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EX-31.1 - EXHIBIT 31.1 - Synutra International, Inc.dp23065_ex3101.htm
EX-32.2 - EXHIBIT 32.2 - Synutra International, Inc.dp23065_ex3202.htm
 


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

FORM 10-K

 
x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended March 31, 2011
 
OR
 
o 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 000-50601
 

   
SYNUTRA INTERNATIONAL, INC.
 

   
DELAWARE
 
13-4306188
(State or Other Jurisdiction of
Incorporation or Organization)
 
I.R.S. Employer
Identification No.
 
 
2275 Research Blvd., Suite 500
Rockville, Maryland 20850
 
(Address of Principal Executive Offices, Zip Code)
 
(301) 840-3888
(Registrant’s Telephone Number, Including Area Code)

 Securities registered pursuant to Section 12(b) of the Act:
 
Title of Each Class
Name of Each Exchange on Which Registered
Common Stock $0.0001 Par Value
NASDAQ Global Select Market
 
Securities registered pursuant to Section 12(g) of the Act: None

 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o Nox
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.  Yeso    Nox

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x       No o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o       No o

Indicate by check mark if disclosure of delinquent filers in response to Item 405 of Regulation S-K 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 x

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   o
Accelerated filer   x
Non-accelerated filer   o
Smaller reporting company   o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o       No x
 
The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant based on the closing sales price of the registrant’s common stock on September 30, 2010 (the last business day of the registrant’s most recently completed second fiscal quarter), as reported on the NASDAQ Global Select Market, was $246.0 million. For purposes of this disclosure, shares of common stock held by persons who hold more than 10% of the outstanding shares of common stock and shares held by officers and directors of the registrant have been excluded in that such persons may be deemed to be affiliates. This determination is not necessarily conclusive for other purposes.

As of June 8, 2011, there were 57,300,713 shares of the registrant’s common stock outstanding.
 
 


 
 
 
 
 
 
 
Page
 
PART I
2
   
16
   
36
   
37
   
38
   
38
   
PART II
   
39
   
40
   
41
 
59
   
60
   
92
   
92
   
93
   
PART III
   
94
   
98
   
101
   
103
   
106
   
PART IV
   
107
   
108
 
 
 
CONVENTIONS THAT APPLY TO THIS ANNUAL REPORT ON FORM 10-K
 
Except where the context otherwise requires and for purposes of this Annual Report on Form 10-K only:
 
 
·  
“we,” “us,” “our company,” “our,” and “Synutra” refer to Synutra International, Inc., and its consolidated subsidiaries;
 
 
·  
“China” or “PRC” refers to the People’s Republic of China, excluding Taiwan and the Special Administrative Regions of Hong Kong and Macau;
 
 
·  
all references to “ton” or “tons” are to “tonne” or “metric ton”;
 
 
·  
all references to “Renminbi” or “RMB” are to the legal currency of China; and
 
 
·  
all references to “U.S. dollars,” “dollars,” or “$” are to the legal currency of the United States.
 
Amounts may not always add to the totals due to rounding.
 
Unless otherwise noted, all translations from Renminbi to U.S. dollars were made at the mid rate published by the People’s Bank of China, or the mid rate, as of March 31, 2011, which was RMB6.5564 to $1.00. We make no representation that the Renminbi amounts referred to in this Annual Report on Form 10-K could have been or could be converted into U.S. dollars at any particular rate or at all. On June 8, 2011, the mid rate was RMB 6.4795 to $1.00.
 
PART I
 
This Annual Report on Form 10-K, or Form 10-K, contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, that are based on our current expectations, assumptions, estimates and projections about us and our industry. All statements other than statements of historical fact in this Form 10-K are forward-looking statements. In some cases, these forward-looking statements can be identified by words or phrases such as “anticipate,” “believe,” “continue,” “estimate,” “expect,” “intend,” “is/are likely to,” “may,” “plan,” “should,” “will,” “aim,” “potential,” “continue,” or other similar expressions. The forward-looking statements included in this Form 10-K relate to, among others:

 
·  
our goals and strategies;
 
 
·  
our future business development, financial condition and results of operations;
 
 
·  
the expected growth of the nutritional products and infant formula markets in China;
 
 
·  
market acceptance of our products;
 
 
·  
the safety and quality of our products;
 
 
·  
our expectations regarding demand for our products;
 
 
·  
our ability to stay abreast of market trends and technological advances;
 
 
·  
competition in the infant formula industry in China;
 
 
·  
PRC governmental policies and regulations relating to the nutritional products and infant formula industries; and
 
 
·  
general economic and business conditions in China.
 
These forward-looking statements involve various risks and uncertainties. Although we believe that our expectations expressed in these forward-looking statements are reasonable, our expectations may turn out to be incorrect. Our actual results could be materially different from our expectations. Important risks and factors that could cause our actual results to be materially different from our expectations are generally set forth in the “Item 1. Business,” “Item 1A. Risk Factors,” “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and other sections in this Form 10-K.
 
The forward-looking statements are made as of the date of this Form 10-K. We undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date on which the statements are made or to reflect the occurrence of unanticipated events.

 
 
 
General Development and Narrative Description of Business

We are a leading infant formula company in China. We principally produce, market and sell our products under the “Shengyuan” or “Synutra” name, together with other complementary brands in mainland China. We focus on selling premium infant formula products, which are supplemented by more affordable infant formulas targeting the mass market as well as other nutritional products and ingredients. We sell our products through an extensive nationwide sales and distribution network covering 30 provinces and provincial-level municipalities in China. As of March 31, 2011, this network comprised over 580 independent distributors and over 1,000 independent sub-distributors who sell our products in over 71,000 retail outlets.
 
We currently have three reportable segments which are:

o
Powdered formula segment: Powdered formula segment covers the sale of powdered infant and adult formula products. It includes the brands of Super, U-Smart, My Angel, Mingshan and Helanruniu;
   
o
Baby food segment: Baby food segment covers the sale of prepared baby food for babies and children. It includes the brand of Huiliduo;
   
o
Nutritional ingredients and supplements segment: Nutritional ingredients and supplements segment covers the production and sale of nutritional ingredients and supplements such as chondroitin sulfate, and microencapsulated Docosahexanoic Acid (“DHA”) and Arachidonic Acid (“ARA”).
 
Our Other business includes non-core businesses such as sales of ingredients and milk powder to industrial customers. Although the transaction amounts for the Other business varied significantly from quarter to quarter as we disposed surplus milk powder when our production and sales were negatively affected by the melamine contamination incident in 2008 and the prematurity event (as defined and described below), management does not regard the Other business as a core business because the chief operating decision maker does not receive reports on the operating results or allocate resources to assess its performance.
 
In August 2010, there were several media reports alleging our infant formula products caused symptoms of hormone-triggered sexual prematurity in infants in the Hubei province of China (the media reports, together with the reactions thereto, the “prematurity event”). In response to such media reports, the Ministry of Health ("MOH") of China conducted tests on samples of our products and concluded that there was no link between our infant milk powder products and premature development in infants.

The following table shows our result as impacted by the prematurity event and our efforts to recover from it:

   
Fiscal Year 2011
 
   
First
   
Second
   
Third
   
Fourth
 
   
(In thousands except percentage)
 
Powdered formula segment
                               
- Net sales
 
$
79,244
   
$
37,285
   
$
20,722
   
$
48,318
 
- Gross margin
   
56.9%
     
28.6%
     
16.1%
     
39.9%
 
                                 
Overall
                               
- Income (loss) from operations
   
16,290
     
(26,101
)
   
(24,100
)
   
(6,431
)
                                 

In response to the prematurity event, we have launched new marketing campaigns and initiatives to boost sales and recover market share. For example, we have trained and provided incentives to our in-store promoters to generate more sales by paying potential consumers more home visits, initiating more phone calls and conducting more educational programs. We have launched a new product line “My Angel” to target the specialty baby stores and introduced the new all-imported Super Series to compete more effectively with foreign brands. As these efforts have helped our market share stabilize in the last few months and are designed to bring in more consumers and sales in the coming quarters, we believe we would see further improvement in our operating results in the coming quarters.

Our net sales for the fiscal year ended March 31, 2011 decreased by 14.9% to $248.5 million from $291.9 million for the prior fiscal year. Our gross profit for the fiscal year ended March 31, 2011 decreased by 6.8% to $77.7 million from $83.4 million for the prior fiscal year. Our net loss attributable to Synutra International, Inc. common stockholders for the fiscal year ended March 31, 2011 was $40.1 million, as compared to $24.6 million for the prior fiscal year.
 
 
 

Our Corporate Structure and History
 
Synutra International, Inc is a Delaware holding company that conducts its business through its operating subsidiaries in China. It owns all or majority of the equity interests in its operating subsidiaries, directly or indirectly, through Synutra, Inc., or Synutra Illinois, an intermediate holding company, and Synutra International Company Limited. Synutra Illinois was incorporated in Illinois in 2000 and has no other significant assets and operations of its own. Our corporate structure reflects common practice for companies with operations in the PRC where separate legal entities are often used for tax or administrative reasons.
 
On July 15, 2005, Synutra Illinois completed a reverse acquisition transaction with Vorsatech Ventures, Inc., or Vorsatech. Upon the consummation of this share exchange transaction, Vorsatech’s total issued and outstanding common stock equaled 50,000,713 shares, including 48,879,500 shares issued pursuant to the reverse acquisition transaction and 1,121,213 shares owned by Vorsatech’s existing stockholders. Thereafter, Synutra Illinois became Vorsatech’s wholly owned subsidiary and Vorsatech became the reporting entity for our business. We subsequently changed the name of the reporting entity to Synutra International, Inc.
 
On May 24, 2007, we entered into a Common Stock Purchase Agreement with Warburg Pincus Private Equity IX, L.P., or Warburg, pursuant to which we sold 4,000,000 shares of our common stock for an aggregate purchase price of $66 million. The closing of the transaction took place on June 15, 2007.

On June 30, 2010, we completed an offering (“Offering”) of 3,300,000 shares of common stock at a price to public of $19.00 per share. The net proceeds from the Offering, after deducting underwriting discounts, commissions and offering expenses, totaled approximately $58.8 million.

The following is a brief description of our major operating subsidiaries in China.
 
 
·  
Shengyuan Nutritional Food Co., Ltd., or Shengyuan Nutrition, located in Qingdao, Shandong, China, was established by Synutra Illinois in September 2001 and is engaged in the dry-blending, packaging, shipping and distribution of all of our powdered formula products; in addition, it plans to provide diagnostic services for pregnant women pursuant to a series of control agreements and an entrustment agreement with related parties.
 
 
·  
Zhangjiakou Chahaer Dairy Co., Ltd., or Zhangjiakou, formerly known as Zhangjiakou Shengyuan Dairy Co., Ltd., located in Zhangjiakou, Hebei, China, was established in March 2004 with Synutra Illinois and Sheng Zhi Da holding 40% and 60%, respectively, of its equity interests and is engaged in raw milk processing and the production of powdered formula. Synutra Illinois acquired the remaining 60% ownership interest in Zhangjiakou from Sheng Zhi Da in April 2005.
  
 
·  
Inner Mongolia Huiliduo Food Co., Ltd., or Inner Mongolia Huiliduo, formerly known as Inner Mongolia Shengyuan Food Co., Ltd., located in Zhenglanqi, Inner Mongolia, China, was established in September 2006. Inner Mongolia Huiliduo began operations in August 2010 to produce prepared baby food, using the Huiliduo brand.
 
 
·  
Meitek Technology (Qingdao) Co., Ltd., or Meitek, located in Qingdao, Shandong, China, was established in November 2006 to produce certain nutritional supplements and ingredients. Meitek began operations in October 2008.
  
 
·  
Beijing Shengyuan Huiliduo Food Technology Co., Ltd., or Beijing Huiliduo, located in Beijing, China, was established in July 2008 to produce prepared baby food. Huiliduo began operations in March 2009.
 
 
·  
Beijing Shengyuan Huimin Technology Service Co., Ltd., or Huimin, a variable interest entity which was incorporated on July 10, 2008, provides diagnostic services for pregnant women through medical institutions. Huimin is currently in testing stage.
 
 
·  
Global Food Trading (Shanghai) Co., Ltd., or Global Food, located in Shanghai, China, was acquired in June 2009, and is mainly engaged in sales of liquid milk using the Helanruniu brand.

 
·  
Heilongjiang Mingshan Dairy Co., Ltd., or Mingshan, located in Luobei, Heilongjiang, China, was established in April 2001 and is engaged in raw milk processing and the production of powdered formula. Synutra Illinois acquired 67% and 33% of the ownership interest in Mingshan from Sheng Zhi Da Dairy Group Corporation (“Sheng Zhi Da”) and Xiuqing Meng, the wife of Liang Zhang, our chairman and chief executive officer, respectively, in January 2005.

 
·  
Inner Mongolia Mengyuan Food Co., Ltd., or Mengyuan, located in Fengzhen, Inner Mongolia, China, commenced operations in July 2007 and is engaged in raw milk processing. Mengyuan was acquired by Zhangjiakou from its then shareholders in November 2006.

 
·  
Heilongjiang Longshan Dairy Co., Ltd., or Longshan, previously know as Harbin Shengyuan Dairy Co., Ltd., located in Harbin, Heilongjiang, China, was acquired in July 2008 to produce concentrated milk.
 
 

 
The following chart reflects our organizational structure as of March 31, 2011.
 
 
The following chart shows the structure of our control agreements and the affiliated entities consolidated into our group consolidated financial results as a result of the control agreements:

 
 
*
Control Agreements include:
 
 
(a)
Exclusive Consulting and Service Agreement entered into by and between Nutritional and Huimin;
 
 
(b)
Business Operating Agreement entered into by and among Nutritional, Huimin, Jibin Zhang (who is our Director of Loans) and Yunpeng Jiang (who is our Director of Strategic Acquisitions);
 
 
(c)
Call Option Agreement entered into by and among Nutritional, Huimin, Jibin Zhang and Yunpeng Jiang;
 
 
(d)
Pledge Agreement entered into by and among Nutritional, Jibin Zhang and Yunpeng Jiang; and
 
 
(e)
Entrustment Agreement entered into by and among Nutritional, Jibin Zhang and Yunpeng Jiang.
 
 
**
Entrustment Agreement entered into by and among Nutritional, Jibin Zhang, Yunpeng Jiang and Honnete.
 
For a more detailed description of the control agreements, see “Item 13. Certain Relationships and Related Transactions, and Director Independence.”
 
 
 
 

Our Brands
 
We primarily market our products under the Synutra, or Shengyuan, name which has been associated with infant formula products in China for more than 10 years. In addition to the Synutra, or Shengyuan name, our products are marketed in China under brands that we have developed through our national sales and marketing efforts.
 
Synutra Family of Brands
 
The Synutra family of brands includes several of China’s leading infant formula and children’s nutrition brands, including Super and U-Smart. We have positioned the Synutra family of brands as high quality brands, which provide unique, clinically supported health and developmental benefits. The Synutra family of brands features products that include DHA and ARA, which support brain, visual and nervous system development of infants. Building upon the strength of our brand equity, we are extending the Synutra family of brands into the fast growing children’s nutrition market, such as prepared baby foods.

Complementary Brands
 
In addition to the Synutra family of brands, we market several other brands targeted at various consumer segments and designed to meet the nutritional needs of the broader consumer population in China. These brands include the Mingshan (powdered formula), My Angel (powdered formula), Helanruniu (adult formula), Meitek (nutritional supplements), and Huiliduo (prepared baby foods).

Our Products
 
Our nutritional products are grouped by category of production process and usage as well as internal resources allocation: (1) Powdered Formula, (2) Baby Foods, (3) Nutritional Ingredients and Supplements, and (4) Other business. Sales of Powdered Formula, Baby Foods, Nutritional Ingredients and Supplements, and Other business comprised approximately 74.7%, 0.2%, 0.4%, and 24.7% of our net sales for the fiscal year ended March 31, 2011. A major portion of Other business for the fiscal year ended March 31, 2011 consist of sales of surplus industrial milk powder.

Powdered Formula Products
 
Powdered formula segment covers the sale of powdered infant and adult formula products. It includes the brands of Super, U-Smart, Mingshan which was launched in October 2008, Helanruniu, which was launched in December 2008, and My Angel, which was launched in January 2011. Infant formula is our primary product line in the powdered formula segment, accounting for 92.3%, 92.8% and 85.9% of our total net sales in the powdered formula segment for the fiscal years ended March 31, 2011, 2010, and 2009, respectively.
 
Each of our Super, U-Smart, Mingshan and My Angel product lines has multiple formulations designed to meet nutritional requirements and help promote a baby or child’s healthy growth at each developmental stage. We endeavor to bring our infant formula products closer to the quality of breast milk. We have devoted resources to extensively adjust our product portfolio, upgrade our product lines, and add new products or line extensions to respond to market needs and target a wider group of consumers. To meet consumer expectations, we also periodically upgrade our product concepts, packaging, and pricing of our products.
 
We supplement our powdered infant formula products with other nutritional products for both adults and children through the Helanruniu brand. Our products are targeted at, and come in formulations that are developed to address specific types of consumer profiles, such as middle-aged and elderly consumers with cardiologic health issues, diabetic conditions, and calcium deficiency. Furthermore, we have developed a product specially designed for young adults to address their calcium and other nutrient fortification needs. Our products for women and young adults have also undergone product extensions and upgrades to further clarify the health and nutritional message and product image we intend to convey.
 
We continue to improve our rice cereal products as supplemental and functional foods to our powdered infant and children formula products. These improvements included upgrades to packaging as well as product extensions with new functionalities, new tastes and flavors, and new protein sources such as fish and chicken.
 
 
 

Baby Food Products
 
Baby food segment covers the sale of prepared baby food for babies and children. It includes the brand of Huiliduo which was launched in the quarter ended March 31, 2009. These products are designed to be part of a child’s healthy diet with enhanced nutrition value at different stages of development.

Nutritional Ingredients and Supplements
 
Nutritional ingredients and supplements segment covers the production and sale of nutritional ingredients and supplements such as chondroitin sulfate, microencapsulated DHA and ARA. In the past, we had sourced and exported chondroitin sulfate, a nutrient for joint health, to U.S. industrial customers through our exclusive third-party agent. With the completion of our Meitek facilities in October 2008, we are now able to produce chondroitin sulfate ourselves. In addition, our Meitek facilities can produce microencapsulated DHA and ARA powders and other nutritional ingredients and supplements for our own use and for external industrial customers.

Other business
 
Other business covers the sales of surplus milk powder, whey protein, raw milk, etc, to industrial customers. As affected by melamine incident and prematurity event, the production needs for raw material were less than the orders we placed with suppliers, especially overseas suppliers which require orders several months before dispatch.

Production
 
Powdered Formula Processing
 
In the fiscal year ended March 31, 2011, all of our milk powder used for our Super, U-Smart, My Angel and Helanruniu brands is imported from Fonterra Co-operative Group (“Fonterra”) in New Zealand, and all of our whey protein used for infant powdered formula products is imported from Eurosérum S.A.S (“Eurosérum”) in France.
 
At our Qingdao facility, milk powder is mixed in large automated mechanical mixers with whey protein powder and other additives in a method known as dry-mixing. Our dry-mixing equipment can automatically adjust the level of ingredients to achieve the complex formulations required by our premium products. The resulting milk powder is then checked to ensure proper granule size before packaging and distribution.

Currently, milk powder produced at our own facilities is primarily used for commercial resale to industrial customers which is recorded in our Other business. Only the Mingshan series of products continues to use locally produced raw milk. Raw milk is collected from dairy farmers. Local dairy farmers bring their dairy cattle to collection stations owned by us where raw milk is automatically received using fully enclosed, stainless-steel vacuum milking machines. These collection stations collect and transport the raw milk to our production facilities which are located within 100 kilometers of these milk collection stations. Although raw milk can remain fresh for up to 72 hours, we normally process it within 24 hours.  Once received, the raw milk is processed with refrigeration equipment that cools the raw milk to approximately four degrees Celsius. The raw milk is then stored in air-tight tanks in preparation for advanced processes, which include milk fat separation, sterilization and spray-drying. At our Mingshan facilities, sterilized raw milk is mixed with whey protein powder and other nutrients to the specifications of product formula through a wet mixing method. The resulting mixture is then spray dried into milk powder and transported to our Qingdao facility for final packaging.
 
Packaging
 
The bulk of our powdered formula and other nutritional products come in three types of retail packaging: tin canisters, standup/display pouches, or sealed packages in a box. All packaging labels carry product information, nutritional profile, user instructions, product tracing data and shelf life date, product certification status, quality control and assurance remarks, manufacturer contact information, as well as customer service information that comply with PRC labeling requirements. Selected products are also retail-packaged in single-use sizes. Before any product leaves our packaging facility to distributors, we generally engage in an extensive testing and inspection of the final product.
 
 
 
 
Production and Packaging Facilities
 
Our processing and packaging facilities, which are all owned by us, are located in various locations in China, including Beijing, Qingdao, Luobei, Zhangjiakou, Fengzhen and Zhenglanqi. These facilities encompass approximately 144,650 square meters of office, plant, and warehouse space. Our distribution center located in Qingdao includes approximately 25,000 square meters of owned office space. All of our production facilities are built based on the GMP standard, with equipment imported from Europe and all of our facilities that have commenced operation have ISO9000 and HACCP series qualifications with some also being ISO14000 certified.
 
We currently own and operate four processing facilities and one packaging facility for our powdered formula production. As of March 31, 2011, we had raw milk processing capacity of 32,600 tons per year, packaging capacity of 82,000 tons per year and dry-mixing processing capacity of 73,000 tons per year.
 
Our Qingdao facility serves as our dry-mixing and packaging plant. Various ingredients, such as milk powder, whey protein powder and nutritional additives arrive at our Qingdao facility from our production facilities and our suppliers, and are mixed using the dry-mixing method. Qingdao facility repackages the mixed ingredients into retail-size tin canisters or stand up/display pouches or sealed packages in boxes. This packaging facility also provides inventory control and logistics management, product quality monitoring and product development assistance.
 
Our production facility for prepared baby foods is located in Beijing and Zhenglanqi. As of March 31, 2011, the Beijing facility had a processing capacity of 540 tons per year, and the Zhenglanqi facility had a processing capacity of 18,000 tons per year.
 
Our production facility for nutritional ingredients and supplements is located in Qingdao. As of March 31, 2011, this facility had a processing capacity of 700 tons per year for chondroitin sulfate, 1,000 tons per year for collagen protein, and 700 tons for microencapsulated DHA and ARA powders and other nutritional ingredients.
 
For information with respect to the installed capacity, location and function of our processing and packaging facilities, see “Item 2. Properties”.

Raw Materials and Suppliers
 
Raw Materials
 
Our business depends on maintaining a regular and adequate supply of high-quality raw materials. In the aftermath of the melamine contamination incident, we decided to use imported milk powder for the production of our higher end powdered formula products. We currently source approximately 99% of milk powder used in our production from New Zealand. We also pay market prices or premium prices in certain regions in China for our raw milk. Our milk suppliers are primarily dairy farmers located throughout Heilongjiang and Hebei provinces and in Inner Mongolia.
 
Whey protein powder is the other key ingredient used in the production of our powdered infant formula products and our other dairy-based products. Like all powdered milk producers, we use whey protein powder as the active ingredient to help reconstituted dairy-based formula to mimic the consistency of breast milk, which can constitute approximately 55% of the final powdered infant formula product by weight. Whey protein powder is a byproduct of cheese-making processes, and is difficult and costly to produce as a stand-alone product. Since China is not a large consumer or producer of cheese and cheese products, we and other domestic producers typically obtain whey protein powder in volume from overseas sources, such as France.
 
Based on our experience, prices of milk powder and whey protein powder can fluctuate over relatively short periods of time depending on market conditions. Our sourcing team monitors price movements and makes major purchases at times when prices are attractive, subject to projected customer order flow and other factors.
 
Some of our powdered milk products, including our powdered infant formulas, also include additives such as DHA and ARA fatty acids and other nutritional additives. DHA and ARA fatty acids are long-chain poly-unsaturated fatty acids found in breast milk that are believed to aid in the development of an infant’s brain, eyes and nervous system. Studies have suggested that DHA and ARA fortification can replicate some of the nutritional benefits of breast milk in infant formulas. Currently we are producing microencapsulated DHA and ARA powders at our Meitek facility which began operations in October 2008 for both internal use and external sales.
 
We use vegetable oils in our dry-spraying powder infant formula production processes as a binder for the dry ingredients, helping diminish the occurrence of “lumpiness” or uneven texture when reconstituting powdered infant formula.
 
We purchase animal cartilage from third-party suppliers for the production of chondroitin sulfate, a substance that provides nutrients for joints, tendon, ligaments and bones, in our Meitek facility.
 
 
 

Suppliers and Supplier Arrangements
 
Prior to September 2008, we were able to meet our milk powder production needs by purchasing raw milk on the open market in established dairy regions in northern and northeastern China. We generally negotiate the purchase price of raw milk with many dairy farmers and cooperatives.
 
In the fiscal year ended March 31, 2011, we have been purchasing approximately 99% of our milk powder from Fonterra in New Zealand. The purchase prices are determined through Fonterra’s online auction process and we do not sign long term contracts with our suppliers.
 
Prior to June 2007, we obtained our supply of whey protein powder from Honnete, a large volume importer of processed dairy products in China. Honnete, a company controlled by Liang Zhang, our chairman and chief executive officer, is a major supplier of China’s whey protein powder. Beginning in June 2007, we began sourcing our whey protein powder directly from Eurosérum S.A.S (“Eurosérum”), Honnete’s supplier in France.

Sales and Distribution
 
Sales
 
We generally sell our products to distributors and in limited circumstances directly to retailers such as supermarkets. With the introduction of My Angel series infant powdered formula products in the fourth quarter of fiscal year 2011, we began to sell directly to baby stores. Our sales and marketing approach combines advertising, brand-building and store-level promotions. Our sales team of more than 200 employees use our customer relations management, or CRM, database in order to acquire, process, and manage targeted customer information.
 
We have built a sales network that currently covers 30 provinces and provincial-level municipalities. Our sales group is divided into multiple sub-sales regions. Each sub-sales region covers between eight to twenty urban sales areas which acts as an independent operating unit, while each urban sales area covers three to twenty county sales areas. As of March 31, 2011, we had a sales and marketing force of more than 3,200 employees, complemented by more than 18,000 commissioned field nutrition consultants or retail site promoters employed by our distributors and sub-distributors to promote and sell our products.
 
Our sales teams work directly with each retail outlet to manage the sales process and to collect customer and purchasing related data. We use multiple criteria to select our distributors, including reviewing each potential distributor’s financial condition. We intend to expand our sales organization into additional cities and regions that we do not currently serve. City managers are rotated periodically among various cities. We have set up a sales budget management team to manage our sales expenses and to supervise the execution of our budgeting plan. This team reports directly to the director of marketing and sales.
 
We compensate our sales personnel through a combination of fixed salaries and bonuses based on sales growth. Our targeted sales incentive programs compensate our sales personnel on a product-specific level, thereby enabling us to incentivize our sales personnel to focus their sales and promotion efforts on certain product lines, such as our premium product lines or larger product packages.
 
 

 
Distribution
 
We primarily work directly with over 580 independent distributors, who in turn work with over 1,000 independent sub-distributors, and more than 71,000 retail outlets. Our dry-mixing and packaging subsidiary, Shengyuan Nutritional Food Co., Ltd., also serves as our national distribution center for our distributors in China. From the beginning of 2007, prior to the melamine contamination incident, we only offered credit for our products to a few selected distributors. In light of the financial difficulties experienced by our distributors as a result of the melamine contamination incident and prematurity event, we extended credit to more distributors and increased the amount of credit we granted to distributors whom we had previously extended credit to. We ask our distributors to provide monthly inventory reports which allow us to monitor their inventory levels. Our sales personnel also regularly inspect distributors’ inventories to identify and control any potential inventory buildup by our distributors. We employ trucking companies locally and nationally to distribute retail packaged products to various regional and provincial distributors.
 
Distributors normally have exclusive distribution rights in their respective regions and cities to distribute our products, and are also responsible for developing the sub-distributors in their own region and cities. We typically enter into a contract with each of our distributors that establishes the range of sales obligations and their respective pricing ranges. However, our obligation to sell and the distributor’s obligation to purchase arise only at the time a purchase order is accepted. We seek to carefully manage our distributors through an evaluation system that monitors and grades each distributor with respect to performance criteria such as monthly sales and investment in promotional activities. We seek to incentivize well-performing distributors by providing discounts, larger sales territory and other incentives. While we do not directly manage our sub-distributors, we do track sub-distributor performance through coordinated efforts between our own sales personnel in the field and distributors. Our distributors generally have the right to return products due to package damage.
 
We currently distribute our nutritional products across China. Our logistics center in our Qingdao facilities occupies an area of 25,000 square meters. This logistics center can currently dispatch 6,900 tons of our products for shipment to our distributors per month. Our Qingdao facility also has the capability to respond to urgent requests for product shipments within an average of five days.
 
We currently work with approximately 24 transportation companies that transport our goods directly from our Qingdao facilities to distributors in a timely and efficient manner.
 
We have an enterprise resource planning system, or ERP system, which is a financial information system with an inventory module that manages and records inventory transactions.

Seasonality
 
Our business experiences some seasonal fluctuations. Summer time is typically a slow time for the infant formula market because the population generally consumes less food during the summer. Furthermore, Chinese parents tend to choose the summer time to switch from milk feeding to more concrete food for their babies. As a result, we generally experience weaker sales in our first and second fiscal quarters.
 
 

 
Marketing, Advertising and Promotion
 
Advertising
 
We advertise through various media, including television, print media and the Internet. Additionally, we conduct promotional activities with supermarket chains and entertainment companies in order to reach our target market.
 
We started nationwide television advertising coverage in September 2006. In certain cases, we supplement our nationwide television coverage with local television coverage. We also pursue advertising over the Internet. Our advertising spending was $22.6 million, $16.7 million and $72.8 million for the fiscal years ended March 31, 2011, 2010 and 2009, respectively. Our advertising spending has enabled us to secure prime-time placements with China Central Television and other premium regional or satellite television stations. We had an aggressive advertising and promotional campaign from October 2008 to March 2009 to regain market share in the aftermath of the melamine contamination incident. We slowed down our advertising and promotional expenses in the fiscal year ended March 31, 2010 to better utilize our resources. Due to the prematurity event, we spent aggressively on advertising and promotions to rebuild our brand image and to regain customers and market share. As our market share stabilizes, we plan to reduce our spending on advertising and promotion, and we do not expect significant increase in advertising and promotion expenses going forward.

Marketing and Promotion
 
As part of our sales and marketing approach, our sales force works with more than 15,000 healthcare facilities across China to provide maternity, infant nutrition and health education programs. We have also established a national customer service call center providing live assistance and a toll-free line to provide consumers with prenatal, nursing, baby care education, product information, and address complaints and dispute resolution.
 
We provide displays, posters and other promotional print to retail outlets and sales consultants employed by our distributors at each point of sale. We also pay entry fees to various retail outlets to place our products within such outlets. We collect customer information through surveys voluntarily provided by each customer via the point of sale or via mailed forms provided to our customers in each product package. We also have promotional activities with supermarket chains and entertainment companies in order to reach our target market.

Quality Control
 
We place primary importance on quality. We have established quality control and food safety management systems for the purchase of raw materials, raw milk checks, raw milk processing, packaging, storage and transportation. We use commercial strength 25KG poly kraft bags for packaging before shipping the formula products to our retail packaging and distribution facilities. Additionally, we maintain cold storage areas at each of our three raw milk processing facilities to store fluid milk. All of our processing facilities are equipped with in-house laboratories for quality assurance and quality control purposes. Our laboratory in Qingdao has been qualified as a National Standard Laboratory by the China National Accreditation Service for Conformity Assessment.
 
In order to ensure the quality and safety of our ingredients and products, we have also installed testing equipment and have implemented control procedures at each stage of production, including at the initial raw material purchase stage. There are over 1,100 quality control points throughout the entire production process, including quality control points at the milk collection stations. We employ strict internal procedures and monitoring by highly trained employees during production, transportation and storage. Additionally, we have been increasing our investment in quality control equipment and training. All policies relating to quality control are subject to PRC laws and regulations.

 
 
Highlights of our quality control procedures are summarized below, organized by the main stages of production:

Imported Milk Powder and Whey Protein:
 
 
·  
Procurement staff inspects the Certificate of Analysis to ensure the products are manufactured and tested according to production countries’ national standard;
 
 
·  
Entry-Exit Inspection and Quarantine of the People’s Republic of China performs quality test to ensure the products are up to national standard and issue a Sanitary Certificate; and
 
 
·  
Central Lab staff of the Company performs detailed test on quality and nutritional ingredients of the products before using them in production.
 
Purchase of Raw Milk:
 
 
·  
Raw milk procurement manager conducts pre-purchase assessment of dairy farmers and requests issuance of clean bill of health for dairy cows;
 
 
·  
Procurement staff conducts on-site inspection in compliance with our quality standards and rejects nonconforming supply;
 
 
·  
Inspection of specimen—sampling in the process of raw milk collection for inspection at our facilities pursuant to national standards; and
 
 
·  
Sterilization of equipment for raw milk collection.
 
Milk Powder Production:
 
 
·  
Compliance with production process control procedure, HACCP Plan implemented at all plants;
 
 
·  
All raw materials are subject to prior inspection;
 
 
·  
Detailed process designed for all parts of the production process including pretreatment, vaporization, drying, powder receiving, cooling and packaging;
 
 
·  
Maintain hygiene standards for staff, equipment, environment and any other object; and
 
 
·  
Inspection conducted throughout the production process.
 
Packaging, Storage and Transport:
 
 
·  
Establishment and practice of total process management with respect to product identification and traceability;
 
 
·  
Inspection before warehousing of products;
 
 
·  
Maintain hygiene standards in the course of transport and storage; and
 
 
·  
Products must be positioned according to their category during transport and storage.
 
In the fiscal year ended March 31, 2011, approximately 99% of the milk power used in our powdered formula product is imported from Fonterra of New Zealand. There are three steps of quality control for imported milk powder: (1) the exporters conduct their own quality control before they ship the milk powder; (2) all of our milk powder imports are inspected by China’s import-export inspection and quarantine authorities at landing, pursuant to a national standard of inspection, and (3) our Qingdao laboratory tests each batch of imported milk powder using strict standards for quality assurance.
 
 

 
Research and Development
 
Our research and development activities focus on new product formulation, new ingredient development, creation of new methods to incorporate certain nutrients in our products, and improvement in product tastes and ingredient shelf stabilities. We engage in regular product refinement and new product development for our dairy-based formula products, as well as other forms of foods and nutritional supplements.
 
We utilize our research and development facilities to engage in the development of bringing our infant formula products closer to the quality of breast milk and promote our brand image. We also engage third-party research institutions to research and develop such trial products for us.
 
We seek to leverage our research and development resources in order to extend our new product pipeline. We believe we can accomplish this goal with new formulations and product concepts in dairy-based formula products as well as other nutritional food products and supplements.
 
In addition to new formulations and products, we have also developed a variety of product packaging such as small pack for single use which can provide the formula to the end-user in convenient single packets instead of bulky large canisters.
 
During each of the fiscal years ended March 31, 2011, 2010 and 2009, we spent approximately 0.4%, 0.2% and 0.2% of net sales per year on research and development, respectively.

Competition
 
The infant formula industry in China is highly competitive. We generally compete with both multinational and domestic infant formula producers. Competitive factors include brand recognition, distribution network, quality, advertising, formulation, packaging and price. Many of our competitors have significant market share in the markets we compete in. Our principal competitors can be classified generally into the following two groups:
 
Multinational Producers
 
 
·  
Abbot Laboratories’ Ross Products Division, a U.S. producer and distributor of infant formulas marketed under the brand names of Similac and Enfalac family of formulas;
 
 
·  
Mead Johnson Nutrition Co., or Mead Johnson, formerly a Bristol-Myers Squibb Company Division, a U.S. producer and distributor of the Enfamil family of formulas;
 
 
·  
Groupe Danone SA’s Numico division, or Numico, a Dutch producer of baby foods, which sells and markets infant formula products in China under the Dumex brand;
 
 
·  
Nestlé Suisse SA, or Nestlé, a Swiss producer and distributor of starter and follow-up formulas, milk, cereals, oral supplements and performance foods marketed under Nestlé brands such as Carnation; and
 
 
·  
Wyeth, a U.S. producer and distributor of infant formula sold under private label brands.
 
Domestic Producers
 
 
·  
Inner Mongolia Yili Industrial Group Co., Ltd., or Yili, a PRC producer and distributor of liquid and powdered milk under their Yili brand;
 
 
·  
Beingmate Group Company Limited, or Beingmate, a PRC producer and distributor of infant formula products under their Beingmate brand;
 
 
·  
Guangdong Yashili Group Co., Ltd., or Yashili, a PRC consumer brand marketer which sells a line of infant formula products under their Yashili brand; and
 
 
·  
American Dairy, Inc., a PRC producer and distributor of milk formula products under their Feihe brand.
 
According to data collected by the PRC National Commercial Information Center, or CIC, an entity affiliated with the PRC General Chamber of Commerce responsible for collecting retail sales data, the top ten brands accounted for 83.3% of total infant formulas sold in China in calendar year 2010.
 
 

Intellectual Property
 
All of our product formulations have been developed in-house and are proprietary. We have not registered or applied for protections in China for most of our intellectual property or proprietary technologies relating to the formulations of our powdered infant formula. See Item 1A. Risk factors—Risks Related to Our Business—Failure to adequately protect our intellectual property rights may undermine our competitive position, and litigation to protect our intellectual property rights may be costly. Although we believe that, as of today, patents and copyrights have not been essential to maintaining our competitive market position, we intend to assess in the future whether to seek patent and copyright protections for those aspects of our business that provide significant competitive advantages.
 
As of March 31, 2011, we had 194 registered trademarks in China, and 6 registered trademarks in other districts and countries. Additionally, we had 44 trademark applications pending approval in China.
 
We rely on trade secret protection and confidentiality agreements to protect our proprietary information and know-how. Our management and each of our research and development personnel have entered into annual employment contracts, each of which includes a confidentiality clause and a clause acknowledging that all inventions, designs, trade secrets, works of authorship, developments and other processes generated by them on our behalf are our property, and assigning to us any ownership rights that they may claim in those works. Despite our precautions, it may be possible for third parties to obtain and use, without our consent, intellectual property that we own or are licensed to use. Unauthorized use of our intellectual property by third parties, and the expenses incurred in protecting our intellectual property rights, may adversely affect our business. See Item 1A. Risk factors—Risks Related to Our Business—Failure to adequately protect our intellectual property rights may undermine our competitive position, and litigation to protect our intellectual property rights may be costly.

Environmental Matters
 
Our manufacturing facilities are subject to various pollution control regulations in China with respect to noise, water and air pollution and the disposal of waste and hazardous materials. We are also subject to periodic inspections by local environmental protection authorities in China. We are not currently subject to any pending actions alleging any violations of applicable PRC environmental laws.
 
Our Employees
 
As of March 31, 2011, we employed approximately 5,200 employees in all of our facilities, with approximately 140 head office management staff and research and development employees, approximately 1,900 production employees, and approximately 3,200 sales and marketing employees. Our employees are not represented by a labor organization or covered by a collective bargaining agreement. We have not experienced any work stoppages.
 
We offer our employees both a base salary and a profit sharing program composed of performance bonuses and rewards for exceptional performance. As required by PRC regulations, we participate in various employee benefit plans that are organized by municipal and provincial governments, including pension, work-related injury benefits, maternity insurance, medical and unemployment benefit plans. We are required under PRC law to make contributions to the employee benefit plans at specified percentages of the salaries, bonuses and certain allowances of our employees, up to a maximum amount specified by the local government from time to time. Members of the retirement plan are entitled to a pension equal to a fixed proportion of the member’s salary amount at the member’s retirement date.
 
 

 
Regulation
 
The food industry, of which nutritional and infant formula products form a part, and medical institutions, are subject to extensive regulations in China. This section summarizes the most significant PRC regulations governing our business in China.

Food Hygiene and Safety Laws and Regulations
 
As a producer of nutritional products, and particularly dairy-based infant formula products, in China, we are subject to a number of PRC laws and regulations governing the manufacturing (including composition of ingredients), labeling, packaging, safety and hygiene of food products:
 
 
·  
the PRC Product Quality Law;
 
 
·  
the PRC Food Safety Law;
 
 
·  
the Implementation Rules on the PRC Food Safety Law;
 
 
·  
the Dairy Product Industrial Policies (2009 Version);
 
 
·  
the Regulation on the Supervision and Administration of the Quality and Safety of Dairy Products;
 
 
·  
The Outlines of the Rectification and Revival of the Dairy Industry;
 
 
·  
 the Measures of the Administration on the New Food-Additives;
 
 
·  
the Measures of the Filing of the Enterprise Standard of the Food Safety;
 
 
·  
the Implementation Rules on the Administration and Supervision of Quality and Safety in Food Producing and Processing Enterprises;
 
 
·  
the Regulation on the Administration of Production Licenses for Industrial Products;
 
 
·  
the General Standards for the Labeling of Prepackaged Foods;
 
 
·  
the Implementation Measures on Examination of Dairy Product Production Permits;
 
 
·  
the Standardization Law;
 
 
·  
the Raw Milk Collection Standard;
 
 
·  
the Whole Milk Powder, Skimmed Milk Powder, Sweetened Whole Milk Powder and Flavored Milk Powder Standards;
 
 
·  
the General Technical Requirements for Infant Formula Powder and Supplementary Cereal for Infants and Children;
 
 
·  
Rules for the Examination of Licensing Criteria for Enterprises Producing Formula Milk Powder of Infant Use (2010 version); and

 
·  
Rules for the Examination of Licensing Criteria for Enterprises Producing Milk Products (2010 version)

These laws and regulations set out safety and hygiene standards and requirements for various aspects of food production, such as the use of additives, production, packaging, handling, labeling and storage, as well as facilities and equipment. Failure to comply with these laws and regulations may result in confiscation of our products and proceeds from the sales of non-compliant products, destruction of our products and inventory, fines, suspension of production and operation, product recalls, revocation of licenses, and, in extreme cases, criminal liability.
 
As a result of the melamine contamination incident, the PRC government authorities have conducted extensive dairy industry inspections. In addition to the initial 22 companies implicated in the incident, these subsequent government inspections have identified other companies with unacceptable contamination in their products. On October 7, 2008, the State General Administration of Quality Supervision, Inspection and Quarantine (“AQSIQ”) issued a national standard on the detection of melamine in raw milk and dairy based products. On October 9, 2008, the State Council promulgated with immediate effect a Regulation for the Quality and Safety Supervision of Dairy Based Products, which, among other things, imposes more stringent requirements for inspection, production, packaging, labeling and product recall on dairy product producers. This regulation also established a “Black-List” system to ensure that illegal business operators in the dairy production chain are timely disclosed and severely punished.
 
On April 22, 2010, MOH issued 66 food safety national standards (“New National Standard”), including the national standard for infant powdered formula, which impose strict requirement for production of infant powdered formula. As a result, certain portion of our imported milk powder is not compliant with the New National Standard and was sold to industrial customers.
On November 1, 2010, AQSIQ issued Rules for the Examination of Licensing Criteria for Enterprise Producing Formula Milk Powder of Infant Use (2010 version) and Rules for the Examination of Licensing Criteria for Enterprise Producing Milk Products (2010 version) to tighten the supervision of milk product quality and safety. Under the new rules, milk producers are required to pass higher safety and quality tests in order to have their licenses re-issued. One of our subsidiaries, Mingshan, was not compliant with the required production standard and testing standard, and was closed in April 2011.

 
 
Environmental Regulations
 
We are subject to various governmental regulations related to environmental protection. The major environmental regulations applicable to us include:
 
 
·  
the Environmental Protection Law of the PRC;
 
 
·  
the Law of PRC on the Prevention and Control of Water Pollution;
 
 
·  
Implementation Rules of the Law of PRC on the Prevention and Control of Water Pollution;
 
 
·  
the Law of PRC on the Prevention and Control of Air Pollution;
 
 
·  
Implementation Rules of the Law of PRC on the Prevention and Control of Air Pollution;
 
 
· 
the Law of PRC on the Prevention and Control of Solid Waste Pollution; and
 
 
·  
the Law of PRC on the Prevention and Control of Noise Pollution.
 
We are periodically inspected by local environmental protection authorities. Our operating subsidiaries have received certifications from the relevant PRC government agencies in charge of environmental protection indicating that their business operations are in compliance with the relevant PRC environmental laws and regulations.

Dairy Industry Access Conditions and Policies
 
In June 2009, the PRC National Development and Reform Commission, or the NDRC, and the Ministry of Industry and Information Technology, or the MIIT, jointly promulgated and issued Dairy Industry Policies (2009 Version), or the Policies. The Policies set forth the conditions an entity must satisfy in order to engage, or continue to engage, in the dairy products processing business, including technique and equipment, product quality, energy and water consumption, sanitation and environmental protection, as well as production safety. Any new or continuing dairy products processing projects or enterprises will be required to meet all the conditions and requirements set forth in the Policies. For projects or enterprises that already commenced operations before the promulgation of the Policies, improvements or rectification actions may need to be taken in order to have such projects or enterprises meet the conditions before the end of 2010.
 
The Policies also set forth some requirements relating to the location, processing capacity and raw milk source for any new or continuing dairy products processing project or enterprise. Any new or continuing dairy products processing projects or enterprises that fail to meet the requirements will not be able to procure land, license, permits, loan facility and electricity necessary for the processing of dairy products, and those projects or enterprises already in operation before the promulgation of the Policies will be deregistered and ordered to shut down if they fail to meet the conditions before the end of 2010. We believe that all of our existing entities and facilities meet the requirements under the Access Conditions. See Item 1A. Risk Factors—Risks Associated with Doing Business in China—Changes in the regulatory environment for dairy and infant nutrition products in China could negatively impact our business.

Medical Institutions
 
On February 26, 1994, the State Council promulgated the Regulations of Administration on Medical Institutions which established the regulations for establishing, managing and supervision of medical institutions. In particular, the regulations required a medical institution to be approved by and register with the applicable administrative department of public health prior to establishment. On December 14, 2009, the Ministry of Public Health promulgated the Standards of Medical Inspection Laboratory which set forth the standards for establishing and managing medical inspection laboratories.

Financial Information about Segments and Geographic Areas
 
We have three reportable segments, which are powdered formula, baby food and nutritional ingredients and supplements. In addition, in the fiscal year ended March 31, 2011, sales from our Other business which includes non-core operations accounted for 24.7% of our net sales. Please refer to Note 18 to the Consolidated Financial Statements for further discussion about segments and geographic areas.

Available Information
 
Our Internet website address is www.synutra.com. We make available at this address, free of charge, our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the United States Securities and Exchange Commission, or SEC. Information available on our website is not incorporated by reference in and is not deemed a part of this Form 10-K. The public may read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F. Street, N.E., Washington, DC, 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issues that file electronically with the SEC at www.sec.gov.

 
 
 
Because of the following factors, as well as other factors affecting our financial condition and operating results, past financial performance should not be considered to be a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods.
 
You should carefully consider the following risks and other information in this Form 10-K before making an investment decision with respect to our common stock. The following risks and uncertainties could materially and adversely affect our business, results of operations and financial condition. The risks described below are not the only ones we face. Additional risks that we are not presently aware of or that we currently believe are immaterial may also impair our business operations.

Risks Related to Our Business
 
We are highly dependent upon consumers’ perception of the safety and quality of our products. Any ill effects, product liability claims, recalls, adverse publicity or negative public perception regarding particular ingredients or products or our industry in general, could harm our reputation and damage our brand, and adversely affect our results of operations.
 
We sell products for human consumption, which involves risks such as product contamination, spoilage and tampering. We may be subject to liability if the consumption of any of our products causes injury, illness or death. Adverse publicity or negative public perception regarding particular ingredients, our products, our actions relating to our products, or our industry in general could result in a substantial drop in demand for our products. This negative public perception may include publicity regarding the safety or quality of particular ingredients or products in general, of other companies or of our products or ingredients specifically. Negative public perception may also arise from regulatory investigations or product liability claims, regardless of whether those investigations involve us or whether any product liability claim is successful against us.
 
On September 16, 2008, China’s Administration of Quality Supervision, Inspection and Quarantine, or China AQSIQ, announced its finding that the formula products of 22 Chinese formula producers, including certain lots of our U-Smart products, were contaminated by melamine, a substance not approved for use in food and linked to the illness and deaths of infants and children in China. To date, there have been six reported deaths and approximately 300,000 children have suffered kidney-related illnesses due to the contaminated infant formula of one of our competitors. This contamination incident has resulted in significant negative publicity for the entire domestic dairy and formula industries in China and demand for domestically-produced dairy and formula products, including our products, has declined significantly since September 2008 until late 2009. We recalled our affected U-Smart products as well as all other products produced at the same facilities in the Hebei and Inner Mongolia regions of China, where we believe the contaminated milk supplies originated. We also suspended production at our facilities in Qingdao, Hebei and Inner Mongolia for two weeks pending government and internal investigations. The total cost of this action was $100.6 million which was recognized as a charge to cost of sales, selling and distribution expenses and general and administrative expenses in our consolidated statement of income mostly in fiscal year 2009.
 
Although we have not confirmed any cases of kidney-related or other illnesses caused by our products, we cannot assure you that such cases will not surface in the future. The Chinese government has provided medical screening, treatment, and care for consumers affected by melamine contamination in infant formula products. We have contributed a net amount of $2.3 million to a compensation fund set up by China Dairy Industry Association to settle existing and potential claims arising in China from families of infants affected by melamine contamination. We cannot assure you that the Chinese government will not seek further reimbursement from dairy and formula product manufacturers, including us.
 
We believe the melamine contamination incident negatively impacted our brand and reputation in China. It also affected investor confidence in us as reflected by the significant decrease in our stock price after September 16, 2008. We cannot predict the long-term effect this recall and the negative publicity associated with the melamine contamination incident will have on our reputation among our customers, consumers and investors. Our results of operations and financial position, may, in the future, continue to be severely impacted if our customers and consumers cease to purchase our products as a result of lingering concerns from the melamine contamination incident.

 
 
In addition, in August 2010, several media reports alleging our infant formula products caused symptoms of hormone-triggered sexual prematurity in infants in the Hubei province of China. Our business was significantly and negatively impacted since then as a result of these media reports, and our sales volume decreased significantly. We increased the spending on advertising after the prematurity event to repair our reputation and regain market share. As a result, we had a significant net loss for the fiscal year ended March 31, 2011.
 
In the past, there have also been occurrences of counterfeiting and imitation of products in China that have been widely publicized. We cannot guarantee that contamination or counterfeiting or imitation of our or similar products will not occur in the future or that we will be able to detect it and deal with it effectively. Any occurrence of contamination or counterfeiting or imitation could negatively impact our corporate and brand image or consumers’ perception of our products or similar nutritional products generally, particularly if the counterfeit or imitation products cause injury or death to consumers. For example, in April 2004, sales of counterfeit and substandard infant formula in Anhui, China caused the deaths of 13 infants as well as harming many others. Although this incident did not involve the counterfeiting of our products, it caused significant negative publicity for the entire infant formula industry in China. The mere publication of information asserting that infant formula ingredients or products may be harmful could have a material adverse effect on us, regardless of whether these reports are scientifically supported or concern our products or the raw materials used in our products.
 
We believe that the melamine contamination incident, the prematurity event and any other adverse news related to formula products in China will also result in increased regulatory scrutiny of our industry, which may result in increased costs and reduce our margins and profitability. The government has enhanced its regulations on the industry aimed to ensure the safety and quality of dairy products, including but not limited to compulsory batch by batch inspection. This is likely to increase our operating costs and capital expenditure.
 
In addition, we are currently subject to claims and litigation stemming from the melamine contamination incident. See Item 3, Legal Proceedings. An adverse judgment in any of these cases could materially and negatively affect our results of operations or further damage our reputation and brand. Moreover, even if these claims are not successful, to the extent certain plaintiffs continue to pursue such claims and litigation, we may suffer continuing harm to our reputation and brand, which could negatively impact our market share and ability to compete. In the event any of these claims is successful, other potential claimants may be more likely to bring similar claims against us in the future.

If we fail to obtain raw materials in the quantity and the quality we need, and at commercially acceptable prices, our results of operations, financial condition and business prospects would be materially and adversely affected.
 
Our business requires certain key raw materials, such as raw milk, milk powder and whey protein powder. We may experience a shortage in the supply of certain raw materials in the future, which could materially and adversely affect our production and results of operations. We do not have guaranteed supply contracts with any of our raw material suppliers, and some of our suppliers may, without notice or penalty, terminate their relationship with us at any time. We also rely on a small number of suppliers for some of our raw materials, such as whey protein powder and imported milk powder. After the melamine contamination incident, we began importing milk powder from New Zealand for our U-Smart, Super, My Angel and Helanruniu, or Holsteina products as consumers have less confidence in domestically-produced milk powder. If any supplier is unwilling or unable to provide us with high quality raw materials in required quantities and at acceptable prices, we may be unable to find alternative sources or at commercially acceptable prices, on satisfactory terms, in a timely manner, or at all. Our inability to find or develop alternative sources could result in delays or reductions in production, product shipments or a reduction in our profit margins. Moreover, these suppliers may delay material shipments or supply us with inferior quality raw materials that may adversely impact the timely delivery or the quality of our products. If any of these events were to occur, our product quality, competitive position, reputation and business could suffer.
 
In addition, most of the raw materials used in our business are imported, such as whey protein powder and milk powder. For example, approximately 99% of the milk powder used in the powdered formula production is now imported from New Zealand. Our imported raw materials are subject to various PRC governmental permit requirements, approval procedures and import duties, and may also, from time to time, be subject to export controls and other legal restrictions imposed by foreign countries. Should the PRC government refuse to issue the necessary permits or approvals to us or our suppliers, or take any administrative actions to limit imports of certain raw materials, or if we or our suppliers fail to pay any required import duties, or if governmental agencies or laws of foreign countries prevent the timely export of certain raw materials we require to China, our ability to produce and sell our products in China could be materially and adversely affected. In addition, import duties increase the cost of our products and may make them less competitive.
 
Finally, certain suppliers of raw materials within our supply chain may contaminate our raw material supplies or provide us with substandard raw material supplies that adversely impact the quality of our products exposing our customers to health risks and damaging our reputation, brand and financial condition. For a more detailed description of this risk, and in particular the impact of the melamine contamination incident in China, see Part 1 - Item 1A. Risk Factors — We are highly dependent upon consumers’ perception of the safety and quality of our products. Any ill effects, product liability claims, recalls, adverse publicity or negative public perception regarding particular ingredients or products or our industry in general, could harm our reputation and damage our brand, and adversely affect our results of operations.

 
 
Any interruption in our supply of milk powder and raw milk could materially and adversely affect our results of operations, financial condition and business prospects.
 
We currently import approximately 99% of the milk powder used in the powdered formula production from New Zealand. The continuity of the milk powder supplies is of critical importance to our business. The importation of milk powder is influenced by numerous factors beyond our control, including, among other: (1) export control policy in the originating countries, (2) China’s government policy and regulation on milk powder importation as well as China’s custom inspection standards and (3) acts of God such as wars and natural disasters. Any interruption in our milk powder supplies could have a material adverse effect on our results of operations, financial condition and business prospects. In addition, we currently source substantially all of our milk powder from one supplier, Fonterra. If Fonterra fails to deliver the milk powder we need on the terms we have agreed, we may not be able to find an alternative source at a comparable price or on other favorable terms, and any delays in securing an alternative source could result in production delays and late shipments of our products to distribution and end customers.
 
We purchase most of our raw milk from individual dairy farmers and cooperatives without long-term contractual arrangements. Our raw milk supply is limited by the ability of the individual dairy farmers and cooperatives to provide raw milk in the amount and quality to meet our requirements. Raw milk production is, in turn, influenced by numerous factors beyond our control such as: (1) seasonal factors, with dairy cows generally producing more milk in temperate weather as opposed to cold or hot weather and extended unseasonably cold or hot weather potentially leading to lower than expected production; (2) environmental factors, with the volume and quality of milk produced by dairy cows closely linked to the quality of the nourishment provided by the environment around them; and (3) impact of governmental agricultural and environmental policy, with government grants, subsidies, provision of land, technical assistance and other agricultural and environmental policies having a direct effect on the viability of individual dairy farmers and dairy cooperatives, and the numbers of dairy cows and quantities of milk they are able to produce. We cannot assure you that we will be able to establish relationships with additional milk collection centers or that there will be sufficient supplies of raw milk from individual dairy farmers and cooperatives to be provided to any milk collection centers. Any interruption in our supply of raw milk could materially and adversely affect our ability to produce products that rely on raw milk.

Our results of operations may be affected by fluctuations in availability and price of raw materials. 

The raw materials we use are subject to price fluctuations due to various factors beyond our control, including increasing market demand, inflation, severe climatic and environmental conditions, commodity price fluctuations, currency fluctuations, changes in governmental and agricultural regulations and programs and other factors. We also expect that our raw material prices will continue to fluctuate and be affected by inflation in the future. Changes to our raw materials prices may result in increases in production and packaging costs, and we may be unable to raise the prices of our products to offset these increased costs in the short-term or at all. As a result, our results of operations may be materially and adversely affected.

 
 
We might face inventory write-down if milk powder inventory continues to increase and milk powder prices continue to decline. We maintain inventories of raw materials and finished products, and our inventories may spoil.
 
In the fiscal year ended March 31, 2011, all of milk powder used for the production of our Super, U-Smart, My Angel and Helanruniu series of products is imported. However, our domestic production facilities continued to purchase raw milk locally to produce milk powder for commercial resale and for our Mingshan series of products. As a result of the melamine contamination incident, there has been a decline in the consumption of dairy based products in the PRC, and a significant increase in milk powder imports. This has caused a nationwide inventory build up of domestically produced milk powder in the PRC. According to the Dairy Industry Association of China, as of March 31, 2009, surplus milk powder inventory in the PRC was estimated at 300,000 tons. Such inventory build up has caused a significant decline in domestically produced milk powder prices. For the fiscal year ended March 31, 2010, we took a write-down of our inventory of industrial milk powder of $6.7 million. Since March 31, 2010, we have seen a decrease in the milk powder inventory and stabilization of milk powder prices. However, we cannot be certain that we will not face significant inventory write-down which will adversely affect our financial results in the future.
 
Most of our finished products have an average shelf life of 18 to 24 months before the product is opened. Our raw materials, excluding raw milk, have an average shelf life of 12 months. Our inventory levels are based, in part, on our expectations regarding future sales. While we do not currently maintain large inventory levels for long periods, we may in future periods experience inventory buildup if our sales slow for any reason. Any significant shortfall in sales may result in higher inventory levels of raw materials and finished products than we require, thereby increasing our risk of inventory spoilage and corresponding inventory write-downs and write-offs, which may materially and adversely affect our results of operations.

Any major outbreak of illness or disease relating to cows in China and in the regions in which we import milk powder could lead to significant shortfalls in the supply of our raw milk and milk powder, and could result in consumers avoiding dairy products, which could result in substantial declines in our sales and possibly substantial losses.
 
A major outbreak of any illness or disease in cows in China and globally could lead to a serious loss of consumer confidence in, and demand for, dairy products. A major outbreak of mad cow disease (bovine spongiform encephalopathy), bovine tuberculosis, or bovine TB, or other serious disease in the principal regions supplying our raw milk and milk powder could lead to significant shortfalls in the supply of our raw milk and milk powder. Limited cases of bovine TB have occurred in several parts of China in the past. Furthermore, adverse publicity about these types of concerns, whether or not valid, may discourage consumers from buying dairy products or cause production and delivery disruptions. If consumers generally were to avoid our products, our sales would decline substantially and we could suffer substantial losses.

We may experience problems with product quality or product performance, or the perception of such problems, which could materially and adversely affect our reputation or result in a decrease in customers and revenue, unexpected expenses and loss of market share.
 
Our operating results depend, in part, on our ability to deliver high quality products on a timely and cost-effective manner. Our quality control and food safety management systems are complex. For example, there are over 1,100 quality control points throughout the whole production process. If the quality of any of our products deteriorated, it could result in delays in shipments, cancellations of orders or customer returns and complaints, loss of goodwill, and harm to our brand and reputation. In addition, following the melamine contamination incident, we purchase all of the milk powder used for our U-Smart, Super, My Angel and Helanruniu, or Holsteina products from New Zealand. We may be unable to exercise the same degree of quality control over this overseas supplier as we can over our own facilities. Any quality problems associated with the milk powder produced by this supplier would also affect our products’ quality and lead to negative publicity against us, materially and adversely affecting our reputation and brand, and causing a decrease in sales of our products and a loss of market share. For example, the melamine contamination incident in China has resulted in certain of our products being contaminated, impacting our brand and reputation.

 
 
Product liability claims against us could result in adverse publicity and potentially significant monetary damages.
 
As with other infant formula producers, we are also exposed to risks associated with product liability claims if the consumption of infant formula products we sell results in injury or death. We cannot predict what impact such product liability claims or resulting negative publicity would have on our business or on our brand image. The successful assertion of product liability claims against us could result in potentially significant monetary damages, diversion of management resources and require us to make significant payments and incur substantial legal expenses. We do not have product liability insurance and have not made provisions for potential product liability claims. Therefore, we may not have adequate resources to satisfy a judgment if a successful claim is brought against us. Even if a product liability claim is not successfully pursued to judgment by a claimant, we may still incur substantial legal expenses defending against such a claim and our brand image and reputation would suffer. Finally, serious product quality concerns could result in governmental actions against us, which, among other things, could result in the suspension of production or distribution of our products, loss of certain licenses, or other governmental penalties.
 
For example, the melamine contamination incident in China in 2008 resulted in certain of our products being contaminated. As a result, lawsuits have been filed against us in both China and the U.S. by Chinese families alleged to have been affected by melamine contamination, seeking compensatory and punitive damages. See “Item 3 - Legal Proceedings.” We may incur significant legal expenses and be subject to significant monetary damages in connection with such claims, which may adversely affect our results of operations and further harm our reputation and damage our brand. Further, we cannot assure you that we will not become subject to future product liability claims in connection with the melamine contamination incident. See Part 1 - Item 1A. Risk Factors — We are highly dependent upon consumers’ perception of the safety and quality of our products. Any ill effects, product liability claims, recalls, adverse publicity or negative public perception regarding particular ingredients or products or our industry in general could harm our reputation and damage our brand and adversely affect our results of operations.”

Our sales, results of operations, brand image and reputation could be materially and adversely affected if we fail to efficiently manage our operations without interruption, or fail to ensure that our products are delivered on time.
 
Our business requires successful coordination of several sequential and complex processes, the disruption of any of which could interrupt our operations and materially and adversely affect our relationships with our distributors, sub-distributors and end-customers, our brand name and reputation, and our financial performance. Our operations involve the coordination of raw material sourcing from third parties, internal production processes and external distribution processes. We may face difficulties in coordinating the various aspects of our production processes, resulting in downtime and delays.
 
In addition, we may encounter interruptions in our production processes due to a catastrophic loss or events beyond our control, such as fires, explosions, labor disturbances, earthquakes or other natural disasters. If there is a stoppage in production at any of our facilities, even if only temporary, or delays in deliveries to our customers, our business and reputation could be materially and adversely affected. Along with many other producers of dairy and consumer products in China, we generally rely on third-party logistics companies and distributors for the delivery of our products. Delivery may be disrupted for various reasons, many of which are beyond our control, including natural disasters, weather conditions or social unrest and strikes, which could lead to delayed or lost deliveries. In addition, transportation and related infrastructure conditions are often generally under-developed in some of the regions where we sell our products. We currently do not have business interruption insurance to offset these potential losses, delays and risks, so a material interruption of our business operations could materially damage our business.

 
 
We rely primarily on third-party distributors and cannot assure you that their marketing and distribution of our products will be effective or will not harm our brand and reputation. Moreover, if we fail to timely identify and appoint additional or replacement distributors as needed, or are unable to successfully manage our distribution network, our operating results could suffer.
 
We primarily rely on third-party distributors and sub-distributors for the distribution and sales of our products. We sell our products through an extensive nationwide distribution and sales network covering 30 provinces and provincial-level municipalities in China. As of March 31, 2011, this network comprised over 580 independent distributors and over 1,000 independent sub-distributors who sell our products in over 71,000 retail outlets. Our distributors normally have exclusive distribution rights in their respective regions, and are also responsible for developing the sub-distributors located in their own regions. In addition, our distributors are not required to exclusively distribute our products. We typically do not enter into long-term agreements with distributors and have no control over their everyday business activities. Consequently, our distributors may engage in activities that are prohibited under our arrangements with them, that violate PRC laws and regulations governing the dairy industry or other PRC laws and regulations generally, or that are otherwise harmful to our business or our reputation. Due to our dependence on distributors for the sale and distribution of our products to retail outlets, any one of the following events could cause material fluctuations or declines in our revenue and have a material adverse effect on our financial condition and results of operations:
 
 
·  
reduction, delay or cancellation of orders from one or more of our distributors;
 
 
·  
selection or increased sales by our distributors of our competitors’ products; and
 
 
·  
our failure to timely identify and appoint additional or replacement distributors upon the loss of one or more of our distributors.
 
The competition for distributors is intense in our industry in China and many of our competitors are expanding their distribution networks in China. We may not be able to compete successfully against the larger and better-funded sales and marketing operations of some of our current or future competitors, especially if these competitors provide more favorable arrangements for distributors. As a result, we may lose some of our distributors to our competitors, which may cause us to lose some or all of our favorable arrangements with such distributors and may even result in the termination of our relationships with some of our distributors. While we do not believe we are substantially dependent upon any individual distributor, finding replacement distributors could be time-consuming and any resulting delay may be disruptive and costly to our business. In addition, we may not be able to successfully manage our distributors and the cost of any consolidation or further expansion of our distribution network may exceed the revenue generated from these efforts. The occurrence of any of these factors could result in a significant decrease in the sales volume of our products and therefore materially harm our financial condition and results of operations.

Our results of operations and business prospects may be impaired by changing consumer preferences if we do not develop and offer products to meet changing preferences.
 
Consumer preferences evolve over time and the success of our products depends on our ability to identify the tastes and nutritional needs of our customers and to offer products that appeal to their preferences. We introduce new products and improved products from time to time and incur significant development and marketing costs. If our products fail to meet consumer preferences, then our strategy to grow sales and profits with new products will be less successful.

More mothers may breastfeed their babies rather than use our products, resulting in reduced demand for our products and adversely affecting our revenues.
 
Our results of operations are affected by the number of mothers who choose to use our products rather than breastfeeding their babies. Much publicly available data suggests that breastfeeding has many health benefits for the baby that cannot be replicated by dairy-based infant formula products. Additionally, popular literature, cultural pressure, government policies and medical advice in China generally promote the benefits of breastfeeding. For example, on August 1, 2007, China’s Ministry of Health issued an Infant Feeding Strategy which promoted breastfeeding and requested all local relevant departments to publicize the benefits of breastfeeding through radio broadcasting, television and newspapers during World Breastfeeding Week, which took place in early August 2007. Thus, to the extent that private, public and government sources increasingly promote the benefits of breastfeeding, there could be a reduced demand for our products and our revenues could be adversely affected.
 
In addition, we believe the melamine contamination incident has deteriorated customer confidence in the safety and quality of infant formula products made in China and the number of mothers (and future mothers) who choose to breastfeed their babies may significantly increase. The overall market demand for infant formula products has slowed and may continue to decline and reduced demand for our products will negatively impact our revenues and growth prospects.
 
 
 
 
The disruptions in the overall economy and the financial markets that started in late calendar year 2007 may adversely impact our business and results of operations and may limit our access to additional financing.
 
Financial markets in the United States, Europe and Asia had experienced extreme disruptions that started in late calendar year 2007, including, among other things, extreme volatility in security prices, the failure and near failure of a number of large financial services companies, severely diminished liquidity and credit availability, rating downgrades of certain investments and declining valuations of others.
 
The infant formula industry can be affected by macro economic factors, including changes in national, regional, and local economic conditions, employment levels and consumer spending patterns.  Though the disruptions in the overall economy and financial markets was less severe in China than in the U.S., it could reduce consumer confidence in the economy and negatively affect consumers’ spending, which could be harmful to our financial position and results of operations.
 
In addition, if the capital and credit markets continue to experience volatility and the availability of funds remains limited, we will incur increased costs associated with equity and/or debt financing. It is possible that our ability to access the capital and credit markets may be limited by these or other factors at a time when we would like, or need, to do so, which could have an adverse impact on our ability to refinance maturing debt and/or react to changing economic and business conditions. In addition, fluctuations in interest rate could impact our floating rate debt negatively and increase our debt obligations.

Failure to execute our expansion plan could adversely affect our financial condition and results of operations.
 
We may increase our annual production capacity in the future to meet any expected increase in demand for our products. Our decision to increase our production capacity is based in part on our projections of increases in our sales volume and growth in the size of the infant formula product market in China. If actual customer demand does not meet our projections, we will likely suffer overcapacity problems and have idle capacity, which may materially and adversely affect our financial condition and results of operations. Our future success depends on our ability to expand our business to address expected growth in demand for our current and future products. Our ability to add production capacity and increase output is subject to significant risks and uncertainties, including:
 
 
·  
the availability and cost of additional funding to expand our production capacity, build new processing and packaging facilities, make additional investments in our subsidiaries, acquire additional businesses or production facilities, purchase additional fixed assets and purchase raw materials on favorable terms or at all;
 
 
·  
delays and cost overruns as a result of a number of factors, many of which may be beyond our control, such as problems with equipment vendors and suppliers of raw materials;
 
 
·  
failure to maintain high quality control standards;
 
 
·  
global or local shortage of raw materials, such as raw milk or whey protein powder;
 
 
·  
our inability to obtain, or delays in obtaining, required approvals by relevant government authorities;
 
 
·  
diversion of significant management attention and other resources; and
 
 
·  
failure to execute our expansion plan effectively.
 
As our business grows, we will need to implement a variety of new and upgraded operational and financial systems, procedures and controls, including improvements to our accounting and other internal management systems by dedicating additional resources to our reporting and accounting functions, and improvements to our record keeping and contract tracking system. We will need to respond to competitive market conditions and continue to enhance existing products and develop new products, and retain existing customers and attract new customers. We will also need to recruit more personnel and train and manage our growing employee base. Furthermore, we will need to maintain and expand our relationships with our current and future customers, suppliers, distributors and other third parties, and there is no guarantee that we will succeed.
 
If we encounter any of the risks described above, or are otherwise unable to establish or successfully operate additional production capacity or to increase production output, we may be unable to grow our business and revenues, reduce our operating costs, maintain our competitiveness or improve our profitability, and our business, financial condition, results of operations and prospects may be adversely affected.
 
 

 
Any future expansion into many of China’s major urban centers may be costly, time-consuming and difficult. If we do not successfully expand into such markets, our results of operations and prospects may be materially and adversely affected.
 
Our future success may depend upon our ability to successfully expand into many of China’s major urban centers. To further promote our brand and generate demand for our products in such markets, we may increase our spending on marketing and promotion. We may be unable to attract a sufficient number of distributors with the experience and ability to penetrate these markets, and our selected distributors may not be suitable for selling our products in these markets for other reasons. We may also fail to attract new customers in such markets who may have less familiarity with our brand and products. Furthermore, we may fail to anticipate and address competitive conditions in these new markets that are different from those in our existing primary markets. These competitive conditions may make it difficult or impossible for us to effectively operate in these markets. If our expansion efforts in existing and new markets are unsuccessful, our results of operations and prospects may be materially and adversely affected.

Part of our strategy involves the development of new products and new business segments, and if we fail to timely develop new products or we incorrectly gauge the potential market for new products, our financial results would be adversely affected.
 
We plan to utilize our in-house research and development capabilities to develop new products that could become new sources of revenue for us in the future and help us to diversify our revenue base. We have also entered into new business segments such as the prepared baby food segment, and the nutritional ingredients and supplements segment. Our future research and development efforts will focus on further expanding our product offerings beyond dairy-based nutritional products. If we fail to timely develop these and other new products or if we incorrectly gauge market demand for such new products, we may not be able to grow our sales revenue at expected growth rates and may incur expenses and capital expenditure costs relating to the development of new products that are not offset by the sales they generate.

We operate in a competitive environment, which may lead to declining revenue growth or other circumstances that would negatively affect our results of operations.
 
The market for pediatric nutritional products is competitive, and we believe that competition in this market will continue to intensify. We believe that the principal competitive factors in our markets are brand recognition, quality, advertising, formulation, packaging, and price. We face significant competition from a number of competitors, including multinational companies, such as Abbot Laboratories’ Ross Products Division, Mead Johnson, Nestle, Numico and Wyeth, and domestic companies, such as Beingmate, Yashili, Feihe and Yili. See “Item 1. Business—Competition”. Many of our competitors have longer operating histories, greater name recognition, significantly larger market shares, access to larger customer bases and significantly greater financial resources and economies of scale in financial, sales and marketing, production, distribution, technical and other resources than we do. Some of these competitors have used, and we expect will continue to use, more aggressive pricing strategies, greater amounts of incentives and subsidies for distributors, retailers and customers and more advanced processes and technologies. Furthermore, consolidation among industry participants in China may potentially result in stronger domestic competitors that are better able to compete as end-to-end suppliers as well as competitors who are more specialized in particular areas and geographic markets. This could have a material adverse effect on our business, financial condition, results of operations and prospects. In addition, as a result of the melamine contamination incident, customers have lost confidence in infant formula produced by domestic companies for the time being, which gives multinational infant formula companies an advantage over us.
 
In order to compete successfully in our markets, we will need to continue to restore customer confidence in our brand and products, develop new products and enhance our product offerings while maintaining price competitiveness. Even if we successfully restore customer confidence, if and to the extent we fail to develop new products that differentiate us from our competitors, we may need to compete largely on price, which may cause our operating margins to decline. Our inability to compete successfully against competitors and pricing pressures could result in lost customers, loss of market share and reduced operating margins, which would adversely impact our results of operations.
 
 

 
If we grant employee stock options and other stock-based compensation in the future, we will be required to recognize stock-based compensation expense, which would adversely affect our results of operations.
 
As of the date of this Form 10-K, we have not granted any stock-based compensation and thus have not been required to reflect any such expenses in our results of operations. We adopted a stock -based compensation plan in June 2008 and intend to grant certain employees and directors stock-based compensation, which we believe will be important to attract and retain key personnel. We will be required to account for compensation costs for all stock options, including stock options granted to our directors and employees, using the fair value method and recognize the expense in our consolidated statement of operations in accordance with Accounting Standards Codification (ASC) 718-10, “Compensation – Stock Compensation – Overall” (previously Statement of Financial Accounting Standards (SFAS) No. 123-R, “Share-Based Payment”) which may have a material adverse effect on our results of operations.

We may be exposed to liabilities under the Foreign Corrupt Practices Act, and any determination that we violated the Foreign Corrupt Practices Act could have a material adverse effect on our business.
 
We are subject to the Foreign Corrupt Practice Act, or the FCPA, and other laws that prohibit improper payments or offers of payments to foreign governments and their officials and political parties by U.S. persons and issuers as defined by the statute for the purpose of obtaining or retaining business. We have operations, agreements with third parties and make sales in China, which may experience corruption. Our activities in China create the risk of unauthorized payments or offers of payments by one of the employees, consultants, sales agents or distributors of our company, because these parties are not always subject to our control. It is our policy to implement safeguards to discourage these practices by our employees. However, our existing safeguards and any future improvements may prove to be less than effective, and the employees, consultants, sales agents or distributors of our Company may engage in conduct for which we might be held responsible. Violations of the FCPA may result in severe criminal or civil sanctions, and we may be subject to other liabilities, which could negatively affect our business, operating results and financial condition. In additions, the government may seek to hold our Company liable for successor liability of FCPA violations committed by companies in which we invest or that we acquire.

We have previously experienced certain material weaknesses and deficiencies with our internal control over financial reporting. Any further failure to accurately report our financial results, including any resulting restatement, could result in harm to our business, loss of investor confidence in our financial reporting and a lower trading price of our common stock, or possibly lead to the delisting of our common stock by the NASDAQ Global Select Market.
 
In connection with the review of our financial statements for the fiscal year ended March 31, 2008, our independent registered public accounting firm and our management identified certain material weaknesses and significant deficiencies. A material weakness is defined by the Public Company Accounting Oversight Board, or PCAOB, as 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. A significant deficiency is defined by the PCAOB as a deficiency, or combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of our financial reporting.
 
Due to the material weaknesses and significant deficiencies in our internal control over financial reporting for the fiscal year ended March 31, 2008—as evidenced by the significant number and magnitude of out-of-period adjustments identified during the year-end and period-end closing process—we previously concluded in our prior SEC filings that our disclosure controls and procedures and our internal control over financial reporting were not effective at the reasonable assurance level, and, prior to the restatement of certain prior periods, that investors should not rely on our prior financial statements. We have taken steps to remediate our material weaknesses and deficiencies in our internal control over financial reporting, and we believe that the material weakness identified as of March 31, 2008 has been fully remediated, see “Part II. Item 9A. Controls and Procedures.” of 10-K for the fiscal year ended March 31, 2009. There can be no assurance that any current or future deficiencies will not contribute to, or cause, possible material weaknesses in the future or, that we will be able to implement effectively new or improved controls or that our management or our independent registered public accounting firm will determine that our disclosure controls and procedures or our internal control over financial reporting will be effective in the future.
 
 Moreover, a lack of effective internal control over financial reporting in the future could cause us to fail to provide accurate financial statements or fail to meet our reporting obligations, either of which could cause investors to lose confidence in our reported financial information, and have a negative effect on the trading price of our common stock. Our failure to meet our reporting obligations in a timely fashion may also lead to the delisting of our common stock by the NASDAQ Global Select Market.
 
 

 
Our success depends to a substantial degree upon our senior management and key personnel, and our business operations may be significantly and negatively affected if we fail to attract and retain highly competent senior management and key personnel.
 
Our future success depends substantially on the continued services of our key personnel including, particularly, Liang Zhang, our chairman and chief executive officer. We rely substantially on their experience in the dairy and nutritional products industry, and on their relationships and ability to work with our suppliers and distributors and other customers. If we lose the services of one or more of these key personnel, we may not be able to replace them readily, if at all, with suitable or qualified candidates, and may incur additional expenses to recruit and retain new officers and key personnel, which could severely disrupt our business and growth. We do not maintain key-man life insurance for any of our key personnel.
 
In addition, if any of these key personnel joins a competitor or forms a competing company, we may lose some of our distributors. We have entered into employment agreements with each of these key personnel, which contain confidentiality and non-competition provisions. However, if any disputes were to arise between these key personnel and us, it is not clear, in light of uncertainties associated with the PRC legal system, what the court decisions would be and the extent to which these court decisions could be enforced in China, where most of these key personnel reside and hold some of their assets. See “Item 1A. Risk Factors—Risks Associated with Doing Business in China—Uncertainties with respect to the PRC legal system could limit the legal protections available to you and us.” Furthermore, as we expect to continue to expand our operations and develop new products, we will need to continue attracting and retaining experienced management and key research and development personnel.
 
Competition for experienced management and research and development personnel in China is intense, and the availability of experienced, suitable and qualified candidates is limited. Competition for these individuals may require us to pay higher compensation and other benefits in order to attract and retain them, which could have a material adverse effect on our financial condition and results of operations. We may also be unable to attract or retain the personnel necessary to achieve our business objectives, and any failure in this regard could severely disrupt our business and growth.

Liang Zhang’s association with other businesses could impede his ability to devote sufficient time to our business and could present potential conflicts of interest.
 
Liang Zhang, our founder, chairman, chief executive officer and principal beneficial stockholder, controls several other companies, including Honnete, a supplier of whey protein powder in China. Liang Zhang devotes most of his time to our affairs and the remainder of his time to the affairs of the other companies. Liang Zhang’s decision-making responsibilities for these other companies are similar in the areas of public relations, risk management and strategic planning. As a result, conflicts of interest may arise from time to time and we cannot assure you that they will be resolved in our favor. Additionally, even though Liang Zhang devotes most of his time to our affairs and is further accountable to us and our stockholders as a fiduciary, which requires that he exercise good faith and due care in handling our affairs, we cannot assure you this will always be the case and his existing responsibilities to other businesses and entities may limit the amount of time he can spend on our affairs.

Our chairman and chief executive officer, Liang Zhang, beneficially owns a substantial amount of our common stock and will have significant influence over our corporate affairs.
 
Our founder, chairman and chief executive officer, Liang Zhang, beneficially owns approximately 62.8% of our outstanding common stock through a company owned by his wife as of March 31, 2011. Accordingly, Liang Zhang will be able to direct the outcome of matters requiring approval of the stockholders, including the election of our directors and other corporate actions such as:
 
 
·  
our merger with or into another company;
 
 
·  
a sale of our assets; and
 
 
·  
amendments to our certificate of incorporation.
 
The decisions of Liang Zhang may conflict with our interests or the interests of our other stockholders.
 

 
 
 
We may not succeed in identifying suitable acquisition targets, which could adversely affect our ability to expand our operations and service offerings and enhance our competitiveness.
 
Our strategy contemplates growth through acquisitions. We have pursued and may in the future pursue strategic acquisition opportunities to increase our scale and geographic presence and expand the number of our product offerings. However, we may not be able to identify suitable acquisition or investment candidates, or, even if we do identify suitable candidates, we may not be able to complete those transactions on terms commercially favorable to us or at all, which could adversely affect our competitiveness and our growth prospects.
 
If we acquire other companies in the future, we could face the following risks:
 
 
·  
difficulty in integrating the target company’s personnel, operations, products, services and technology into our operations;
 
 
·  
the presence of unforeseen or unrecorded liabilities;
 
 
·  
entry into unfamiliar markets;
 
 
·  
inability to generate sufficient revenues to offset acquisition costs; and
 
 
·  
tax and accounting issues.
 
Many recently joined employees may decide not to work with us or to leave shortly after joining our company. These difficulties could disrupt our ongoing business, distract our management and current employees and increase our expenses, including write-offs or impairment charges. Acquired companies also may not perform to our expectations for various reasons, including the loss of key personnel, key distributors, key suppliers or key customers, and our strategic focus may change. As a result, we may not realize the benefits we anticipated. If we fail to integrate acquired businesses or realize the expected benefits, we may lose the return on the investment in these acquisitions or incur additional transaction costs and our operations may be negatively impacted as a result. Further, any acquisition or investment that we attempt, whether or not completed, or any media reports or rumors with respect to any such transactions, may adversely affect our competitiveness, our growth prospects, and the value of our common stock.

Our business is capital intensive and our growth strategy may require additional capital that may not be available on favorable terms or at all.
 
We have, in the past, obtained loans and sold our common stock to raise additional capital. Our business requires significant capital and although we believe that our current cash, and cash flow from operations will be sufficient to meet our present and reasonably anticipated cash needs, we may, in the future, require additional cash resources due to changed business conditions, implementation of our strategy to expand our production capacity or other investments or acquisitions we may decide to pursue. If our own financial resources are insufficient to satisfy our capital requirements, we may seek to sell additional equity or debt securities or obtain additional credit facilities. For example, the melamine contamination incident has significantly impacted our liquidity due to our product recall and required us to obtain additional funding through short-term loans for working capital purposes after the incident. In addition to these short-term loans, we may need to obtain additional private or public financing including debt or equity financing and there can be no assurance that such financing will be available as needed or, if available, on terms favorable to us. Any additional equity financing may be dilutive to stockholders and such additional equity securities may have rights, preferences or privileges that are senior to those of our existing common stock. The incurrence of indebtedness would result in increased debt service obligations and could require us to agree to operating and financial covenants that would restrict our operations. If we are unable to generate sufficient cash flow from operating activities or obtain funds for required payments of interest and principal on such additional indebtedness, or if we fail to comply with our debt covenants, we will be in default. In addition, changes in our debt rating due to the melamine contamination incident could have a material adverse effect on our interest costs and financing sources. Financing may not be available in amounts or on terms acceptable to us, if at all. Any failure by us to raise additional funds on terms favorable to us, or at all, could limit our ability to expand our business operations and could harm our overall business prospects.
 
 

 
We have recently incurred operating losses; this may have a harmful effect on our business and the value of our common stock.
 
As a result of the melamine contamination incident, we have incurred losses from the quarter ended September 30, 2008 to the quarter ended December 31, 2009 from the lingering impact of the product recall and only returned to profitability in the quarters ended March 31, 2010 and June 30, 2010. In addition, as a result of the prematurity event, we incurred losses for the quarters ended September 30, 2010, December 31, 2010 and March 31, 2011. Though we expect this to be a short-term financial challenge for us, the melamine contamination incident and the prematurity event have negatively impacted our brand and reputation in China and may impact our future revenues. We have incurred expenses relating to the melamine contamination incident and the prematurity event and we may incur more expenses in the future relating to expanding our production capacity or other investments or acquisitions we may decide to pursue. If our revenue does not increase or if we fail to maintain our expenses at an amount less than our projected revenues, we will not be able to achieve or sustain operating profitability on a consistent basis. Given our planned operating and capital expenditures as well as our overall business plan, for the foreseeable future we expect our results of operations to fluctuate, and during this period we may continue to incur losses. Our lack of profitability may have an adverse effect on the market value of our common stock and on our cash flow and liquidity.

We may face liquidity challenges to meet our debt obligations and may require additional funding in the future.
 
As a result of the melamine contamination incident, we had negative cash flow from operations of $109.5 million for the fiscal year ended March 31, 2009. In addition, at March 31, 2009, we had short-term debt of $224.6 million, consisting of short-term debt from banks in the amount of $182.6 million, an additional $7.5 million in short-term loans from related parties, and $34.5 million under our loan agreement (the “RBS Loan”) with The Royal Bank of Scotland, N.V. (“RBS”) which has been reclassified as a current liability since we did not meet our financial covenants under the loan as of March 31, 2009. We amended the RBS Loan in the fiscal year ended March 31, 2010 and our results improved in the fiscal year ended March 31, 2010. However, we still had negative cash flow from operations of $11.8 million for the fiscal year ended March 31, 2010 and as of March 31, 2010, we had short-term debt and long-term debt due within one year of $159.3 million. In addition, as a result of the prematurity event, we had negative cash flow from operations of $66.3 million for the fiscal year ended March 31, 2011. At March 31, 2011, we had short-term debt of $124.3 million and long-term debt due within one year of $38.1 million. Our consolidated financial statements have been prepared assuming we will continue as a going concern, however, our ability to meet our debt obligations will depend on our future performance, which will be affected by financial, business, domestic and foreign economic conditions and other factors, many of which we are unable to control. As a result, we cannot be assured that our revenues will provide cash flow in excess of our cash needs, and we therefore may have negative cash flow in the future. If our cash flow is not sufficient to service our debt, we may be required to obtain additional financing in the future, and such additional financing may not be available at times, in amounts or on terms acceptable to us or at all, which would have a material adverse effect on our business. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources.”

We have limited property insurance coverage and do not carry any business interruption insurance.
 
Operation of our facilities involves many risks, including equipment failures, natural disasters, industrial accidents, power outages, labor disturbances and other business interruptions. Furthermore, if any of our products are faulty or contaminated, then we may become subject to product liability claims or we may have to engage in a product recall.
 
We do not carry any business interruption insurance, and have limited property insurance coverage. Therefore, our existing insurance coverage may not be sufficient to cover all risks associated with our business. As a result, we may be required to pay for financial and other losses, damages and liabilities, including those caused by natural disasters and other events beyond our control, out of our own funds, which could have a material adverse effect on our business, financial condition and results of operations. For example, all of the costs we have incurred to date and may incur in the future that are related to our product recall in connection with the melamine contamination incident is not covered by our existing insurance policies.
 
 

 
Failure to adequately protect our intellectual property rights may undermine our competitive position, and litigation to protect our intellectual property rights may be costly.
 
We rely primarily on trade secrets and other contractual restrictions to protect our intellectual property. We have not registered or applied for protections in China for most of our intellectual property or proprietary technologies relating to the formulations of powdered infant formula that we produce. In order to protect our proprietary technology and processes, we also rely in part on nondisclosure agreements with our employees, licensing partners, third-party producers, consultants, agents and other organizations to which we disclose our proprietary information. The actions we have taken to protect our intellectual property rights may not be adequate to provide us with meaningful protection or commercial advantage. As a result, third parties may use the intellectual property or proprietary technologies that we have developed and compete with us, which could have a material adverse effect on our business, financial condition and operating results.
 
PRC intellectual property-related laws and their implementation are still under development. Accordingly, intellectual property rights and confidentiality protections in China may not be as effective as in the United States or many other countries. In addition, policing unauthorized use of proprietary technology can be difficult and expensive. Litigation may be necessary to enforce our intellectual property rights and the outcome of any such litigation may not be in our favor. Given the relative unpredictability of China’s legal system and potential difficulties enforcing a court judgment in China, there is no guarantee that we would be able to halt the unauthorized use of our intellectual property through litigation in a timely manner or at all. Furthermore, any such litigation may be costly and may divert management attention away from our business and cause us to expend significant resources. An adverse determination in any such litigation will impair our intellectual property rights and may harm our business, prospects and reputation. In addition, we have no insurance coverage against litigation costs and would have to bear all costs arising from such litigation to the extent we are unable to recover them from other parties. The occurrence of any of the foregoing could have a material adverse impact on our business, financial condition and results of operations.

We may be exposed to infringement or misappropriation claims by third parties, which, if determined adversely against us, could disrupt our business and subject us to significant liability to third parties.
 
Our success largely depends on our ability to use and develop our know-how and product formulations without infringing upon the intellectual property rights of third parties. We may be subject to litigation involving claims of infringement or violation of other intellectual property rights of third parties. The holders of patents and other intellectual property rights potentially relevant to our product offerings may be unknown to us or may otherwise make it difficult for us to acquire a license on commercially acceptable terms.
 
There may also be technologies licensed to and relied on by us that are subject to infringement or other corresponding allegations or claims by others which could damage our ability to rely on such technologies. In addition, although we endeavor to ensure that companies that work with us possess appropriate intellectual property rights or licenses, we cannot fully avoid the risks of intellectual property rights infringement created by suppliers of raw materials used in our products, our third-party producers, or by companies with which we work in cooperative research and development activities. Our current or potential competitors, many of which have substantial resources and have made substantial investments in competing technologies, may have obtained or may obtain patents that will prevent, limit or interfere with our ability to make, use or sell our products in China or other countries. The defense of intellectual property claims, including patent infringement suits, and related legal and administrative proceedings can be both costly and time-consuming, and may significantly divert the efforts and resources of our technical and management personnel. Furthermore, an adverse determination in any such litigation or proceeding to which we may become a party could cause us to:
 
 
·  
pay damage awards;
 
 
·  
seek licenses from third parties, which may not be available on reasonable terms or at all;
 
 
·  
pay additional ongoing royalties, which could decrease our profit margins;
 
 
·  
redesign our products, which may be costly, if possible at all; or
 
 
·  
be restricted by injunctions.
 
These factors could effectively prevent us from pursuing some or all of our business and result in our customers or potential customers deferring, canceling or limiting their purchase or use of our products, which could have a material adverse effect on our financial condition and results of operations.
 
 
 
Our Independent Registered Public Accounting Firm issued a clean opinion to our consolidated financial statements for the fiscal year ended March 31, 2009; however, it contained an emphasis paragraph raising substantial doubt about our ability to continue as a going concern.
 
Our financial statements for the fiscal year ended March 31, 2009 were prepared assuming that we would continue as a going concern. By discussing the difficulties we were experiencing after the melamine contamination incident, we raised substantial doubt about our ability to continue as a going concern. Our independent registered public accounting firm issued a clean opinion on our consolidated financial statements, however, they included an emphasis paragraph in its report on our fiscal year ended March 31, 2009 financial statements with a statement raising substantial doubt regarding our ability to continue as a going concern.  In the fiscal year ended March 31, 2010, we had refinanced our debt and our liquidity position had improved, as a result, our independent registered public accounting firm’s report on our financial statements no longer contains a reference to our ability to continue as a going concern. In the fiscal year ended March 31, 2011, we had refinanced our debt, obtained credit facilities from certain PRC banks, as a result, our independent registered public accounting firm’s report on our financial statements does not contain a reference to our ability to continue as a going concern. However, we cannot assure you that our liquidity position will not deteriorate in the future and that there will not be renewed doubt about our ability to continue as a going concern, which could materially and adversely affect our relationships with suppliers or customers.

Risks Associated With Doing Business in China
 
Adverse changes in political and economic policies of the PRC government could impede the overall economic growth of China, which could reduce the demand for our products and damage our business.
 
We conduct our operations and generate all of our revenues in China. Accordingly, our business, financial condition, results of operations and prospects are affected significantly by economic, political and legal developments in China. The PRC economy differs from the economies of most developed countries in many respects, including:
 
 
·  
the higher level of government involvement and regulation;
 
 
·  
the early stage of development of the market-oriented sector of the economy;
 
 
·  
the rapid growth rate;
 
 
·  
the higher rate of inflation;
 
 
·  
the higher level of control over foreign exchange; and
 
 
·  
government control over the allocation of many resources.
 
As the PRC economy has been transitioning from a planned economy to a more market-oriented economy, the PRC government has implemented various measures to encourage economic growth and guide the allocation of resources. While these measures may benefit the overall PRC economy, they may also have a negative effect on us.
 
Although the PRC government has in recent years implemented measures emphasizing the utilization of market forces for economic reform, the PRC government continues to exercise substantial control over virtually every sector of the PRC economy through the allocation of resources, controlling payment of foreign currency-denominated obligations, setting monetary policy and imposing policies that impact particular industries or companies in different ways. Our ability to operate in China may be harmed by changes in PRC laws and regulations, including those relating to how we conduct our business, taxation, import and export tariffs, environmental regulations, land use rights, property and other matters. We believe that our operations in China are in material compliance with all applicable legal and regulatory requirements. However, the central or local governments of the jurisdictions in which we operate may impose new, stricter regulations or interpretations of existing regulations that would require additional expenditures and efforts on our part to ensure our compliance with such regulations or interpretations.
 
Accordingly, government actions in the future, including any decision not to continue to support recent economic reforms and to return to a more centrally planned economy or regional or local variations in the implementation of economic policies, could have a significant adverse effect on economic conditions in China or particular regions thereof and could require us to divest ourselves of any interest we then hold in PRC properties or joint ventures.
 
 

 
PRC food hygiene and safety laws may become more onerous, which may adversely affect our operations and financial performance and lead to an increase in our costs which we may be unable to pass on to our customers.
 
Operators within the PRC dairy industry and infant formula sector are subject to compliance with PRC food hygiene and safety laws and regulations. Such laws and regulations require all enterprises engaged in the production of dairy and infant formula products to obtain a hygiene license. They also set out hygiene standards with respect to food and food additives, packaging and containers, and labeling on packaging as well as hygiene requirements for food production and sites, facilities and equipment used for the transportation and the sale of food. Failure to comply with PRC food hygiene and safety laws may result in fines, suspension of operations, loss of hygiene license and, in certain cases, criminal proceedings against an enterprise and its management. Although we are in compliance with current PRC food hygiene and safety laws and regulations, in the event that such laws and regulations become more stringent or widen in scope, we may fail to comply with such laws, or if we comply, our production and distribution costs may increase, and we may be unable to pass these additional costs on to our customers. For example, in response to the melamine contamination incident, the PRC State Council abolished the regulations on inspection exemptions for food on September 18, 2008 so that our products were to be subject to batch by batch inspection going forward. In addition, the PRC State Council promulgated with immediate effect the Regulation on Supervision and Administration of Quality and Safety of Dairy Products on October 9, 2008 which, among other things, imposes more stringent requirements for inspection, production, packaging, labeling and product recall on dairy product producers. These measures have increased our costs in the past and are likely to continue to contribute to our costs in the future, which costs we may be unable to pass on to our customers.

Changes in the regulatory environment for dairy and infant nutrition products in China could negatively impact our business.
 
The dairy and infant nutrition product industries in China are regulated and regulatory changes may affect both our customers and us. Any changes in regulations that impose additional requirements for construction of new production lines and facilities or expansion of existing facilities will require us to secure additional government approvals for our current production expansion projects. Similarly, additional safety and quality control regulations could impact our costs of production. For example, on June 26, 2009, NDRC and MIIT jointly, promulgated the Dairy Industry Policies (2009 Version), or the Policies. The Policies impose new conditions that an entity must satisfy in order to engage, or continue to engage, in the dairy products processing business. For a more detailed description of these requirements, see “Item 1. Business—Regulation”. Although we believe our existing entities and facilities meet the Policies requirements, it is possible that our future expansion plans or the establishment of new entities may fail to meet one or more of the requirements under the Policies in the future. Failure to comply with these or any other changes in regulations affecting our business could have a material adverse effect on our business and our results of operations. In addition, the indirect impact of any such changes could adversely affect our business even if the specific regulations do not directly apply to our products or us.

Uncertainties with respect to the PRC legal system could limit the legal protections available to you and us.
 
We conduct our business through our operating subsidiaries in China. Our operating subsidiaries are generally subject to laws and regulations applicable to foreign investments in China and, in particular, laws applicable to foreign-invested enterprises. The PRC legal system is based on written statutes, and prior court decisions may be cited for reference, but have limited precedential value. Over the past several decades, a series of new PRC laws and regulations have significantly enhanced the protections afforded to various forms of foreign investments in China. However, since the PRC legal system continues to rapidly evolve, the interpretations of many laws, regulations and rules are not always uniform and enforcement of these laws, regulations and rules involve uncertainties, which may limit legal protections available to you and us. In addition, any litigation in China may be protracted and result in substantial costs and diversion of resources and management attention.
 
 
 
If we are found to have failed to comply with applicable laws, we may incur additional expenditures or be subject to significant fines and penalties.
 
Our operations are subject to PRC laws and regulations applicable to us. However, many PRC laws and regulations are uncertain in their scope, and the implementation of such laws and regulations in different localities could have significant differences. In certain instances, local implementation rules and/or the actual implementation are not necessarily consistent with the regulations at the national level. Although we strive to comply with all the applicable PRC laws and regulations, we cannot assure you that the relevant PRC government authorities will not later determine that we have not been in compliance with certain laws or regulations. For example, there is a PRC regulation requiring all employees to make contributions to a housing fund based on their salary level and their employers to match such contributions. However, many employees are reluctant to make such contributions as they do not perceive such contribution will benefit them, and this regulation has generally not been rigorously enforced. We have allowed our employees to make contributions on a voluntary basis and then match their contributions. However, we cannot assure you that in the future the PRC government will not start to enforce this regulation more rigorously. Although there are no material penalties stipulated in this regulation, if we are found not to be in compliance, we may be required to bring current any past deficiencies, which could adversely affect our financial condition and results of operations.
 
In addition, our facilities and products are subject to many laws and regulations administered by the PRC State Administration for Industry and Commerce, the PRC State Administration of Taxation, the PRC Ministry of Health and Hygiene Permitting Office, the PRC General Administration of Quality Supervision, Inspection and Quarantine, and the PRC State Food and Drug Administration Bureau relating to the processing, packaging, storage, distribution, advertising, labeling, quality, and safety of food products. Our failure to comply with these and other applicable laws and regulations in China could subject us to administrative penalties and injunctive relief, as well as civil remedies, including fines, injunctions and recalls of our products. It is possible that changes to such laws, more rigorous enforcement of such laws or with respect to our current or past practices, could have a material adverse effect on our business, operating results and financial condition. Further, additional environmental, health or safety issues relating to matters that are not currently known to management may result in unanticipated liabilities and expenditures.

Restrictions on currency exchange may limit our ability to receive and use our sales revenue effectively.
 
All of our sales revenue and expenses are denominated in Renminbi. Under PRC law, the Renminbi is currently convertible under the “current account,” which includes dividends and trade and service-related foreign exchange transactions, but not under the “capital account,” which includes foreign direct investment and loans. Currently, our PRC operating subsidiaries may purchase foreign currencies for settlement of current account transactions, including payments of dividends to us, without the approval of the PRC State Administration of Foreign Exchange, or SAFE, by complying with certain procedural requirements. However, the relevant PRC government authorities may limit or eliminate our ability to purchase foreign currencies in the future.
 
Foreign exchange transactions by PRC operating subsidiaries under the capital account continue to be subject to significant foreign exchange controls and require the approval of or registration with PRC government authorities, including SAFE. In particular, if our PRC operating subsidiaries borrow foreign currency through loans from us or other foreign lenders, these loans must be registered with SAFE, and if we finance the subsidiaries by means of additional capital contributions, these capital contributions must be approved by certain government authorities, including the PRC Ministry of Commerce, or their respective local branches. These limitations could affect our PRC operating subsidiaries’ ability to obtain foreign exchange through debt or equity financing.
 
 
 
Recent PRC regulations relating to investment activities by, and holdings in entities outside of China of, PRC residents and citizens, may subject our PRC resident and citizen stockholders to personal liability and limit our ability to acquire PRC companies or to inject capital into our PRC subsidiaries, limit our PRC subsidiaries’ ability to distribute profits to us or otherwise materially and adversely affect us.
 
In October 2005, SAFE issued a public notice, the Notice on Relevant Issues in the Foreign Exchange Control over Financing and Return Investment Through Special Purpose Companies by Residents Inside China, or Notice 75. In May 2007, SAFE issued the Notice of the State Administration of Foreign Exchange on Operating Procedures Concerning Issues Relating to the Administration of Foreign Exchange in Fund Raising and Return Investment Activities of Domestic Residents Conducted via Offshore Special Purpose Companies, or Notice 106. According to Notice 75 and Notice 106, prior registration with the local SAFE branch is required for PRC residents to establish or to control an offshore company for the purposes of financing that offshore company with assets or equity interests in an onshore enterprise located in the PRC. An amendment to registration or filing with the local SAFE branch by such PRC resident is also required for the injection of equity interests or assets of an onshore enterprise in the offshore company or overseas funds raised by such offshore company, or any other material change involving a change in the capital of the offshore company. Moreover, Notice 75 and Notice 106 apply 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 registration with the local SAFE branch. If any PRC stockholder of any offshore special purpose company fails to make the required SAFE registration and amendment, the PRC subsidiaries of that offshore special purpose company may be prohibited from distributing their profits and the proceeds from any reduction in capital, share transfer or liquidation to the offshore special purpose company. Moreover, failure to comply with the SAFE registration and amendment requirements described above could result in liability under PRC laws for evasion of applicable foreign exchange restrictions.
 
Many of the terms and provisions in Notice 75 and Notice 106 remain unclear and implementation by central SAFE and local SAFE branches of Notice 75 and Notice 106 have been inconsistent since their adoption. Based on the advice of our PRC counsel, De Heng Law Offices, and after consultation with relevant SAFE officials, our PRC resident stockholders and the PRC resident beneficial stockholders of Meitek may be required to complete their respective SAFE registrations pursuant to Notice 75 and Notice 106. The local SAFE branch may not accept their applications for SAFE registration until more detailed rules or announcements concerning the penalties for those who failed to make their SAFE registrations are implemented. Moreover, because of uncertainty over how Notice 75 and Notice 106 will be interpreted and implemented, and how or whether SAFE will apply it to us, we cannot predict how it will affect our business operations or future strategies. For example, our present and prospective PRC subsidiaries’ ability to conduct foreign exchange activities, such as the remittance of dividends and foreign currency-denominated borrowings, may be subject to compliance with Notice 75 and Notice 106 by our PRC resident beneficial holders. In addition, such PRC residents may not always be able to complete the necessary registration procedures required by Notice 75 and Notice 106. We also have little control over either our present or prospective direct or indirect stockholders, the PRC resident beneficial stockholders of Meitek, or the outcome of such registration procedures. A failure by our PRC resident beneficial holders or future PRC resident stockholders to comply with the SAFE notice, if SAFE requires it, could subject us to fines or legal sanctions, restrict our overseas or cross-border investment activities, limit our subsidiary’s ability to make distributions or pay dividends or affect our ownership structure, which could adversely affect our business and prospects.

Fluctuations in exchange rates could adversely affect our business and the value of our common stock.
 
The value of our common stock will be indirectly affected by the foreign exchange rate between the U.S. dollar and the Renminbi and between those currencies and other currencies in which our sales may be denominated. Because our earnings and cash assets are denominated in Renminbi, appreciation or depreciation in the value of the Renminbi relative to the U.S. dollar would affect our financial results reported in U.S. dollar terms without giving effect to any underlying change in our business or results of operations. Fluctuations in the exchange rate will also affect the relative value of any dividend we issue that will be exchanged into U.S. dollars and earnings from, and the value of, any U.S. dollar-denominated investments we make in the future.
 
Since July 2005, the Renminbi has no longer been pegged to the U.S. dollar. Although the People’s Bank of China, or PBOC, regularly intervenes in the foreign exchange market to prevent significant short-term fluctuations in the exchange rate, the Renminbi may appreciate or depreciate significantly in value against the U.S. dollar in the medium to long-term. Moreover, it is possible that in the future the PRC authorities may lift restrictions on fluctuations in the Renminbi exchange rate and lessen intervention in the foreign exchange market.
 
Very limited hedging transactions are available in China to reduce our exposure to exchange rate fluctuations. To date, we have not entered into any hedging transactions in an effort to reduce our exposure to foreign currency exchange risk. While we may enter into hedging transactions in the future, the availability and effectiveness of these transactions may be limited, and we may not be able to successfully hedge our exposure at all. In addition, our foreign currency exchange losses may be magnified by PRC exchange control regulations that restrict our ability to convert Renminbi into foreign currencies.
 
Currently, some of our raw materials and major equipment are imported. In the event that the U.S. dollar appreciated against the Renminbi, our costs may increase. If we cannot pass the resulting cost increases on to our customers, our profitability and operating results will suffer. In addition, to the extent we enter markets outside China in the future, we may be increasingly subject to the risk of foreign currency fluctuations.
 
 

 
Restrictions under PRC law on our PRC subsidiaries’ ability to make dividends and other distributions could materially and adversely affect our ability to grow, make investments or acquisitions that could benefit our business, pay dividends to our shareholders, and otherwise fund and conduct our businesses.
 
Our revenues are earned by our PRC subsidiaries. However, PRC regulations restrict the ability of our PRC subsidiaries to make dividends and other payments to their offshore parent company. PRC legal restrictions permit payments of dividend by our PRC subsidiaries only out of their accumulated after-tax profits, if any, determined in accordance with PRC accounting standards and regulations. Each of our PRC subsidiaries is also required under PRC laws and regulations to allocate at least 10% of our annual after-tax profits determined in accordance with PRC GAAP to a statutory general reserve fund until the amounts in such fund reaches 50% of our registered capital. Allocations to these statutory reserve funds can only be used for specific purposes and are not transferable to us in the form of loans, advances or cash dividends. As of March 31, 2011, the amount of our restricted net assets was $75.3 million. Any limitations on the ability of our PRC subsidiaries to transfer funds to us could materially and adversely limit our ability to grow, make investments or acquisitions that could be beneficial to our business, pay dividends and otherwise fund and conduct our business.

Under China’s New Enterprise Income Tax Law (“EIT Law”), we may be classified as a “resident enterprise” of China. This classification could result in unfavorable tax consequences to us and our non-PRC shareholders.
 
The New EIT Law provides that enterprises established outside of China whose “de facto management bodies” are located in China are considered “resident enterprises” and are generally subject to the uniform 25% enterprise income tax rate on their worldwide income. In addition, a circular issued by the State Administration of Taxation regarding the standards used to classify certain Chinese-invested enterprises established outside of China as “resident enterprises” clarified that dividends and other income paid by such “resident enterprises” will be considered to be PRC source income, subject to PRC withholding tax, currently at a rate of 10%, when recognized by non-PRC shareholders. This circular also subjects such “resident enterprises” to various reporting requirements with the PRC tax authorities. Under the implementation regulations to the enterprise income tax, a “de facto management body” is defined as a body that has material and overall management and control over the manufacturing and business operations, personnel and human resources, finances and treasury, and acquisition and disposition of properties and other assets of an enterprise. In addition, the circular mentioned above details that certain Chinese-invested enterprises will be classified as “resident enterprises” if the following are located or reside in China: senior management personnel and departments that are responsible for daily production, operation and management; financial and personnel decision making bodies; key properties, accounting books, company seal, and minutes of board meetings and shareholders’ meetings; and half or more of the directors or senior management having voting rights. If the PRC tax authorities determine that Synutra, Inc. or Synutra International, Inc. are “resident enterprises,” we may be subject to enterprise income tax at the rate of 25% on our worldwide income and dividends paid by us to our non-PRC shareholders and, while less clear, capital gains recognized by them with respect to the sale of our stock, may be subject to a PRC withholding tax. This will have an impact on our effective tax rate, a material adverse effect on our net income and results of operations, and may require us to withhold tax on our non-PRC shareholders. We are actively monitoring the “resident enterprise” classification rules and are evaluating appropriate organizational changes to avoid this treatment, to the extent possible.
 
If we were treated as a “resident enterprise” by PRC tax authorities, we would be subject to tax in both the U.S. and China, and our PRC tax may not be creditable against our U.S. tax.

The M&A Rule establishes more complex procedures for some acquisitions of Chinese companies by foreign investors, which could make it more difficult for us to pursue growth through acquisitions in China.
 
On August 8, 2006, six PRC regulatory agencies, including the China Securities Regulatory Commission, or CSRC, promulgated the Provisions Regarding Mergers and Acquisitions of Domestic Enterprises by Foreign Investors, or the M&A Rule, which became effective on September 8, 2006.  The M&A Rule establishes additional procedures and requirements that could make some acquisitions of Chinese companies by foreign investors more time-consuming and complex, including requirements in some instances that the PRC Ministry of Commerce be notified in advance of any change-of-control transaction and in some situations, require approval of the PRC Ministry of Commerce when a foreign investor takes control of a Chinese domestic enterprise. In the future, we may grow our business in part by acquiring complementary businesses, although we do not have any plans to do so at this time. The M&A Rule also requires PRC Ministry of Commerce anti-trust review of any change-of-control transactions involving certain types of foreign acquirers. Complying with the requirements of the M&A Rule to complete such transactions could be time-consuming, and any required approval processes, including obtaining approval from the PRC Ministry of Commerce, may delay or inhibit our ability to complete such transactions, which could adversely affect our ability to expand our business or maintain our market share.
 
 
 
 
Our shareholders may have difficulty enforcing judgments against us.
 
We are a Delaware holding company and most of our assets are located outside of the United States. All of our current operations are conducted in the PRC. In addition, most of our directors and officers are nationals and residents of countries other than the United States. A substantial portion of the assets of these persons is located outside the United States. As a result, it may be difficult for our shareholders to effect service of process within the United States upon these persons. It may also be difficult for our shareholders to enforce in U.S. courts judgments on the civil liability provisions of the U.S. federal securities laws against us and our officers and directors. In addition, there is uncertainty as to whether the courts of the PRC would recognize or enforce judgments of U.S. courts. DeHeng Law Offices, our counsel as to PRC law, has advised us that the recognition and enforcement of foreign judgments are provided for under the PRC Civil Procedures Law. Courts in China may recognize and enforce foreign judgments in accordance with the requirements of the PRC Civil Procedures Law based on treaties between China and the country where the judgment is made or on reciprocity between jurisdictions. China does not have any treaties or other arrangements that provide for the reciprocal recognition and enforcement of foreign judgments with the United States. In addition, according to the PRC Civil Procedures Law, courts in the PRC will not enforce a foreign judgment against us or our directors and officers if they decide that the judgment violates basic principles of PRC law or national sovereignty, security or public interest. So it is uncertain whether a PRC court would enforce a judgment rendered by a court in the United States.

The PRC government’s recent measures to curb inflation rates could adversely affect our future results of operations.
 
In recent years, the Chinese economy has experienced periods of rapid expansion and high rates of inflation. Rapid economic growth can lead to growth in the money supply and rising inflation. In April 2008, the change in China’s Consumer Price Index increased to 8.5% according to the National Bureau of Statistics of China, or the NBS. If prices for our products rise at a rate that is insufficient to compensate for the rise in the costs of supplies, it may have an adverse effect on our profitability. 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 constrain inflation. High inflation may in the future cause the Chinese government to impose controls on credit and/or prices, or to take other actions, which could inhibit economic activity in China, and thereby harm the market for our products.
 
Recently, the government of China undertook various measures to alleviate the effects of inflation, particularly on key commodities. On January 16, 2008, the PRC National Development and Reform Commission imposed national price controls on various products, including milk. Similarly, the government of China may conclude that the prices of infant formula or our other products are too high and may institute price controls that would limit our ability to set prices for our products. The government of China has also encouraged local governments to institute price controls on similar products. Such price controls could adversely affect our future results of operations and the price of our common stock.

Our labor costs are likely to increase as a result of changes in Chinese labor laws.
 
We expect to experience an increase in our cost of labor due to changes in Chinese labor laws which are likely to increase costs further and impose restrictions on our relationship with our employees. In June 2007, the National People’s Congress of the PRC enacted new labor law legislation called the Labor Contract Law and more strictly enforced existing labor laws. The new law, which became effective on January 1, 2008, amended and formalized workers’ rights concerning overtime hours, pensions, layoffs, employment contracts and the role of trade unions. As a result of the new law, we have had to reduce the number of hours of overtime its employees can work, increase the salaries of its employees, provide additional benefits to its employees, and revise certain of its other labor practices. The increase in labor cost has increased our operating costs, which we have not always been able to pass through to its customers. In addition, under the new law, employees who have worked for us for at least 10 years or who have had two consecutive fixed-term contracts must be given an “open-ended employment contract” that, in effect, constitutes a lifetime, permanent contract, which is terminable only in the event the employee materially breaches our rules and regulations or is in serious dereliction of his or her duty. Such non-cancelable employment contracts will substantially increase its employment related risks and limit our ability to downsize its workforce in the event of an economic downturn. No assurance can be given that we will not in the future be subject to labor strikes or that we will not have to make other payments to resolve future labor issues caused by the new laws. Furthermore, there can be no assurance that the labor laws will not change further or that their interpretation and implementation will vary, which may have a negative effect upon our business and results of operations.
 
 

 
The PRC government may deem the control agreements between us and certain of our consolidated affiliated entities to be non-compliant with restrictions on foreign investment and as a result we may be subject to penalties or required to perform a costly restructuring of these entities.

PRC laws and regulations currently restrict foreign entities from establishing clinical business in China. Foreign entities that wish to establish medical clinical businesses in China must have domestic entities as partners. In order to comply with PRC law and avoid restrictions on foreign investment in medical clinical operations, we operate our medical treatment services (mostly pre-natal diagnostics services) through four entities -- Nanjing Shengyuan Huiren Clinical Examination Co., Ltd., Taiyuan Shengyuan Huiren Clinical Examination Co., Ltd, Shijiazhuang Shengyuan Huiren Clinical Examination Co., Ltd and Heilongjiang Shengyuan Huiren Clinical Examination Co., Ltd (the “Four Entities”) that are not directly owned by us. We control and consolidate these entities into our group consolidated results through a series of contractual arrangements. See Item 1, Business—Our Corporate Structure and History and “Item 13.  Certain Relationships and Related Transactions, and Director Independence.”

The contractual arrangements we have in place are governed by PRC law.  There are substantial uncertainties regarding the interpretation and application of current and future PRC laws and regulations on these contractual agreements and it is possible that the PRC authorities may in the future find these arrangements unlawful. If these arrangements were to be deemed unlawful, the PRC authorities have broad discretion to penalize us, including:
 
 
·  
revoking the business and operating licenses of our PRC subsidiaries and affiliates;
 
 
·  
discontinuing or restricting our PRC subsidiaries’ and affiliates’ operations;
 
 
·  
imposing fines or confiscating the income of our PRC subsidiaries or affiliates;
 
 
·  
requiring us or our PRC subsidiaries and affiliates to restructure the relevant ownership structure or operations; or
 
 
·  
taking other regulatory or enforcement actions that could be harmful to our clinic examination business.
 
Furthermore, we have no assurance that Jibin Zhang and Yunpeng Jiang, parties to these control agreements, will continue to cooperate with us and honor these control agreements.  There is a risk that they will not always act in our best interests.  If we cannot resolve any conflicts of interest or dispute that may arise between them and us, we may have to take legal action to compel them to fulfill their contractual obligations and there is substantial uncertainty as to the outcome of any such legal proceedings.  It may be difficult for us to change our corporate structure or to bring claims against the Four Entities if they do not perform their obligations under these contractual arrangements.

Risks Related to Our Common Stock
 
The market price of our common stock is volatile, and its value may be depressed at a time when our stockholders want to sell their holdings.
 
The market price of our common stock is volatile, and this volatility may continue. For instance, between July 1, 2008 and March 31, 2011, the price of our common stock, as reported on the NASDAQ on which our common stock has traded, ranged between $4.60 and $52.24. Though we believe this dramatic fluctuation resulted mainly from the melamine contamination incident and the worldwide market disruption, numerous factors, many of which are beyond our control, may cause the market price of our common stock to fluctuate significantly.
 
In addition to market and industry factors, the price and trading volume for our common stock may be highly volatile for specific business reasons. Factors such as variations in our revenues, earnings and cash flow, announcements of new investments, cooperation arrangements or acquisitions, and fluctuations in market prices for our products could cause the market price for our shares to change substantially. In addition, our stock price may be impacted by the performance, reputation, or stock prices of other Chinese companies that are listed in the U.S.
 
Securities class action litigation is often instituted against companies following periods of volatility in their stock price. This type of litigation could result in substantial costs to us and divert our management’s attention and resources.
 
The trading market for our common stock will also be influenced by research or reports that industry or securities analysts publish about us or our business. If one or more analysts who cover us downgrade our common stock, the market price for our common stock would likely decline. If one or more of these analysts cease coverage of us or fail to regularly publish reports on us, we could lose visibility in the financial markets, which, in turn, could cause the market price for our common stock or trading volume to decline.
 
Furthermore, securities markets may from time to time experience significant price and volume fluctuations for reasons unrelated to operating performance of particular companies. These market fluctuations may adversely affect the price of our common stock and other interests in our company at a time when our stockholders want to sell their interest in us.
 
 

 
Although publicly traded, the trading market in our common stock has been substantially less liquid than the common stock of many companies quoted on the NASDAQ Global Select Market, and this low trading volume may adversely affect the price of our common stock.
 
Although our common stock is traded on the NASDAQ Global Select Market, the trading volume of our common stock has generally been very low. Reported average daily trading volume in our common stock for the three month period ended June 8, 2011 was approximately 87,147 shares. Limited trading volume will subject our shares of common stock to greater price volatility and may make it difficult for our stockholders to sell their shares of common stock at a price that is attractive to them.

Provisions in our charter documents and under Delaware law could discourage a change-of-control that our stockholders may consider favorable.
 
Provisions in our amended and restated certificate of incorporation and bylaws may have the effect of delaying or preventing a change of control or changes in our management. These provisions include the following:
 
 
·  
our board of directors is divided into three classes, with approximately one-third of our directors elected each year;
 
 
·  
our board of directors has the right to elect directors to fill a vacancy created by the expansion of the board of directors or the resignation, death or removal of a director, which prevents stockholders from being able to fill vacancies on our board of directors;
 
 
·  
our stockholders must provide timely notice for any stockholder proposals and director nominations;
 
 
·  
we have adopted provisions that eliminate the personal liability of directors for monetary damages for actions taken as a director, with certain exceptions; and
 
 
·  
our board of directors may issue, without stockholder approval, shares of undesignated preferred stock, which makes it possible for our board of directors to issue preferred stock with voting or other rights or preferences that could impede the success of any attempt to acquire us.
 
As a Delaware corporation, we are also subject to certain Delaware anti-takeover provisions. Under Delaware law, a corporation may not engage in a business combination with any holder of 15% or more of its capital stock unless the holder has held the stock for three years or, among other things, the board of directors has approved the transaction. Our board of directors could rely on Delaware law to prevent or delay an acquisition of us.


 
None.
 
 

 
 
Our headquarter is currently located in Beijing with around 6,400 square meters of leased office space. We have rented 45,500 square meters of office space with 31,300 additional square meters of land in Beijing as our management, marketing, and research and development headquarter that we plan to move in from our current rental office. Synutra Illinois leases an executive office in Rockville, Maryland, USA. Our processing and packaging facilities are located in various locations in China, including Beijing, Qingdao, Luobei, Zhangjiakou, Fengzhen and Zhenglanqi. These facilities encompass approximately 144,650 square meters of office, plant, and warehouse space. Our distribution center located in Qingdao includes approximately 25,000 square meters of owned office space. All of our production facilities are built based on the GMP standard, with equipment imported from Europe and all of our facilities that have commenced operation have ISO9000 and HACCP series qualifications with some also being ISO14000 certified.
 
We currently own four processing facilities and one packaging facility for our powder formula products. As of March 31, 2011, we had raw milk processing capacity of 32,600 tons per year, packaging capacity of 82,000 tons per year and dry-mixing processing capacity of 73,000 tons per year.
 
The following table sets forth certain information with respect to our production, processing and packaging facilities.
 
 
Facility
 
 
Province/Region
 
Installed Capacity as
of March 31, 2011
 
 
Description
 
 
Property Right
       
(tons per year)
       
Zhangjiakou facility
 
Hebei
 
22,000
 
Raw milk processing
 
Land Use Right
Luobei facility
 
Heilongjiang
 
  3,600
 
Raw milk processing
 
Land Use Right
Fengzhen facility
 
Inner Mongolia
 
  7,000
 
Raw milk processing
 
Land Use Right
Qingdao facility
 
Shandong
 
73,000
 
Dry-mixing of all of our powdered formula products
 
Land Use Right
       
82,000
 
Packaging of all of our products
 
Land Use Right
Beijing facility
 
Beijing
 
     540
 
Production of prepared baby foods
 
Land Use Right
Zhenglanqi facility
 
Inner Mongolia
 
18,000
 
Production and processing of prepared baby food and other non-core products
 
Land Use Right
Qingdao Meitek facility
 
Shandong
 
  2,400
 
Production and processing of nutritional ingredients and supplement and other non-core products
 
Land Use Right
 
There is no private land ownership in China. Individuals and companies are permitted to acquire land use rights for specific purposes and for limited periods. Each period may be renewed at the expiration of the initial and any subsequent terms. Granted land use rights are transferable and may be used as security for borrowings and other obligations.
 
We believe that our facilities are adequate for our current operations and any increase in production in the near term will not require additional space.


 
 
As of March 31, 2011, the end of the period covered by this report, the Company was subject to  various legal proceedings and claims discussed below, as well as certain other legal proceedings and claims that have not been fully resolved and that have arisen in the ordinary course of business. Other than as discussed below, in the opinion of management, the Company does not have a potential liability related to any current legal proceedings and claims that would individually or in the aggregate have a material adverse effect on its financial condition or operating results. However, the results of legal proceedings cannot be predicted with certainty. The Company intends to contest each lawsuit vigorously but should the Company fail to prevail in any of these legal matters or should several of these legal matters be resolved against the Company in the same reporting period, the operating results of a particular reporting period could be materially and adversely affected.

On March 29, 2010, U.S. District Judge Deborah Chasanow for the District of Maryland ordered the dismissal of a complaint filed January 15, 2009 on behalf of 54 Chinese families alleged to be affected by melamine contamination, against Synutra International, Inc. and Synutra Inc. (Jiali Tang, et al vs. Synutra International, Inc., et al.), alleging negligent or intentional infliction of personal injury, negligent or intentional infliction of emotional distress, battery, breach of warranty, fraudulent or negligent misrepresentation, seeking compensation for punitive damages in the amount of US$500 million, together with any compensatory damages. In an opinion issued the same date of the order above, the court sided with the Company’s positions and granted the motion to dismiss on the grounds of forum non conveniens. The court also granted the motion to file under seal a response to a Notice of Recent Development filed by the Plaintiffs. In considering the motion to dismiss on the grounds of forum non conveniens, the court examined both the availability and adequacy of the alternative forum in China as well as how public and private interests favor the choice of forum. In addition, taking into account that an “alternative compensation plan is undisputedly available to Plaintiffs,” the court ruled that “a conditional dismissal will not be employed to protect the Plaintiffs’ rights to pursue a judicial remedy in the alternative forum.” On June 28, 2010, the plaintiffs filed an opening brief of appeal of the dismissal order.  In response, the Company filed an opposing brief on July 28, 2010 with the court of appeals. The plaintiffs’ reply brief was filed on August 16, 2010. On March 22, 2011, the court of appeals for the Fourth Circuit heard oral argument and now has the appeal under advisement. Management believes the possibility of a significant loss from this lawsuit is remote. Therefore, no accrual has been established for any potential loss in connection with this lawsuit.


 
 

 
PART II
 

Price Range of our Common Stock
 
Our common stock has been trading on the NASDAQ Global Select Market under the symbol “SYUT” since November 8, 2007. Our common stock was previously quoted on the Over-The-Counter Bulletin Board, or OTCBB, under the trading symbol “SYUT.OB” until April 11, 2007. On April 12, 2007, our common stock was listed on the NASDAQ Global Market and subsequently approved for listing on the NASDAQ Global Select Market on November 8, 2007.
 
The high and low bid prices reflect inter-dealer prices, without retail mark-up, mark-down or commission, and may not represent actual transactions.
 
   
The NASDAQ Global/Global Select Market Price per Share
 
   
High
   
Low
 
Fiscal Year Ending March 31, 2012
           
First Quarter (through June 8, 2011)
 
$
11.73
   
$
9.73
 
Fiscal Year Ended March 31, 2011
               
Fourth Quarter
 
$
14.36
   
$
10.58
 
Third Quarter
   
14.60
     
10.33
 
Second Quarter
   
17.96
     
9.11
 
First Quarter
   
24.42
     
16.17
 
Fiscal Year Ended March 31, 2010
               
Fourth Quarter
 
$
23.47
   
$
12.8
 
Third Quarter
   
14.50
     
10.79
 
Second Quarter
   
16.60
     
9.92
 
First Quarter
   
13.37
     
6.87
 

As of May 6, 2011, we had 30 registered stockholders of our common stock on record. This number does not include shares held by brokerage clearing houses, depositories or otherwise in unregistered form or shares held by a custodian for the benefit of our employees.

Dividend Policy
 
We have never declared or paid any dividends on shares of our common stock. We intend to retain any future earnings to fund the development and growth of our business, and we do not anticipate paying any dividends in the foreseeable future.
 
Our revenues are earned by our PRC subsidiaries. However, PRC regulations restrict the ability of our PRC subsidiaries to make dividends and other payments to their offshore parent company. PRC legal restrictions permit payments of dividend by our PRC subsidiaries only out of their accumulated after-tax profits, if any, determined in accordance with PRC accounting standards and regulations. Each of our PRC subsidiaries is also required under PRC laws and regulations to allocate at least 10% of our annual after-tax profits determined in accordance with PRC GAAP to a statutory general reserve fund until the amounts in such fund reaches 50% of our registered capital. Allocations to these statutory reserve funds can only be used for specific purposes and are not transferable to us in the form of loans, advances or cash dividends. In addition, there are restrictions on the distribution of share capital from the Company’s PRC subsidiaries. As of March 31, 2011 the amount of our restricted net assets was $75.3 million.
 
Recent Sales of Unregistered Securities
 
None.
 

 
 
The following selected consolidated financial data for the fiscal years ended March 31, 2011, 2010 and 2009 are derived from our audited consolidated financial statements included elsewhere in this Form 10-K. The financial data for the years ended March 31, 2008 and 2007 are derived from audited consolidated financial statements which are not included in this Form 10-K. The results of operations for past accounting periods are not necessarily indicative of the results to be expected for any future accounting period.
 
The financial data set forth below should be read in conjunction with, and are qualified in their entirety by reference to “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and our consolidated financial statements and related notes included elsewhere in this Form 10-K.
 
   
Fiscal Year Ended March 31,
 
   
2011
   
2010
   
2009
   
2008
   
2007
 
   
(in thousands except earnings per share data)
Selected Consolidated Statement of Income Data:
                             
Net sales
 
$
248,516
   
$
291,886
   
$
312,528
   
$
362,090
   
$
216,605
 
Cost of sales
   
170,769
     
208,476
     
259,086
     
175,568
     
109,900
 
Gross profit
   
77,747
     
83,410
     
53,442
     
186,522
     
106,705
 
Selling and distribution expenses
   
48,409
     
43,989
     
44,178
     
34,449
     
25,561
 
Advertising and promotion expenses
   
41,420
     
33,854
     
115,478
     
76,388
     
52,322
 
General and administrative expenses
   
28,261
     
24,509
     
25,455
     
16,013
     
7,031
 
Impairment of goodwill
   
1,440
     
     
     
     
 
Impairment loss from assets disposal
   
     
5,894
     
     
     
 
Other operating income, net
   
1,441
     
894
     
5,790
     
1,492
     
1,109
 
Income (loss) from operations
   
(40,342
)
   
(23,942
)
   
(125,879
)
   
61,164
     
22,900
 
Interest expense
   
10,321
     
8,603
     
4,857
     
6,354
     
1,896
 
Interest income
   
820
     
1,850
     
341
     
1,801
     
356
 
Other income (expense), net
   
277
     
(1,081
)
   
(580
)
   
(3,084
)
   
110
 
Income (loss) before income tax expense (benefit)
   
(49,566
)
   
(31,776
)
   
(130,975
)
   
53,527
     
21,470
 
Income tax expense (benefit)
   
(9,306
)
   
(6,904
)
   
(30,386
)
   
7,855
     
1,596
 
Net income (loss)
   
(40,260
)
   
(24,872
)
   
(100,589
)
   
45,672
     
19,874
 
Net income (loss) attributable to the noncontrolling interest
   
(192
)
   
(257
)
   
(40
)
   
11
     
 
Net income (loss) attributable to Synutra International, Inc. common stockholders
 
$
(40,068
)
 
$
(24,615
)
 
$
(100,549
)
 
$
45,661
   
$
19,874
 
Earnings (loss) per share-basic
 
$
(0.71
)
 
$
(0.46
)
 
$
(1.86
)
 
$
0.86
   
$
0.40
 
Earnings (loss) per share-diluted
 
$
(0.71
)
 
$
(0.46
)
 
$
(1.86
)
 
$
0.85
   
$
0.40
 
 
   
March 31,
 
   
2011
   
2010
   
2009
   
2008
   
2007
 
   
(in thousands)
 
Selected Balance Sheets Data:
                             
Cash and cash equivalents
 
$
48,741
   
$
48,693
   
$
37,736
   
$
97,425
   
$
20,836
 
Working capital (deficit)
   
(479
)
   
(27,593
)
   
(80,432
)
   
111,230
     
(8,281
)
Inventory
   
67,372
     
52,134
     
114,724
     
61,853
     
16,406
 
Total assets
   
398,704
     
349,357
     
472,571
     
294,318
     
127,271
 
Short-term debt
   
124,281
     
98,069
     
224,647
     
21,228
     
53,104
 
Long-term debt due within one year
   
38,131
     
61,194
     
     
1,923
     
 
Long-term debt
   
62,722
     
41,018
     
8,777
     
34,184
     
 
Capital lease obligation
   
5,568
     
5,372
     
5,254
     
     
 
Total long-term liabilities
   
74,338
     
52,497
     
20,468
     
39,993
     
4,138
 
Total equity
 
$
75,926
   
$
52,931
   
$
76,859
   
$
171,259
   
$
42,701
 
 
 
 
 
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes that appear elsewhere in this Form 10-K. In addition to historical consolidated financial information, the following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this Form 10-K, particularly in “Item 1A. Risk Factors.”

Overview
 
We are a leading infant formula company in China. We principally produce, market and sell our products under the “Shengyuan” or “Synutra” name, together with other complementary brands in mainland China. We focus on selling premium infant formula products, which are supplemented by more affordable infant formulas targeting the mass market as well as other nutritional products and ingredients. We sell our products through an extensive nationwide sales and distribution network covering 30 provinces and provincial-level municipalities in China. As of March 31, 2011, this network comprised over 580 independent distributors and over 1,000 independent sub-distributors who sell our products in over 71,000 retail outlets.
 
We currently have three reportable segments which are:

o
Powdered formula segment: Powdered formula segment covers the sale of powdered infant and adult formula products. It includes the brands of Super, U-Smart, My Angel, Mingshan and Helanruniu;
   
o
Baby food segment: Baby food segment covers the sale of prepared baby food for babies and children. It includes the brand of Huiliduo;
   
o
Nutritional ingredients and supplements segment: Nutritional ingredients and supplements segment covers the production and sale of nutritional ingredients and supplements such as chondroitin sulfate, and microencapsulated Docosahexanoic Acid (“DHA”) and Arachidonic Acid (“ARA”).

Our Other business includes non-core businesses such as sales of milk powder to industrial customers. Recently, China has tightened the production standard for infant powdered formula product. As a result, 20% to 30% of our imported milk powder was not compliant with the new national standard, could not be used in infant powdered formula production, and were sold to industrial customers. In addition, Fonterra conducts its online auction several months before actual shipment of the products, and it takes one to two months to ship the milk powder from New Zealand to China. Due to the long lead time required to purchase the raw material, we usually keep a high level of stock. As a result of the prematurity event, our production slowed down, and it led to an overstock of milk powder. As a result, we sold surplus milk powder to industrial customers and it increased the transaction amount of Other business. Management does not regard the Other business as a core business because the chief operating decision maker does not receive reports on the operating results or allocate resources to assess its performance.

In August 2010, there were several media reports alleging our infant formula products caused symptoms of hormone-triggered sexual prematurity in infants in the Hubei province of China. In response to such media reports, MOH of China conducted tests on samples of our products and concluded that there was no link between our infant milk powder products and premature development in infants.

The following table shows our results as impacted by the prematurity event and our efforts to recover from it:

   
Fiscal Year 2011
 
   
First
   
Second
   
Third
   
Fourth
 
   
(In thousands except percentage)
 
Powdered formula segment
                               
- Net sales
 
$
79,244
   
$
37,285
   
$
20,722
   
$
48,318
 
- Gross margin
   
56.9%
     
28.6%
     
16.1%
     
39.9%
 
                                 
Overall
                               
- Income (loss) from operations
   
16,290
     
(26,101
)
   
(24,100
)
   
(6,431
)
                                 

 
In response to the prematurity event, we have launched new marketing campaigns and initiatives to boost sales and recover market share. For example, we have trained and provided incentives to our in-store promoters to generate more sales by paying potential consumers more home visits, initiating more phone calls and conducting more educational programs. We have launched a new product line “My Angel” to target the specialty baby stores and introduced the new all-imported Super Series to compete more effectively with foreign brands. These efforts are designed to bring in more consumers and sales in the coming quarters.

As a result of these efforts, operating results have shown significant improvement in the fourth fiscal quarter of fiscal year 2011 compared to the previous two fiscal quarters when the prematurity event hit us. Our sales of powdered formula segment increased by 133.2% and gross margin more than doubled in the fourth fiscal quarter compared to the third fiscal quarter. Operating loss of fourth fiscal quarter has narrowed to approximately one fourth of the previous fiscal quarter. We believe that the destocking of channel inventory is drawing to an end. As our market share started to stabilize in the last few months of fiscal 2011 and the distributors started to adjust their inventory level upward accordingly, we believe we would see further improvement in our operating results in the coming quarters.

As a result of the prematurity event, we spent $1.5 million to finance studies relating to the causes of and treatments for premature development in infants, and to educate the public on the issue. We also spent aggressively on advertising and promotions immediately after the prematurity event to rebuild our brand image and to gain customers and market share. As our market share stabilizes, we have reduced our spending on advertising and promotion, which also contributed to the decrease in operating loss of the fourth fiscal quarter.

As a result of the prematurity event, our net sales for the fiscal year ended March 31, 2011 decreased by 14.9% to $248.5million from $291.9 million for the prior fiscal year. Our gross profit for the fiscal year ended March 31, 2011 decreased by 6.8% to $77.7 million from $83.4 million for the prior fiscal year. Our net loss attributable to Synutra International, Inc. common stockholders for the fiscal year ended March 31, 2011 was $40.1 million, as compared to $24.6 million for the prior fiscal year.

Unless otherwise noted, all translations from Renminbi to U.S. dollars were made at the mid rate published by the People’s Bank of China, or the mid rate, as of March 31, 2011, which was RMB6.5564 to $1.00. We make no representation that the Renminbi amounts referred to in this Annual Report on Form 10-K could have been or could be converted into U.S. dollars at any particular rate or at all. On June 8, 2011, the mid rate was RMB6.4795 to $1.00.

Factors Affecting Our Results of Operations
 
Our operating results are primarily affected by the following factors:

Perceptions of Product Quality and Safety
 
Rising consumer wealth in China has contributed to a greater acceptance by consumers in China of and desire for higher-priced products with perceived quality advantages associated with such products. Thus, we believe that infant formula producers with a reputation for quality and safety should be able to command higher average selling prices and thereby generate higher gross margins than competitors that do not possess the same perceived reputation for quality and safety. Conversely, any decrease in consumer perceptions of quality and safety could adversely impact such producers’ sales and gross margins. Moreover, a decrease in the quality and safety of any particular product could trigger wider negative perception of the decrease in the quality and safety of all producers, thereby affecting the industry generally. For example, the melamine contamination incident had resulted in a significant reduction in the sales of a number of major dairy product companies in China, including us, and the prematurity event resulted in a significant decline in our sales. If a future market crisis involving any of our products should occur, especially if management failed to respond to such crisis in a timely and effective manner, our brand recognition and reputation could be severely damaged, which could adversely affect our results of operations. See Part I - Item 1A. Risk Factors—Risks Related to Our Business—We are highly dependent upon consumers’ perception of the safety and quality of our products. Any ill effects, product liability claims, recalls, adverse publicity or negative public perception regarding particular ingredients or products or our industry in general could harm our reputation and adversely affect our results of operations.
 

 
Brand Recognition and Customer Loyalty
 
In recent years, there has been growing demand in China for premium infant formula products due to increasing consumer awareness of brand image and nutritional value of the products offered by leading producers. Although the market is still highly competitive, we believe that companies with strong national brands and customer loyalty will increasingly capture market share from regional brands with less brand recognition. Moreover, we believe brand recognition and customer loyalty are predominantly influenced by customer perceptions of the quality and safety of branded products. We believe the melamine contamination incident involving 22 infant formula producers has increased the importance of consumer perception of quality and safety and the need to maintain and increase brand recognition and customer loyalty.

Competition and Market Position
 
While China’s infant formula market is expected to grow significantly, competition is intense. We face significant competition from domestic and multinational producers. A small number of multinational players enjoy significant market share in China, particularly in the more affluent major urban areas, based on greater brand name recognition among Chinese consumers. In addition, competition from domestic producers has become more intense in recent years, especially from large national milk companies, such as Yili, Yashili, Beingmate and Feihe, which have entered the infant formula market.
 
We focus on developing and marketing premium products for the infant formula market in China. By leveraging our focused marketing strategy, our brand name and our sales and marketing infrastructure, we have been able to sell infant formula products to consumers in China’s small to mid-size cities and rural areas and aside from the prematurity event, had been perceived to deliver premium quality that justifies our premium prices.

Product Offering and Pricing
 
Infant formula has been, and is expected to remain, our primary product. Due to rising economic affluence in China, infant formula products have become more affordable, resulting in the rapid growth of the overall market for infant formula in China. Despite the recent rapid growth, we believe much of the market is still underserved with respect to infant formula. We believe this growth in demand will help drive sales for many PRC infant formula producers, but companies with strong brand loyalty and extensive distribution networks in China will have greater ability to capitalize on such growth as well as to increase prices and pass on higher raw material costs to customers. This can be accomplished through launching higher-priced new infant formula product lines or re-launching older product lines with higher prices and improved product features.

Raw Material Supply and Prices
 
The per unit costs of producing our infant formula are subject to the supply and price volatility of raw milk and other raw materials, which are affected by the PRC and global markets. For example, raw milk prices are affected by factors such as geographic location, fluctuations in production and competition. Historically, we have been able to meet our raw milk supply needs by building our processing facilities close to our milk suppliers and by maintaining long-term business relationships with milk collection stations. In the fiscal year ended March 31, 2011, all of the milk powder used for our Super, U-Smart, My Angel and Helanruniu series products is imported. This has led to a significant reduction in our raw milk procurement.
 
Although we have not used as much raw milk in the aftermath of the melamine contamination incident, increases in the price of raw milk, milk powder and whey protein powder would negatively impact our gross margins if we are not able to offset such price increases through increases in our selling price or change in product mix. See Part I - Item 1A. Risk Factors—Risks Related to Our Business—We might face inventory write-down if milk powder inventory continues to increase and milk powder prices continue to decline. We maintain inventories of raw materials and finished products, and our inventories may spoil.

Advertising and Sales Promotion Costs
 
We have historically relied on our extensive distribution network, our consumer education programs and customer relation services to market and sell our products. We spent aggressively on advertising and promotions to rebuild our brand image and to recover customers and market share after the prematurity event. As our market share has stabilized, we reduced our spending on advertising and promotion, and refocused our efforts to achieve effective market pull-through with new customers by supporting increased activities on the consumer-end and beyond the distribution channels by our field promoters in the communities and our nutrition education professionals at the medical and healthcare facilities. For example, we trained our in-store promoters to approach potential consumers more proactively, including conducting more home visits, phone communications and educational programs. We do not expect significant increase in advertising and promotion expenses going forward.

 
 
Taxation
 
We file separate tax returns in the United States and China. Income taxes of our subsidiaries are calculated in accordance with taxation principles currently effective in the PRC. For Synutra Illinois and Synutra Delaware, applicable U.S. tax laws are followed.
 
On March 16, 2007, the National People’s Congress of the PRC approved and promulgated a new tax law, which took effect beginning January 1, 2008. The Company’s PRC subsidiaries then measure and pay enterprise income tax pursuant to the new tax law. Under the new tax law, foreign investment enterprise and domestic companies are subject to a uniform income tax rate of 25%. The new tax law provides a five-year transition period from its effective date for those enterprises which were established before the promulgation date of the new tax law and which were entitled to a preferential lower tax rate under the then effective tax laws or regulations.
 
We operate under tax holidays in PRC, which are effective through December 2012. The impact of these tax holidays increased PRC tax benefit by $42,000 for fiscal years ended March 31, 2011, decreased PRC tax benefit by $1.4 million for fiscal years ended March 31, 2010, and increased PRC tax benefit by $3.2 million for fiscal years ended March 31, 2009. The benefit of the tax holidays on earnings per share was zero, $(0.03) and $0.06 for fiscal years ended March 31, 2011, 2010 and 2009, respectively.
 
Some of the Company’s PRC subsidiaries are eligible under the transition rules to continue enjoying tax holidays or reduced tax rate until expiration. The following table illustrates the applicable tax rate and tax holidays of major PRC subsidiaries under the new EIT Law:
 
Name of Subsidiaries
 
 
Statutory Tax Rate Beginning
January 1, 2008
 
 
Tax Holiday (based on calendar year)
Shengyuan Nutritional Food Co., Ltd.
 
25%
 
12.5% (2008)
Heilongjiang Mingshan Dairy Co., Ltd.
 
25%
 
3 years tax at 12.5% (2008-10)
Zhangjiakou Chahaer Dairy Co., Ltd.
 
25%
 
3 years tax at 12.5% (2008-10)
Inner Mongolia Huiliduo Food Co., Ltd.
 
25%
 
2 years tax free (2008, 2009); 3 years tax at 12.5% (2010-12)
Inner Mongolia Mengyuan Food Co., Ltd.
 
25%
 
No tax holiday
Meitek Technology (Qingdao) Co., Ltd.
 
25%
 
2 years tax free (2008, 2009); 3 years tax at 12.5% (2010-12)
Beijing Shengyuan Huiliduo Food Technology Co., Ltd.
 
25%
 
No tax holiday
Beijing Shengyuan Huimin Technology Service Co., Ltd.
 
25%
 
No tax holiday
Global Food Trading (Shanghai) Co., Ltd.
 
25%
 
20% (2009), 22% (2010), 24% (2011), 25% (2012)

Our income will be derived from dividends we receive from our PRC operating subsidiaries described above. The New EIT Law and its implementing rules generally provide that a 10% withholding tax applies to China-sourced income derived by non-resident enterprises for PRC enterprise income tax purposes. We expect that such 10% withholding tax will apply to dividends paid to us by our PRC subsidiaries but this treatment will depend on our status as a non-resident enterprise. For detailed discussion of PRC tax issues related to resident enterprise status, see Part-I - Item 1A. Risk Factors—Risks Associated with Doing Business in China—Under China’s New Enterprise Income Tax Law (“EIT Law”), we may be classified as a “resident enterprise” of China. This classification could result in unfavorable tax consequences to us and our non-PRC shareholders.
 
Each of our PRC subsidiaries files stand-alone tax returns and we do not file a consolidated tax return.

Critical Accounting Policies and Estimates
 
We prepare our financial statements in accordance with US GAAP. The preparation of these financial statements requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Management periodically evaluates the estimates and judgments made. Management bases its estimates and judgments on historical experience and on various factors that are believed to be reasonable under the circumstances. Actual results may differ materially from these estimates as a result of different assumptions or conditions.
 
The following critical accounting policies involve more significant judgments and estimates used in the preparation of our financial statements.

 
 
Revenue
 
We recognize revenue when title and risk and rewards for the products are transferred to the customer, price is fixed and determinable and collectability is reasonably assured. At the time of the sale, we also record estimates for a variety of sales deductions, including value added taxes, rebates, discounts and incentives, trade promotions and product returns. Sales deductions are reported as a reduction of revenue. Most of our nutritional product sales are made through distributors. Under the distributor arrangement, evidenced by purchase order together with advance payment, sales revenue is realized and earned upon acceptance of delivery of products by the distributors. The revenue recognition of our newly launched My Angel series, which is directly sold to baby stores, is similar to that of our sales through distributors, and the sales revenue is realized and earned upon acceptance of delivery of products by the baby stores. We apply this revenue recognition policy uniformly to all nutritional products, including all dairy-based pediatric and adult nutritional products.
 
A small fraction of our nutritional product sales are through supermarket retailers directly. Our revenue arrangement with some of these retailers includes a right of return clause. Our price to the supermarkets is fixed. The supermarkets’ obligation to us would not be changed in the event of theft or physical destruction or damage of the product. We recognize revenue when the supermarkets have paid us, or the supermarkets are obligated to pay us and the obligation is not contingent on resale of the product. The amount of future returns are estimated and recognized in the current period.
 
Our gross sales are subject to various deductions, primarily comprised of rebates and discounts to distributors and retailers. These deductions represent estimates of the related obligations, requiring the use of judgment when estimating the impact of these sales deductions on gross sales for a reporting period. We report these adjustments as a reduction of gross sales to arrive at net sales.
 
 
·
We offer rebates to distributors and supermarket retailers to sustain and increase our product market share. These rebate programs provide that distributors and supermarket retailers receive a rebate after attaining certain performance parameters relating to product purchases, formulary status and/or pre-established market share milestones relative to competitors. Since rebates are contractually agreed upon, we estimate rebates based on the specific terms in each agreement, historical experience, anticipated reimbursement channel mix and product growth rates. We consider the sales performance of products subject to rebates and other contract discounts and adjust the provision periodically to reflect actual experience. Actual amounts may differ if the actual performance vary from estimates. The Company records rebates as a reduction of revenues in the year in which these programs are offered.
 
 
·
We offer product discounts to compensate distributors for the promotional activities which were previously performed by us. Prior to August 2009, promotional activities were generally jointly performed by distributors and us, and each party was responsible for the pre-determined portion of expense respectively. Effective August 2009, we established a monthly budget for promotional expenses. Distributors are responsible for organizing the promotional activities, and providing the documentation of their expenses, which would be recorded as product discounts to offset receivable from distributors in the applicable month.
 
 
·
We record a provision for estimated sales returns due to package damage and termination of distributorships. Due to the melamine contamination incident, the turnover days of products in the distribution channel to end customers was significantly increased. To avoid the potential loss the distributors might suffer, we offered certain product exchange for those products approaching the expiration dates. To respond to the exchange program, since October 2009, we recorded estimated replacement costs for future potential product exchange program. The sales return amount represents management’s best estimates based on the available information at the time of estimate.
 
 
·
For product sales and promotions at supermarkets and shopping malls, certain expenses in relation to shelf display, end-cap placement, bar-coding, banner advertising, etc. are paid to supermarkets and shopping mall operators. These expenses are deducted from revenues in accordance with ASC 605, Revenue Recognition (previously EITF 01-9 “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Product).”)

Allowance for Doubtful Accounts
 
We maintain allowances for doubtful accounts primarily based on the age of receivables and factors surrounding the credit risk of specific customers. An estimate for doubtful accounts is made when collection of the full amount is no longer probable. We perform risk assessment for each customer, and provide specific allowance for those deemed to have high risk of uncollectibility. We also record provision for other customers without specific risks by review the aging of the receivables. For the fiscal year ended March 31, 2011, the age of receivables increased as a result of the prematurity event, and led to increased balance of allowance for doubtful accounts. Bad debts are written off as incurred.

 
 
Inventories
 
Our inventories are stated at the lower of cost or market. The valuation of inventory requires us to estimate excess and slow moving inventory. The determination of the value of excess and slow moving inventory is based upon assumptions of future demands and market conditions. If actual market conditions are less favorable than those projected by management, inventory write-downs may be required. We routinely evaluate quantities and value of our inventories in light of current market conditions and market trends, and record write-down against the cost of inventories for a decline in market. Inventory write-down charges establish a new cost basis for inventory. In estimating obsolescence, we utilize our backlog information and project future demand. Market conditions are subject to change and actual consumption of inventories could differ materially from forecasted demand. Furthermore, the price of raw milk and milk powder are subject to fluctuations based on global supply and demand. If actual market conditions are less favorable or other factors arise that are significantly different from those anticipated by management, additional inventory write-downs or increases in obsolescence reserves may be required.

Income Taxes
 
The provision for income taxes has been determined using the asset and liability approach of accounting for income taxes. Under this approach, deferred taxes represent the future tax consequences expected to occur when the reported amounts of assets and liabilities are recovered or paid. The provision for income taxes represents income taxes paid or payable for the current year plus the change in deferred taxes during the year. Deferred taxes result from differences between the financial and tax bases of our assets and liabilities and are adjusted for changes in tax rates and tax laws when changes are enacted. Valuation allowances are recorded to reduce deferred tax assets when it is more likely than not that a tax benefit will not be realized. The assessment of whether or not a valuation allowance is required often requires significant judgment including the long-range forecast of future taxable income and the evaluation of tax planning initiatives. Adjustments to the deferred tax valuation allowances are made to earnings in the period when such assessments are made.
 
Our tax rate is based on expected income, statutory tax rates and tax planning opportunities available in the various jurisdictions in which we operate. For interim financial reporting, we estimate the annual tax rate based on projected taxable income for the full year and record a quarterly income tax provision in accordance with the anticipated annual rate. As the year progresses, we refine the estimates of the year’s taxable income as new information becomes available, including year-to-date financial results. This continual estimation process often results in a change to our expected effective tax rate for the year. When this occurs, we adjust the income tax provision during the quarter in which the change in estimate occurs so that the year-to-date provision reflects the expected annual tax rate. Significant judgment is required in determining our effective tax rate and in evaluating our tax positions.
 
In accordance with ASC 740, “Income Taxes” (previously SFAS No. 109, “Accounting for Income Taxes,”) we recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax basis of assets and liabilities. Deferred tax assets represent items to be used as a tax deduction or credit in future tax returns for which we have already properly recorded the tax benefit in the income statement. At least quarterly, we assess the likelihood that the deferred tax asset balance will be recovered from future taxable income. We take into account such factors as prior earnings history, expected future earnings, carry-back and carry-forward periods, and tax strategies that could potentially enhance the likelihood of a realization of a deferred tax asset. To the extent recovery is unlikely, a valuation allowance is established against the deferred tax asset and increasing our income tax expense in the year such determination is made.
 
ASC 740-30, “Income Taxes – Other Considerations or Special Areas” (previously APB Opinion No. 23, “Accounting for Income Taxes, Special Areas,”) does not require U.S. income taxes to be provided on foreign earnings when such earnings are indefinitely reinvested offshore. We periodically evaluate our investment strategies with respect to each foreign tax jurisdiction in which we operate to determine whether foreign earnings will be indefinitely reinvested offshore and, accordingly, whether U.S. income taxes should be provided when such earnings are recorded. As of March 31, 2011, we believed all earnings generated in China would be permanently reinvested and as a result, we did not record any income taxes on such earnings.
 
We adopted ASC 740-10, “Income Taxes” (previously FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109”) effective April 1, 2007. In accordance with ASC 740-10, we recognize a tax benefit associated with an uncertain tax position when, in our judgment, it is more likely than not that the position will be sustained upon examination by a taxing authority. For a tax position that meets the more-likely-than-not recognition threshold, we initially and subsequently measure the tax benefit as the largest amount that we judge to have a greater than 50% likelihood of being realized upon ultimate settlement with a taxing authority. Our liability associated with unrecognized tax benefits is adjusted periodically due to changing circumstances, such as the progress of tax audits, case law developments and new or emerging legislation. Such adjustments are recognized entirely in the period in which they are identified. Our effective tax rate includes the net impact of changes in the liability for unrecognized tax benefits and subsequent adjustments as considered appropriate by management. As of March 31, 2011, we had recorded liabilities of $1.2 million for our PRC subsidiaries.
 
We classify interest and penalties recognized on the liability for unrecognized tax benefits as income tax expense. For the fiscal year ended March 31, 2011, the unrecognized tax benefit did not change significantly and the amount of interest and penalties related to uncertain tax position is immaterial.

 
 
Product Recall
 
We establish a reserve for product recall on a product-specific basis when circumstances giving rise to the recall become known. Facts and circumstances related to the recall, including where the product affected by the recall or withdrawal is located (e.g., with consumers, in distributors’ inventory, or in the Company’s inventory), the expected product return rates by our distributor and end-customers, cost estimates for shipping and handling for returns and estimated replacement costs are considered when establishing a product recall reserve. These factors are updated and reevaluated each period and the related reserves are adjusted when these factors indicate that the recall reserve is either not sufficient to cover or exceeds the estimated product recall expenses.

Impairment of Goodwill and Indefinite Lived Intangible Assets
 
We account for goodwill and intangible assets with indefinite lives in accordance with Accounting Standards Codification (ASC) No. 350-10, “Intangibles-Goodwill and other – Overall” (previously Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets”) or ASC No.350-10. ASC No.350-10 states that goodwill and intangible assets with indefinite lives are not amortized, but are instead reviewed for impairment annually (or more frequently if impairment indicators arise). We conduct our annual impairment testing on March 31 to determine if we will be able to recover all or a portion of the carrying value of goodwill and intangible assets with indefinite lives.
 
The application of the impairment test requires judgment, including the identification of reporting units, assignments of assets and liabilities to reporting units and the determination of the fair value of each reporting unit. Further, the impairment test involves the use of accounting estimates and assumptions related to future operating results. Consistent with the requirements of ASC No.350-10, the fair values of our reporting units are generally based on discounted cash flow projections that are believed to be reasonable under current and forecasted circumstances, the results of which form the basis for making judgments about carrying values of the reported net assets of our reporting units.
 
Prior to performing the goodwill impairment testing process for a reporting unit under ASC No.350-10, if there is reason to believe that other non-goodwill related intangible assets may be impaired, these other intangible assets must first be tested for impairment under ASC No.350-10 or ASC No.360-10 -35, “Property, plant and equipment – Overall – Subsequent measurement” (previously SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”), or ASC No.360-10 -35. Assets governed by ASC No.360-10 -35 require a recoverability test for impairment whereby the gross undiscounted cash flows are determined specific to the asset. For non-goodwill related intangible assets with indefinite lives, a fair value determination is made. If the carrying value of the asset exceeds the fair value, then impairment occurs. The carrying values of these assets are impaired as necessary to provide the appropriate carrying value for the goodwill impairment calculation.
 
These impairment tests also involve the use of accounting estimates and assumptions that management believed to be reasonable, the results of which form the basis for our conclusions. Significant changes to these estimates and assumptions could adversely impact our conclusion to these impairment tests.  We will continue to closely monitor our financial performance and projections for our reporting units and the economic conditions of the product end-markets. Any significant change in market conditions and estimates or judgments could give rise to impairment in the period that the change becomes known.
 
Goodwill with a carrying amount of $1.4 million and a know-how, which represents the acquired recipe, with a carrying amount of $0.3 million were written down to their fair value of zero, resulting in a loss of $1.7 million, which was included in general and administrative expenses of baby food segment for the fiscal year ended March 31, 2011.
 
 

 
Results of Operations
 
The following table sets forth, for the periods indicated, our consolidated statements of operation and certain other information, each expressed as a percentage of net sales.
 
   
Fiscal Years Ended March 31,
 
   
2011
   
2010
   
2009
 
   
Amount
   
% of Net Sales
   
Amount
   
% of Net Sales
   
Amount
   
% of Net Sales
 
   
(in thousands)
 
Net sales
 
$
248,516
     
100.0
%
 
$
291,886
     
100.0
%
 
$
312,528
     
100.0
%
Cost of sales
   
170,769
     
68.7
%
   
208,476
     
71.4
%
   
259,086
     
82.9
%
Gross profit
   
77,747
     
31.3
%
   
83,410
     
28.6
%
   
53,442
     
17.1
%
Selling and distribution expenses
   
48,409
     
19.5
%
   
43,989
     
15.1
%
   
44,178
     
14.1
%
Advertising and promotion expenses
   
41,420
     
16.7
%
   
33,854
     
11.6
%
   
115,478
     
36.9
%
General and administrative expenses
   
28,261
     
11.4
%
   
24,509
     
8.4
%
   
25,455
     
8.1
%
Impairment of goodwill
   
1,440
     
0.6
%
   
     
     
     
 
Impairment loss from assets disposal
   
     
     
5,894
     
2.0
%
   
     
 
Other operating income, net
   
1,441
     
0.6
%
   
894
     
0.3
%
   
5,790
     
1.9
%
Loss from operations
   
(40,342
)
   
-16.2
%
   
(23,942
)
   
-8.2
%
   
(125,879
)
   
-40.3
%
Interest expense
   
10,321
     
4.2
%
   
8,603
     
2.9
%
   
4,857
     
1.6
%
Interest income
   
820
     
0.3
%
   
1,850
     
0.6
%
   
341
     
0.1
%
Other income (expense), net
   
277
     
0.1
%
   
(1,081
   
-0.4
%
   
(580
   
-0.2
%
Loss before income tax benefit
   
(49,566
)
   
-19.9
%
   
(31,776
)
   
-10.9
%
   
(130,975
)
   
-41.9
%
Income tax benefit
   
(9,306
)
   
-3.7
%
   
(6,904
)
   
-2.4
%
   
(30,386
)
   
-9.7
%
Net loss
   
(40,260
)
   
-16.2
%
   
(24,872
)
   
-8.5
%
   
(100,589
)
   
-32.2
%
Net loss attributable to the noncontrolling interest
   
(192
)
   
-0.1
%
   
(257
)
   
-0.1
%
   
(40
)
   
-0.0
%
Net loss attributable to Synutra International, Inc. common stockholders
 
$
(40,068
)
   
-16.1
%
 
$
(24,615
)
   
-8.4
%
 
$
(100,549
)
   
-32.2
%

Fiscal Year Ended March 31, 2011 Compared to Fiscal Year Ended March 31, 2010
 
Net Sales
 
Net sales for the fiscal year ended March 31, 2011 decreased by 14.9% to $248.5 million from $291.9 million for the prior fiscal year. This decrease in net sales was mainly due to the decrease in net sales of the powdered formula segment, as the business was significantly and negatively affected by the prematurity event, and decrease in net sales of our Other business, as we disposed of a large amount of surplus milk powder in the prior fiscal year.
 
 Powdered formula segment
 
Net sales of our powdered formula products, including infant powdered formula and other powdered formula products for children and adults under our Super, U-Smart, My Angel, Mingshan and Helanruniu brand names accounted for 74.7% of our total sales for the fiscal year ended March 31, 2011. Net sales of our powdered formula products for the fiscal year ended March 31, 2011 decreased by 4.5% to $185.6 million from $194.4 million for the prior fiscal year, primarily as a result of the following factors:
 
 
·
Sales volume of powdered formula products increased slightly to 24,927 tons for the fiscal year ended March 31, 2011 from 24,438 tons for the prior fiscal year, due primarily to the increase in sales volume before the prematurity event, as we recovered from the earlier melamine contamination incident, partially offset by the decrease in sales volume after the prematurity event.
 
 
·
The average selling price of our powdered formula products for the fiscal year ended March 31, 2011 decreased by 6.4% to $7,444 per ton from $7,954 per ton for the prior fiscal year. The decrease in average selling price is mainly due to the prematurity event. While we provided discounts to our distributors at a pre-event level, our sales volume decreased significantly immediately after the incident, and it resulted in significant decrease in the average selling price for the quarters ended September 30, 2010 and December 31, 2010. The decrease in average selling price was partially offset by the high average selling price for the fiscal quarter ended June 30, 2010, when the powdered formula products were recovering from the earlier melamine contamination incident.
\

 
Baby food segment
 
Net sales of baby food segment for the fiscal year ended March 31, 2011 was $495,000, as compared to $886,000 for prior fiscal year. The products in this segment comprised mainly of prepared baby food, such as cooked meat and vegetables. Because of the prematurity event, we focused our efforts on the recovery of the powdered formula segment, and did not develop the baby food segment as planned.
 
Nutritional ingredients and supplements segment
 
Net sales of nutritional ingredients and supplements segment for the fiscal year ended March 31, 2011 was $1.0 million, as compared to $1.5 million for prior fiscal year. The products in this segment comprised mainly of chondroitin sulfate sold to third parties. There were also inter-segment sales of $8.3 million of nutritional ingredients, such as microencapsulated DHA and ARA, which were used in the production of powdered infant formula products, as compared to $11.3 million of nutritional ingredients and chondroitin sulfate for the prior fiscal year.
 
Other
 
Other sales for the fiscal year ended March 31, 2011 was $61.5 million, which mainly included sales of surplus milk powder, whey protein and raw milk to industrial customers, as compared to $95.2 million for the prior fiscal year.  Our milk powders are purchased from New Zealand, and we generally place orders with our supplier several months before delivery. Due to the long lead time required to purchase the raw material, we usually keep a high level of stock. Due to the prematurity event, our production slowed down, and it led to an overstock of milk powder, which we sold to industrial customers. In addition, the sales of 20%-30% imported milk powder which is not compliant with the new national standard discussed above increased the transaction amount of Other business.

Cost of Sales
 
Cost of sales for the fiscal year ended March 31, 2011 decreased by 18.1% to $170.8 million from $208.5 million for the prior fiscal year. The decrease in the cost of sales is mainly due to the decrease of cost of sales of Other business, partially offset by the increase of cost of sales of the powdered formula segment.
 
Powdered formula segment
 
Cost of sales for the powdered formula products for the fiscal year ended March 31, 2011 increased by 9.3% to $107.3 million from $98.2 million for the prior fiscal year. The increase in the cost of sales is due primarily to the increase in raw material price, such as milk powder and whey protein.
 
Baby food segment
 
Cost of sales of baby food segment for the fiscal year ended March 31, 2011 was $1.7 million, as compared to $0.8 million for the prior fiscal year.
 
Nutritional ingredients and supplements segment
 
Cost of sales of the nutritional ingredients and supplements segment for the fiscal year ended March 31, 2011 was $3.1 million, as compared to $2.7 million for the prior fiscal year.
 
Other
 
Other cost of sales for the fiscal year ended March 31, 2011 was $58.7 million, which mainly included the cost of sales of surplus milk powder, whey protein and raw milk to industrial customers. Other cost of sales was $106.8 million for the prior fiscal year, which mainly included cost of sales of surplus milk powder that was overstocked due to the melamine contamination incident.

 
 
Gross Profit and Gross Margin
 
As a result of the foregoing, gross profit for the fiscal year ended March 31, 2011 decreased by 6.8% to $77.7 million from $83.4 million for the prior fiscal year. Gross profit for our powdered formula products for the fiscal year ended March 31, 2011 decreased by 18.6% to $78.3 million from $96.2 million for the prior fiscal year.
 
Our overall gross margin increased to 31.3% for the fiscal year ended March 31, 2011 from 28.6% for the prior fiscal year. Our gross margin for powdered formula products was 42.2% for the fiscal year ended March 31, 2011, as compared to 49.5% for the prior fiscal year.

Selling and Distribution Expenses
 
Selling and distribution expenses for the fiscal year ended March 31, 2011 increased by 10.0% to $48.4 million from $44.0 million for the prior fiscal year. This increase was mainly due to the increase in compensation expenses. Total compensation expense for the fiscal year ended March 31, 2011 increased to $30.4 million from $25.3 million for the prior fiscal year due to an increase in base salary of the sales staff.

Advertising and Promotion Expenses
 
Advertising and promotion expenses for the fiscal year ended March 31, 2011 increased 22.3% to $41.4 million from $33.9 million for the prior fiscal year. Advertising expenses for the fiscal year ended March 31, 2011, which accounted for 54.5% of total advertising and promotion expenses, increased by 35.3% to $22.6 million from $16.7 million for the prior fiscal year. The increase in advertising expenses is mainly due to more advertisement on TV in reaction to the prematurity event. Promotion expenses for the fiscal year ended March 31, 2011, which accounted for 45.5% of total advertising and promotion expenses, increased by 9.8% to $18.9 million from $17.2 million for the prior fiscal year. The increase in promotion expense is mainly due to increased spending on promotions to consumers.

General and Administrative Expenses
 
General and administrative expenses for the fiscal year ended March 31, 2011 increased by 15.3% to $28.3 million from $24.5 million for the prior fiscal year. The increase was mainly due to $1.5 million to finance prematurity-related research and related public education, $0.5 million impairment loss for long-lived assets, and $0.3 million impairment loss of an intangible asset of the baby food setment.

Impairment of goodwill

Impairment of goodwill for the fiscal year ended March 31, 2011 was $1.4 million, which represented the difference between the estimated fair value and carrying value of goodwill generated in the acquisition of the baby food business.

Impairment Loss from assets disposal
 
The impairment loss for the fiscal year ended March 31, 2010 was $5.9 million, which represented the difference between the estimated fair value and carrying value of the assets held by two of our subsidiaries.

Other Operating Income, Net
 
Other operating income for the fiscal year ended March 31, 2011 was $1.4 million, as compared to $894,000 for the prior fiscal year. The income represented general purpose subsidy from local governments.

 
Interest Expense
 
Interest expense for the fiscal year ended March 31, 2011 increased to $10.3 million from $8.6 million for the prior fiscal year. The increase was mainly due to the fact that in the prior fiscal year, we received $1.2 million of government subsidy related to interest expense and reversed $657,000 of interest expense according to revised terms of the RBS Loan Agreement.

Interest Income
 
Interest income for the fiscal year ended March 31, 2011 decreased to $820,000 from $1.9 million for the prior fiscal year. The decrease was mainly due to the decrease in restricted cash, which had a higher interest rate than cash and cash equivalent.

Other Income (Expense), Net
 
Other income for the fiscal year ended March 31, 2011 was $277,000, as compared to other expense of $1.1 million for the prior fiscal year. 

Income Tax Benefit
 
As a result of the loss generated, we recorded an income tax benefit of $9.3 million for the fiscal year ended March 31, 2011, as compared to $6.9 million for prior year. Our effective tax rate was 18.8% for the fiscal year ended March 31, 2011, as compared to 21.7% for the prior fiscal year.  The decrease in the effective tax rate was driven primarily by the effect of tax refund of overpaid income tax prior to the melamine contamination incident in the prior fiscal year, partially offset by the valuation allowance for net operating loss carryforward of certain subsidiaries in the prior fiscal year.

Net Loss Attributable to Synutra International, Inc. Common Stockholders
 
As a result of the foregoing, net loss attributable to Synutra International, Inc. for the fiscal year ended March 31, 2011 was $40.1 million, as compared to net loss of $24.6 million for the prior fiscal year.

Fiscal Year Ended March 31, 2010 Compared to Fiscal Year Ended March 31, 2009
 
Net Sales
 
Net sales for the fiscal year ended March 31, 2010 decreased by 6.6% to $291.9 million from $312.5 million for the prior fiscal year. This decrease in net sales was mainly due to the lingering impact of melamine contamination incident on our powdered formula segment, partially offset by an increase in the sales of surplus industrial milk powder of our “Other” business.
 
Powdered formula segment
 
Net sales of our powdered formula products, including infant powdered formula and other powdered formula products for children and adults under our Super, U-Smart, Mingshan and Helanruniu brand names accounted for 66.6% of our total sales for the fiscal year ended March 31, 2010. Net sales of our powdered formula products for the fiscal year ended March 31, 2010 decreased by 31.8% to $194.4 million from $284.8 million for the prior fiscal year, primarily as a result of the following factors:
 
 
·
Sales volume of powdered formula products decreased by 19.6% to 24,438 tons for the fiscal year ended March 31, 2010 from 30,383 tons for the prior fiscal year, due primarily to a slow-down in sales activities following the melamine contamination incident.
 
 
·
The average selling price of our powdered formula products for the fiscal year ended March 31, 2010 decreased by 15.1% to $7,954 per ton from $9,374 per ton for the prior fiscal year. While our quoted product prices have not changed significantly from August 2008 to March 2010 and our revenue mix is shifting to higher-priced products, our average selling prices has remained below pre-recall levels, because management believes more aggressive rebates and discounts to distributors, which are recorded as a reduction to our net sales, are important incentives to motivate our sales and distribution networks in regaining market share. Also, beginning in August 2009, distributors are responsible for organizing local promotion activities, which were previously jointly organized by the distributors and us, to make quicker response to market trends and to improve efficiency. The compensation to distributors for this change are recorded as reduction of net sales, instead of marketing expense. As we recover from the melamine contamination incident, we believe the average selling price should gradually return to pre-recall levels and we expect to decrease the amount of rebates to our distributors. For example, the average selling price of our powdered formula products for the fiscal quarter ended March 31, 2010 was $8,619 per ton, compared to the pre-recall level of $9,036 per ton for the fiscal quarter ended June 30, 2008.

 
 
Baby food segment
 
Net sales of baby food segment for the fiscal year ended March 31, 2010 was $886,000, representing sales of prepared baby food, such as cooked meat and vegetables, which began its operation in March 2009.
 
Nutritional ingredients and supplements segment
 
Net sales of nutritional ingredients and supplements segment for the fiscal year ended March 31, 2010 was $1.5 million, representing chondroitin sulfate sold to third parties. There were also inter-segment sales of $11.3 million of nutritional ingredients, such as microencapsulated DHA and ARA, which were used in the production of powdered infant formula products, and chondroitin sulfate, as compared to $3.4 million fro the fiscal year ended March 31, 2009. We did not have any external sales in this segment for the fiscal year ended March 31, 2009.
 
Other
 
Other sales for the fiscal year ended March 31, 2010 was $95.2 million, which mainly included sales of surplus milk powder to industrial customers of $80.0 million, as compared to $27.4 million for the prior fiscal year.  The significant increase was due to the fact that after the melamine contamination incident, actual sales of powdered formula segment was lower than what we had initially estimated which led to a build up of milk powder, both imported and self-produced. We sold the surplus portion of the milk powder to industrial customers during the fiscal year ended March 31, 2010 and generated immediate cash.
 
Cost of Sales
 
Cost of sales for the fiscal year ended March 31, 2010 decreased by 19.5% to $208.5 million from $259.1 million for the prior fiscal year. The decrease in the cost of sales is due primarily to a decrease in the sales volume of our powdered formula products in the fiscal year ended March 31, 2010, and the product recall cost which was recorded in the fiscal year ended March 31, 2009, and partially offset by an increase in cost of sales of surplus industrial milk powder in the fiscal year ended March 31, 2010.
 
 Powdered formula segment
 
Cost of sales for the powdered formula products for the fiscal year ended March 31, 2010 decreased by 58.1% to $98.2 million from $234.5 million for the prior fiscal year. The decrease in the cost of sales is due primarily to the lingering impact of the melamine contamination incident on the sales volume of our powdered formula products for the fiscal year ended March 31, 2010, and the significant product recall cost recorded in the fiscal year ended March 31, 2009.
 
Baby food segment
 
Cost of sales of baby food segment for the fiscal year ended March 31, 2010 was $0.8 million, representing cost of sales of prepared baby food, such as cooked meat and vegetables, which began its operation in March 2009.
 
Nutritional ingredients and supplements segment
 
Cost of sales of nutritional ingredients and supplements segment for the fiscal year ended March 31, 2010 was $2.7 million, representing chondroitin sulfate sold to third parties. There were also inter-segment sales of nutritional ingredients, such as microencapsulated DHA and ARA, which were used in the production of powdered infant formula products. We did not have external cost of sales in this segment for the fiscal year ended March 31, 2009.
 
Other
 
Other cost of sales for the fiscal year ended March 31, 2010 was $106.8 million, which mainly included the cost of sales of surplus milk powder of $85.4 million and write-down of industrial milk powder of $6.7 million due to a decline in selling price as a result of lower-priced domestically produced milk powder, as compared to $24.5 million for the prior fiscal year.
 

 
Gross Profit and Gross Margin
 
As a result of the foregoing, gross profit for the fiscal year ended March 31, 2010 increased by 56.1% to $83.4 million from $53.4 million for the prior fiscal year. Gross profit for our powdered formula products for the fiscal year ended March 31, 2010 increased by 91.1% to $96.2 million from $50.3 million for the prior fiscal year. Gross loss for other business for the fiscal year ended March 31, 2010 was $11.7 million, primarily due to the loss from sales of domestically produced milk powder and write-down of domestically produced milk powder in inventory. In order to improve our working capital situation, we sold part of milk powder which was surplus to our own requirement for the fiscal year ended March 31, 2010.
 
Our overall gross margin increased to 28.6% for the fiscal year ended March 31, 2010 from 17.1% for the prior fiscal year. Our gross margin for powdered formula products was 49.5% for the fiscal year ended March 31, 2010, as compared to 17.7% for the prior fiscal year. Gross margin for Other business for the fiscal year ended March 31, 2010 was negative 12.3%.
 
Selling and Distribution Expenses
 
Selling and distribution expenses for the fiscal year ended March 31, 2010 decreased slightly by 0.4% to $44.0 million from $44.2 million for the prior fiscal year. This decrease was a combined result of a decrease in freight charges and sales administration expense due to tightened budgetary control, partially offset by an increase in compensation expenses for our sales force. Total compensation for our sales force for the fiscal year ended March 31, 2010 increased by 16.8% to $25.3 million from $21.7 million for the prior fiscal year due to a pay raise for the sales staff in the fiscal quarter ended June 30, 2009, partially offset by a slight decrease in the number of sales staff to 2,917 as of March 31, 2010 from 2,997 as of March 31, 2009. Freight charges for the fiscal year ended March 31, 2010 decreased by 36.1% to $4.7 million from $7.4 million for prior fiscal year, due primarily to the freight charges accrual for product recall in prior fiscal year and a decrease of sales volume.
 
Advertising and Promotion Expenses
 
Advertising and promotion expenses for the fiscal year ended March 31, 2010 decreased significantly by 70.7% to $33.9 million from $115.5 million for the prior fiscal year. Advertising expenses for the fiscal year ended March 31, 2010, which accounted for 49.3% of total advertising and promotion expenses, decreased by 77.1% to $16.7 million from $72.8 million for the prior fiscal year. Promotion expenses for the fiscal year ended March 31, 2010, which accounted for 50.7% of total advertising and promotion expenses, decreased by 59.8% to $17.2 million from $42.7 million for the prior fiscal year, as certain promotions were carried out directly by distributors in exchange for us providing such distributors with an increase in product discount which was recorded as reduction to net sales. Following aggressive advertising and promotional campaigns in the fiscal quarter ended March 31, 2009 to regain market share in the immediate aftermath of the melamine contamination incident, we reduced our advertising and promotion expenses, and have refocused our efforts in the subsequent quarters to achieve effective market pull-through with new customers and to improve brand loyalty. The significant decrease reflected a redeployment of resources to support activities on the consumer-end and beyond the distribution channels by our field promoters in the communities and our nutrition education professionals at the medical and healthcare facilities. The reduction of advertising and promotion expenses also helped to improve our liquidity position in early quarters of the fiscal year ended March 31, 2010. As our operations gradually returned to their normal condition, we resumed since March 2010 our advertisement in major Chinese TV stations and we expect to increase our advertising and promotion expenses going forward.
 
General and Administrative Expenses
 
General and administrative expenses for the fiscal year ended March 31, 2010 decreased slightly by 3.7% to $24.5 million from $25.5 million for the prior fiscal year. The decrease in general and administrative expenses was a combined result of a net contribution of $2.3 million made to the compensation fund set up by China Dairy Industry Association for the settlement of existing and potential claims in China from families of infants affected by melamine contamination and $1.8 million write-off of legal and professional fees incurred for the terminated equity capital markets transaction for the prior fiscal year, partially offset by an increase of $2.3 million in bad debt allowance in the fiscal year ended March 31, 2010 due to extended credit term to help the recovery of distributors and termination of certain distributorship after the melamine contamination incident.

 
 
Impairment Loss from assets disposal
 
We recorded impairment loss of $5.9 million for the fiscal year ended March 31, 2010 which represented the difference between the estimated fair value and carrying value of the assets sold by our subsidiaries, Baoquanling and Cow Breeding.
 
Other Operating Income, Net
 
Other operating income for the fiscal year ended March 31, 2010 decreased to $894,000 from $5.8 million for the prior fiscal year. Other operating income for the fiscal year ended March 31, 2010 represents a general purpose government subsidy from a local government.
 
Interest Expense
 
Interest expense for the fiscal year ended March 31, 2010 increased to $8.6 million from $4.9 million for the prior fiscal year, due primarily to the significant increase in bank borrowings after the melamine contamination incident.
 
Interest Income
 
Interest income for the fiscal year ended March 31, 2010 increased to $1.9 million from $0.3 million for the prior fiscal year, due primarily to the increased cash deposit pledged for short-term loans, which had a higher interest rate than cash equivalents.
 
Income Tax Benefit
 
As a result of the net loss, we recorded an income tax benefit of $6.9 million for the fiscal year ended March 31, 2010, as compared to $30.4 million for prior year. Our effective tax rate decreased to 21.7% for the fiscal year ended March 31, 2010 from 23.2% for the prior fiscal year.  The decrease in the effective tax rate was driven primarily by the valuation allowance for net operating loss carryforward of certain subsidiaries and tax credits carryforward for PRC equipment purchasing, partially offset by the effect of tax refund which represented refund of overpaid income tax prior to the melamine contamination incident.
 
Net Loss Attributable to Synutra International, Inc. Common Stockholders
 
As a result of the foregoing, net loss attributable to Synutra International, Inc. for the fiscal year ended March 31, 2010 was $24.6 million, as compared to net loss of $100.5 million for the prior fiscal year.

 
 
Liquidity and Capital Resources

Our primary sources of liquidity are cash from operations and available borrowings. Cash flows from operating activities represent the inflow of cash from our customers and the outflow of cash for inventory purchases, manufacturing, operating expenses, interest and taxes. Cash flows used in investing activities primarily represent capital expenditures for equipment and buildings. Cash flows from financing activities primarily represent borrowings from banks, and for the fiscal year ended March 31, 2011, it also includes the issuance of 3.3 million shares of common stock, with net proceeds of approximately $58.8 million.

The consolidated financial statements of the Company have been prepared in accordance with accounting principles generally accepted in the United States of America (“US GAAP”). The accompanying consolidated financial statements have been prepared assuming the Company will continue as a going concern. Under that assumption, it is expected that assets will be realized and liabilities will be satisfied in the normal course of business. As a result of the prematurity event and subsequent loss of sales, the Company experienced significant operating losses and negative cash flows from operations for the fiscal year ended March 31, 2011.
 
Apart from the Company’s efforts of improving financial performance as discussed in Overview section, the Company took the following measurements to overcome liquidity difficulties:
 
 
·
Debt restructuring: Part of the Company’s debt has been refinanced subsequent to the balance sheet date. From April 1, 2011 to June 8, 2011, in order to further improve working capital condition, the Company repaid short-term and long-term borrowings from PRC banks before due in the amount of $25.9 million, with original maturity date from September 2011 to October 2011 and with weighted average interest rate of 6.25%, and borrowed long-term loan from the same PRC banks in the same amount, with $1.5 million of indebtedness to mature in June 2012 and $24.4 million to mature from December 2012 to May 2013 and with weighted average interest rate of 6.92%.

 
·
Availability of credit facilities: The Company has unused committed and available bank standby credit facilities of $48.0 million as of March 31, 2011.
 
  
 
·
Sales of surplus industrial milk powder: during the fiscal year ended March 31, 2011, the Company sold surplus milk powder to industrial customers for $46.2 million, most of which has generated operating cash flow for the Company.

On July 7, 2010, the Company entered into a supplementary agreement with Beijing Oriental Campus Property Management Co., Ltd., pursuant to which the Company was required to prepay its head office building and land rental expense of $17.6 million, representing rental expense from September 1, 2010 to August 31, 2018, before December 31, 2010. We paid $9.5 million of this expense by March 31, 2011. Due to the tight cash flow we experienced after the prematurity event, we negotiated with the counterparty and temporarily ceased payment of the remaining balance. Any further payment will be made on a negotiated basis.

 
 
The following table sets forth, for the periods indicated, certain information relating to our cash flows:

   
Fiscal Year Ended March 31,
 
   
2011
   
2010
   
2009
 
   
(in thousands)
 
Net cash used in operating activities
 
$
(66,265
)
 
$
(11,824
)
 
$
(109,488
)
Net cash provided by (used in) investing activities
   
(9,368
   
56,529
     
(127,287
)
Net cash provided by (used in) financing activities
   
73,684
     
(33,804
)
   
174,871
 
Effect of foreign currency translation on cash and cash equivalents
   
1,997
     
56
     
2,215
 
Net cash flow
 
$
48
   
$
10,957
   
$
(59,689
)

Cash Flows from Operating Activities
 
Net cash used in operating activities was $66.3 million for the fiscal year ended March 31, 2011, as compared to $11.8 million for the prior fiscal year. Net cash used in operating activities for the fiscal year ended March 31, 2011 included net loss of $40.3 million, non-cash items not affecting cash flows of $8.1 million, and a $34.1 million increase in working capital. The changes in working capital for the fiscal year ended March 31, 2011, were primarily related to a $22.9 million increase in accounts receivable due to our support to distributors to help their recovery, and $13.0 million increase in goods in transit of inventories caused by the long lead time to import raw materials. In the fiscal year ended March 31, 2011, we spent $224.9 million to purchase raw materials and other production materials, $42.1 million in staff compensation and social welfare, $23.9 million in other taxes, $71.5 million in selling and distribution, advertising and promotion, and general and administrative expenses, and received $304.6 million from our customers.

Net cash used in operating activities was $11.8 million for the fiscal year ended March 31, 2010, as compared to $109.5 million for the prior fiscal year. Net cash used in operating activities for the fiscal year ended March 31, 2010 included net loss of $24.9 million, non-cash items not affecting cash flows of $18.2 million, and a $5.2 million increase in working capital. The changes in working capital for the fiscal year ended March 31, 2010, were primarily related to a $61.3 million decrease in inventories due to sales of surplus industrial milk powder, and a $57.2 million decrease in accounts payable due to the settlement of certain accumulated extended liabilities. In the fiscal year ended March 31, 2010, we spent $217.7 million to purchase raw materials and other production materials, $38.1 million in staff compensation and social welfare, $33.2 million in other taxes, $86.4 million in selling and distribution, advertising and promotion, and general and administrative expenses, and received $374.7 million from our customers.
 
Net cash used in operating activities was $109.5 million for the fiscal year ended March 31, 2009. Net cash used in operating activities for the fiscal year ended March 31, 2009 included net loss of $100.5 million, non-cash items not affecting cash flows of $20.0 million, and a $11.1 million increase in working capital. The changes in working capital for the fiscal year ended March 31, 2009, were primarily related to a $50.9 million increase in inventories due to the increase in goods-in-transit for imported milk powder, a $77.0 million increase in accounts payable due to a credit term extension from our suppliers resulting from our tightened liquidity position and payable for goods-in-transit for imported milk powder, a $13.4 million increase in accounts receivable due to our extended credit term to certain distributors, a $5.6 million increase in income tax receivable due to prepaid income tax before the melamine contamination incident, and a $4.5 million increase in product recall provision. For the fiscal year ended March 31, 2009, we spent $238.8 million to purchase raw materials and other production materials, $33.0 million in staff compensation and social welfare, $33.8 million in other taxes, $197.1 million in selling and distribution, advertising and promotion, and general and administrative expenses, and received $403.8 million from our customers.
 

 
Cash Flows from Investing Activities
 
Net cash used in investing activities was $9.4 million for the fiscal year ended March 31, 2011, as compared to $56.5 million for the prior fiscal year. Cash invested in purchases of property and equipment was $8.2 million and $13.3 million for the fiscal year ended March 31, 2011 and 2010, respectively. Cash outflow from restricted cash was $2.9 million for the fiscal year ended March 31, 2011, as compared to cash inflow from restricted cash of $51.1 million for the prior fiscal year. Cash outflow from payment of land lease was $7.5 million, representing the prepayment on the lease for our Beijing headquarter. Restricted cash represents cash deposited with banks as security against the issuance of letters of credit for the import of raw materials and as pledges for certain short-term borrowings.

Net cash provided by investing activities was $56.5 million for the fiscal year ended March 31, 2010, as compared to net cash used in investing activities of $127.3 million for the prior fiscal year. Cash invested in purchases of property and equipment was $13.3 million and $44.9 million for the fiscal year ended March 31, 2010 and 2009, respectively. The decrease is mainly due to the suspension of major investing projects in the aftermath of the melamine contamination incident. We expect the suspension will slow down our expansion into the baby food business. Cash inflow from restricted cash was $51.1 million for the fiscal year ended March 31, 2010 due to repayment of certain bank borrowings which was secured by cash, as compared to cash outflow for restricted cash of $73.9 million for the prior fiscal year. Restricted cash represents cash deposited with banks as security against the issuance of letters of credit for the import of machinery and raw materials and as pledges for certain short-term borrowings.
 
Net cash used in investing activities was $127.3 million for the fiscal year ended March 31, 2009. Cash invested in purchases of property and equipment was $44.9 million for the fiscal year ended March 31, 2009. This increase in net cash used in investing activities is primarily due to our plant expansion to increase our production capacity prior to the melamine contamination incident, partially offset by the suspension of major investing projects in the aftermath of such event. We expect the suspension will slow down our expansion into the baby food business. Cash outflow for restricted cash was $73.9 million for the fiscal year ended March 31, 2009, due to a significant increase in certain bank borrowings which was pledged by cash. Restricted cash represents cash deposited with banks as security against the issuance of letters of credit for the import of machinery and raw materials and as pledges for certain short-term borrowings.

Cash Flows from Financing Activities
 
Net cash provided by financing activities was $73.7 million for the fiscal year ended March 31, 2011. Cash provided by financing activities during the fiscal year ended March 31, 2011 was primarily related to $206.1 million in short-term loans from PRC banks in China, $57.7 million in long-term loans from PRC banks in China, $62.7 million from issuance of common stock, offset by $179.6 million repayment of short-term loans to banks in China, $67.3 million repayment of long-term loans to banks in China, and $2.0 million representing prepayment on the capital lease of our Beijing headquarter.

Net cash used in financing activities was $33.8 million for the fiscal year ended March 31, 2010. Cash provided by financing activities during the fiscal year ended March 31, 2010 was primarily related to $337.7 million in short-term loans from PRC banks in China and a company controlled by our Chairman and Chief Executive Officer, $32.2 million in long-term loans from domestic banks in China, offset by $403.7 million repayment of short-term loans to banks in China.
 
Net cash provided by financing activities was $174.9 million for the fiscal year ended March 31, 2009. Cash provided by financing activities during the fiscal year ended March 31, 2009 was primarily related to $238.2 million in short-term loans from banks in China, $7.5 million loan from related parties, $8.8 million in long-term loans from banks in China, offset by $77.3 million repayment of short-term loans from PRC banks and $1.9 million repayment of long-term loans from PRC banks.
 

 
Outstanding Indebtedness
 
For information on our short-term and long-term borrowings, see “Item 8.  Financial Statements and Supplementary Data – Note 12 to Consolidated Financial Statements.”

Tabular Disclosure of Contractual Obligations
 
Our cash flows from operations are dependent on a number of factors, including fluctuations in our operating results, accounts receivable collections, inventory management, and the timing and amount of tax and other payments. We plan for and measure our liquidity and capital resources through an annual budgeting process.
 
Below is a table setting forth our contractual obligations as of March 31, 2011

   
Total
   
Less than
1 year
   
1-3 years
   
3-5 years
   
More than
5 years
 
   
(in thousands)
 
Long-term debt and related interest payment obligations
 
$
107,347
   
$
42,718
   
$
64,629
   
$
   
$
 
Capital lease obligations
   
18,025
     
493
     
986
     
986
     
15,560
 
Operating lease obligations
   
67,581
     
1,962
     
3,822
     
3,646
     
58,151
 
Purchase commitments
   
33,761
     
33,761
     
     
     
 
Capital expenditure commitments
   
2,154
     
2,099
     
55
     
     
 
Total
 
$
228,868
   
$
81,033