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EX-32.2 - EXHIBIT 32.2 - SKYSTAR BIO-PHARMACEUTICAL COv233000_ex32-2.htm
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EX-31.1 - EXHIBIT 31.1 - SKYSTAR BIO-PHARMACEUTICAL COv233000_ex31-1.htm
EX-32.1 - EXHIBIT 32.1 - SKYSTAR BIO-PHARMACEUTICAL COv233000_ex32-1.htm
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

FORM 10-Q

 
x
Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended June 30, 2011

or

 
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 001-34394


SKYSTAR BIO-PHARMACEUTICAL COMPANY
(Exact name of small business issuer as specified in its charter)

Nevada
 
33-0901534
(State or other jurisdiction of
 
(I.R.S. employer
incorporation or organization)
  
identification number)

4/F Building B, Chuangye Square, No. 48 Keji Road,
Gaoxin District, Xi’an Province, P.R. China
(Address of principal executive offices and zip code)

(8629) 8819-3188
(Registrant’s telephone number, including area code)

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (Check one):
 
 
Large Accelerated Filer ¨
Accelerated Filer ¨
 
Non-accelerated filer ¨
Smaller Reporting Company x

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

APPLICABLE ONLY TO CORPORATE ISSUERS:

As of August 15, 2011, the Registrant had 7,161,919 shares of common stock outstanding.

 
 

 

SKYSTAR BIO-PHARMACEUTICAL COMPANY

FORM 10-Q

INDEX
 
   
Page No.
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
  3
     
PART I.  FINANCIAL INFORMATION
  4
       
Item 1.
Condensed Consolidated Financial Statements
  4
       
 
Condensed Consolidated Balance Sheets as of June 30, 2011 (unaudited) and December 31, 2010
  4
       
 
Condensed Consolidated Statements of Income and Other Comprehensive Income for the Six Months Ended June 30, 2011 and 2010 (unaudited)
  5
       
 
Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2011 and 2010 (unaudited)
  6
       
 
Condensed Consolidated Statements of Shareholders’ Equity (unaudited)
  7
       
 
Notes to the Condensed Consolidated Financial Statements (unaudited)
  8
       
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
  24
       
Item 4.
Controls and Procedures
  31
       
PART II.  OTHER INFORMATION
  32
       
Item 6.
Exhibits
  32
       
SIGNATURES
  33

 
2

 

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

This report contains forward-looking statements. All forward-looking statements are inherently uncertain as they are based on current expectations and assumptions concerning future events or future performance of the Company. Readers are cautioned not to place undue reliance on these forward-looking statements, which are only predictions and speak only as of the date hereof. Forward-looking statements usually contain the words “estimate,” “anticipate,” “believe,” “expect,” or similar expressions, and are subject to numerous known and unknown risks and uncertainties. In evaluating such statements, prospective investors should carefully review various risks and uncertainties identified in this report and in our other SEC filings. These risks and uncertainties could cause our actual results to differ materially from those indicated in the forward-looking statements. We undertake no obligation to update or publicly announce revisions to any forward-looking statements to reflect future events or developments.

Although forward-looking statements in this Quarterly Report on Form 10-Q reflect the good faith judgment of our management, such statements can only be based on facts and factors currently known by us. Consequently, forward-looking statements are inherently subject to risks and uncertainties, and actual results and outcomes may differ materially from the results and outcomes discussed in or anticipated by the forward-looking statements. Readers are urged not to place undue reliance on these forward-looking statements, which speak only as of the date of this Quarterly Report. You can read and copy any materials we file with the SEC at the SEC’s Public Reference Room, 100 F. Street, NE, Washington, D.C. 20549 on official business days during the hours of 10 a.m. to 3 p.m. You can obtain additional information about the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains an Internet site (www.sec.gov) that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC, including the Company.

We undertake no obligation to revise or update any forward-looking statements in order to reflect any event or circumstance that may arise after the date of this Quarterly Report. Readers are urged to carefully review and consider the various disclosures made throughout the entirety of this Quarterly Report, which attempt to advise interested parties of the risks and factors that may affect our business, financial condition, results of operations and prospects.

 
3

 

PART I.  FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

SKYSTAR BIO-PHARMACEUTICAL COMPANY AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS
 
    
June 30,
   
December 31,
 
   
2011
(Unaudited)
   
2010
 
ASSETS
           
CURRENT ASSETS:
           
Cash
 
$
5,046,502
   
$
5,887,831
 
Accounts receivable, net of allowance for doubtful accounts of $345,736 (Unaudited) and $339,031 as of June 30, 2011 and December 31, 2010, respectively
   
3,979,063
     
4,977,850
 
Inventories
   
16,146,631
     
7,202,223
 
Deposits and prepaid expenses
   
16,770,200
     
17,074,000
 
Loans receivable
   
          2,113,202
     
8,040,100
 
Other receivables
   
1,563,512
     
1,558,775
 
Total current assets
   
45,619,110
     
44,740,779
 
                 
PLANT AND EQUIPMENT, NET
   
22,608,122
     
22,613,113
 
                 
CONSTRUCTION-IN-PROGRESS
   
6,249,534
     
1,590,720
 
                 
OTHER ASSETS:
               
Long-term prepayments
   
1,222,130
     
1,454,226
 
Long-term prepayments for acquisitions
   
4,901,402
     
4,806,352
 
Intangible assets, net
   
5,820,403
     
6,043,941
 
Total other assets
   
11,943,935
     
12,304,519
 
Total assets
 
$
86,420,701
   
$
81,249,131
 
                 
LIABILITIES AND SHAREHOLDERS’ EQUITY
               
                 
CURRENT LIABILITIES:
               
Accounts payable
 
$
789,758
   
$
201,850
 
Other payable and accrued expenses
   
1,421,029
     
1,845,051
 
Short-term loans
   
4,208,846
     
3,025,884
 
Deposits from customers
   
1,574,905
     
1,260,030
 
Taxes payable
   
54,482
     
749,836
 
Shares to be issued to related parties
   
79,575
     
53,050
 
Due to related parties
   
437,341
     
217,912
 
Total current liabilities
   
8,565,936
     
7,353,613
 
                 
OTHER LIABILITIES:
               
Deferred government grant
   
1,005,550
     
986,050
 
Warrant liability
   
323,992
     
1,419,639
 
Total other liabilities
   
1,329,542
     
2,405,689
 
Total liabilities
   
9,895,478
     
9,759,302
 
                 
COMMITMENTS AND CONTINGENCIES
               
                 
SHAREHOLDERS’ EQUITY
               
Preferred stock, $0.001 par value, 50,000,000 shares authorized, No Series “A” shares authorized, 48,000,000 Series “B” shares authorized, No Series “B” shares issued and outstanding
               
Common stock, $0.001 par value, 40,000,000 shares authorized, 7,161,919 shares issued and outstanding as of June 30, 2011 (Unaudited) and December 31, 2010
   
7,162
     
7,162
 
Paid-in capital
   
35,784,378
     
35,784,378
 
Statutory reserves
   
5,695,236
     
5,695,236
 
Retained earnings
   
28,286,512
     
24,847,290
 
Accumulated other comprehensive income
   
6,751,935
     
5,155,763
 
Total shareholders’ equity
   
76,525,223
     
71,489,829
 
Total liabilities and shareholders’ equity
 
$
86,420,701
   
$
81,249,131
 

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

 
4

 

SKYSTAR BIO-PHARMACEUTICAL COMPANY AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND OTHER COMPREHENSIVE INCOME
(Unaudited)

    
For Three Months Ended June 30,
   
For Six Months Ended June 30,
 
   
2011
   
2010
   
2011
   
2010
 
                         
REVENUE, NET
 
$
9,096,141
   
$
8,264,541
   
$
16,183,095
   
$
13,133,784
 
                                 
COST OF REVENUE
   
4,637,007
     
3,905,063
     
8,128,353
     
6,196,282
 
                                 
GROSS PROFIT
   
                 4,459,134
     
4,359,478
     
               8,054,742
     
6,937,502
 
                                 
OPERATING EXPENSES:
                               
Research and development
   
1,801,551
     
192,088
     
2,089,023
     
236,083
 
Selling expenses
   
609,826
     
431,810
     
979,230
     
602,944
 
General and administrative
   
515,293
     
998,034
     
1,810,091
     
1,617,584
 
Total operating expenses
   
                 2,926,670
     
1,621,932
     
               4,878,344
     
2,456,611
 
                                 
INCOME FROM OPERATIONS
   
                 1,532,464
     
2,737,546
     
               3,176,398
     
4,480,891
 
                                 
OTHER INCOME (EXPENSE):
                               
Other income (expense), net
   
(4,549
)
   
36,257
     
(4,367
)
   
36,674
 
Interest income (expense), net
   
(98,973
)
   
(12,976
)
   
(69,301
)
   
(17,792
)
Change in fair value of derivative liability
   
360,153
     
158,054
     
1,095,647
     
(159,326
)
Total other income (expense), net
   
                    256,631
     
181,335
     
               1,021,979
     
(140,444
)
                                 
INCOME BEFORE PROVISION FOR INCOME TAXES
   
                 1,789,095
     
2,918,881
     
               4,198,377
     
4,340,447
 
                                 
PROVISION FOR INCOME TAXES
   
281,705
     
540,486
     
759,155
     
865,805
 
                                 
NET INCOME
   
1,507,390
     
2,378,395
     
               3,439,222
     
3,474,642
 
                                 
OTHER COMPREHENSIVE INCOME:
                               
Foreign currency translation adjustment
   
1,130,579
     
280,998
     
               1,596,172
     
240,182
 
                                 
COMPREHENSIVE INCOME
 
$
                 2,637,969
   
$
2,659,393
   
$
               5,035,394
   
$
3,714,824
 
                                 
EARNINGS PER SHARE:
                               
Basic
 
$
                          0.21
   
$
0.33
   
$
                        0.48
   
$
0.49
 
Diluted
 
$
                          0.21
   
$
0.33
   
$
                        0.48
   
$
0.49
 
                                 
WEIGHTED AVERAGE NUMBER OF COMMON SHARES:
                               
Basic
   
                 7,169,419
     
7,104,606
     
               7,168,176
     
7,083,149
 
Diluted
   
                 7,169,419
     
7,140,518
     
               7,174,888
     
7,119,846
 

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

 
5

 

SKYSTAR BIO-PHARMACEUTICAL COMPANY AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE SIX MONTHS ENDED JUNE 30, 2011 AND 2010
(Unaudited)
 
   
Six months ended
June 30,
 
   
2011
   
2010
 
CASH FLOWS FROM OPERATING ACTIVITIES:
           
Net income
  $ 3,439,222     $ 3,474,642  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation
    498,760       299,848  
Amortization
    385,722       77,133  
Bad debt expense
    -       287,561  
Allowance for slow moving inventories
    -       63,001  
Common stock issued for services
    -       16,245  
Common stock to be issued to related parties for compensation
    26,525       70,367  
Change in fair value of warrant liability
    (1,095,647 )     159,326  
Change in operating assets and liabilities
               
Accounts receivable
    1,085,951       (3,584,456 )
Inventories
    (8,711,510 )     (9,252,221 )
Deposits and prepaid expenses
    (56,093 )     7,729,174  
Other receivables
    791,371       (56,090 )
Accounts payable
    577,915       253,565  
Other payable and accrued expenses
    (449,155 )     (88,372 )
Deposits from customers
    286,977       349,949  
Taxes payable
    (702,883 )     753,555  
Net cash (used in) provided by operating activities
    (3,922,845 )     553,227  
                 
CASH FLOWS FROM INVESTING ACTIVITIES:
               
                 
Payments of long-term prepayments
    (307,642 )     -  
Prepayment for asset acquisition
    -       (5,518,478 )
Loans to third parties
    (2,847,846 )     -  
Collection of loans to third parties
    8,871,193       -  
Purchases of intangible assets
    (46,186 )     -  
Purchases of plant and equipment
    (51,222 )     (2,136,531 )
Payments on construction-in-progress
    (4,013,980 )     (748,449 )
Net cash provided by (used in)  investing activities
    1,604,317       (8,403,458 )
                 
CASH FLOWS FROM FINANCING ACTIVITIES:
               
Proceeds from short-term loans
    1,724,019       -  
Repayment for short-term loans
    (612,440 )     (220,035 )
Repayment to shareholders and directors
    -       (110,018 )
Due (from) to related parties
    190,630       (47,874 )
Net cash provided by (used in) financing activities
    1,302,209       (377,927 )
                 
EFFECT OF EXCHANGE RATE CHANGES ON CASH
    174,990       11,318  
                 
DECREASE IN CASH
    (841,329 )     (8,216,840 )
                 
CASH, beginning of period
    5,887,831       11,699,398  
                 
CASH, end of period
  $ 5,046,502     $ 3,482,558  
                 
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
               
Cash paid for interest
  $ 119,128     $ 7,435  
Cash paid for income taxes
  $ 1,262,699     $ 578,055  
Non-cash investing and financing activities
               
Long-term prepayment transferred to construction-in-progress
  $ 571,692     $ -  
Long-term prepayment transferred to property, plant and equipment
  $ -     $ 439,897  
Construction-in-progress transferred to property, plant and equipment
  $ -     $ 1,396,211  
Cashless exercise of warrants
  $ -     $ 1,511,604  
Issuance of common stock accrued in previous year
  $ -     $ 25,002  

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

 
6

 

SKYSTAR BIO-PHARMACEUTICAL COMPANY AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(UNAUDITED)
 
                      
Accumulated
     
             
Retained earnings
 
other
     
 
Common stock
 
Paid-in
 
Statutory
     
comprehensive
     
 
Shares
 
Amount
 
capital
 
reserves
 
Unrestricted
 
income
 
Total
 
BALANCE, December 31, 2010
    7,161,919     $ 7,162     $ 35,784,378     $ 5,695,236     $ 24,847,290     $ 5,155,763     $ 71,489,829  
                                                         
Foreign currency translation
    -       -       -       -       -       1,596,172       1,596,172  
Net income
    -       -       -       -       3,439,222       -       3,439,222  
                                                         
BALANCE, JUNE 30, 2011
    7,161,919     $ 7,162     $ 35,784,378     $ 5,695,236     $ 28,286,512     $ 6,751,935     $ 76,525,223  

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

 
7

 

SKYSTAR BIO-PHARMACEUTICAL COMPANY AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2011
(Unaudited)

Note 1 - ORGANIZATION

Organization and description of business

Skystar Bio-Pharmaceutical Company (“Skystar” or the “Company”) was incorporated in Nevada on September 24, 1998. Since its acquisition on November 7, 2005 of Skystar Bio-Pharmaceutical (Cayman) Holdings Co., Ltd. (“Skystar Cayman”), a Cayman Islands company, the Company has been engaged in research, development, production, marketing, and sales of veterinary healthcare and medical care products. All current operations of the Company are in the People’s Republic of China (“China” or the “PRC”).

All of the Company’s operations are carried out by Xian Tianxing Bio-Pharmaceutical Co., Limited (“Xian Tianxing”), a PRC joint stock company that the Company controls through contractual arrangements originally between Skystar Cayman and Xian Tianxing. On March 10, 2008, the Company entered into a series of agreements transferring all of the rights and obligations of Skystar Cayman under the contractual arrangements to Sida Biotechnology (Xian) Co., Ltd. (“Sida”), a PRC company. Sida is the wholly owned subsidiary of Fortunate Time International Limited (“Fortunate Time”), a Hong Kong company and wholly owned subsidiary of Skystar Cayman. Xian Tianxing also has a wholly owned subsidiary, Shanghai Siqiang Biotechnological Co., Ltd. (“Shanghai Siqiang”), a PRC company.

As a result of these contractual arrangements, which obligate Sida to absorb all of the risk of loss from Xian Tianxing’s activities and enable Sida to receive all of its expected residual returns, the Company accounts for Xian Tianxing as a variable interest entity (“VIE”) under Financial Accounting Standards Board’s (“FASB”) interpretation on consolidation of variable interest entities. Accordingly, the Company consolidates Xian Tianxing’s results, assets, and liabilities.

Hereinafter, Skystar, Skystar Cayman, Fortunate Time, Sida, Xian Tianxing, Skystar Jingzhou and Shanghai Siqiang are sometimes collectively referred to as the “Company.”

Note 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of consolidation

The accompanying condensed consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The condensed consolidated financial statements include the financial statements of the Company, its wholly owned subsidiaries, and its VIEs. All significant inter-company transactions and balances between the Company, its subsidiaries, and VIEs have been eliminated in consolidation.

Certain information and footnote disclosures normally present in annual consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted pursuant to such rules and regulations. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and footnotes included in the Company’s Annual Report on Form 10-K. The results for the three and six months ended June 30, 2011 are not necessarily indicative of the results to be expected for the full year ending December 31, 2011.

Use of estimates

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. For example, the Company estimates its allowance for doubtful accounts and useful lives of plant and equipment. Because of the use of estimates inherent in the financial reporting process, actual results could materially differ from those estimates upon which the carrying values were based.

Foreign currency translation

The Company uses the United States dollar (“U.S. dollar”) for financial reporting purposes and the Chinese Renminbi (“RMB”) as its functional currency. The Company’s subsidiaries and VIEs maintain their books and records in their functional currency, being the primary currency of the economic environment in which their operations are conducted.

 
8

 

The Company translates the subsidiaries’ and VIEs’ assets and liabilities into U.S. dollars using the applicable exchange rates prevailing at the balance sheet dates, and the statements of operations and cash flows are translated at average exchange rates during the reporting period. As a result, amounts related to assets and liabilities reported on the consolidated statements of cash flows will not necessarily agree with changes in the corresponding balances on the consolidated balance sheets. Equity accounts are translated at historical rates. Adjustments resulting from the translation of the subsidiaries’ and VIEs’ financial statements are recorded as accumulated other comprehensive income.

The quotation of the exchange rates does not imply free convertibility of RMB to other foreign currencies. All foreign exchange transactions continue to take place either through the People’s Bank of China or other banks authorized to buy and sell foreign currencies at the exchange rate quoted by the People’s Bank of China. The rates of exchange quoted by the People’s Bank of China on June 30, 2011 and December 31, 2010 were US $1.00 to RMB 6.46 and RMB 6.59, respectively. The average translation rates of US $1.00 to RMB 6.53 and RMB 6.82 was applied to the income statement accounts for the six months ended June 30, 2011 and 2010, respectively.

Approval of foreign currency payments by the People’s Bank of China or other institutions requires submitting a payment application form together with invoices, shipping documents and signed contracts. Transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the functional currency are included in the results of operations as incurred.

Fair values of financial instruments

The accounting standards regarding fair value of financial instruments and related fair value measurements defines financial instruments and requires fair value disclosures of those financial instruments.  This accounting standard defines fair value, establishes a three-level valuation hierarchy for disclosures of fair value measurement and enhances disclosures requirements for fair value measures.  Certain current assets and current liabilities qualify as financial instruments and management believes their carrying amounts are a reasonable estimate of fair value because of the short period of time between the origination of such instruments and their expected realization and if applicable, their current interest rates are equivalent to interest rates currently available.  The three levels of valuation hierarchy are defined as follows:

Level 1 inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.

Level 2 inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the assets or liability, either directly or indirectly, for substantially the full term of the financial instruments.

Level 3 inputs to the valuation methodology are unobservable and significant to the fair value measurement.

The Company has stock purchase warrants which are treated as derivative liabilities.  These warrants do not trade in an active securities market, and as such, the Company estimates the fair value of these warrants using the Black-Scholes Option Pricing Model (“Black-Scholes Model”) using the following assumptions:
 
   
Warrants – (1)
   
Purchase Options – (2)
 
   
June 30,
2011
(Unaudited)
   
December 31,
2010
   
June 30,
2011
(Unaudited)
   
December 31,
2010
 
Stock price
  $ 3.17     $ 9.73     $ 3.17     $ 9.73  
Exercise price
  $ 5.00     $ 5.00     $ 8.11     $ 8.11  
Annual dividend yield
    -       -       -       -  
Expected term (years)
    0.67       1.16       3.00       3.50  
Risk-free interest rate
    0.15 %     0.30 %     0.81 %     1.50 %
Expected volatility
    54 %     51 %     153 %     180 %
 

(1)
As of December 31, 2010, 34,230 warrants with an exercise price of $5.00 were outstanding. As of June 30, 2011, 34,230 of these warrants were outstanding.

(2)
As of December 31, 2010, 140,000 purchase options with an exercise price of $8.11 were outstanding. As of June 30, 2011, 140,000 of these options were outstanding.

Expected volatility is based on historical volatility. Historical volatility was computed using daily pricing observations for recent periods that correspond to the term of the warrants. The Company believes this method produces an estimate that is representative of future volatility over the expected term of these warrants. The Company has no reason to believe future volatility over the expected remaining life of these warrants is likely to differ materially from historical volatility. The expected life is based on the remaining term of the warrants. The risk-free interest rate is based on U.S. Treasury securities according to the remaining term of the warrants.

 
9

 

As required by the FASB’s accounting standards, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. Depending on the product and the terms of the transaction, the fair values warrant liability were modeled using a series of techniques, including closed-form analytic formula, such as the Black-Scholes Model, which does not entail material subjectivity because the methodology employed does not necessitate significant judgment, and the pricing inputs are observed from actively quoted markets.

The fair value of the 174,230 warrants and options outstanding as of June 30, 2011 was determined using the Black-Scholes Model, defined in the FASB’s accounting standard of fair value measurement as level 2 inputs, and recorded the change in earnings. As a result, the warrant liability is carried on the consolidated balance sheets at fair value. The Company recognized a gain of $360,153 and $158,054 from the change in fair value of derivative liability for the three months ended June 30, 2011 and 2010, respectively, and a gain of $1,095,647 and a loss of $159,326 for the six months ended June 30, 2011 and 2010, respectively.

The following table sets forth by level within the fair value hierarchy our financial assets and liabilities that were accounted for at fair value on a recurring basis as of June 30, 2011:
 
   
Carrying Value at
   
Fair Value Measurement at
June 30, 2011
 
   
June 30, 2011
   
Level 1
   
Level 2
   
Level 3
 
Warrant liability (unaudited)
  $ 323,992     $     $ 323,992     $  

In addition to assets and liabilities that are recorded at fair value on a recurring basis, the Company is required to record assets and liabilities at fair value on a non-recurring basis.  Generally, assets are recorded at fair value on a non-recurring basis as a result of impairment charges.  For the six months ended June 30, 2011, there were no impairment charges.

Revenue recognition

Revenue of the Company is primarily from the sales of veterinary healthcare and medical care products in China. Sales are recognized when the following four revenue criteria are met: persuasive evidence of an arrangement exists, delivery has occurred, the selling price is fixed or determinable, and collectability is reasonably assured. Sales are presented net of value added tax (“VAT”). No estimated allowance for sales returns is reflected on these consolidated financial statements as sales returns are de minimis based on historical experience.

There are two types of sales upon which revenue is recognized:

a.
Credit sales: revenue is recognized when the products have been delivered to the customers.

b.
Full payment before delivering: revenue is recognized when the products have been delivered to customers.

Shipping and handling costs related to goods sold are included in selling expenses, which totaled $350,054 and $213,109 for the three months ended June 30, 2011 and 2010, respectively, and $544,270 and $284,880 for the six months ended June 30, 2011 and 2010, respectively.

The Company’s revenues and cost of revenues by product line were as follows:

   
Three months ended June 30,
   
Six months ended June 30,
 
   
2011
   
2010
   
2011
   
2010
 
   
(Unaudited)
   
(Unaudited)
   
(Unaudited)
   
(Unaudited)
 
Revenue
                       
Micro-organism
 
$
1,981,128
   
$
1,985,095
   
$
3,577,222
   
$
3,191,673
 
Veterinary Medications
   
6,341,859
     
5,533,020
     
11,206,906
     
8,729,279
 
Feed Additives
   
390,872
     
368,537
     
717,279
     
604,577
 
Vaccines
   
382,282
     
377,889
     
681,688
     
608,255
 
Total Revenue
   
9,096,141
     
8,264,541
     
16,183,095
     
13,133,784
 
                                 
Cost of Revenue
                               
Micro-organism
   
580,806
     
520,911
     
1,074,988
     
863,930
 
Veterinary Medications
   
3,842,551
     
3,197,770
     
6,664,457
     
5,020,027
 
Feed Additives
   
164,382
     
146,984
     
305,248
     
247,030
 
Vaccines
   
49,268
     
39,398
     
83,660
     
65,295
 
Total Cost of Revenue
   
4,637,007
     
3,905,063
     
8,128,353
     
6,196,282
 
Gross Profit
 
$
4,459,134
   
$
4,359,478
   
$
8,054,742
   
$
6,937,502
 

 
10

 

Cash

Cash includes cash on hand, demand deposits with banks and liquid investments with an original maturity of three months or less.

Accounts receivable and other receivables

Accounts receivable are recorded at net realizable value consisting of the carrying amount less an allowance for uncollectible accounts, as needed. The Company uses the aging method to estimate the allowance for anticipated uncollectible receivable balances. Under the aging method, bad debt percentages determined by management based on historical experience, as well as current economic climate, are applied to customers’ balances categorized by the number of months the underlying invoices have remained outstanding. At each reporting period, the allowance balance is adjusted to reflect the amount computed as a result of the aging method. When facts subsequently become available to indicate that the allowance provided requires an adjustment, a corresponding adjustment is made to the allowance account as a change in estimate. The ultimate collection of the Company’s accounts receivable may take one year. Delinquent account balances are reserved after management determines that the likelihood of collection is not probable, and known bad debts are written-off against allowance for doubtful accounts when identified.

Inventories

Inventories are stated at the lower of cost or market, as determined on a moving weighted-average basis. Inventories include purchases and related costs incurred in bringing the inventories to their present location and condition. Management reviews inventories for obsolescence and cost in excess of net realizable value at least annually and records a reserve against the inventory and additional cost of goods sold when the carrying value exceeds net realizable value.

Plant and equipment

Plant and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. Expenditures for maintenance and repairs which do not improve or extend the useful lives of the assets are charged to operations as incurred, while renewals and betterments are capitalized. Gains and losses on disposals are included in the results of operations. Estimated useful lives of the assets are as follows:

 
Estimated Useful Life
Buildings
 
20-40 years
Machinery and equipment
 
10 years
Computer, office equipment and furniture
 
5 years
Vehicles
 
5-10 years

Management assesses the carrying value of plant and equipment annually, more often when factors indicating impairment are present, and reduces the carrying value of such assets by the amount of the impairment. The Company determines the existence of such impairment by measuring the expected future cash flows (undiscounted and without interest charges) and comparing such amount to the net asset carrying value. An impairment loss, if it exists, is measured as the amount by which the carrying amount of the asset exceeds the fair value of the asset. Based on its review, management believes that, as of June 30, 2011 and December 31, 2010, there was no impairment for its plant and equipment.

Construction-in-progress

Construction-in-progress includes direct costs of construction of a factory building. Interest incurred during the period of construction, if significant, is capitalized. All other interest is expensed as incurred. Construction-in-progress is not depreciated until such time the assets are completed and put into service.

Intangible assets

Land Use Rights — Land use rights represent the amounts paid to acquire a long-term interest to utilize the land underlying the Company’s facilities. This type of arrangement is common for the use of land in the PRC. Land use rights are amortized on a straight-line basis over its 50-year term.

Technological Know-How — Purchased technological know-how includes confidential formulas, manufacturing processes, technical and procedural manuals, and is amortized using the straight-line method over the weighted average useful life of nine years, which reflects the period over which such confidential formulas, manufacturing processes, and technical and procedural manuals are kept confidential by the Company as agreed between the Company and the selling parties.

 
11

 

Impairment of Intangible Assets The Company evaluates the carrying value of intangible assets annually, or more often when factors indicating impairment may exist. The Company determines the existence of such impairment by measuring the estimated future cash flows (undiscounted) and comparing such amount to the net asset carrying value. If the undiscounted cash flow estimated to be generated by any such intangible asset is less than its carrying amount, a loss is recognized based on the amount by which the carrying amount exceeds the intangible asset’s fair market value. Loss on intangible assets to be disposed of is determined in a similar manner, except that fair market values are reduced by the cost of disposal. Based on its review, the Company believes that, as of June 30, 2011, there was no impairment of its intangible assets.

 Comprehensive income

Comprehensive income and loss is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. Accumulated other comprehensive income is comprised of the changes in foreign currency exchange rates.

Research and development costs

Research and development costs are charged to operations as incurred and include salaries, professional fees and technical support fees related to such efforts.

Advertising costs

Advertising costs are charged to operations currently. Advertising costs for the three months ended June 30, 2011 and 2010 were $406 and $4,818, respectively, and for the six months ended June 30, 2011 and 2010 were $505 and $6,469, respectively.

Income taxes

The Company accounts for income taxes in accordance with the FASB’s accounting standard for income taxes. Under the asset and liability method as required by this accounting standard, deferred income taxes are recognized for the tax consequences of temporary differences by applying enacted statutory tax rates applicable to future years to differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. The effect on deferred income taxes of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is recognized if it is more likely than not that some portion, or all of, a deferred tax asset will not be realized.

Further, in accordance with this accounting standard, a tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded. The standard also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosures, and transition. The adoption had no effect on the Company’s condensed consolidated financial statements.

The Company’s operations are subject to income and transaction taxes in the United States and in the PRC jurisdictions. Significant estimates and judgments are required in determining the Company’s worldwide provision for income taxes. Some of these estimates are based on interpretations of existing tax laws or regulations. The ultimate amount of tax liability may be uncertain as a result.

According to the PRC Tax Administration and Collection Law, the statute of limitations is three years if the underpayment of taxes is due to computational or other errors made by the taxpayer or the withholding agent. The statute of limitations extends to five years under special circumstances. In the case of transfer pricing issues, the statute of limitations is ten years. There is no statute of limitations in the case of tax evasion. Accordingly, the income tax returns of the Company’s PRC operating subsidiaries for the years ended December 31, 2008 through 2010 are open to examination by the PRC state and local tax authorities.

The Company does not anticipate any events which could cause a change to these uncertainties.

Stock-based compensation

The Company records and reports stock-based compensation by measuring the cost of services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost is recognized over the period during which services are received. Stock compensation for stock granted to non-employees is determined as the fair value of the consideration received or the fair value of equity instruments issued, whichever is more reliably measured.

 
12

 

Earnings per share

The Company reports earnings per share and present both basic and diluted earnings per share in conjunction with the disclosure of the methodology used in computing such earnings per share. Basic earnings per share is based upon the weighted-average number of common shares outstanding. Diluted earnings per share is based on the assumption that all dilutive convertible shares, including convertible preferred shares, and stock options were converted or exercised. Further, the method requires that stock dividends or stock splits be accounted for retroactively if the stock dividends or stock splits occur during the period, or retroactively if the stock dividends or stock splits occur after the end of the period but before the release of the financial statements, by considering it outstanding of the entirety of each period presented. Dilution is computed by applying the treasury stock method. Under this method, options and warrants are assumed to be exercised at the beginning of the period (or at the time of issuance, if later), and as if funds obtained thereby were used to purchase common stock at the average market price during the period.

Related parties

Parties are considered to be related to the Company if the parties, directly or indirectly, through one or more intermediaries, control, are controlled by, or are under common control with the Company. Related parties also include principal owners of the Company, its management, members of the immediate families of such principal owners and management, and other parties with which the Company may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests.

Recently issued accounting pronouncements

In January 2010, FASB issued ASU No. 2010-06 – Improving Disclosures about Fair Value Measurements. This update provides amendments to Subtopic 820-10 that requires new disclosure to include transfers in and out of Levels 1 and 2 and activity in Level 3 fair value measurements. Further, this update clarifies existing disclosures on level of disaggregation and Disclosures about inputs and valuation techniques. A reporting entity should provide fair value measurement disclosures for each class of assets and liabilities and should provide disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements. Those disclosures are required for fair value measurements that fall in either Level 2 or Level 3. The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. The adoption of this ASU did not have a material impact on the Company’s condensed consolidated financial statements.

In April 2010, the FASB issued Accounting Standards Update 2010-13, “Compensation—Stock Compensation (Topic 718): Effect of Denominating the Exercise Price of a Share-Based Payment Award in the Currency of the Market in Which the Underlying Equity Security Trades,” or ASU 2010-13. ASU 2010-13 provides amendments to Topic 718 to clarify that an employee share-based payment award with an exercise price denominated in currency of a market in which a substantial portion of the entity’s equity securities trades should not be considered to contain a condition that is not a market, performance, or service condition. Therefore, an entity would not classify such an award as a liability if it otherwise qualifies as equity. The amendments in this Update are effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2010. The adoption of this ASU did not have a material impact on the Company’s condensed consolidated financial statements.

In December 2010, the FASB issued Accounting Standards Update 2010-28, Intangibles—Goodwill and Other (Topic 350): When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts (a consensus of the FASB Emerging Issues Task Force). ASU No. 2010-28 addresses questions about entities that have reporting units with zero or negative carrying amounts. The amendments modify Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For those reporting units, an entity is required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. In determining whether it is more likely than not that goodwill impairment exists, an entity should consider whether there are any adverse qualitative factors indicating that impairment may exist. The qualitative factors are consistent with the existing guidance and examples in paragraph 350-20-35-30, which requires that goodwill of a reporting unit be tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. In addition, current GAAP will be improved by eliminating an entity’s ability to assert that a reporting unit is not required to perform Step 2 because the carrying amount of the reporting unit is zero or negative despite the existence of qualitative factors that indicate the goodwill is more likely than not impaired. As a result, goodwill impairments may be reported sooner than under current practice. The provisions of ASC No. 2010-28 are effective for fiscal years, and interim periods within those years, beginning after Dec. 15, 2010. Early adoption is not permitted. The adoption of this ASU did not have a material impact on the Company’s condensed consolidated financial statements.

In December 2010, the FASB issued Accounting Standards Update 2010-29, Business Combinations (Topic 805) — Disclosure of Supplementary Pro Forma Information for Business Combinations. ASU No. 2010-29 clarifies that, when presenting comparative financial statements, SEC registrants should disclose revenue and earnings of the combined entity as though the current period business combinations had occurred as of the beginning of the comparable prior annual reporting period only. The amendments expand the supplemental pro forma disclosures to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. ASU 2010-29 is effective prospectively for material (either on an individual or aggregate basis) business combinations entered into in fiscal years beginning on or after December 15, 2010 with early adoption permitted.

 
13

 

In June 2011, the FASB issued new guidance on the presentation of comprehensive income that eliminates the option to report the components of other comprehensive income as part of the statement of shareholders’ equity. Instead, comprehensive income must be reported in either a single continuous statement of comprehensive income which contains two sections, net income and other comprehensive income, or in two separate but consecutive statements. This guidance will be effective during the interim and annual periods beginning after December 15, 2011 with early adoption permitted. The adoption of this guidance is not expected to have a material impact on the Company’s consolidated financial statements.

Note 3 - CONCENTRATIONS AND CREDIT RISK

For the three months and six months ended June 30, 2011 and 2010, all of the Company’s sales occurred in the PRC. In those periods, no individual customer accounted for more than 10% of the Company’s total revenues. In addition, all accounts receivable at June 30, 2011 and December 31, 2010 also arose in the PRC.

The Company’s six largest vendors accounted for approximately 59% and 66% of the Company’s total purchases for the three months and six months ended June 30, 2011, respectively, while the Company’s six largest vendors accounted for approximately 61% and 59% of the Company’s total purchases for the three months and six months ended June 30, 2010, respectively.

The Company had one product that accounted for 22% and 19% of the Company’s total revenues for the three months and six months ended June 30, 2011, respectively, while the Company had one product that accounted for 23% and 21% of the Company’s total revenues for the three months and six months ended June 30, 2010, respectively.

Note 4 - ACCOUNTS RECEIVABLE, NET

Accounts receivable consisted of the following:
 
   
June 30,
2011
   
December 31,
2010
 
Account receivable
 
$
4,324,799
   
$
5,316,881
 
Allowance for bad debts
   
(345,736
)
   
(339,031
)
Account receivable, net
 
$
3,979,063
   
$
4,977,850
 

The following table presents the movement of allowance for doubtful accounts:

Allowance for bad debt, January 1, 2011
  $
339,031
 
Addition
   
 
Recovery
   
 
Translation adjustment
   
6,705
 
Allowance for bad debt, June 30, 2011 (unaudited)
 
$
345,736
 

Note 5 – INVENTORIES

Inventories consisted of the following:
 
 
 
June 30,
2011
 
 
December 31,
2010
 
Raw materials
 
$
13,270,803
    $
5,466,902
 
Packing materials
   
1,117,095
     
170,843
 
Work-in-process
   
25,231
     
23,071
 
Finished goods
   
1,918,770
     
1,721,943
 
Other
   
25,070
     
25,723
 
Total
   
16,356,969
     
7,408,482
 
Less: Allowance for slow moving raw materials
   
(210,338
   
(206,259
)
Total
 
$
16,146,631
    $
7,202,223
 

The Company periodically reviews its reserves for slow-moving and obsolete inventories.

 
14

 

Note 6 - DEPOSITS AND PREPAID EXPENSES

Deposits and prepaid expenses were comprised of the following:

 
 
June 30,
2011
 
 
December 31,
 2010
 
Prepayment for raw materials purchasing
 
$
15,399,475
   
$
15,967,236
 
Prepayment for packaging materials purchasing
   
379,111
     
767,623
 
Prepaid income tax (Note 16)
     338,914       -  
Other
   
652,700
     
339,141
 
Total
 
$
16,770,200
   
$
17,074,000
 

Note 7 - PLANT AND EQUIPMENT, NET

Plant and equipment consisted of the following:

 
 
June 30,
2011
 
 
December 31,
2010
 
Building and improvements
 
$
21,168,054
   
$
20,757,554
 
Machinery and equipment
   
3,715,637
     
3,640,635
 
Office equipment and furniture
   
310,097
     
256,690
 
Vehicles
   
578,342
     
566,718
 
Total
   
25,772,130
     
25,221,597
 
Less: Accumulated depreciation
   
(3,164,008
)
   
(2,608,484
)
Plant and equipment, net
 
$
22,608,122
   
$
22,613,113
 

The Company’s one year loan with Shaanxi Agricultural Yanta Credit Union is collateralized by the Company’s office buildings located in Xi’an City.

The Company’s line of credit with Bank of East-Asia is secured by the Company’s manufacturing plant in Huxian County.

Depreciation expense was $166,332 and $176,364 for the three months ended June 30, 2011 and 2010, respectively. For the six months ended June 30, 2011 and 2010, depreciation expense was $498,760 and $299,848, respectively.

Note 8 - CONSTRUCTION-IN-PROGRESS

Xian facility
 
Construction-in-progress (“CIP”) is related to a plant being built in accordance with the PRC’s Good Manufacturing Practices (“GMP”) Standard. Construction of the vaccine facility commenced in 2005 and was completed in 2010. The facility is currently waiting for the GMP certification from the Ministry of Agriculture. The Company expects the GMP certification will be completed by the end of 2011.
 
During the six months ended June 30, 2011, the Company started a facility improvement project in the amount of $309,400 (RMB 2,000,000) for the Animal Laboratory. The Company also started two projects in the vaccine facility to modify the air filtration, water treatment and other facility changes based on recommendations by the outside experts hired by the Company to advise on the GMP qualification process for the vaccine facility.
 
Kunshan facility
 
The Company incurred $4,544,450 (RMB 29,375,891) for construction and supporting projects at Kunshan facility including plumbing, sewer, electrical, HVAC, fire protection and alarm system, drainage, office, lab, road construction, parking, and landscaping. During the three months and six months ended June 30, 2011, no amount was transferred from CIP to property, plant and equipment. During the three months and six months ended June 30, 2010, some general facility improvements were completed and placed in service resulting in a transfer from CIP to property, plant and equipment of $72,249. No depreciation is provided for construction-in-progress until such time the assets are completed and placed into service.

 
15

 

The construction projects the Company is in the progress of completing are:
 
Project
 
Total in CIP
 as of
June 30, 2011
   
Estimate cost
to Complete
   
Estimated
Total Cost
 
Estimated
Completion Date
Vaccine facility
 
1,297,059
     
-
   
1,297,059
 
December 2011
Kunshan facility
   
4,643,075
     
261,716
     
4,904,791
 
December 2011
Animal laboratory
   
309,400
     
-
     
309,400
 
December 2011
Total
 
6,249,534
           
6,511,250
 
   

As of June 30, 2011 and December 31, 2010, the Company had construction in progress amounting to$6,249,534 and $1,590,720, respectively. No interest expense was capitalized for construction in progress for the three months and six months ended June 30, 2011 and 2010 as management determined the amount of capitalized interest was insignificant.

 
Note 9 - LONG-TERM PREPAYMENTS

Long-term prepayments consisted of the following:

 
 
June 30,
2011
 
 
December 31,
2010
 
R&D project
 
$
309,400
   
$
303,400
 
Construction deposit
   
464,100
     
455,100
 
Deposit for building and equipment purchase
   
448,630
     
695,726
 
Deposit for potential acquisitions
   
4,901,402
     
4,806,352
 
Total
 
$
6,123,532
   
$
6,260,578
 

As of June 30, 2011, deposits for building and equipment purchase of $448,630 represented deposits made for the purchase of equipment.

As of June 30, 2011 and December 31, 2010, deposits for potential acquisitions totaled $4,901,402 and $4,806,352, respectively, all of which was held by an unrelated third party engaged to facilitate the purchase of a Kunshan based micro-organism manufacturing facility located in Jiangsu Province for the Company. On June 20, 2011, the Company received the real estate property license for this facility. As of June 30, 2011, the appraisal required to determine the property value has not been completed. The Company is still waiting for clearing all the necessary government approvals for this facility and expects to close the purchase by the end of 2011.

Note 10 – INTANGIBLE ASSETS

Intangible assets consisted of the following:
 
 
 
June 30,
2011
 
 
December 31,
2010
 
Land use rights
 
$
4,781,163
   
$
4,650,521
 
Technological know-how
   
2,165,800
     
2,123,800
 
Patent
   
309,400
     
303,400
 
Total
   
7,256,363
     
7,077,721
 
Less: accumulated amortization
   
(1,435,960)
)
   
(1,033,780
)
Intangible assets, net
 
$
5,820,403
   
$
6,043,941
 

In 2009, the Company paid $1,172,880 (RMB 8,000,000) for fish disease vaccine technology transfer for an eleven-year term from September 2009 through September 2020.

The Company’s line of credit with Bank of East-Asia is collateralized by the Company’s land use rights in Huxian County.

The Company’s one year loan with Industrial and Commercial Bank of China Songzi Branch is secured by the Company’s land use rights in Jingzhou, Hubei Province.

For the three months ended June 30, 2011 and 2010, the amortization expense for intangibles amounted to $154,800 and $38,577, respectively. For the six months ended June 30, 2011 and 2010, the amortization expense for intangibles amounted to $385,722 and $77,133, respectively.

 
16

 

Amortization expense for the future five years and thereafter is as follows:

Years ending December 31,
 
Amount
 
2011 (six months)
 
241,813
 
2012
   
408,585
 
2013
   
408,585
 
2014
   
408,585
 
2015
   
334,985
 
Thereafter
   
4,017,850
 
Total
 
$
5,820,403
 

Note 11 – LOANS RECEIVABLE
 
In August 2010, the Company issued an unsecured loan to an unrelated third party in the amount of $464,100 (RMB 3,000,000) for one year from August 10, 2010 through August 9, 2011, with an annual interest rate of 0.6%. As of August 16, 2011, this unrelated party repaid the entire loan plus interest in the amount of $2,756 (RMB 18,000).
 
On January 4, 2011, the Company entered a loan agreement with Shaanxi Feilong Logistics Co., Ltd., one of its largest logistics providers, to lend up to $3,094,000 (RMB 20,000,000) to Feilong. This loan agreement expires within one year with an annual interest rate of 6%. During the six months ended June 30, 2011, Feilong borrowed a total amount of $2,877,420 (RMB 18,600,000) from the Company, of which Feilong repaid $1,228,318 (RMB 7,940,000). As of August 8, 2011, Feilong repaid the entire $2,877,420 (RMB 18,600,000) loan.
 
Note 12 – SHORT-TERM LOANS

On August 24, 2010, the Company obtained a one year loan with Shaanxi Agricultural Yanta Credit Union for $773,500 (RMB 5,000,000) at an annual interest rate of 8.66%. This loan is collateralized by the Company’s office buildings located in Xi’an City.

The Company entered into a line of credit agreement with Bank of East-Asia that allows the Company to borrow up to $3,000,000 (RMB 20,000,000). This line of credit agreement expires within two years starting with the first withdrawal. The Company withdrew $478,023 (RMB 3,090,000), $525,052 (RMB 3,394,000) and $1,309,149 (RMB 8,462,500) on September 7, 2010, September 9, 2010 and October 12, 2010, respectively, at an annual interest rate of 6.372% with interest due every three months starting on the date of the first withdrawal. This line of credit is collateralized by the Company’s land use right and manufacturing plant located in Huxian County.

On March 24, 2011, the Company obtained a six month unsecured loan with Kunshan Agricultural Credit Union Rural Microfinance Limited for $773,500 (RMB 5,000,000) at an annual interest rate of 16%.
 
On May 5, 2011, the Company obtained a one year loan with Industrial and Commercial Bank of China Songzi Branch for $464,100 (RMB 3,000,000) at an annual interest rate determined by using the People's Bank of China floating benchmark lending rate over the same period plus 30% of that rate. During the six months ended June 30, 2011, the Company repaid $154,700 (RMB 1,000,000). The effective interest rate at June 30, 2011 was 8.3%. This loan is collateralized by the Company’s land use rights in Jingzhou, Hubei Province.
 
During the six months ended June 30, 2011, the Company obtained one month and two month short-term loans with three third-party individuals for a total amount of $504,322 (RMB 3,260,000), of which the Company has repaid $464,100 (RMB 3,000,000). These loans are non-interest bearing and are unsecured.
 
Interest expense incurred and associated with the short-term loans amounted to $95,341 and $149,750 for the three months and six months ended June 30, 2011, respectively, none of which has been capitalized as part of construction-in-progress in 2011. Interest expense incurred and associated with the short-term loans amounted to $0 and $1,365 for the three months and six months ended June 30, 2010, respectively, none of which has been capitalized as part of construction-in-progress in 2010.

Note 13 - DEFERRED GOVERNMENT GRANT

Deferred government grant represents subsidies for Good Manufacturing Practice projects granted by various levels of the PRC government. To date, the Company received government subsidies totaling $1,160,250 (RMB 7,500,000) of which, RMB 5,000,000 were granted by the PRC Government, of which, RMB 1,000,000 was re-paid on December 7, 2010, with the remaining fund to be paid back in 2012. RMB 2,000,000 was granted by Shaanxi Provincial Government, and RMB 500,000 was granted by Xi’an Municipal Government. The Shaanxi Provincial Government grant and Xi’an Municipal Government Grant do not need to be repaid.

Note 14 - CAPITAL TRANSACTIONS

Stock-based compensation

On March 30, 2010, the Company agreed to issue 2,500 shares of common stock to a non-executive director in exchange for services unrelated to directorship at the fair market value of $11.74 per share based on the closing price of March 30, 2010. On April 16, 2010, the Company entered into another agreement to grant 10,000 shares of common stock to that director for his one-year service from April 1, 2010. The closing price per share on the grant date was $10.61. The common stock compensation vests in four equal quarterly installments of 2,500 shares. Shares owed were accrued at end of each quarter at the fair market value of the grant date at $10.61 per share. A total of $0 and $27,025 was charged to general and administrative expense for the three months ended on June 30, 2011 and 2010, respectively. A total of $26,525 and $53,550 was charged to general and administrative expense for the six months ended on June 30, 2011 and 2010, respectively. On October 25, 2010, 5,000 shares were issued to the director for the shares vested in the first two quarters of 2010. As of June 30, 2011, 7,500 shares were accrued at the closing price of the grant date of $10.61 per share and pending to be issued.
 
 
17

 
 
On May 26, 2009, the Company renewed the one-year service agreement with the former CFO and agreed to issue 14,440 shares of common stock, which would vest in four equal installments of 3,610 shares every quarter starting August 5, 2009. Compensation expense is recognized on the straight-line method over the vesting period. On February 26, 2010, 10,830 shares were issued at the fair market value of $8.57. Effective April 16, 2010, the former CFO resigned from his position and the last installment of 3,610 shares was prorated to 2,880 shares. The Company issued the 2,880 common shares to the former CFO on October 25, 2010 at the fair market value of $7.81 per share. Total compensation expense of $0 and $29,205 were charged to general and administrative expenses for the six months ended June 30, 2011 and 2010, respectively.

On May 26, 2009, the Company agreed to issue 5,556 shares of common stock to a director at the beginning of each term of his directorship. The trading value of the common stock on May 26, 2009 was $4.50 per share. The amount was charged to general and administrative expenses in 2009 and $0 and $16,245 were expensed for the six months ended June 30, 2011 and 2010, respectively. The Company issued 5,556 shares on February 26, 2010. In accordance with the agreement between the Company and this director, this director must continue to serve as a member of the Board until his successor is duly elected and qualified in order to receive the shares. This director has continued in his position and the Company is in the process of finalizing its agreement with this director and expects to complete this process shortly.

Warrants and Purchase Options

On February 28, 2007, the Company issued 195,000 warrants to four investors with an exercise price of $6.00 per share for a term of three years. On the same date, the Company also issued warrants to the private placement agent, exercisable for 114,100 shares of the Company’s common stock at a price of $5.00 per share for a five-year term. For the three and six months ended June 30, 2011, no warrants were exercised. For the three and six months ended June 30, 2010, 15,974 and 218,024 shares of warrants were exercised.

In connection with the 2009 equity offering discussed below, the Company granted 140,000 common stock purchase options to five designees of the Underwriters with a vesting date of June 30, 2010. The options are exercisable from June 30, 2010 to June 30, 2014, and each option is exercisable for one share of the Company’s common stock at an exercise price at $8.11 per share. All options were provided for services performed. On June 30, 2010, the purchase options were reclassified from equity to warrant liabilities, and the Company reclassified $779,674 from additional paid in capital to derivative liability.
 
The fair value of each warrant and purchase option is estimated on the date of grant using the Black-Scholes option-pricing model that uses the assumptions noted in the following table. Expected volatilities are based on historical volatility of the Company’s stock, and reflect the assumption that the historical volatilities are indicative of future trends, which may not necessarily be the actual outcome. Expected term of each warrant and purchase option award represents the period of time that options granted are expected to be outstanding and is estimated based on the historical exercise behavior of separate groups of employees or officers. The risk-free rate reflects the interest rate for United States Treasury Notes with similar time-to-maturity to that of the options.
 
   
June 30,
2011
   
June 30,
2010
 
Expected term (year)
   
0.67 – 3.00
     
1.67- 4.00
 
Expected volatility
   
54% - 153
%
   
143% - 193
%
Weighted average volatility
   
54% - 153
%
   
143% - 193
%
Expected dividend yield
   
0
%
   
0
%
Risk-free rate
   
0.15% - 0.81
%
   
0.51% - 1.40
%

Following is an activity summary of the Company’s outstanding warrants and purchase options:

 
 
Number of
warrants/purchase
options
 
 
Weighted –
average
exercise price
 
 
Weighted-
average
remaining
contractual
term
(Year)
 
Outstanding at January 1, 2010
   
392,254
   
$
5.57
       
Granted
   
-
   
$
         
Forfeited
   
-
               
Exercised
   
(218,024
)
   
5.72 
       
Outstanding at December 31, 2010
   
174,230
   
$
7.50
       
Granted
   
-
     
-
       
Forfeited
   
-
     
-
       
Exercised
   
-
   
$
         
Outstanding at June 30, 2011
   
174,230
   
$
7.50
     
2.54
 
Vested and expected to vest at June 30, 2011
   
174,230
   
$
7.50
     
2.54
 
Exercisable at June 30, 2011
   
174,230
   
$
7.50
     
2.54
 
 
 
18

 

Equity Compensation Plan

On December 8, 2009, the Company’s board of directors approved a stock incentive plan for officers, directors, employees and consultants entitled the “Skystar Bio-Pharmaceutical Company 2010 Stock Incentive Plan” (the “2010 Plan”). The maximum number of shares that may be issued under the 2010 Plan is 700,000 shares of common stock. The 2010 Plan was approved by the Company’s stockholders on December 31, 2009, and awards may be granted thereunder until December 7, 2019. As of June 30, 2011, there are 690,000 shares of the Company’s common stock remaining available for future issuance under the Plan.

Note 15 - STATUTORY RESERVES

Statutory reserves represent restricted retained earnings. Based on the legal formation of the entities, all PRC entities are required to set aside 10% of its net income as reported in its statutory accounts on an annual basis to the statutory surplus reserve fund. Once the total statutory surplus reserve reaches 50% of the entity’s registered capital, further appropriations are discretionary. The statutory surplus reserve can be used to increase the entity’s registered capital (upon approval by relevant government authorities) and eliminate its future losses under PRC GAAP (upon a resolution by the board of directors). The statutory surplus reserve is not distributable to shareholders except in the event of liquidation. As of June 30, 2011, apart from Xian Tianxing meeting the statutory surplus reserve requirement, we must transfer approximately $10,418,518 to the respective statutory surplus reserve of our other PRC subsidiaries.
 
Appropriations to the above statutory reserves are accounted for as a transfer from unrestricted earnings to statutory reserves. There are no legal requirements in the PRC to fund these statutory reserves by the transfer of cash to any restricted accounts, and as such, the Company has not transferred any cash to these accounts. These reserves are not distributable as cash dividends.
 
Note 16 – TAXES

Skystar is subject to United States federal income tax provisions. Skystar Cayman is a tax-exempt company incorporated in the Cayman Islands and conducts all of its business through its subsidiaries, Fortune Time, Sida, Fortune Time’s subsidiary Skystar Kunshan, Sida’s subsidiary Skystar Jingzhou, and Sida’s PRC VIEs, Xi’an Tianxing, Shanghai Siqiang and Sikeda.

Sida, Skystar Jingzhou, Skystar Kunshan, Xi’an Tianxing, and Shanghai Siqiang are subject to the PRC’s Enterprise Income Tax. Pursuant to the PRC Income Tax Laws, Enterprise Income Tax is generally imposed at a statutory rate of 25%. Xi’an Tianxing has been approved as a new technology enterprise, and under PRC Income Tax Laws is entitled to a preferential tax rate of 15%.

The following table reconciles the U.S. statutory rates to the Company’s effective tax rate for the three and six months ended June 30, 2011 and 2010:

   
For the three months ended
June 30,
   
For the six months ended
June 30,
 
   
2011
   
2010
   
2011
   
2010
 
   
(Unaudited)
   
(Unaudited)
   
(Unaudited)
   
(Unaudited)
 
U.S. Statutory rate
   
34.0
%
   
34.0
%
   
34.0
%
   
34.0
%
Foreign income not recognized in the U.S.
   
(34.0
)
   
(34.0
)
   
(34.0
)
   
(34.0
)
China income tax rate
   
25.0
     
25.0
     
25.0
     
25.0
 
China income tax exemption
   
(10.0
)
   
(10.0
)
   
(10.0
)
   
(10.0
)
Other item (1)
   
0.7
     
3.5
     
3.1
     
4.9
 
Total provision for income taxes
   
15.7
%
   
18.5
%
   
18.1
%
   
19.9
%
 

(1)
The other item is operating expenses incurred by Skystar that are not deductible in the PRC which resulted in an increase of 0.7% and 3.5% for the three months ended June 30, 2011 and 2010, respectively, and an increase of  3.1% and 4.9% for the six months ended June 30, 2011 and 2010, respectively.
 
 
19

 

Taxes payable consisted of the following:
 
   
June 30,
2011
   
December 31,
2010
 
Income taxes payable
 
$
-
   
$
432,722
 
Value added tax
   
18,530
     
203,684
 
Other taxes
   
35,952
     
113,430
 
Total
 
$
54,482
   
$
749,836
 
 
As of June 30, 2011, the Company had a prepaid income tax expense of $338,914.

The estimated tax savings due to the reduced tax rate for the six months ended June 30, 2011 and 2010 amounted to $311,824 and $577,204, respectively.
 
Skystar is incorporated in the U.S. and has incurred a net operating loss for income tax purposes for the three and six months ended June 30, 2011. As of June 30, 2011, the estimated net operating loss carryforwards for U.S. income tax purposes amounted to $5,364,196 which may be available to reduce future years’ taxable income. These carryforwards will expire, if not utilized, beginning in 2026 and continue through 2030. Management believes that the realization of the benefits arising from this loss appears to be uncertain due to the Company’s limited operating history and continuing losses for U.S. income tax purposes. Accordingly, the Company has provided a 100% valuation allowance at June 30, 2011 and December 31, 2010. The valuation allowance at June 30, 2011 and December 31, 2010 was $1,823,827 and $1,781,954, respectively. The Company’s management reviews this valuation allowance periodically and makes adjustments as necessary.
 
The Company has cumulative undistributed earnings of foreign subsidiaries of approximately $43 million as of June 30, 2011, which are included in consolidated retained earnings and will continue to be indefinitely reinvested in international operations. Accordingly, no provision has been made for U.S. deferred taxes related to future repatriation of these earnings, nor is it practicable to estimate the amount of income taxes that would have to be provided if we concluded that such earnings will be remitted in the future.
 
Note 17 - EARNINGS PER SHARE

The following is the calculation of earnings per share:

   
For the three months ended
June 30,
   
For the six months ended
June 30,
 
   
2011
   
2010
   
2011
   
2010
 
Net income
 
$
1,507,389
   
$
2,378,395
   
$
3,439,222
   
$
3,474,642
 
                                 
Weighted average shares used in basic computation
   
7,169,419
     
7,104,606
     
7,168,176
     
7,083,149
 
Diluted effect of stock warrants
   
-
     
35,912
     
6,712
     
36,697
 
Weighted average shares used in diluted computation
   
7,169,419
     
7,140,518
     
7,174,888
     
7,119,846
 
                                 
Earnings per share:
                               
                                 
Basic
 
$
0.21
   
$
0.33
   
$
0.48
   
$
0.49
 
Diluted
 
$
0.21
   
$
0.33
   
$
0.48
   
$
0.49
 
 
For the three months ended June 30, 2011, a total of 34,230 warrants were excluded from the diluted earnings per share calculation as they were anti-dilutive as the average stock price was less than the exercise prices of the options. For the six months ended June 30, 2011, the average stock price was greater than the exercise prices of warrants which resulted in additional weighted-average common stock equivalents of 6,712. For the three and six months ended June 30, 2011, a total of 140,000 options were excluded from the diluted earnings per share calculation as they are anti-dilutive as the average stock price was less than the exercise prices of the options.

For the three months ended June 30, 2010, the average stock price was greater than the exercise prices of warrants which resulted in additional weighted-average common stock equivalents of 35,912. For the six months ended June 30, 2010, the average stock price was greater than the exercise prices of warrants which resulted in additional weighted-average common stock equivalents of 36,697.
 
 
20

 

Note 18 - RELATED PARTY TRANSACTIONS AND ARRANGEMENTS

Amounts payable to related parties are summarized as follows:
 
 
 
June 30, 
2011
   
December 31, 
2010
 
Shares to be issued to related party
               
Scott Cramer – non-executive director (1)
 
$
79,575
   
$
53,050
 
                 
Amounts due to related parties
               
Scott Cramer – non-executive director and shareholder
   
186,380
     
170,937
 
Officer and shareholder (2)
   
250,961
     
46,975
 
Total
 
$
437,341
   
$
217,912
 
 

(1) As of  June 30, 2011 and December 31, 2010, the Company had $79,575 (representing 7,500 common shares) and $53,050 (representing 5,000 common shares), respectively, under agreement to issue shares to Scott Cramer, as compensation for being a representative of the Company in the United States for the periods from April 1, 2010 to March 31, 2011. 

(2) As of June 30, 2011, the amount due to officer and shareholder includes accrued expense to Mr. Weibing Lu. 

Note 19 - COMMITMENTS AND CONTINGENCIES

(a) Lease commitments

The Company recognizes lease expense on the straight-line basis over the term of the lease in accordance to the FASB’s accounting standard of accounting for leases. The Company entered into a tenancy agreement for the lease of factory premises for a period of ten years from October 1, 2004 to December 31, 2014. The annual rent for the factory premises has been adjusted to about $17,945 (RMB 116,000) and subject to a 10% increase every two years starting October 1, 2009.
 
The Company leases office space from Weibing Lu, the Company’s chief executive officer, for a period of five years from January 1, 2007 to December 31, 2011, with annual rent of approximately $25,618 (or RMB 165,600). The Company also entered into a tenancy agreement with Weibing Lu for the lease of Shanghai Siqiang’s office for a period of ten years from August 1, 2007 to August 1, 2017, with annual rent of approximately $22,277 (or RMB 144,000).

The Company entered into a tenancy agreement for the lease of an office space in California for a period of three years from July 1, 2009 to July 1, 2012 with monthly rent of $1,100. The Company dissolved the California entity in December 2010. There are no future lease liabilities related to this office.
 
The Company entered into a one-year tenancy agreement for leasing Tianxing’s sales office space in Tianjin from April 21, 2010 to April 20, 2011 with annual rent of approximately $3,713 (RMB 24,000).

The Company entered into a one-year tenancy agreement for an office lease in Kunshan, Jiangsu Province from April 15, 2011 to April 14, 2012 with annual rent of approximately $2,970 (RMB 19,200).
 
The minimum future lease payments for the next five years and thereafter are as follows:
 
Period
 
Amount
 
Six months ending December 31, 2011
 
$
51,097
 
Year ending December 31, 2012
   
78,062
 
Year ending December 31, 2013
   
79,137
 
Year ending December 31, 2014
   
55,731
 
Year ending December 31, 2015
   
22,277
 
Year ending December 31, 2016 and thereafter
   
35,272
 
 Total
 
$
321,576
 

Rental expense for the three months ended June 30, 2011 and 2010 amounted to $21,064 and $29,643, respectively. Rental expense for the six months ended June 30, 2011 and 2010 amounted to $35,460 and $36,411, respectively.
 
 
21

 

(b) Legal proceedings
 
From time to time, the Company is involved in legal matters arising in the ordinary course of business. Management currently is not aware of any legal matters or pending litigation which would have a significant effect on the Company’s consolidated financial statements as of June 30, 2011.

In May 2007, Andrew Chien filed suit against the Company, Scott Cramer, Steve Lowe, David Wassung and Weibing Lu in United States District Court for the District of Connecticut, alleging causes of action for violation of Sections 10(b) and 20(a) of the Exchange Act. On July 17, 2008, in a decision that is now published, the Court granted defendants’ motion to dismiss and subsequently dismissed the lawsuit, entering judgment on behalf of the defendants. Mr. Chien filed a notice of appeal of the Court’s dismissal of his lawsuit, opposed by the defendants, which remains pending. Additionally, on February 5, 2009, the Court issued a ruling on defendants’ motion for sanctions, finding the action filed by Mr. Chien to have been entirely frivolous, and to have constituted a “substantial” violation of Federal Rule of Civil Procedure Rule 11, and imposed significant monetary sanctions on both Mr. Chien and his former attorney. As part of the basis for imposing sanctions on Mr. Chien personally, the Court specifically found that Mr. Chien had knowledge of facts directly contradicting the allegations of his complaint, as evident in internet postings he made on online message boards. Mr. Chien subsequently filed motions seeking to “re-open” this case, and to recuse the judge, but both motions were denied. A Notice of Appeal concerning the ruling awarding sanctions against him was also filed by Mr. Chien. All appeals, including the one referenced below concerning Mr. Chien’s second lawsuit, were subsequently consolidated and remain pending, although briefing has been completed.

Subsequently, Mr. Chien, proceeding pro se (i.e., he represented himself without an attorney), filed another lawsuit against the Company, Scott Cramer, Steve Lowe, David Wassung and Weibing Lu in Connecticut Superior Court, alleging causes of action similar to those alleged in his federal complaint described above as well as state law causes of action. The case was removed to the U.S. District Court, District of Connecticut, and assigned to the same Judge who dismissed Mr. Chien’s related federal action. On June 8, 2009, the Court granted defendants’ motion to dismiss this action in its entirety, and denied Mr. Chien’s motion to further amend his complaint. Mr. Chien filed a Notice of Appeal concerning the ruling dismissing this lawsuit, which has been consolidated with Mr. Chien’s appeal of his other lawsuit. On May 26, 2010, the court of appeals for the Second Circuit upheld Judge Kravtiz’s ruling against Mr. Chien.

Subsequently, The Court of Appeals issued a Mandate upholding the decision granting defendant’s motion to dismiss and found that the District Court did not “abuse its discretion” in issuing moderate sanctions against Chien in light of the circumstances and facts on record.  This Mandate was entered on November 8, 2010. On January 22, 2011, Chien filed a petition with the Supreme Court of the United States, appealing the lower court’s ruling. Appeals to the U.S. Supreme Court far exceed the number of cases it actually hears. As of this date we have not received notice of further action by the Supreme Court.

Other than the above described legal proceedings, the Company is not aware of any other legal matters in which purchasers, any director, officer, or any owner of record or beneficial owner of more than five percent of any class of voting securities of the Company, or any affiliate of purchaser, or of any such director, officer, affiliate of the Company, or security holder, is a party adverse to the Company or has a material adverse interest to the Company. No provision has been made in the consolidated financial statements for the above contingencies.
 
(c) Ownership of leasehold property

In 2005, a shareholder contributed a leasehold office building as additional capital of Xi’an Tianxing. However, the title of the leasehold property has not passed to the Company. The Company does not believe there are any legal barriers for the shareholder to transfer the ownership to the Company. However, in the event that the Company fails to obtain the ownership certificate for the leasehold property, there is a risk that the building will need to be vacated due to unofficial ownership. Management believes that this possibility is remote, and as such, no provision has been made in the consolidated financial statements for this potential occurrence.

(d) R&D Project
 
During the first quarter of 2008, Xian Tianxing contracted with Northwestern Agricultural Technology University to jointly work on an R&D project concerning the application of nano-technology in the prevention of major milk cow disease. The total projected budget for this project is approximately $618,800 (RMB 4,000,000), which is to be paid according to the completed stages of the project. The project’s completion date has been delayed.  The Company now expects this project to be completed in 2011. For the six months ended June 30, 2011 and 2010, the Company incurred $0 and $161,359 (RMB 1,100,000) relating to this project. The project reached trial stage in June 2009, and the Company expects to obtain veterinary permit for the new product from government in 2011.
 
During the year ended December 31, 2009, Xian Tianxing contracted with the Fourth Military Medical University to jointly work on a R&D project with a contracted amount of approximated $928,200 (RMB 6,000,000).  For the six months ended June 30, 2011 and 2010, the Company incurred approximately $45,933 (RMB 300,000) and $74,724 (RMB 509,402) of expenses, respectively, relating to this project.
 
 
22

 

During the first quarter of 2011, Xi’an Tianxing contracted with the Fourth Military Medical University to jointly work on a R&D project to develop new treatment and diagnosis method for Mycoplasmal pneumonia of swine. The Project term is from January 2011 through June 2013. The cost to the Company for the initial phase is approximately $309,400 (RMB 2,000,000), of which $76,555 (RMB 500,000) has been paid for the six months ended June 30, 2011.

During the second quarter of 2011, Xi’an Tianxing launched four new R&D projects to develop ceftiofur sodium for injection (powder for injection), a sulfuric acid injection neostigmine, dexamethasone sodium phosphate injection and houttuynia preparation of compound application in weaning piglets. The projected budget for the R&D project of ceftiofur sodium for injection (powder for injection) is approximately $541,450 (RMB 3,500,000), of which $422,584 (RMB 2,760,000) has been paid during the second quarter of 2011. The projected budget for the R&D project of a sulfuric acid injection neostigmine is approximately $464,100 (RMB 3,000,000), of which $260,298 (RMB 1,700,071) has been paid during the second quarter of 2011. The projected budget for the R&D project of dexamethasone sodium phosphate injection is approximately $541,450 (RMB 3,500,000), of which $448,033 (RMB 2,926,215) has been paid during the second quarter of 2011. The projected budget for the R&D project of houttuynia preparation of compound application in weaning piglets is approximately $696,150 (RMB 4,500,000), of which $657,398 (RMB 4,293,630) has been paid during the second quarter of 2011.
 
(e) Capital commitment
 
From July 2010 to June 2011, the Company contracted with sixteen different business entities to construct or implement plumbing, sewer, electrical, HVAC, fire protection and alarm system, drainage, office, lab, road construction, parking, and landscaping at a micro-organism manufacturing facility located in Kunshan, Jiangsu Province. The total projected budget for this project is approximately $4,939,540 (RMB 31,929,798), which is to be paid according to the completed stages of the project. For the six months ended June 30, 2011 and 2010, the Company incurred $4,544,450 (RMB 29,375,891) and $0 relating to this project. The Company expects this project to be completed by the end of 2011.

 
23

 

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
 
Overview

We were incorporated in Nevada on September 24, 1998.  We are a holding company that, through our wholly owned subsidiaries in China, including Skystar Bio Technology (Jingzhou) Co. (“Skystar Jingzhou”), and a variable interest entity (“VIE”), Xi’an Tianxing Bio-Pharmaceutical Co., Ltd. (“Xi’an Tianxing”), researches, develops, manufactures, and distributes veterinary health care and medical care products in the People’s Republic of China (“PRC”).

All of our operations are carried out by our subsidiaries in China and Xi’an Tianxing, which the Company controls through contractual arrangements between Xi’an Tianxing and Sida Biotechnology (Xi’an) Co., Ltd. (“Sida”), the wholly owned subsidiary of Fortunate Time International Limited, the wholly owned subsidiary of Skystar Bio-Pharmaceutical (Cayman) Holdings Co., Ltd. (“Skystar Cayman”), which became our wholly owned subsidiary in 2005. Such contractual arrangements are necessary to comply with PRC laws limiting foreign ownership of certain companies. Through these contractual arrangements, we have the ability to substantially influence Xi’an Tianxing’s daily operations and financial affairs, appoint its senior executives, and approve all matters requiring shareholder approval. As a result of these contractual arrangements, which enable us to control Xi’an Tianxing, we are considered the primary beneficiary of Xi’an Tianxing.

On August 21, 2007, Xi’an Tianxing invested $68,550 (RMB 500,000) to establish Shanghai Siqiang Biotechnological Company Limited (‘Shanghai Siqiang’). Xi’an Tianxing is the 100% shareholder. Shanghai Siqiang serves as a research and development center for Xi’an Tianxing to engage in research, development, production and sales of feed additives and veterinary disease diagnosis equipments.

In addition to Xi’an Tianxing, Skystar Jingzhou also manufactures and distributes veterinary medicines including aquaculture medicines in China. Skystar Jingzhou is a wholly owned subsidiary of the Company’s Sida entity. It was formed with the August 2010 acquisition of a veterinary medicine manufacturing facility in Hubei Province, China.

Our financial statements are prepared in U.S. dollars and in accordance with accounting principles generally accepted in the United States of America. See “Exchange Rates” below for information concerning the exchanges rates at which Renminbi were translated into U.S. dollars at various pertinent dates and for pertinent periods.

Critical Accounting Policies and Estimates

In preparing the consolidated financial statements in accordance with U.S. GAAP, we make estimates and assumptions about the effect of matters that are inherently uncertain and may change in subsequent periods. The resulting accounting estimates will, by definition, vary from the related actual results. We consider the following to be the most critical accounting policies:

Principles of consolidation

The accompanying consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The consolidated financial statements include the financial statements of the Company, its wholly owned subsidiaries, and its VIEs. All significant inter-company transactions and balances between the Company, its subsidiaries, and its VIEs have been eliminated in consolidation.

Revenue recognition

Revenue of the Company is primarily from the sales of veterinary healthcare and medical care products in China. Sales are recognized when the following four revenue criteria are met: persuasive evidence of an arrangement exists, delivery has occurred, the selling price is fixed or determinable, and collectability is reasonably assured. Sales are presented net of value added tax (“VAT”). No estimated allowance for sales returns is reflected on these consolidated financial statements as sales returns are de minimal based on historical experience.
 
There are two types of sales upon which revenue is recognized:

a.
Credit sales: revenue is recognized when the products have been delivered to the customers.

b.
Full payment before delivering: revenue is recognized when the products have been delivered to the customers.
 
 
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Accounts receivable and other receivables

Accounts receivable are recorded at net realizable value consisting of the carrying amount less an allowance for uncollectible accounts, as needed. The Company uses the aging method to estimate the allowance for anticipated uncollectible receivable balances. Under the aging method, bad debt percentages determined by management, based on historical experience and current economic climate, are applied to customers’ balances categorized by the number of months the underlying invoices have remained outstanding. At each reporting period, the allowance balance is adjusted to reflect the amount computed as a result of the aging method. When facts subsequently become available to indicate that the allowance provided requires an adjustment, a corresponding adjustment is made to the allowance account as a change in estimate. The ultimate collection of the Company’s accounts receivable may take one year. Delinquent account balances are reserved after management determines that the likelihood of collection is not probable, and known bad debts are written-off against allowance for doubtful accounts when identified.

Intangible assets

Land Use Rights — Land use rights represent the amounts paid to acquire a long-term interest to utilize the land underlying the Company’s facilities. This type of arrangement is common for the use of land in the PRC. Land use rights are amortized on a straight-line basis over the term granted by the government.
 
Technological Know-How — Purchased technological know-how includes confidential formulas, manufacturing processes, and technical and procedural manuals, and is amortized using the straight-line method over the weighted average useful life of nine years, which reflects the period over which such confidential formulas, manufacturing processes, and technical and procedural manuals are kept confidential by the Company as agreed between the Company and the selling parties.
 
Impairment of Intangible Assets The Company evaluates the carrying value of intangible assets annually or more often when factors indicating impairment are present. The Company determines the existence of such impairment by measuring the estimated future cash flows (undiscounted) and comparing such amount to the net asset carrying value. If the undiscounted cash flow estimated to be generated by any such intangible asset is less than its carrying amount, a loss is recognized based on the amount by which the carrying amount exceeds the intangible asset’s fair market value. Loss on intangible assets to be disposed of is determined in a similar manner, except that fair market values are reduced by the cost of disposal. Based on its review, the Company believes that, as of June 30, 2011, there was no impairment of its intangible assets.

Earnings per share

The Company reports earnings per share and present both basic and diluted earnings per share in conjunction with the disclosure of the methodology used in computing such earnings per share. Basic earnings per share is based upon the weighted-average number of common shares outstanding. Diluted earnings per share is based on the assumption that all dilutive convertible shares, including convertible preferred shares, warrants and stock options were converted or exercised. Further, the method requires that stock dividends or stock splits be accounted for retroactively if the stock dividends or stock splits occur during the period, or retroactively if the stock dividends or stock splits occur after the end of the period but before the release of the financial statements, by considering it outstanding of the entirety of each period presented. Dilution is computed by applying the treasury stock method. Under this method, options and warrants are assumed to be exercised at the beginning of the period (or at the time of issuance, if later), and as if funds obtained thereby were used to purchase common stock at the average market price during the period.

Recent Issued Accounting Pronouncements

In January 2010, FASB issued ASU No. 2010-06 – Improving Disclosures about Fair Value Measurements. This update provides amendments to Subtopic 820-10 that requires new disclosure to include transfers in and out of Levels 1 and 2 and activity in Level 3 fair value measurements. Further, this update clarifies existing disclosures on level of disaggregation and Disclosures about inputs and valuation techniques. A reporting entity should provide fair value measurement disclosures for each class of assets and liabilities and should provide disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements. Those disclosures are required for fair value measurements that fall in either Level 2 or Level 3. The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. The adoption of this ASU did not have a material impact on our consolidated financial statements.

In April 2010, the FASB issued Accounting Standards Update 2010-13, “Compensation—Stock Compensation (Topic 718): Effect of Denominating the Exercise Price of a Share-Based Payment Award in the Currency of the Market in Which the Underlying Equity Security Trades,” or ASU 2010-13. ASU 2010-13 provides amendments to Topic 718 to clarify that an employee share-based payment award with an exercise price denominated in currency of a market in which a substantial portion of the entity’s equity securities trades should not be considered to contain a condition that is not a market, performance, or service condition. Therefore, an entity would not classify such an award as a liability if it otherwise qualifies as equity. The amendments in this Update are effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2010. The adoption of this ASU did not have a material impact on our consolidated financial statements.
 
 
25

 

In December 2010, the FASB issued Accounting Standards Update 2010-28, Intangibles—Goodwill and Other (Topic 350): When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts (a consensus of the FASB Emerging Issues Task Force). ASU No. 2010-28 addresses questions about entities that have reporting units with zero or negative carrying amounts. The amendments modify Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For those reporting units, an entity is required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. In determining whether it is more likely than not that goodwill impairment exists, an entity should consider whether there are any adverse qualitative factors indicating that impairment may exist. The qualitative factors are consistent with the existing guidance and examples in paragraph 350-20-35-30, which requires that goodwill of a reporting unit be tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. In addition, current GAAP will be improved by eliminating an entity’s ability to assert that a reporting unit is not required to perform Step 2 because the carrying amount of the reporting unit is zero or negative despite the existence of qualitative factors that indicate the goodwill is more likely than not impaired. As a result, goodwill impairments may be reported sooner than under current practice. The provisions of ASC No. 2010-28 are effective for fiscal years, and interim periods within those years, beginning after Dec. 15, 2010. Early adoption is not permitted. The adoption of this ASU did not have a material impact on our consolidated financial statements.
 
In December 2010, the FASB issued Accounting Standards Update 2010-29, Business Combinations (Topic 805) — Disclosure of Supplementary Pro Forma Information for Business Combinations. ASU No. 2010-29 clarifies that, when presenting comparative financial statements, SEC registrants should disclose revenue and earnings of the combined entity as though the current period business combinations had occurred as of the beginning of the comparable prior annual reporting period only. The amendments expand the supplemental pro forma disclosures to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. ASU 2010-29 is effective prospectively for material (either on an individual or aggregate basis) business combinations entered into in fiscal years beginning on or after December 15, 2010 with early adoption permitted.

In June 2011, the FASB issued new guidance on the presentation of comprehensive income that eliminates the option to report the components of other comprehensive income as part of the statement of shareholders’ equity. Instead, comprehensive income must be reported in either a single continuous statement of comprehensive income which contains two sections, net income and other comprehensive income, or in two separate but consecutive statements. This guidance will be effective during the interim and annual periods beginning after December 15, 2011 with early adoption permitted. The adoption of this guidance is not expected to have a material impact on our consolidated financial statements.

Results of Operations – Three Months ended June 30, 2011 and 2010
 
The following table summarizes our results of operations for the three months ended June 30, 2011 and 2010.
 
   
Three Months Ended June 30,
 
   
2011
   
2010
 
   
Amount
   
% of
total revenue
   
Amount
   
% of
total revenue
 
Revenue
  $ 9,096,141       100.0 %   $ 8,264,541       100.0 %
Gross Profit
  $ 4,459,134       49.0 %   $ 4,359,478       52.7 %
Operating Expenses
  $ 2,926,670       32.2 %   $ 1,621,932       19.6 %
Income from Operations
  $ 1,532,464       16.8 %   $ 2,737,546       33.1 %
Other Income
  $ 256,631       2.8 %   $ 181,335       2.2 %
Income Tax Expenses
  $ 281,705       3.1 %   $ 540,486       6.5 %
Net Income
  $ 1,507,390       16.5 %   $ 2,378,395       28.8 %
 
Revenue.   All of our revenue is derived from the sale of veterinary healthcare and medical care products in the PRC. For the three months ended June 30, 2011, we had revenue of $9,096,141 as compared to revenue of $8,264,541 for the three months ended June 30, 2010, an increase of approximately 10.1%. We generate revenue from sales of four product lines: veterinary medications, micro-organism, feed additives, and vaccines.  Selling prices have not changed from the same period last year for most of our past customers.

Revenue — Veterinary Medications.   Revenue from sales of our veterinary medications increased by $808,839 or 14.6% from $5,533,020 for the three months ended June 30, 2010 to $6,341,859 for the three months ended June 30, 2011.  The increase was primarily due to increased utilization of expanded veterinary medicine facility at our Huxian plant and increased sales efforts to market our products.  In addition, our Jingzhou plant that we acquired in August 2010 also contributed to this quarter’s revenue growth.  The increase in veterinary medications sales contributed the majority or 97% of revenue growth for the entire company during the three months ended June 30, 2011. Of the total revenues from veterinary medications during three months ended June 30, 2011, approximately 22% of total revenue resulted from the sale of Praziquantel tablets, which treats schistosomiasis.
 
 
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Revenue — Micro-Organism.   Revenue from sales of our micro-organism products decreased slightly by $3,967 or 0.2% from $1,985,095 for the three months ended June 30, 2010 to $1,981,128 during the three months ended June 30, 2011.  The minor decrease was primarily the result of soft market demand for micro-organism products during the second quarter of 2011.
 
Revenue — Feed Additives.   Revenue from sales of our feed additives product line increased by $22,335 or 6.1% from $368,537 for the three months ended June 30, 2010 to $390,872 for the three months ended June 30, 2011.  The increase was primarily the result of increased sales efforts for our multi-enzyme feed additive products.

Revenue — Vaccines. Revenue from sales of our vaccines increased by $4,393 or 1.2% from $377,889 for the three months ended June 30, 2010 to $382,282 for the three months ended June 30, 2011. This moderate increase was the result of increased market demand for our vaccine products and our current production capacity limitation. We are presently operating at full production capacity for our vaccine product line and therefore cannot significantly increase sales until we expand our production capabilities. We completed the construction of a new vaccine facility at our Huxian plant in 2010. The facility is currently waiting for GMP certification from the Ministry of Agriculture. The Company expects the GMP certification will be complete by the end of 2011, and we expect to commence production shortly thereafter.
 
Cost of Sales. Cost of revenue, which consists of raw materials, direct labor, and manufacturing overhead for our four product lines, was $4,637,007 for the three months ended June 30, 2011, as compared to $3,905,063 for the three months ended June 30, 2010, an increase of approximately 18.7%, as a result of increased sales and higher raw material costs because of elevated inflation in China. For the three months ended June 30, 2011, raw material costs contributed the majority or approximately 80% of total cost of sales, packing material costs contributed approximately 16% of total cost of sales and labor costs contributed approximately 4% of total cost of sales. The impact to our gross margins mainly came from higher raw materials costs.
 
Cost of Sales — Veterinary Medications. Cost of revenue for our veterinary medications increased by $644,781 or 20.2% from $3,197,770 for the three months ended June 30, 2010 to $3,842,551 for the three months ended June 30, 2011. This increase was mainly due to the corresponding increase in sales and higher raw material costs. The increase of costs in veterinary medications sales contributed to the majority or 88% of the increase in cost of sales for the entire company during three months ended June 30, 2011.

Cost of Sales — Micro-Organism.   Cost of revenue for our micro-organism products increased by $59,895 or 11.5%, from $520,911 for the three months ended June 30, 2010 to $580,806 for the three months ended June 30, 2011.  This increase was mainly due to higher raw material costs.
 
Cost of Sales — Feed Additives.   Cost of revenue for our feed additives increased by $17,398 or 11.8% from $146,984 for the three months ended June 30, 2010 to $164,382 for the three months ended June 30, 2011.  The increase was primarily due to the corresponding increase in sales and higher raw material costs.

Cost of Sales — Vaccines.   Cost of revenue for our vaccines products increased by $9,870 or 25.1% from $39,398 for the three months ended June 30, 2010 to $49,268 for the three months ended June 30, 2011.  This increase was a result of the corresponding increase in sales and higher raw material costs.

The following table summarizes our operating expenses for the three months ended June 30, 2011 and 2010.
 
   
Three Months Ended June 30,
 
   
2011
   
2010
 
   
Amount
   
% of total
revenue
   
Amount
   
% of total
revenue
 
Operating Expenses
                               
Research and Development Costs
 
$
1,801,551
     
19.8
%
 
$
192,088
     
2.3
%
Selling Expenses
 
$
609,826
     
6.7
%
 
$
431,810
     
5.2
%
General and Administrative Expenses
 
$
515,293
     
5.7
%
 
$
998,034
     
12.1
%
Total Operating Expenses
 
$
2,926,670
     
32.2
%
 
$
1,621,932
     
19.6
%

Research and Development Costs.  Research and development costs, which consist of salaries, professional fees, and technical support fees, totaled $1,801,551 for the three months ended June 30, 2011, as compared to $192,088 for the three months ended June 30, 2010, an increase of approximately 837.9%.   The increase was due to significantly increased R&D efforts during the second quarter of 2011. Xi’an Tianxing launched four new R&D projects to develop new veterinary medications and incurred a total of $1,788,312 of R&D costs for the three months ended June 30, 2011.

Selling Expenses.  Selling expenses, which consist of commissions, advertising and promotion expenses, freight charges, and salaries, totaled $609,826 for the three months ended June 30, 2011 as compared to $431,810 for the three months ended June 30, 2010, an increase of approximately 41.2%.  This increase was primarily due to the increase in our shipping and handling costs related to delivering our products to customers as we continued to expand our market to remote areas, and to inflation pressure in China, which resulted in higher transportation and delivery costs.
 
 
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General and Administrative Expenses.  General and administrative expenses totaled $515,293 for the three months ended June 30, 2011, as compared to $998,034 for the three months ended June 30, 2010, a decrease of approximately 48.4%.  The decrease was mainly due to no bad debt expense being incurred during the quarter ended June 30, 2011 while we incurred $287,561 in bad debt expense in the same quarter last year. Lower office expenses were also contributable to the decrease in general and administrative expenses for the three months ended June 30, 2011.
 
Results of Operations – Six Months ended June 30, 2011 and 2010
 
The following table summarizes our results of operations for the six months ended June 30, 2011 and 2010.
 
   
Six Months Ended June 30,
 
   
2011
   
2010
 
   
Amount
   
% of
total revenue
   
Amount
   
% of
total revenue
 
Revenue
  $ 16,183,095       100.0 %   $ 13,133,784       100.0 %
Gross Profit
  $ 8,054,742       49.8 %   $ 6,937,502       52.8 %
Operating Expenses
  $ 4,878,344       30.1 %   $ 2,456,611       18.7 %
Income from Operations
  $ 3,176,398       19.7 %   $ 4,480,891       34.1 %
Other Income (Expenses)
  $ 1,021,979       6.3 %   $ (140,444 )     (1.1 %)
Income Tax Expenses
  $ 759,155       4.7 %   $ 865,805       6.6 %
Net Income
  $ 3,439,222       21.3 %   $ 3,474,642       26.4 %
 
Revenue.   All of our revenue is derived from the sale of veterinary healthcare and medical care products in the PRC. For the six months ended June 30, 2011, we had revenue of $16,183,095 as compared to revenue of $13,133,784 for the six months ended June 30, 2010, an increase of approximately 23.2%. We generate revenue from sales of four product lines: veterinary medications, micro-organism, feed additives, and vaccines.  Selling prices have not changed from the same period last year for most of our past customers.

Revenue — Veterinary Medications. Revenue from sales of our veterinary medications increased by $2,477,627 or 28.4% from $8,729,279 for the six months ended June 30, 2010 to $11,206,906 for the six months ended June 30, 2011. The increase was primarily due to improved utilization of manufacturing capacity at our Huxian plant, a better product mix to meet customer demands, increased sales efforts, and the contribution of our new Jingzhou plant to our revenue growth. The increase in veterinary medications sales contributed the majority or approximately 81% of revenue growth for the entire company during the six months ended June 30, 2011. Of total revenues from veterinary medications during six months ended June 30, 2011, approximately 19% of total revenue resulted from the sale of Praziquantel tablets, which treats schistosomiasis.

Revenue — Micro-Organism.   Revenue from sales of our micro-organism products increased by $385,549 or 12.1% from $3,191,673 for the six months ended June 30, 2010 to $3,577,222 during the six months ended June 30, 2011.  The increase was primarily the result of improved utilization of the micro-organism production capacity at the Huxian plant.
 
Revenue — Feed Additives.   Revenue from sales of our feed additives product line increased by $112,702 or 18.6% from $604,577 for the six months ended June 30, 2010 to $717,279 for the six months ended June 30, 2011.  The increase was the result of increased sales efforts of our multi-enzyme feed additive products.

Revenue — Vaccines. Revenue from sales of our vaccines increased by $73,433 or 12.1% from $608,255 for the six months ended June 30, 2010 to $681,688 for the six months ended June 30, 2011. This increase was the result of increased market demands for our vaccine products. We are presently operating at full production capacity for our vaccine product line and therefore cannot significantly increase sales until we expand our production capabilities. We completed the construction of a new vaccine facility at the Huxian plant in 2010. The facility is currently waiting for GMP certification from the Ministry of Agriculture. The Company expects the GMP certification will be completed by the end of 2011, and we expect to commence production shortly thereafter.
 
Cost of Sales. Cost of revenue, which consists of raw materials, direct labor, and manufacturing overhead for our four product lines, was $8,128,353 for the six months ended June 30, 2011, as compared to $6,196,282 for the six months ended June 30, 2010, an increase of approximately 31.2%, as a result of increased sales and higher raw material costs. For the six months ended June 30, 2011, raw material costs contributed the majority or approximately 77% of total cost of sales, packing material costs contributed approximately 17% of total cost of sales and labor costs contributed approximately 6% of total cost of sales. The impact to our gross margins mainly came from higher raw materials costs.
 
Cost of Sales — Veterinary Medications.   Cost of revenue for our veterinary medications increased by $1,644,430 or approximately 32.8% from $5,020,027 for the six months ended June 30, 2010 to $6,664,457 for the six months ended June 30, 2011.  This increase was mainly due to the corresponding increase in sales and higher raw material costs. The increase of costs in veterinary medications sales contributed to the majority or 85% of the increase in cost of sales for the entire company during six months ended June 30, 2011.
 
 
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Cost of Sales — Micro-Organism.   Cost of revenue for our micro-organism products increased by $211,058 or 24.4%, from $863,930 for the six months ended June 30, 2010 to $1,074,988 for the six months ended June 30, 2011.  This increase was mainly due to the corresponding increase in sales and higher raw material costs.
 
Cost of Sales — Feed Additives.   Cost of revenue for our feed additives increased by $58,218 or 23.6% from $247,030 for the six months ended June 30, 2010 to $305,248 for the six months ended June 30, 2011.  The increase was primarily due to the corresponding increase in sales and higher raw material costs.

Cost of Sales — Vaccines.   Cost of revenue for our vaccines products increased by $18,365 or 28.1% from $65,295 for the six months ended June 30, 2010 to $83,660 for the six months ended June 30, 2011.  This increase was a result of the corresponding increase in sales and higher raw material costs.

The following table summarizes our operating expense for the six months ended June 30, 2011 and 2010.
 
   
Six Months Ended June 30,
 
   
2011
   
2010
 
   
Amount
   
% of total
revenue
   
Amount
   
% of total
revenue
 
Operating Expenses
                               
Research and Development Costs
 
$
2,089,023
     
12.9
%
 
$
236,083
     
1.8
%
Selling Expenses
 
$
979,230
     
6.1
%
 
$
602,944
     
4.6
%
General and Administrative Expenses
 
$
1,810,091
     
11.2
%
 
$
1,617,584
     
12.3
%
Total Operating Expenses
 
$
4,878,344
     
30.1
%
 
$
2,456,611
     
18.7
%

Research and Development Costs.  Research and development costs, which consist of salaries, professional fees, and technical support fees, totaled $2,089,023 for the six months ended June 30, 2011, as compared to $236,083 for the six months ended June 30, 2010, an increase of approximately 784.9%.   The increase was due to a significant increase in R&D efforts during the six months ended June 30, 2011. In addition to continuing to fund existing joint R&D projects with universities, we launched four new R&D projects to develop new veterinary medications during the second quarter of 2011.

Selling Expenses.  Selling expenses, which consist of commissions, advertising and promotion expenses, freight charges, and salaries, totaled $979,230 for the six months ended June 30, 2011 as compared to $602,944 for the six months ended June 30, 2010, an increase of approximately 62.4%.  This increase is primarily a result of increased shipping and handling costs related to delivering our products to customers. Increased labor costs for sales staff and higher travel costs also contributed to the increase in selling costs.

General and Administrative Expenses.  General and administrative expenses totaled 1,810,091 for the six months ended June 30, 2011, as compared to $1,617,584 for the six months ended June 30, 2010, an increase of approximately 11.9%.  The increase was mainly due to increased depreciation and amortization expenses, higher labor costs for administrative staff, and higher travel costs.
 
Liquidity
 
For the six months ended June 30, 2011, cash used in operating activities was $3,922,845 compared to cash provided by operations of $553,227 for the same period in 2010. The major operating activities that provided cash during the six months ended June 30, 2011 were net income of $3,439,222, a decrease in accounts receivable of $1,085,951, a decrease in other receivable of $791,371 and an increase in accounts payable of $577,915. The major operating activities that used cash during the six months ended June 30, 2011 were a build-up in inventory that used $8,711,510, a change in fair value of warrant liability of $1,095,647, and a decrease in taxes payable of $702,883 mainly for tax payments made during the second quarter of 2011.

Based on the Company’s research and feedback from the market, we believe the current inflationary pressure will continue to build in 2011 and cost of raw materials will continue to escalate.  We accumulated more inventory than in the past to ensure the supply of raw materials at lower cost levels and to protect our profit margins from being eroded by escalated inflation. As a result, the negative impact to the gross margins from the cost increases of raw materials has been relatively moderate for the six months ended June 30, 2011.  However, if the government is unsuccessful in reining in inflation, there may be greater negative impact to our gross margins from cost increases of raw materials in the future. As of June 30, 2011, we had approximately 43 suppliers that we made advances to in order to secure our raw material needs and to obtain favorable pricing.  We will continue to closely manage these advances to balance the need for lower materials cost and sufficient cash flow.
 
 
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Cash provided by investing activities for the six months ended June 30, 2011 was $1,604,317, as compared to cash used by investing activities of $8,403,458 for the six months ended June 30, 2010. Cash provided by investing activities for the six months ended June 30, 2011 was largely due to the collection of short term loans made to suppliers.  Cash used by investing activities for the six months ended June 30, 2011 was largely due to the payment of construction in progress and short-term loans made to a service provider and an unrelated third party.
 
Cash provided by financing activities for the six months ended June 30, 2011was $1,302,209, as compared to cash used by financing activities of $377,927 for the six months ended June 30, 2010. Cash generated by financing activities for the six months ended June 30, 2011 was primarily the result of short-term loans the Company took out in China.

As of June 30, 2011, we had cash of $5,046,502. Our total current assets were $45,619,110, and our total current liabilities were $8,565,936, which resulted in a net working capital of $37,053,174.
 
Capital Resources
 
We borrowed $1,724,019 in short-term loans and repaid $612,440 during the six months ended June 30, 2011. Considering our existing working capital position and our ability to access debt funding sources, we believe we have sufficient capital to support our ongoing operations. 

   
Payments Due by Period
 
Contractual Obligations
 
Total
   
Less than
1 year
   
1 – 3 years
   
3 – 5 years
   
More than
5 years
 
R&D Project Obligation
 
$
1,316,216
   
1,316,216
   
$
-
   
$
-
   
$
-
 
Operating Lease Obligations
   
321,576
     
51,097
     
157,199
     
78,008
     
35,272
 
Government Grant Obligation
   
618,800
     
-
     
618,800
     
-
     
-
 
Total
 
$
2,256,592
   
1,367,313
     
775,999
     
78,008
     
35,272
 

In addition to the contractual obligations listed above, we have a future registered capital commitment related to our newly created subsidiary Skystar Kunshan, located in Kunshan, Jiangsu province, China. The Skystar Kunshan subsidiary has a registered capital of $15,000,000, of which we invested $2,250,000 in cash. The remaining $12,750,000 of capital must be invested prior to May 7, 2012. We have also been making prepayments in an effort to acquire assets in a micro-organism manufacturing facility in Kunshan. Upon completion of such an acquisition, the assets purchased will be transferred to Skystar Kunshan to satisfy some of our registered capital commitment. If such an acquisition does not close, we may request a reduction or cancellation of the registered capital requirement. As of the date of this report, we have not completed the acquisition.
 
Off-Balance Sheet Arrangements
 
We do not have any outstanding financial guarantees or commitments to guarantee the payment obligations of any third parties. We have not entered into any derivative contracts that are indexed to our shares and classified as stockholders’ equity or that are not reflected in our consolidated financial statements. Furthermore, we do not have any retained or contingent interest in assets transferred to an unconsolidated entity that serves as credit, liquidity, or market risk support to such entity. We do not have any variable interest in any unconsolidated entity that provides financing, liquidity, market risk, or credit support to us or engages in leasing, hedging, or research and development services with us.

Exchange Rate

The Company’s operating subsidiaries in China maintain their books and records in Renminbi (“RMB”), the currency of China. In general, for consolidation purposes, we translate the subsidiaries’ assets and liabilities into US Dollars using the applicable exchange rates prevailing at the balance sheet date, and the statement of income is translated at average exchange rates during the reporting period. Adjustments resulting from the translation of the financial statements of the Company’s Chinese subsidiaries are recorded as accumulated other comprehensive income.

The exchange rates used to translate amounts in RMB into US Dollar for the purposes of preparing the consolidated financial statements or otherwise stated in this MD&A were as follows:
 
   
June 30, 2010
 
December 31, 2010
 
June 30, 2011
Assets and liabilities
 
1 RMB = 0.14730 USD
 
1 RMB = 0.15170 USD
 
1 RMB = 0.15470 USD
Statements of operations and cash flows for the period/year ended
 
1 RMB = 0.14669 USD
 
1 RMB = 0.14794 USD
 
1 RMB = 0.15311 USD
 
 
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Inflation

We continue to see inflation pressures building in China. Chinese Premier Wen Jiabao said at the end of June that there would be “difficulties” keeping inflation within the government’s 4% ceiling this year after the rate exceeded that level every month in the first half. For the six months ended June 30, 2011, we were able to secure favorable pricing by prepaying for major components to certain suppliers to lock in prices ahead of time. As a result, we did not experience as much cost pressure as evidenced in the spot market prices of the raw materials. However, we are seeing the rising costs of raw materials gradually starting to impact our margins, as evidenced by the moderate decrease in gross margins. We anticipate the inflationary pressures will continue for the rest of 2011. We are taking actions to minimize the negative impact of cost increases that erode our profit margin and monitor the situation closely. We are continuing the practice of prepayments to suppliers but at a reduced scale to lock-in favorable prices for raw materials. We are also taking steps to improve the production process to reduce raw material waste, optimize product mix to meet market demand and improve profitability, increase R&D efforts to develop new and profitable products, and identify new suppliers with better terms on the supply of raw materials.

ITEM 4. CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized, and reported within the time periods specified in the Commission’s rules and forms, and that such information is accumulated and communicated to our management, including our principal executive officer (Chief Executive Officer) and principal financial officer (Chief Financial Officer), as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

As of June 30, 2011, our management, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, performed an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act).

Based on the evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of June 30, 2011, our disclosure controls and procedures were ineffective due to an ongoing material weakness related to the lack of accounting and internal audit personnel with an appropriate level of knowledge, experience, and training in the application of U.S. GAAP. We have initiated a plan to implement the following measures to remediate this material weakness:

1.
Recruit sufficient qualified accounting and internal audit personnel and continue to engage outside contractor with technical accounting expertise, as needed.

2.
Reorganize the accounting and finance department to ensure that accounting personnel with adequate experience, skills and knowledge are directly involved in the review and accounting evaluation of our complex, non-routine transactions.

3.
Continue to evaluate our existing staffs and make adjustments as necessary, in addition to providing additional training on accounting principles and internal control procedures for our existing staffs.

4.
Improve the interaction among our management, audit committee, independent auditors and other external advisors.
 
Changes in Internal Control over Financial Reporting

There was no change in our internal control over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. 
 
 
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PART II. OTHER INFORMATION

ITEM 6. EXHIBITS
 
Exh. No.
 
Description
3.1
 
Articles of Incorporation, as amended  (2)
     
3.2
 
Bylaws, as amended (1)
     
31.1
 
Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 *
     
31.2
 
Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 *
     
32.1
 
Certifications of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 *
     
32.2
 
Certifications of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 *


*
Filed herewith.
   
(1)
Incorporated by reference from the Registrant’s Current Report on Form 8-K filed on July 15, 2008.
   
(2)
Incorporated by reference from Registrant’s Quarter Report on Form 10-Q filed on November 15, 2010.
 
 
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SIGNATURES

In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
 
SKYSTAR BIO-PHARMACEUTICAL COMPANY
 
       
August 22, 2011
By: 
/s/ Weibing Lu
 
   
Weibing Lu
 
   
Chief Executive Officer
 
   
(Principal Executive Officer)
 
 
 August 22, 2011
By:  
/s/ Bing Mei
 
   
Bing Mei
 
   
Chief Financial Officer
 
   
(Principal Financial and Accounting Officer)
 
 
 
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