National Bureau of Statistics of China, and is expected to grow at a rate of 15% per year for the foreseeable future. We focus on the infant formula segment of the market, which, according to the Dairy Association of China, has grown even faster in recent years, at a rate of 20%-30% per year. Currently, it is estimated that demand for infant formula in the PRC outstrips supply by at least 2-to-1.

Only holders of an Infant & Baby Formula Milk Powder Production Permit from the State General Administration of Quality Supervision and Inspection and Quarantine of the PRC are permitted to produce formula milk powder in the PRC.  We have received an Infant & Baby Formula Milk Powder Production Permit for our new production facility in Hailun City. Our Infant & Baby Formula Milk Powder Production Permit for our Beian City production facility is currently being renewed.

Because of our close proximity to our sources of fresh milk, we are able to complete the production process in approximately 30-35 hours, which is faster than competitors of ours that are not similarly situated.  Production capacity at our facility in Beian City reached approximately 7,000 tons in 2007, with annual revenue of approximately $29.6 million and net income of approximately $3.6 million. In 2008, by adding a third shift to the existing two shifts working schedule at our facility in Beian City, our production capacity reached approximately 9,000 tons, with revenue of approximately $44.3 million and net income of approximately $2.3 million.  In 2009, while our new production facility was being constructed in Hailun City, our annual production capacity continued at approximately 9,000 tons, with revenue of approximately $44.7 million and net income of approximately $4.2 million.  In November 2010, we commenced production at our new production facility in Hailun City.  This new facility currently has one production line, which has the capacity to produce over 9,000 tons of milk powder annually, giving us a total annual production capacity of over 18,000 tons.  In 2010, we had revenue of approximately $55.3 million and net income of approximately $3.1 million.

 
- 33 -

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

 
·
Heilongjiang Xing An Ling Dairy, Co., a PRC company (“XAL”), which handles our promotion, sales and administrative functions;
 
 
·
Heilongjiang Beian Nongken Changxing Lvbao Dairy Limited Liability Company, a PRC company (“Lvbao”), which handles production of our products at our production facility in Beian City, Heilongjiang Province, PRC; and

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

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

Economic Downturn

The worldwide economic downturn and market instability, which began in 2008, have made the business climate more volatile and more costly. Although all of our business operations are currently conducted in the PRC, our general business strategy, as well as our results of operations and financial condition, may be adversely affected by unpredictable and unstable market conditions. If the current equity and credit markets deteriorate, or do not improve from current levels, it may make it difficult, if not impossible, for us to obtain debt or equity financing on acceptable terms at a time when we wish to do so. Failure to secure any necessary financing in a timely manner and on favorable terms could have a material adverse effect on our growth strategy, financial performance and stock price and could require us to delay or abandon our expansion plans. We do not expect this economic downturn to have a significant effect on our business or operations in the near future. However, we cannot predict the timing or duration of any economic slowdown or recession or the timing or strength of a subsequent recovery, worldwide, or in the specific markets we serve. If the markets for our products significantly deteriorate due to these economic effects, our business, financial condition and results of operations may be materially and adversely affected.
 
 
- 34 -

 

Narrowing of Gap in Milk Consumption

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

Industry Growth

The dairy market is one of the fastest growing markets in the PRC. It has been growing at a rate of 14% per year over the past six years, according to the National Bureau of Statistics of China, and is expected to grow at a rate of 15% per year for the foreseeable future. On its website, the Dairy Association of China estimates that the infant formula market segment, which is the market segment we target, has grown even faster in recent years, at a rate of 20%-30% per year. We believe the following three factors are the main drivers of the infant formula market:

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

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

 
·
Increased popularity and acceptance of infant formula products.

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

Supply of Infant Formula

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

Product Pricing and Raw Material Supply

Historically we have been able to obtain sufficient raw milk and other raw materials to meet our production needs. The price of raw milk is affected by regional market in Heilongjiang Province, PRC, while other raw materials are affected by global markets. We expect that the raw materials we require to produce our products will continue to be readily available to us for the foreseeable future.  In fiscal 2010, the price of raw materials we use to produce our products remained relatively stable.  We believe the prices of the raw materials we use will stay relatively stable for the foreseeable future.
 
 
- 35 -

 

Brand Name and Product Quality

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

Organic Label Milk Products

In February 2008, we obtained organic label certification from Guangdong Zhongjian Certification Co., Ltd.  In June 2009, we started to develop an organic baby formula line for the high-end market. To meet the standards for an organic product, we were required to maintain a herd of 527 organic-fed cows that were closely monitored by certification authorities to ensure they met the rigid organic farming standards.  After 16 months of monitoring and subsequent product testing, our organic farming operation and production line were approved by China's Guangdong Zhongjiang Certification Co.  We recently began commercializing an organic product line.  We use the “China Organic Product” seal on our organic formula packaging and in associated marketing materials.  We believe that, similar to the growth of the organic milk market in the U.S., organic milk products will be popular in the PRC.  Over time, we believe our proposed organic product line will help increase our revenues.

Factors Affecting Raw Milk Production

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

 
·
Seasonal factors: dairy cows generally produce more milk in temperate weather than in cold or hot weather and extended unseasonably cold or hot weather could lead to lower than expected production;

 
·
Environmental factors: the volume and quality of milk produced by dairy cows is closely linked to the quality of the nourishment provided by the environment around them, if environmental factors cause the quality of nourishment to decline, milk production could decline and we may have difficulty finding sufficient raw milk; and

 
·
Governmental agricultural and environmental policy: declines in government grants, subsidies, provision of land, technical assistance and other changes in agricultural and environmental policies may have a negative effect on the viability of individual dairy farms, and the numbers of dairy cows and quantities of milk they are able to produce.
 
 
- 36 -

 

Contamination of Milk Powder Products Produced in the PRC

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

Subcontracting

Our subcontracting arrangements consist of producing milk powder products on a contract basis for third parties, which then resell such products under their own brand names.

In fiscal 2008, our sole production facility in Beian City, Heilongjiang Province, PRC was operating at maximum capacity, producing 9,000 tons of milk powder per annum.  At this time, our management began phasing out subcontracting activities after determining it would be more profitable to focus on sales of our own higher margin products.  This adjustment in our sales mix resulted in a reduction in our cost of goods sold.

In July 2008, we began construction of a new production facility in Hailun City, Heilongjiang Province, PRC, which was completed in the fourth quarter of 2010. Initially, the new facility has one production line, with the capacity to produce over 9,000 additional tons of milk powder annually.  A second production line can be added at this new facility, which, when completed, would enable us to produce over 9,000 additional tons of milk powder per year (a total of over 27,000 tons per annum).

In mid-2010, in anticipation of our completion of the first production line at the Hailun City facility, management determined to increase subcontracting activities once again.  The primary reason for this increase was to help absorb excess production capacity at our new production facility.  As we increase sales of our higher margin products in the future, management will continue to assess its subcontracting activities.

Outstanding Debt

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

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

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

 
·
adversely affecting our ability to respond to changing business or economic conditions.
 
 
- 37 -

 

Historically, we have not been able to repay certain of our loans as they have come due.  In fact, outstanding promissory notes in the aggregate principal amount of $3,466,411 are currently past due.  We are currently negotiating with the lenders for extensions of the maturity dates of the applicable promissory notes, and expect to have the executed modification agreements and extensions shortly.  However, there can be no assurance that we will be able to extend the maturity dates of these notes on terms acceptable to us.

Results of Operations

Fiscal Year Ended December 31, 2010 Compared to Fiscal Year Ended December 31, 2009

The following summarizes changes in our operations for the fiscal years ended December 31, 2010 and 2009. Net income decreased by $1,099,098, or 26.1%, from $4,212,023 in the fiscal year ended December 31, 2009 to $3,112,925 for the fiscal year ended December 31, 2010. The decrease in net income during the year ended December 31, 2010, as compared to the same time period in the prior year, was primarily due to liquidated damages we incurred during the current year in connection with the extension of the expiration dates of certain of our issued and outstanding warrants, which offset an increase in our gross profit as further described below.

Sales and Cost of Goods Sold
 
   
For the Fiscal Years
Ended December 31,
 
   
2010
   
2009
 
             
Sales
  $ 55,269,755     $ 44,729,276  
Cost of Goods Sold
    28,181,754       24,056,601  
Gross Profit
  $ 27,088,001     $ 20,672,675  
 
Sales. Sales volume increased by 1,574 metric tons, or 18.6%, to 10,050 metric tons for the fiscal year ended December 31, 2010, from 8,476 metric tons for the fiscal year ended December 31, 2009, primarily due to an increased demand for our products, in addition to the start of production at our new facility during the fourth quarter of 2010.  Sales revenues increased by $10,540,479, or 23.6%, from $44,729,276 in the fiscal year ended December 31, 2009 to $55,269,755 for the fiscal year ended December 31, 2010, primarily due to an increase in the average selling price of our products, of $222 per metric ton, as compared to the fiscal year ended December 31, 2009, occurring because we produced more of our high end product line in fiscal 2010.

Sales by product line. A break-down of our sales by product line for the years ended December 31, 2010 and 2009 is as follows:

     
Fiscal Year Ended December 31,
          
     
2010
     
2009
     
Period-on-period
  
Product category
  
Quantity
(tons)
     
$ Amount
     
% of sales
     
Quantity
(tons)
     
$ Amount
     
% of
sales
     
Qty.
Variance
 
                                           
Milk powder
   
7,421
     
47,299,237
     
85.6
     
6,217
     
38,590,606
     
86.3
     
1,204
 
Rice powder
   
293
     
1,677,401
     
3.0
     
239
     
1,358,127
     
3.0
     
54
 
Soybean powder
   
883
     
1,459,072
     
2.6
     
681
     
1,164,347
     
2.6
     
202
 
Subcontracting
   
1,453
     
4,834,045
     
8.7
     
1,339
     
3,616,196
     
8.1
     
114
 
Total
   
10,050
     
55,269,755
     
100.0
     
8,476
     
44,729,276
     
100.0
     
1,574
 
 
 
- 38 -

 

There were various changes to the break-down of sales among our product lines over the fiscal year ended December 31, 2010, as we increased production in all of our product lines, but attempted to adjust our sales mix to higher margin products. Milk powder accounted for 85.6% of the fiscal year 2010 sales mix, at an average selling price of $6,374 per metric ton, as compared to 86.3% of the fiscal year 2009 sales mix, at an average selling price of $6,207 per metric ton. Rice powder accounted for 3.0% of the fiscal year 2010 sales mix, at an average selling price of $5,725 per metric ton, as compared to 3.0% of the fiscal year 2009 sales mix, at an average selling price of $5,683 per metric ton. Soybean powder accounted for 2.6% of our sales mix for the fiscal year 2010, at an average selling price of $1,652 per metric ton, as compared to 2.6% of our sales mix in fiscal year 2009, at an average selling price of $1,710 per metric ton. We increased our subcontract production during fiscal year 2010 to 8.7% of the sales mix, at an average selling price of $3,327 per metric ton, as compared to 8.1% of the sales mix in fiscal year 2009, at an average sales price of $2,701 per metric ton.  The primary reason for the increase in our sales from subcontracting was that we began extending relationships with other companies for which we can subcontract to help absorb the extra production capacity we have ay our new production facility.

A breakdown of our average selling price by product line for the years ended December 31, 2010 and 2009 is as follows:

   
Fiscal Year Ended
December 31,
 
Average selling prices
 
2010
   
2009
   
Variance
 
   
$
   
$
   
$
   
%
 
Milk powder
   
6,374
     
6,207
     
167
     
2.7
 
Rice powder
   
5,725
     
5,683
     
42
     
0.7
 
Soybean powder
   
1,652
     
1,710
     
(58
)
   
(3.4
)
Subcontracting
   
3,327
     
2,701
     
626
     
23.2
 
Total
   
5,499
     
5,277
     
222
     
4.2
 

Cost of Goods Sold. Cost of goods sold increased by $4,125,153, or 17.1%, from $24,056,601 in the fiscal year ended December 31, 2009, to $28,181,754 for the fiscal year ended December 31, 2010. This increase was directly related to our increased production. Overall our cost per metric ton decreased by $34, or 1.2%, to $2,804 per metric ton in the fiscal year ended December 31, 2010, as compared to $2,838 per metric ton in fiscal year ended December 31, 2009, due to a decrease in the cost of our raw materials during the year. We expect the prices of the raw materials we use to produce our products to remain relatively stable for the foreseeable future.

A breakdown of cost of sales by product line for the years ended December 31, 2010 and 2009 is as follows:

   
Fiscal Year Ended December 31,
 
   
2010
   
2009
   
Variance
 
   
$
   
$
   
$
   
%
 
Cost of sales
                       
Milk powder
   
22,377,446
     
19,348,556
     
3,028,890
     
15.7
 
Rice powder
   
657,804
     
532,599
     
125,205
     
23.5
 
Soybean powder
   
1,013,244
     
853,857
     
159,387
     
18.7
 
Subcontracting
   
4,133,260
     
3,321,589
     
811,671
     
24.4
 
     
28,181,754
     
24,056,601
     
4,125,153
     
17.1
 
                                 
Cost per units sold(per ton)
                               
Milk powder
   
3,015
     
3,112
     
(97
)
   
(3.1
)
Rice powder
   
2,245
     
2,228
     
17
     
0.7
 
Soybean powder
   
1,148
     
1,254
     
(106
)
   
(8.5
)
Subcontracting
   
2,845
     
2,481
     
364
     
14.7
 
Average cost per unit sold
   
2,804
     
2,838
     
(34
)
   
(1.2
)
 
 
- 39 -

 
 
Gross Profit. Gross profit was $27,088,001, or 49.0% of our sales for the fiscal year ended December 31, 2010, as compared to gross profit of $20,672,675, or 46.2% for the fiscal year ended December 31, 2009. During the fiscal year ended December 31, 2010 our gross margin on milk powder increased to 52.7% from 49.9% in the prior year, due to an increase in the average sales price of 2.7%, while there was a 3.1% decrease in the cost per metric ton from the fiscal year ended December 31, 2009. The gross margin for rice powder stayed consistent at 60.8%. The gross margin for soybean powder increased 3.9% to 30.6% in fiscal year 2010 as compared to 26.7% in fiscal year 2009, due to the decrease in the average cost per ton of 8.4% in fiscal year 2010 as compared to fiscal year 2009.

A breakdown of gross margin by product line for the years December 31, 2010 and 2009 is as follows:

    
Fiscal Year Ended December 31,
          
     
2010
     
2009
     
Period-on-period
  
Product category
  
$ Amount
     
Gross
Margin %
     
$ Amount
     
Gross
Margin %
     
Margin
Variance
 
                               
Milk powder
   
24,921,791
     
52.7
     
19,242,050
     
49.9
     
2.8
 
Rice powder
   
1,019,597
     
60.8
     
825,528
     
60.8
     
-
 
Soybean powder
   
445,828
     
30.6
     
310,490
     
26.7
     
3.9
 
Subcontracting
   
700,785
     
14.5
     
294,607
     
8.1
     
6.4
 
Total
   
27,088,001
     
49.0
     
20,672,675
     
46.2
     
2.8
 

Operating Expenses
 
   
For the Fiscal Years
Ended December 31,
 
   
2010
   
2009
 
Operating Expenses
           
Selling expenses
  $ 12,683,225     $ 10,047,861  
Administrative expenses
    3,141,843       3,271,892  
Liquidated damages
    5,021,669       -  
Depreciation and amortization
    288,267       178,281  
Total operating expenses
  $ 21,135,004     $ 13,498,034  
 
Selling Expenses. Selling expenses overall increased by $2,635,364, or 26.2%, from $10,047,861 in fiscal year ended December 31, 2009, to $12,683,225 for the fiscal year ended December 31, 2010. The major factors in the increase in selling expenses are as follows:

 
·
Advertising and promotion increased by $2,185,716, or 54.3%, to $6,209,407 in 2010, from $4,023,691 in 2009, due to our increased advertising in 2010 to further increase our brand awareness.
 
 
- 40 -

 
 
 
·
Sales salaries increased by $335,426, or 15.0%, to $2,578,489 in 2010, from $2,243,063 in 2009, due to an increase in the number of our sales staff from year to year.

 
·
Transportation expenses increased by $94,477, or 9.5%, to $1,085,305 in 2010, from $990,828 in 2009, as a result of our shipping more products in 2010 as compared to 2009.

Rather than using a wholesaler, our sales people deal directly with the retail outlets. This business model has higher sales expenses compared to the traditional business model, but creates better profit margins for us. For a more complete discussion regarding the costs and profits of our retail sales model, see “Description of Business — Company Strategy — Market Strategy — Sales Channel.”

Administrative Expenses. Administrative expenses decreased by $130,049, or approximately 4.0%, from $3,271,892 in fiscal year ended December 31, 2009, to $3,141,843 for the fiscal year ended December 31, 2010. The major factors in the decrease in administrative expenses are as follows:

 
·
Decrease in salary expenses of $248,674, or 38.6%, from $644,702 in 2009 to $396,027 in 2010 due to a bonus we paid in 2009 but not in 2010.

 
·
Decrease in legal and accounting expenses of $382,894, or 38.1%, to $621,348 in 2010, from $1,004,243 in 2009, due to decreased use of outside legal counsel and accounting services during 2010.

This decrease was partially offset by:

 
·
Increase in stock option expenses of $371,308, or 139.7%, from $265,825 incurred in 2009 to $637,133 in 2010 from employee awards.

 
·
Increase in investor relations expenses of $128,857, or 87.3%, to $276,419 in 2010, from $147,562 in 2009, due to increased assistance from investor relations professionals.

Liquidated Damages. We recorded $5,021,669 in liquidated damages during the year ended December 31, 2010, as a result of the extension of warrants previously issued by us to satisfy certain registration rights provisions. See Note 17 of the Notes to Condensed Consolidated Financial Statements for additional information.

Provision for Income Taxes

   
For the Fiscal Years
Ended December 31,
 
   
2010
   
2009
 
Provision for Income Taxes
           
Current
 
$
1,686,847
   
$
1,327,527
 
Deferred
   
     
 
   
$
1,686,847
   
$
1,327,527
 

Provision for Income Taxes. Income taxes increased by $359,320, or 27.1%, from $1,327,527 in fiscal year ended December 31, 2009, to $1,686,847 for the fiscal year ended December 31, 2010. This increase was due to the increase in our taxable income resulting from an increase of gross profit of approximately $6.4 million in our operating subsidiaries. The increase in our gross profit was related to a reduction in the price of our raw materials combined with our production of more of our higher end products.
 
 
- 41 -

 
 
Liquidity and Capital Resources

Uses of Capital

   
For the Fiscal Years Ended
December 31,
 
   
2010
   
2009
 
             
Net cash provided by operating activities
 
$
11,880,880
   
$
4,480,926
 
                 
Net cash used in investing activities
   
(14,634,061
)
   
(6,088,608
)
                 
Net cash provided by financing activities
 
$
5,593,217
   
$
7,758,588
 

Net Cash Provided By Operating Activities. For the fiscal year ended December 31, 2010, $11,880,880 was provided by operating activities, compared with $4,480,926 provided by operating activities for the fiscal year ended December 31, 2009. Our net cash flows provided from operating activities increased during 2010 due primarily to the following factors:

 
·
Trade accounts receivable decreased by $759,872, due to collections we made from our customers.

 
·
Deposits to suppliers and other receivables decreased by $861,530, due primarily to the delivery of goods from suppliers.

 
·
Inventory decreased at December 31, 2010 by $288,632, due to a decrease in the amount of work-in-process at year end.

 
·
Accounts payable increased by $3,389,052 at December 31, 2010, due to increased production levels in 2010.

Net Cash Used In Investing Activities. For the fiscal year ended December 31, 2010, we used $14,634,061 in investing activities, compared with $6,088,608 used in investing activities for the fiscal year ended December 31, 2009. The increase in net cash flows used in investing activities during 2010 was due to costs incurred on construction our new production facility as well as equipment for the new facility.

Net Cash Provided By Financing Activities. For the fiscal year ended December 31, 2010, $5,593,217 was provided by financing activities, compared with $7,758,588 provided by financing activities for the fiscal year ended December 31, 2009. Net cash was provided by the following financing activities:

 
·
We raised $1,180,000 through the sale of promissory notes payable during 2010.

 
·
We received $296,408 from the exercise of warrants in the year ended December 31, 2010.

 
·
We completed a Sale and Leaseback Transaction (described below) with regard to certain equipment which provided $5,648,881 during the year ended December 31, 2010.

 
- 42 -

 
 
General

Cash and cash equivalents at December 31, 2010 increased by approximately 27.0%, to $17,131,274, from $13,486,429 at December 31, 2009. Working capital increased from approximately $17.3 million at December 31, 2009, to approximately $24.4 million at December 31, 2010. Based upon our short term liabilities, we believe our cash and cash equivalents are adequate to satisfy our working capital needs and sustain our ongoing operations for the next twelve months.

We believe that a lack of adequate production capacity has been a significant impediment to our ability to increase our revenue in recent years. Our growth strategy for the next three years will be primarily focused on expanding production capacity and strengthening sales efforts. Management plans to achieve this strategy by increasing our production capacity through the opening of our new production facility, and increasing both sales staff and advertising expenditures.

In November 2010, we commenced production at our new production facility. The new facility currently has one production line, which has the capacity to produce over 9,000 tons of milk powder annually. This first phase of this project has cost us an aggregate of approximately $22.0 million, including land use rights, construction expenses and equipment costs.

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

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

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

In fiscal 2010, we:

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

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

 
·
consummated a sale and leaseback transaction with Fenghui Leasing Co., Ltd. (“Fenghui”), pursuant to which, among other things Fenghui purchased certain equipment from HXD, for a purchase price of approximately $5,161,176, and Fenghui leased the equipment back to HXD for 36 monthly payments of approximately $164,124 (a total of approximately $5,908,464), a commission fee of $154,835, and a refundable deposit of $774,176 (the “Sale and Leaseback Transaction”).
 
 
- 43 -

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

Currently, we spend approximately 8%-12% of total revenues on advertising and promotional efforts throughout the year. We spent approximately $6.1 million on advertising and promotion in fiscal 2010. We currently expect to spend an aggregate of approximately $8.0 million on advertising and promotion in fiscal 2011, of which we have already spent approximately $2.0 million during the three months ended March 31, 2011.

Registration Rights and Liquidated Damages

We entered into Registration Rights Agreements with the investors (the “October 2007 Investors”) in the private placements we consummated in October 2007 (the “October 2007 Private Placements”), pursuant to which we agreed that within thirty (30) business days of the respective closing date (the “Filing Date”), we would file a registration statement with the SEC (the “Registration Statement”) covering the resale of (i) the shares of common stock purchased in the October 2007 Private Placements (the “Purchased Shares”), and (ii) the common stock issuable upon exercise of the October 2007 Warrants (collectively (i) and (ii), the “Registrable Securities”). Further, we agreed to use our best efforts to (i) cause the Registration Statement to be declared effective within ninety (90) calendar days from the Filing Date, or, if reviewed by the SEC, within one hundred eighty (180) calendar days after the Filing Date, and (ii) keep the Registration Statement continuously effective until all of the Registrable Securities have been sold, or may be sold without volume restrictions pursuant to Rule 144.

Pursuant to the Registration Rights Agreements, we were required to pay liquidated damages to the holders of the Purchased Shares if (i) we failed to file the Registration Statement on or before the Filing Date, (ii) the SEC did not declare the Registration Statement effective within ninety (90) days of the Filing Date (or one hundred eighty (180) days in the event of a review by the SEC) (the “Effectiveness Date”), (iii) we failed to request acceleration of effectiveness within five (5) business days of a notice of no further review from the SEC, (iv) we failed to respond to the SEC within ten (10) business days of receipt by us of any comments on the Registration Statement, or (v) after it has been declared effective, the Registration Statement ceases to be effective or available or if we suspend the use of the prospectus forming a part of the Registration Statement (A) for more than thirty (30) days in any period of 365 consecutive days if we suspend in reliance on its ability to do so due to the existence of a development that, in the good faith discretion of its board of directors, makes it appropriate to so suspend or which renders us unable to comply with SEC requirements, or (B) for more than ninety (60) days in any period of 365 consecutive days for any reason. The liquidated damages accumulate at the rate of one and one-half percent (1.5%) of the purchase price paid by the October 2007 Investors for units of our securities purchase in the October 2007 Private Placements for each thirty (30) day period during which a registration default is continuing; provided, however, that (i) we would not be liable for liquidated damages with respect to any warrants or shares of common stock underlying the warrants, and (ii) in no event would we be liable for liquidated damages in excess of 1.5% of the aggregate purchase price of the securities purchased in the October Offerings in any 30 day period, and (iii) the maximum aggregate liquidated damages payable to any of the October 2007 Investors shall be 20% of the aggregate purchase price paid by such purchaser. The Registration Rights Agreements further required that if we failed to pay any partial liquidated damages in full within seven days after the date payable, we will pay interest thereon at a rate of 15% per annum, until such amounts, plus all such interest thereon, are paid in full.

We did not satisfy these registration requirements and, as a result, accrued a total of $1,201,998 in liquidated damages and $172,900 in interest. As of October 5, 2009, we issued an aggregate of 775,833 shares in full payment of the liquidated damages and interest.
 
 
- 44 -

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

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

The Renminbi is currently not a freely convertible currency, and the restrictions on currency exchange may limit our ability to use revenues generated in RMB to fund our business activities outside the PRC, or to make dividends or other payments in United States dollars. The PRC government strictly regulates conversion of RMB into foreign currencies. Over the years, foreign exchange regulations in the PRC have significantly reduced the government’s control over routine foreign exchange transactions under current accounts. In the PRC, SAFE, regulates the conversion of the RMB into foreign currencies. Pursuant to applicable PRC laws and regulations, foreign invested enterprises incorporated in the PRC are required to apply for “Foreign Exchange Registration Certificates.” Currently, conversion within the scope of the “current account” (e.g. remittance of foreign currencies for payment of dividends, etc.) can be effected without requiring the approval of SAFE. However, conversion of currency in the “capital account” (e.g. for capital items such as direct investments, loans, securities, etc.) still requires the approval of SAFE.  See the discussion in Risk Factors commencing on page 16 of this report.

Warrants

As of the date hereof, we have outstanding exercisable warrants to purchase an aggregate of 8,108,651 shares of our common stock, of which:
 
 
·
833,811 are exercisable at a price of $1.50 per share;
 
 
·
2,233,891 are exercisable at a price of $1.63 per share;
 
 
·
1,717,600 are exercisable at a price of $1.65 per share;
 
 
·
875,515 are exercisable at a price of $2.04 per share;
 
 
·
75,000 are exercisable at a price of $2.61 per share; and
 
 
·
2,372,834 are exercisable at a price of $3.26 per share.
 
If all of the vested warrants are exercised, we will receive gross proceeds of approximately $17,443,238, although there can be no assurance that any of these warrants will be exercised.
 
Promissory Notes

The December 2010 Term Loan Note

The promissory note we issued in connection with a loan transaction we consummated in December 2010 (the “December 2010 Term Loan Note”), has a principal balance of $380,000 and bears interest at a rate of 10% per annum, which is also payable on maturity. The December 2010 Term Loan Note has a stated maturity date of December 1, 2011. Upon the maturity of the December 2010 Term Loan Note, by acceleration or otherwise, interest on unpaid amounts shall thereafter be payable at the rate of 12% per annum default interest, until the obligation is paid in full. Any regular interest or default interest not paid when due under the December 2010 Term Loan Note shall be added to the principal of the December 2010 Term Loan Note. We may from time-to-time prepay any amount due under the December 2010 Term Loan Note, in whole or in part, without penalty. The entire unpaid principal balance, together with accrued interest, shall become due and payable, without presentment, demand, protest, notice of protest or other notice of dishonor of any kind upon the occurrence of an “Event of Default,” as defined in our Loan Agreement with the lender.
 
 
- 45 -

 
 
Sale and Leaseback Transaction

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

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

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

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

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

The June 2010 Term Loan Note

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

The December 2009 Notes

The promissory notes we originally issued in connection with the private placement we consummated in December 2009 (the “December 2009 Notes”), as amended on December 24, 2010, which matured on February 22, 2011, have an aggregate principal balance of $1,750,000.  We are currently negotiating an extension of the maturity dates of the December 2009 Notes, although there can be no assurance that the noteholders will agree to extend the maturity dates of the December 2009 Notes on terms acceptable to us.  The December 2009 Notes had an interest rate of 10% through February 22, 2011 (which interest we have paid in full), and currently bear interest at a rate of 15% per annum.  So long as we have any obligations under the December 2009 Notes, there are limitations on our ability to: (a) pay dividends or make other distributions on our capital stock; (b) redeem, repurchase or otherwise acquire any of our securities; (c) create, incur or assume any liability for borrowed money; (d) sell, lease or otherwise dispose of any significant portion of our assets; (e) lend money, give credit or make advances; or (f) assume, guarantee, endorse, contingently agree to purchase or otherwise become liable upon the obligation of any other person or entity. The entire unpaid principal balance, together with accrued interest, shall become due and payable, without presentment, demand, protest, notice of protest or other notice of dishonor of any kind upon the occurrence of an “Event of Default,” as defined in the December 2009 Notes (which includes, among other things, the occurrence of a default under any other (x) indebtedness or (y) obligation exceeding $250,000). Our repayment of amounts due under the December 2009 Notes is secured by a pledge of an aggregate of 5,883,329 shares of our common stock beneficially owned by Yang Yong Shan, our Chairman, Chief Executive Officer and President.
 
 
- 46 -

 
 
The November 2009 Term Loan Note

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

The Amended June 2008 Note

A promissory note we originally issued in connection with the private placement we consummated in June 2008, as amended on December 31, 2008 and December 31, 2009 (the “Amended June 2008 Note”), which matured on December 31, 2010, has a principal balance of $1,716,411 (which amount includes interest accrued through December 31, 2009).  We are currently negotiating an extension of the maturity date of the Amended June 2008 Note, although there can be no assurance that the noteholder will agree to extend the maturity date of the Amended June 2008 Note on terms acceptable to us.  The Amended June 2008 Note had an interest rate of 8% through December 31, 2008, 10% through December 31, 2011, and currently bears interest at a rate of 15% per annum.  So long as we have any obligation under the Amended June 2008 Note, there are limitations on our ability to: (a) pay dividends or make other distributions on our capital stock; (b) redeem, repurchase or otherwise acquire any of our securities; (c) create, incur or assume any liability for borrowed money (except as is related to the completion of the construction of our new production facility); (d) sell, lease or otherwise dispose of any significant portion of its assets; (e) lend money, give credit or make advances; or (f) assume, guarantee, endorse, contingently agree to purchase or otherwise become liable upon the obligation of any other person or entity. The entire unpaid principal balance, together with accrued interest, shall become due and payable, without presentment, demand, protest, notice of protest or other notice of dishonor of any kind upon the occurrence of an “Event of Default,” as defined in the Amended June 2008 Note. Our repayment of amounts due under the Amended June 2008 Note is secured by a pledge of an aggregate of 2,104,950 shares of our common stock beneficially owned by Yang Yong Shan, our Chairman, Chief Executive Officer and President.

Dividends

We have not paid any dividends. In all likelihood, we will use any earnings to develop our business and do not intend to declare dividends for the foreseeable future. Any decision to pay dividends on our common stock in the future will be made by our board of directors on the basis of earnings, financial requirements and other such conditions that may exist at that time. In addition, certain of our outstanding promissory notes contain restrictive covenants on our payment of dividends, as further described in “— Promissory Notes” above.
 
 
- 47 -

 
 
Contractual Obligations and Commercial Commitments

Our contractual obligations, as of December 31, 2010, were as follows:

Payments Due By Period
 
Contractual obligations
 
Total
   
Less than
1 year
   
1-3 years
   
After
3-5 years
   
More than
5 years
 
Equipment purchase
 
$
486,194
   
$
486,194
     
-
     
-
     
-
 
Construction contract
   
506,613
     
506,613
     
-
     
-
     
-
 
Debt Obligations
   
6,774,266
     
6,774,266
     
-
     
-
     
-
 
Capital leases
   
5,057,288
     
2,022,915
     
3,034,373
     
-
     
-
 
Operating leases
   
158,356
     
158,356
     
-
     
-
     
-
 
Advertising contract
   
90,877
     
90,877
     
-
     
-
     
-
 
Total:
 
$
13,073,594
   
$
10,039,221
     
3,034,373
     
-
     
-
 

Critical Accounting Policies and Estimates

We have established various accounting policies that govern the application of accounting principles generally accepted in the U.S., which were utilized in the preparation of our 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.  Management considers such accounting policies to be critical accounting policies.  The judgments and assumptions used by management are based on 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.

While our significant accounting policies are more fully described in Note 3 to our financial statements included in this Annual Report on Form 10-K for the year ended December 31, 2010, we believe that the following accounting policies are the most critical to aid you in fully understanding and evaluating our reported financial results and affect the more significant judgments and estimates that we use in the preparation of our financial statements.

Long Lived Assets

Our long-lived assets and other assets (consisting of property and equipment and purchased intangible assets) are reviewed for impairment in accordance with the guidance of the FASB Topic ASC 360, “Property, Plant, and Equipment”, and FASB ASC Topic 205 “Presentation of Financial Statements ”.  We test for impairment losses on long-lived assets used in operations whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable.  Recoverability of an asset to be held and used is measured by a comparison of the carrying amount of an asset to the future undiscounted cash flows expected to be generated by the asset.  If such asset is considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds its fair value.  Impairment evaluations involve management’s estimates on asset useful lives and future cash flows.  Actual useful lives and cash flows could be different from those estimated by management which could have a material effect on our reporting results and financial positions.  Fair value is determined through various valuation techniques including discounted cash flow models, quoted market values and third-party independent appraisals, as considered necessary.  Through December 31, 2010, we had not experienced impairment losses on our long-lived assets. However, there can be no assurances that demand for our products or services will continue, which could result in an impairment of long-lived assets in the future.
 
 
- 48 -

 
 
Revenue Recognition

Revenue is recognized in when the following criteria are met: (1) persuasive evidence of an arrangement exists; (2) the service has been rendered; (3) the selling price is fixed or determinable; and (4) collection of the resulting receivable is reasonably assured.

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

As of December 31, 2010, we had no sales or contracts that included multiple deliverables that would fall under accounting guidance.

Freestanding Financial Instruments with Characteristics of Both Liabilities and Equity

In accordance with accounting guidance FASB Topic ASC 825, we account for financial instruments as a liability if it embodies an obligation to repurchase the issuer’s equity shares, or is indexed to such an obligation, and that requires or may require the issuer to settle the obligation by transferring assets.  Freestanding financial instruments are financial instruments that are entered into separately and apart from any of the entity's other financial instruments or equity transactions, or that is entered into in conjunction with some other transaction and is legally detachable and separately exercisable.  As of December 31, 2010 and 2009, there were no financial instruments recorded as liability.

Share-based compensation

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

There was $637,133 and $265,825 share-based compensation in the years ended December 31, 2010 and 2009, respectively.

Recent accounting pronouncements

Refer to Note 3 to the Financial Statements included in Item 8 of this Annual Report on Form 10-K, which discusses new accounting pronouncements we adopted during 2010, as well as accounting pronouncements recently issued or proposed but not yet required to be adopted.

Off-Balance Sheet Arrangements

We are not a party to any off-balance sheet arrangements.
 
 
- 49 -

 
 
Item 7A.  Quantitative and Qualitative Disclosures About Market Risk

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

Item 8.  Financial Statements and Supplementary Data.

Financial Statements for the years ended December 31, 2010 and 2009 (see pages F-1 through F-34 hereof).

 
- 50 -

 

EMERALD DAIRY INC.

CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2010

CONTENTS
 
Independent Auditors’ Report of Windes & McClaughry Accountancy Corporation
F-2
   
Consolidated Balance Sheet
F-3
   
Consolidated Statements of Operations
F-4
   
Consolidated Statements of Changes in Stockholders’ Equity and Accumulated Other Comprehensive Income
F-5
   
Consolidated Statements of Cash Flows
F-6
   
Footnotes to Consolidated Financial Statements
F-7 - F-34
 
 
F-1

 
 
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
 
 
To the Board of Directors and
Stockholders of Emerald Dairy, Inc.:

We have audited the accompanying consolidated balance sheets of Emerald Dairy, Inc. and subsidiaries as of December 31, 2010 and 2009, and the related consolidated statements of income, stockholders’ equity and accumulated other comprehensive income and cash flows for each of the years in the two-year period ended December 31, 2010.  Emerald Dairy, Inc’s management is responsible for these consolidated financial statements. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the company’s internal control over financial reporting.  Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Emerald Dairy, Inc. and subsidiaries as of December 31, 2010 and 2009, and the results of their operations and their cash flows the each of the years in the two-year period ended December 31, 2010, in conformity with accounting principles generally accepted in the United States of America.
 
 
/s/ Windes & McClaughry
Windes & McClaughry Accountancy Corporation
Long Beach, California
April 15, 2011
 
 
 
F-2

 
 
Emerald Dairy Inc. and Subsidiaries
Consolidated Balance Sheet
December 31, 2010

   
2010
   
2009
 
             
ASSETS
           
             
Current Assets
           
Cash and cash equivalents
  $ 17,131,274     $ 13,486,429  
Trade accounts receivable,net
    8,220,622       7,223,016  
Inventory, net
    1,052,594       1,298,488  
Advances to equipment supplier
    10,154,264       3,710,707  
Advances to suppliers and other receivables
    2,607,069       1,221,151  
Deposits
    90,877       71,598  
Total current assets
    39,256,700       27,011,389  
                 
Property, plant and equipment
               
Property, plant and equipment, net
    23,039,183       5,946,330  
Contruction in progress
    875,934       8,772,931  
      23,915,117       14,719,261  
                 
Intangible assets, net
    1,348,161       1,341,534  
                 
    $ 64,519,978     $ 43,072,184  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
                 
Current Liabilities
               
Accounts payable
  $ 5,523,712     $ 2,308,866  
Accrued expenses
    1,072,655       608,932  
Notes payable, net of debt discount of $38,116 and $729,830 at December 31, 2010 and 2009, respectively
    6,358,295       5,843,472  
Taxes payable
    539,332       704,056  
Current portion of long-term lease
    1,171,566       -  
Loan from shareholder
    217,294       210,142  
Total current liabilities
    14,882,854       9,675,468  
                 
Long-term lease payable
    2,468,984       -  
                 
Commitments and Contingencies (Note 19)
               
                 
Stockholders' Equity
               
Preferred stock ($0.001 par value, 10,000,000 shares authorized, none issued and outstanding at December 31, 2010 and 2009)
    -       -  
Common stock ($0.001 par value, 100,000,000 shares authorized, 35,976,575 and 34,890,267 issued and outstanding at December 31, 2010 and 2009, respectively)
    35,977       34,890  
Treasury Stock (1,944,444 shares at December 31, 2010 and 2009, respectively)
    (1,944 )     (1,944 )
Additional paid-in capital
    26,007,743       17,003,093  
Retained earnings (of which $3,191,614 and $1,834,742 are restricted at December 31, 2010 and 2009, respectively, for common welfare reserves)
    17,431,350       14,318,425  
Accumulated other comprehensive income
    3,695,014       2,042,252  
Total stockholders' equity
    47,168,140       33,396,716  
                 
    $ 64,519,978     $ 43,072,184  

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

 
F-3

 

Emerald Dairy Inc. and Subsidiaries
Consolidated Statements of Operations
For the Years Ended December 31, 2010 and 2009
 
   
2010
   
2009
 
             
Sales
  $ 55,269,755     $ 44,729,276  
                 
Cost of Goods Sold
    28,181,754       24,056,601  
                 
Gross Profit
    27,088,001       20,672,675  
                 
Operating Expenses
               
Selling expenses
    12,683,225       10,047,861  
Administrative expenses
    3,141,843       3,271,892  
Liquidated damages
    5,021,669       -  
Depreciation and amortization
    288,267       178,281  
Total operating expenses
    21,135,004       13,498,034  
                 
Other Income (Expense)
               
Interest income
    4,698       6,187  
Interest expense
    (1,157,923 )     (236,226 )
Loss on extinguishment of debt
    -       (1,405,052 )
Total other income (expense)
    (1,153,225 )     (1,635,091 )
                 
Net Income Before Provision for Income Tax
    4,799,772       5,539,550  
                 
Provision for Income Taxes
               
Current
    1,686,847       1,327,527  
      1,686,847       1,327,527  
                 
Net Income
  $ 3,112,925     $ 4,212,023  
                 
Basic Earnings Per Share
  $ 0.09     $ 0.14  
                 
Basic Weighted  Average Shares Outstanding
    33,741,628       30,661,333  
                 
Diluted Earnings Per Share
  $ 0.09     $ 0.14  
                 
Diluted Weighted  Average Shares Outstanding
    34,179,615       31,001,248  
                 
                 
The Components of Other Comprehensive Income (Loss)
               
Net Income
  $ 3,112,925     $ 4,212,023  
Foreign currency translation adjustment
    2,504,185       (26,236 )
Income tax related to other comprehensive income
    (851,423 )     8,920  
                 
Comprehensive Income
  $ 4,765,687     $ 4,194,707  

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

 
F-4

 
 
Emerald Dairy Inc. and Subsidiaries
Consolidated Statements of Stockholders' Equity and Accumulated Other Comprehensive Income
For the Years Ended December 31, 2010 and 2009

    
Common Stock
                     
Accumulated
       
   
Number
               
Additional
         
Other
   
Total
 
   
of
   
Par
   
Treasury
   
Paid-In
   
Retained
   
Comprehensive
   
Stockholders'
 
   
Shares
   
Value
   
Stock
   
Capital
   
Earnings
   
Income
   
Equity
 
                                           
Balance at December 31, 2008
    31,243,776     $ 31,244     $ (1,944 )   $ 8,225,922     $ 10,106,402     $ 2,059,568     $ 20,421,192  
                                                         
Warrants exercised
    2,614,222       2,614       -       4,430,977       -       -       4,433,591  
Stock option expense
    -       -       -       265,825       -       -       265,825  
Stock issued for services
    256,436       256       -       426,048       -       -       426,304  
Stock issued for liquidated damages
    775,833       776       -       1,374,111       -       -       1,374,887  
Warrants issued for services
    -       -       -       302,083       -       -       302,083  
Warrants issued as loan discount
    -       -       -       1,974,152       -       -       1,974,152  
Modifcation of warrants
    -       -       -       3,975       -       -       3,975  
Foreign currency translation adjustment, net of tax
    -       -       -       -       -       (17,316 )     (17,316 )
Net income for the Year ended December 31, 2009
    - -       - -       -       -       4,212,023       -       4,212,023  
                                                         
Balance at December 31, 2009
    34,890,267       34,890       (1,944 )     17,003,093       14,318,425       2,042,252       33,396,716  
                                                         
Modification of warrants
    -       -       -       5,021,669       -       -       5,021,669  
Warrants exercised
    1,056,905       1,057       -       1,174,778       -       -       1,175,835  
Stock option expense
    -       -       -       637,133       -       -       637,133  
Stock returned by shareholder
    (180,000 )     (180 )     -       180       -       -       -  
Stock issued for services
    194,403       195       -       265,812       -       -       266,007  
Stock issued for loan extension
    15,000       15       -       18,835       -       -       18,850  
Warrants issued as loan discount
    -       -       -       996,873       -       -       996,873  
Warrants issued for services
    -       -       -       889,370       -       -       889,370  
Foreign currency translation adjustment, net of tax
    -       -       -       -       -       1,652,762       1,652,762  
Net income for the Year ended December 31, 2010
    -       -       -       -       3,112,925       -       3,112,925  
                                                      -  
Balance at December 31, 2010
    35,976,575     $ 35,977     $ (1,944 )   $ 26,007,743     $ 17,431,350     $ 3,695,014     $ 47,168,140  

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

 
F-5

 

Emerald Dairy Inc. and Subsidiaries
Consolidated Statements of Cash Flows
For the Years Ended December 31, 2010 and 2009

   
2010
   
2009
 
             
Cash flows from operating activities
           
Net Income
  $ 3,112,925     $ 4,212,023  
Adjustments to reconcile net cash provided by operating activities
               
Depreciation and amortization
    657,508       538,626  
Amortization of loan discount
    734,864       102,159  
Loss on extinquishment of debt
    -       1,405,052  
Capitalized interest
    (1,502,391 )     (552,683 )
Stock issued for services
    34,657       66,304  
Warrants modified for liquidated damages
    5,021,669       -  
Warrants modified for services
    -       3,975  
Warrants issued for services
    809,379       -  
Warrants issued for loan costs
    79,991       302,083  
Incentive stock options
    637,133       265,825  
Net change in assets and liabilities
               
Trade accounts receivable
    (759,872 )     (1,080,391 )
Inventory
    288,632       (415,773 )
Advances to suppliers and other receivables
    (861,530 )     (311,638 )
Deposits
    (16,922 )     2,972  
Accounts payable
    3,389,053       (953,286 )
Accrued expenses