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EX-31.1 - EXHIBIT 31.1 - Bohai Pharmaceuticals Group, Inc.v326969_ex31-1.htm

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

xQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2012

 

¨TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                        to                          

 

Commission File Number: 000-53401

 

Bohai Pharmaceuticals Group, Inc.

(Exact name of registrant as specified in its charter)

 

Nevada 98-0697405
(State or other jurisdiction of  (I.R.S. Employer Identification No.)
incorporation or organization)  

 

c/o Yantai Bohai Pharmaceuticals Group Co. Ltd.  
No. 9 Daxin Road, Zhifu District  
Yantai, Shandong Province, China 264000
(Address of principal executive offices) (Zip Code)

 

Registrant’s telephone number (including area code): +86(535)-685-7928

 

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 is a large accelerated filer, an accelerated filer, or a non-accelerated filer or a smaller reporting company. See definition 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
(Do not check if a smaller reporting company)    

 

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

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Date 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). x

 

As of November 14, 2012, there were 17,861,085 shares of company common stock issued and outstanding.

 

 
 

 

Bohai Pharmaceuticals Group, Inc.

 

Quarterly Report on Form 10-Q

 

TABLE OF CONTENTS

 

PART I – FINANCIAL INFORMATION  
   
Cautionary Note Regarding Forward-Looking Statements 3
   
Item 1. Financial Statements  
     
 

Condensed Consolidated Balance Sheets as of September 30, 2012 (unaudited) and June 30, 2012 

4
     
  Condensed Consolidated Statements of Income and Comprehensive Income for the Three Months ended September 30, 2012 and 2011 (unaudited) 5
     
  Condensed Consolidated Statements of Changes in Stockholders’ Equity for the Three Months Ended September 30, 2012 (unaudited) 6
     
  Condensed Consolidated Statements of Cash Flows for the Three Months ended September 30, 2012 and 2011 (unaudited) 7
     
  Notes to Condensed Consolidated Financial Statements 8
     
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 26
     
Item 3. Quantitative and Qualitative Disclosures About Market Risk 35
     
Item 4. Controls and Procedures 35
   
PART II – OTHER INFORMATION  
   
Item 1. Legal Proceedings 37
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 37
Item 3. Defaults Upon Senior Securities 37
Item 4. Mine Safety Disclosures 37
Item 5. Other Information 37
Item 6. Exhibits 37
   
SIGNATURES 38

 

2
 

 

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

In addition to historical information, this Quarterly Report on Form 10-Q contains forward looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in such forward-looking statements. We cannot give any guarantee that the plans, intentions or expectations described in the forward looking statements will be achieved. All forward-looking statements involve significant risks and uncertainties, and actual results may differ materially from those discussed in the forward-looking statements as a result of various factors, including those factors described in the “Risk Factors” section of our Annual Report for the fiscal year ended June 30, 2012. Readers should carefully review such risk factors as well as factors described in other documents that we file from time to time with the Securities and Exchange Commission.

 

In some cases, you can identify forward-looking statements by terminology such as “guidance,” “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “projects,” “potential,” “proposed,” “intended,” or “continue” or the negative of these terms or other comparable terminology. You should read statements that contain these words carefully, because they discuss our expectations about our future operating results or our future financial condition or state other “forward-looking” information. There may be events in the future that we are not able to accurately predict or control. You should be aware that the occurrence of any of the events described in our risk factors and other disclosures could substantially harm our business, results of operations and financial condition, and that upon the occurrence of any of these events, the trading price of our securities could decline. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, growth rates, and levels of activity, performance or achievements. Factors that may cause actual results, our performance or achievements, or industry results, to differ materially from those contemplated by such forward-looking statements include, without limitation:

 

§our ability to generate or obtain through financing sufficient working capital to (i) fund the acquisition of Yantai Tianzheng (a total of $25.3million is due); (ii) satisfy our obligations under our convertible notes due October 5, 2012 (currently $9,405,000 due) or (iii) otherwise to support our business plans;
§our ability to integrate the business of Yantai Tianzheng and any future acquisitions into our business;
§our ability to expand our product offerings and maintain the quality of our products;
§the availability of government granted rights to exclusively manufacture or co-manufacture our products;
§the availability of national healthcare reimbursement of our products;
§our ability to manage our expanding operations and continue to fill customers’ orders on time;
§our ability to maintain adequate control of our expenses allowing us to realize anticipated revenue growth;
§our ability to maintain or protect our intellectual property;
§our ability to maintain our proprietary technology;
§the impact of government regulation in China and elsewhere, including the support provided by the Chinese government to the Traditional Chinese Medicine and healthcare sectors in China;
§our ability to implement product development, marketing, sales and acquisition strategies and adapt and modify them as needed;
§our implementation of required financial, accounting and disclosure controls and procedures and related corporate governance policies; and
§our ability to anticipate and adapt to changing conditions in the Traditional Chinese Medicine and healthcare industries resulting from changes in government regulations, mergers and acquisitions involving our competitors, technological developments and other significant competitive and market dynamics.

 

We cannot give any guarantee that our plans, intentions or expectations will be achieved. All forward-looking statements involve significant risks and uncertainties, and actual results may differ materially from those discussed in the forward-looking statements as a result of various factors, including those factors listed above and described in the “Risk Factors” section of our Annual Report on Form 10-K for the fiscal year ended June 30, 2012. Except as required by applicable law and including the securities laws of the United States, we do not intend to update any of the forward-looking statements to conform these statements to actual results.

 

3
 

 

BOHAI PHARMACEUTICALS GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

 

   September 30,   June 30, 
   2012
(UNAUDITD)
   2012 
ASSETS          
Current assets:          
Cash  $19,379,160   $18,386,288 
Restricted cash   9,332,186    9,449,905 
Accounts receivable   33,716,886    29,670,552 
Inventories   4,294,093    3,795,915 
Prepaid expenses and other current assets   1,385,641    879,696 
           
Total current assets   68,107,966    62,182,356 
           
Non - current assets:          
Property, plant and equipment, net   11,570,619    11,681,272 
Prepayment for property, plant and equipment   596,851    594,508 
Intangible assets - pharmaceutical formulas   25,561,170    25,610,557 
Long term prepayments - land use right, net   18,540,617    18,739,297 
Other intangible assets, net   20,678,239    21,497,890 
Goodwill   5,082,320    5,092,139 
Total Non - current assets   82,029,816    83,215,663 
           
TOTAL ASSETS  $150,137,782   $145,398,019 
           
LIABILITIES AND STOCKHOLDERS’ EQUITY          
           
Current liabilities:          
Convertible notes, in default and due on demand  $9,405,000   $10,036,000 
Accounts payable   3,521,371    3,334,101 
Accrued expenses   7,727,712    8,478,054 
Income taxes payable   2,530,941    2,338,825 
Acquisition purchase price payable - current portion   5,000,000    5,000,000 
Derivative liabilities - investor and agent warrants   713,233    1,211,236 
Due to Related Party   38,500    36,002 
           
Total current liabilities   28,936,757    30,434,218 
           
Non - current liabilities:          
Acquisition purchase price payable - non-current portion   20,300,000    20,300,000 
Deferred tax liability   8,251,928    8,161,269 
Total Non - current liabilities   28,551,928    28,461,269 
           
TOTAL LIABILITIES   57,488,685    58,895,487 
           
COMMITMENTS, CONTINGENCIES, AND OTHER MATTERS          
           
STOCKHOLDERS' EQUITY          
Common stock , $0.001 par value, 150,000,000 shares authorized, 17,861,085 shares issued and  outstanding as of September 30, 2012 and June 30, 2012, respectively   17,861    17,861 
Additional paid-in capital   24,615,353    24,615,353 
Accumulated other comprehensive income   5,987,129    6,236,076 
Statutory reserves   2,201,817    2,201,817 
Retained earnings   59,826,937    53,431,425 
           
Total stockholders’ equity   92,649,097    86,502,532 
           
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY  $150,137,782   $145,398,019 

 

See accompanying notes to the condensed consolidated financial statements

 

4
 

 

BOHAI PHARMACEUTICALS GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF

INCOME AND COMPREHENSIVE INCOME

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2012 AND 2011

(UNAUDITED)

 

   For the Three Months Ended
September 30
 
   2012   2011 
         
Net revenues  $35,348,820   $29,927,856 
           
Cost of revenues   8,592,104    6,943,720 
           
Gross profit   26,756,716    22,984,136 
           
Operating expenses:          
Selling, general and administrative   17,207,116    15,604,890 
Depreciation and amortization   958,890    629,599 
           
Total Operating expenses   18,166,006    16,234,489 
           
Income from operations   8,590,710    6,749,647 
           
Other income (expenses):          
Interest income   17,785    21,242 
Interest expense   (513,033)   (2,622,511)
Other (expenses) income, net   (16,706)   (6,720)
Change in fair value of derivative liabilities   498,002    332,485 
           
Total other income (expenses)   (13,952)   (2,275,504)
           
Income before provision for income taxes   8,576,758    4,474,143 
           
Provision for income taxes   (2,181,246)   (1,818,359)
           
Net income  $6,395,512   $2,655,784 
           
Comprehensive income:          
Net income   6,395,512    2,655,784 
Other comprehensive income          
Unrealized foreign currency translation gain (loss)   (248,947)   614,600 
Comprehensive income  $6,146,565   $3,270,384 
           
Net income per common share          
           
Basic  $0.36   $0.15 
Diluted  $0.28   $0.15 
           
Weighted average common shares outstanding          
           
Basic   17,861,085    17,861,085 
Diluted   22,563,585    17,861,085 

 

See accompanying notes to the condensed consolidated financial statements

 

5
 

 

BOHAI PHARMACEUTICALS GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2012

(UNAUDITED)

 

   Common stock     

Accumulated

other

           Total 
   Shares       Additional   comprehensive   Statutory   Retained   Stockholders’ 
   outstanding   Amount   paid-in capital   income   Reserves   Earnings   Equity 
                             
Balance at June 30, 2012   17,861,085   $17,861   $24,615,353   $6,236,076   $2,201,817   $53,431,425   $86,502,532 
                                    
Foreign currency translation adjustment   0    0    0    (248,947)   0    0    (248,947)
                                    
Net income   0    0    0    0    0    6,395,512    6,395,512 
                                    
Balance at September 30, 2012   17,861,085   $17,861   $24,615,353   $5,987,129   $2,201,817   $59,826,937   $92,649,097 

 

See accompanying notes to the condensed consolidated financial statements

 

6
 

 

BOHAI PHARMACEUTICALS GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2012 AND 2011

(UNAUDITED)

 

   For the Three Months Ended 
   September 30, 
   2012   2011 
         
Cash flows from operating activities:          
           
Net income  $6,395,512   $2,655,784 
Adjustments to reconcile net income to net cash provided by operating activities:          
           
Depreciation and amortization   1,083,978    751,660 
Loss on disposal of property, plant and equipment   0    (2,755)
Gain from foreign currency in Tianzheng’s acquisition payable   0    (308,847)
Amortization of debt issue costs   0    237,360 
Non-cash interest-convertible notes   0    2,119,387 
Change in fair value of warrants   (498,002)   (332,485)
Stock based compensation   0    22,000 
Deferred income taxes   106,410    221,722 
           
Changes in operating assets and liabilities:          
Accounts receivable   (4,104,067)   (1,516,059)
Prepaid expenses and other assets   (551,346)   (93,605)
Inventories   (505,562)   (274,098)
           
Accounts payable   193,721    (610,549)
           
Accrued liabilities   (729,970)   (7,353)
Income taxes payable   191,018    442,781 
           
Net cash provided by operating activities   1,581,692    3,304,943 
           
Cash flows used in investing activities:          
Purchases of property, plant and equipment   (11,344)   (429,716)
Proceeds from disposal of property, plant and equipment   0    101,353 
Property, plant and equipment deposits   (3,490)   (255,840)
Cash received in acquisition of business   0    1,358,078 
Cash paid for acquisition of business   0    (6,000,000)
           
Net cash used in investing activities   (14,834)   (5,226,125)
           
Cash flows from financing activities:          
Repayment of short term borrowings   0    (1,473,523)
Borrowing from related party   2,545    7,831 
           
Repayment of convertible notes   (631,000)   0 
Capital contribution from shareholder   0    6,237,136 
Deposit of restricted cash-convertible note escrow deposit   945,195    0 
Release of restricted cash- convertible note escrow deposit   (845,495)   10,000 
           
Net cash flows (used in) provided by financing activities   (528,755)   4,781,444 
           
Effect of foreign currency translation on cash and cash equivalents   (45,231)   25,612 
           
Net increase in cash and cash equivalents   992,872    2,885,875 
           
Cash and cash equivalents at beginning of period   18,386,288    13,344,426 
           
Cash and cash equivalents at end of period  $19,379,160   $16,230,301 
           
Cash paid during the period for:          
Interest  $313,895   $265,762 
Income taxes  $1,878,185   $1,213,899 
           
Supplemental cash flow information          
           
Non-cash investing and financing activities:          
Acquisition liability  $25,300,000   $29,000,000 

 

See accompanying notes to the condensed consolidated financial statements

  

7
 

 

BOHAI PHARMACEUTICALS GROUP, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2012

 

1. ORGANIZATION AND PRINCIPAL ACTIVITIES

 

Bohai Pharmaceuticals Group, Inc. (“BPGI”) was incorporated under the laws of the State of Nevada on January 9, 2008 under the name of Link Resources, Inc. Prior to January 5, 2010, BPGI was a public “shell” company. BPGI became a public operating company on January 5, 2010 pursuant to a Share Exchange Transaction completed on January 5, 2010.

 

BPGI is engaged in the production, manufacturing and distribution of herbal pharmaceuticals based on traditional Chinese medicine (“TCM”) in the People’s Republic of China (“China” or the “PRC”) through the following two operating subsidiaries:

 

(i) YantaiBohai Pharmaceuticals Group Co., Ltd., (“Bohai”) a PRC company and the Company’s original operating subsidiary BPGI controls Bohai through a variable interest entity arrangement (“VIE”) described below; and

 

(ii) Yantai Tianzheng Pharmaceuticals Company, Ltd., a PRC company (“Yantai Tianzheng”) which BPGI acquired effective July 1, 2011 through a newly formed PRC wholly-foreign owned enterprise subsidiary, YantaiNirui Pharmaceuticals, Ltd. (“WFOE II”).

 

BPGI owns 100% of Chance High International Limited, a British Virgin Islands company (“Chance High”). Chance High owns 100% of the issued and outstanding shares of capital stock of a Chinese wholly-foreign owned enterprise known as YantaiShencaojishi Pharmaceuticals Co., Ltd. (the “WFOE”). On December 7, 2009 (prior to the date of the Share Exchange Transaction), the WFOE entered into a series of variable interest entity contractual agreements (the “VIE Agreements”) with Bohai and its three shareholders, including Mr. Hongwei Qu, the Company’s current Chairman and Chief Executive Officer (“Mr. Qu”). Mr. Qu currently owns 96.7% of the outstanding equity interests of Bohai and two other shareholders who collectively own the remaining 3.3% of Bohai.

 

The VIE Agreements include (i) a Consulting Services Agreement, (ii) an Operating Agreement, and (iii) a Proxy Agreement, through which the WFOE has the right to advise, consult, manage and operate Bohai for an annual fee equal to all of Bohai’s yearly net profits after tax. Pursuant to these agreements, the WFOE indirectly owns but has 100% managerial and economic control of the business activities of Bohai including the right to appoint all executives and senior management and members of the board of directors of Bohai. Additionally, Bohai’s shareholders pledged their rights, titles and equity interest in Bohai as security for the WFOE to collect consulting and services fees provided to Bohai pursuant to an equity pledge agreement. In order to further reinforce the WFOE’s rights to control and operate Bohai, Bohai’s shareholders granted the WFOE an exclusive right and option to acquire all of their equity interests in Bohai through an option agreement. The VIE Agreements have perpetual terms unless otherwise determined by PRC law, and can (particularly in the case of the Consulting Services Agreement (which is the principal VIE Agreement) be terminated by the parties under certain circumstances, including material breach, the termination of Bohai’s business or a liquidation of Bohai. The WFOE (which is controlled indirectly by BPGI through Chance High) can also terminate the Consulting Services Agreement at will.

 

BPGI, its wholly owned subsidiary Chance High, WFOE, WFOE II, Bohai and Yantai Tianzheng are referred to herein collectively and as a consolidated basis as the “Company” or “we”, “us” or “our” or similar terminology. Mr. Qu currently serves the Company’s Chairman, Chief Executive Officer and President. As used herein, the term “Common Stock” means the common stock of BPGI, $0.001 par value per share.

 

BPGI is headquartered and maintains its principal operations in the city of Yantai, Shandong Province, China, and conducts business operations exclusively in the PRC.

 

8
 

 

2. LIQUIDITY AND FINANCIAL CONDITION

 

The Company’s net income amounted to $6,395,512 for the three month periods ended September 30, 2012. The Company’s cash flows from operations amounted to approximately $1,581,692 for the three months ended September 30, 2012. The Company had working capital of approximately $39,253,442 as of September 30, 2012, including a $9,405,000 convertible note obligation, which pursuant to an amendment thereto was set to mature on April 5, 2012 (see below and Note 10) but excluding a $713,233 derivative liability for the fair value of warrants that are not expected to result in a cash settlement. The Company has historically financed its operations principally from cash flows generated from operating activities and external financing raised in private placement transactions completed concurrently with and subsequent to the consummation of the Share Exchange.

 

On August 8, 2011, the Company, through WFOE II, a newly formed limited liability company formed under the laws of the PRC and wholly owned by Chance High (the Company’s wholly-owned subsidiary), signed a share transfer agreement with the shareholders acquired 100% of YantaiTianzheng for total purchase consideration of US$35,000,000 (paid in its RMB equivalent, of which US$6,000,000 was paid as of the Execution Date of the acquisition and the remaining $29,000,000 was payable in series of installments which the Company at its discretion, could elect to defer (Note 11). The Company paid $3,700,000 and elected to defer $25,300,000. As of September 30, 2012, $5,000,000 installment that has not been converted is due on February 8, 2013, $8,300,000 is due on February 8, 2014 and the remaining and therefore classified as a current liability in the accompanying balance sheet$12,000,000 is due on August 8, 2014.

 

The Company has expanded its existing product lines through the acquisition of Yantai Tianzheng and is expecting to gain the benefits of the economies of scale that management believes could be realized by combining and streamlining the cost structures of the historical Bohai and the acquired Yantai Tianzheng business. On June 8, 2010, Yantai Huanghai Construction Co. signed an agreement with Yantai Tianzheng to perform certain portions of a factory construction located at the premises of Yantai Tianzheng. The total contract price is approximately $3.07 million (RMB 19.5 million) and the construction is estimated to be completed by the end of December 2012. The remaining commitment of the contract was approximately $1.25 million (RMB 7.9 million) as of September 30, 2012.

 

Management believes, based on the Company’s historical ability to fund operations using internally generated cash flow and the progress made towards expanding the business through the Yantai Tianzheng acquisition, that the Company’s currently available cash and funds it expects to generate from operations will enable it to operate the business and satisfy short term obligations through at least October 1, 2013.

 

Notwithstanding, the Company still has substantial obligations described herein and there is no assurance that unforeseen circumstances would not have a material adverse effect on the Company’s financial condition.

 

As described above, the Company has ongoing obligations with respect to the Yantai Tianzheng acquisition, whether or not the intended benefits of the acquisition are realized. The Company is also required to repay the remaining $9,405,000 balance due on the Company’s convertible notes, which pursuant to a series of amendments to the original credit agreement, were due on October 5, 2012. As described in Note 10, the Company has been unable to convert a sufficient number of RMBs into US dollars due to certain currency restrictions in China. The non-payment of the notes in the absence of a further extension of the maturity date constitutes an event of default under the terms of loan agreement. The Company cannot predict what the implications of the non-payment of the loan will be other than it is continuing to experience difficulty converting sufficiency currency and will maintain an escrow account of restricted funds intended to secure their repayment. The non-payment of the note could have a material adverse effect on the Company should the note holders pursue further action.

 

The Company will require significant additional capital in order to fund these obligations and execute its longer term business plan. If the Company is unable to generate sufficient operating cash flows or raise additional capital, or encounters unforeseen circumstances that place constraints on its capital resources, management will be required to take various measures to conserve liquidity. Such measures could include, but not necessarily be limited to, curtailing the Company’s business development activities, suspending the pursuit of one or more elements of its business plan, and controlling overhead expenses. There is a material risk, and management cannot provide any assurances, that the Company will raise additional capital if needed. The Company has not received any commitments for new financing, and cannot provide any assurance that new financing will be available to the Company on acceptable terms, if at all. The failure of the Company to fund its obligations when needed would have a material adverse effect on its business and results of operations.

 

9
 

 

3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Principles of Consolidation

 

The accompanying consolidated financial statements include the accounts of BPGI, its wholly-owned subsidiary Chance High, WFOE, WFOE II, Yantai Tianzheng and Bohai. All significant intercompany accounts and transactions have been eliminated in consolidation.

 

The Company, in determining whether it is required to consolidate investee businesses, considers both the voting and variable interest models of consolidation as required under applicable GAAP. The Company adopted FAS Accounting Standards Codification (“ASC”) 810-10-15-14 and also ASC 810-10-05-8, which requires that a VIE be consolidated if that company is entitled to receive a majority of the VIE’s residual returns and has direct ability to make decisions on all operating activities of the VIE. The Company controls Bohai through the VIE Agreements described in Note 1, under the following series of agreements entered into on December 7, 2009.

 

Under the Operating Agreement entered into between WFOE and Bohai, the WFOE has the direct ability to make decisions on all the operating activities and exercise all voting rights of Bohai. Under the Consulting Services Agreement entered into between WFOE and Bohai, Bohai agreed to pay all of its net income to WFOE quarterly as a consulting fee. Accordingly, WFOE has the right to receive the expected residual returns of Bohai. As such, the Company is the primary beneficiary of and maintains controlling managerial and financial interest in, Bohai in accordance with ASC 810-10-15-14. Accordingly, Bohai’s financial position and results of operations are consolidated with those of the Company for all periods presented.

 

We initially measured the assets, liabilities, and non-controlling interests of Bohai at their carrying amounts as of the date of the Share Exchange. We have subsequently accounted for the assets, liabilities, and non-controlling interest of Bohai as if it was consolidated based on voting interests. The usual accounting rules for which the VIE operates are applied as they would to a consolidated subsidiary as follows:

 

  · Carrying amounts of the VIE are consolidated into the financial statements of the Company as the primary beneficiary, or Primary Beneficiary (“PB”); and

 

  · Inter-company transactions and balances, such as revenues and costs, receivables and payables between or among the PB and the VIE(s) are eliminated in their entirety.

 

The carrying amount and classification of Bohai’s assets and liabilities included in the condensed consolidated balance sheets are as follows:

 

   September 30,   June 30, 
   2012
(unaudited)
   2012 
         
Total current assets*  $57,038,275   $51,470,381 
Total assets*   105,262,029    99,899,826 
Total current liabilities**   12,168,454    11,689,137 
Total liabilities**  $15,913,546   $15,277,230 

 

*           Includes intercompany accounts in the amounts of $20,665,786 and $20,338,295 in current assets as of September 30, 2012 and June 30, 2012, respectively, that were eliminated in consolidation.

 

**        Includes intercompany accounts in the amounts of $2,485,725 and $2,490,528 in current liabilities as of September 30, 2012 and June 30, 2012, respectively, that were eliminated in consolidation.

 

Basis of Presentation

 

The condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial statements and with the instructions to Form 10-Q and Article 8 of Regulation S-X of the United States Securities and Exchange Commission (“SEC”). Accordingly, they do not contain all information and footnotes required by GAAP for annual financial statements. In the opinion of the Company’s management, the accompanying unaudited condensed consolidated financial statements contain all adjustments necessary (consisting only of normal recurring accruals) to present the financial position of the Company as of September 30, 2012 and the results of operations and cash flows for the periods presented. The results of operations for the three months ended September 30, 2012 are not necessarily indicative of the operating results for the full fiscal year or any future period. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes thereto included in the Company’s Annual Report on Form 10-K for the year ended June 30, 2012. The Company’s accounting policies are described in the Notes to Consolidated Financial Statements in its Annual Report on Form 10-K for the year ended June 30, 2012, filed on September 28, 2012, and updated, as necessary, in this Quarterly Report on Form 10-Q.

 

10
 

 

Reclassifications

 

Certain amounts in the September 30, 2011 condensed consolidated financial statements have been reclassified to conform to the September 30, 2012 presentation.

 

Business Segments

 

The Company’s operates its business through a single reporting segment.

 

Use of Estimates

 

The preparation of the condensed consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Management makes these estimates using the best information available at the time the estimates are made; however, actual results could differ materially from those results.

 

Significant estimates and assumptions include allocating purchase consideration issued in business combinations, valuing equity securities and derivative financial instruments issued in financing transactions and in share-based payment arrangements, accounts receivable reserves, inventory reserves, and the carrying amounts of intangible assets. Certain estimates, including accounts receivable and inventory reserves and the carrying amounts of intangible assets (including present value of future cash flow estimates for the Company’s pharmaceutical formulas) could be affected by external conditions including those unique to the Company’s industry and general economic conditions. It is reasonably possible that these external factors could have an effect on management’s estimates that could cause actual results to differ from management’s estimates.

 

Company management re-evaluates all of accounting estimates at least quarterly based on these conditions and record adjustments, when necessary.

 

Cash and Cash Equivalents

 

We consider all highly liquid investments purchased with original maturities of three months or less to be cash equivalents. We maintain bank accounts in the PRC and a checking account in the United States of America that principally consist of demand deposits. We also have restricted cash accounts in the United States that include funds designated for interest payments due to convertible note holders and for use in investor relations programs pursuant to a securities purchase agreement.

 

Restricted Cash

 

The Company is required by its Note holders to maintain deposits in escrow accounts to fund the principal and interest payments under that Notes. Escrow account balances amounted to $9,332,186 and $9,449,905 as of September 30, 2012 and June 30, 2012, respectively. As of September 30, 2012, the Company had one escrow account in China amounting to $9,325,851 and one escrow account in US amounting to $6,335. As of June 30, 2012, the Company had one escrow account in China amounting to $9,343,870 and one escrow account in US amounting to $106,035.

 

Accounts Receivable

 

Accounts receivable consists of amounts due from customers. We extend unsecured credit to our customers in the ordinary course of business but mitigate the associated risks by performing credit checks and actively pursuing past due accounts. An allowance for doubtful accounts is established and determined based on management’s assessment of known requirements, aging of receivables, payment history, the customer’s current credit worthiness and the economic environment. As of September 30, 2012 and June 30, 2012, no allowance for doubtful accounts was deemed necessary based on management’s assessment.

 

11
 

 

Inventories

 

Inventories are valued at the lower of cost, determined using the weighted average method, or market. Finished goods inventories include the costs of raw materials, direct labor and overhead associated with the manufacturing process. In assessing the ultimate realization of inventories, management makes judgments as to future demand requirements compared to current or committed inventory levels. Our reserve requirements generally increase/decrease due to management’s projected demand requirements, market conditions and product life cycle changes. As of September 30, 2012 and June 30, 2012, management does not believe that any inventory reserves are necessary.

 

Property, Plant and Equipment

 

Property, plant and equipment are carried at cost and are depreciated on a straight-line basis over the estimated useful lives of the assets which range from 5 to 10 years for office equipment, machinery, and vehicles and 30 to 40 years for buildings. The cost of repairs and maintenance is charged to expense as incurred; major replacements and improvements are capitalized. When assets are retired or disposed of, the cost and accumulated depreciation are removed from the accounts, and any resulting gains or losses are included in income in the year of disposition. We examine the possibility of impairment in the value of fixed assets when events or changes in circumstances reflect the fact that their recorded value may not be recoverable.

 

Intangible Asset – Pharmaceutical Formulas

 

The Company has purchased pharmaceutical formulas that were approved by the State Food and Drug Administration of China (“SFDA”). These formulas can be renewed every 5 years without limitation for a minimum fee and are subject to certain protections under PRC drug regulations for an indefinite period of time. These regulations mitigate competition and the ability of other suppliers to replicate the Company’s products or produce comparable substitutes. These intangible assets are measured initially at cost not subject to amortization and are tested for impairment annually or in interim reporting periods if events or changes in circumstances indicate that the carrying amounts of these intangible asset might not be recoverable.

 

There were no impairment charges to record during the three months ended September 30, 2012 and 2011.

 

Common Stock Purchase Warrants and Other Derivative Financial Instruments

 

The Company accounts for the issuance of common stock purchase warrants issued as free standing financial instruments in accordance with the applicable provisions ASC 810 “Derivatives and Hedging Activities.” Based on this guidance, the Company classifies as equity any contracts that (i) require physical settlement or net-share settlement or (ii) gives the Company a choice of net-cash settlement or settlement in its own shares (physical settlement or net-share settlement). The Company classifies as assets or liabilities any contracts that require net-cash settlement (including a requirement to net cash settle the contract if an event occurs and if that event is outside the control of the Company) or (ii) gives the counterparty a choice of net-cash settlement or settlement in shares (physical settlement or net-share settlement). The Company assesses classification of its freestanding derivatives at each reporting date to determine whether a change in classification between assets and liabilities is required. The Company determined that its freestanding derivatives, which principally consist of warrants to purchase common stock required classification as liability instruments at September 30, 2012 and June 30, 2012 due to the existence of non-standard anti-dilution privileges that caused the warrants to not be indexed to the Company’s own stock.

 

Fair Value Measurements and Fair Value of Financial Instruments

 

We adopted the guidance of ASC 820 for fair value measurements, which clarifies the definition of fair value, prescribes methods for measuring fair value, and establishes a fair value hierarchy to classify the inputs used in measuring fair value as follows:

 

12
 

 

Level 1 - Inputs are unadjusted quoted prices in active markets for identical assets or liabilities available at the measurement date.

 

Level 2 - Inputs are unadjusted quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, inputs other then quoted prices that are observable, and inputs derived from or corroborated by observable market data.

 

Level 3 - Inputs are unobservable inputs which reflect the reporting entity’s own assumptions on what assumptions the market participants would use in pricing the asset or liability based on the best available information.

 

The carrying amounts reported in the condensed consolidated balance sheets for cash, accounts receivable, other receivables, short-term borrowings, accounts payable and accrued expenses, customer advances, and amounts due from related parties approximate their fair market value based on the short-term maturity of these instruments.

 

ASC 825-10 “ Financial Instruments, ” allows entities to voluntarily choose to measure certain financial assets and liabilities at fair value (fair value option). The fair value option may be elected on an instrument-by-instrument basis and is irrevocable, unless a new election date occurs. If the fair value option is elected for an instrument, unrealized gains and losses for that instrument should be reported in earnings at each subsequent reporting date. We use Level 3 inputs to value the Company’s derivative liabilities.

 

The following table reflects gains and losses for the three months ended September 30, 2012 for all financial assets and liabilities categorized as Level 3.

 

Liabilities:  Three
months
(unaudited)
 
     
Balance of warrant liabilities as of June 30, 2012  $1,211,236 
Change in the fair value of warrant liabilities   (498,003)
Balance of warrant liabilities as of September 30, 2012  $713,233 

 

Estimating the fair value of derivative financial instruments require the development of significant and subjective estimates that may, and are likely to, change over the duration of the instrument with related changes in internal and external market factors. The assumptions used to value the Company’s derivatives, which had a direct effect on the fair values described above are more fully described in Note 10. In addition, valuation techniques are sensitive to changes in the trading market price of the our Common Stock and its estimated volatility interest rate changes and other variables or market conditions not within the Company’s control that can significantly affect management’s estimates of fair value and changes in fair value. Because derivative financial instruments are initially and subsequently carried at fair value, the Company’s net income may include significant charges or credits as these estimates and assumptions change.

 

Foreign Currency Translation

 

The Company’s reporting currency is the U.S. dollar. The functional currency of the Company’s operating business based in the PRC is the RMB. For the Company’s subsidiaries and affiliates whose functional currencies are the RMB, results of operations and cash flows are translated at average exchange rates during the period, assets and liabilities are translated at the exchange rate in effect as of the end of the period, and equity is translated at historical exchange rates. Translation adjustments resulting from the process of translating the functional currency financial statements into U.S. dollars are included in comprehensive income.

 

13
 

 

Exchange gains or losses arising from foreign currency transactions are included in the determination of net income for the respective periods. All of the Company’s revenue transactions are transacted in the functional currency. The Company has not entered into any material transactions that are either originated, or to be settled, in currencies other than the RMB. Accordingly, transaction gains or losses have not had, and are not expected to have a material effect on the Company’s results of operations.

 

Period end exchange rates used to translate assets and liabilities and average exchange rates used to translate results of operations in each of the reporting periods are as follows:

 

   Three months 
ended 
September 30, 2012
   Three months 
ended 
September 30, 2011
 
Period end US$: RMB exchange rate   6.3265    6.3952 
Average periodic US$: RMB exchange rate   6.3257    6.4132 

 

The RMB is not freely convertible into any other currencies. In addition, all foreign exchange transactions in the PRC must be conducted through authorized institutions. Accordingly, management cannot provide any assurance that the RMB underlying the condensed consolidated financial statement amounts could have been, or could be, converted into US dollars at the exchange rates used to translate the functional currency into the reporting currency.

 

Revenue Recognition

 

Revenue represents the invoiced value of goods sold recognized upon the delivery of goods to distributors. Pursuant to the guidance of ASC Topic 605 and ASC Topic 36, revenue is recognized when all of the following criteria are met:

 

· Persuasive evidence of an arrangement exists;
· Delivery has occurred or services have been rendered;
· The seller’s price to the buyer is fixed or determinable; and
· Collectability is reasonably assured.

 

We account for sales returns by establishing an accrual in an amount equal to management’s estimate of sales recorded for which the related products are expected to be returned. We determine the estimate of the sales return accrual primarily based on the Company’s historical experience regarding sales returns, but also by considering other factors that could impact sales returns. These factors include levels of inventory in the distribution channel, estimated shelf life, product discontinuances, and price changes of competitive products, introductions of generic products and introductions of competitive new products. For the three months ended September 30, 2012 and 2011, the Company’s sales return rate is low and deemed immaterial and accordingly, no provision for sales returns was recorded.

 

Shipping costs

 

Shipping costs are included in selling, general and administrative expense. Shipping costs amounted to $292,643 and $296,175 for the three months ended September 30, 2012 and 2011, respectively.

 

14
 

 

Advertising and Promotion

 

Advertising and promotion costs are charged to expense as incurred. Advertising and promotion expenses included in selling, general and administrative expenses amounted to $1,613,466 and $3,590,338 for the three months ended September 30, 2012 and 2011, respectively.

 

Income Taxes

 

We are governed by the PRC’s Income Tax Laws and the Internal Revenue Code of the United States. Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement and income tax base of assets and liabilities and operating loss and tax credit carry-forwards. Deferred tax assets are reduced by a valuation allowance to the extent that management concludes it is more likely than not that the benefit of such tax assets will not be realized in future periods. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the periods that include the enactment date.

 

We account for certain tax positions based upon authoritative guidance that prescribes a recognition threshold and measurement processes for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The guidance also provides direction on recognition, classification, interest and penalties, accounting in interim periods and related disclosure.

 

Our policy is to classify assessments, if any, for tax related to interest as interest expense and penalties as general and administrative expense.

 

Earnings per Share

 

We report earnings per share in accordance with ASC Topic 260, “Earnings Per Share”. Basic earnings (loss) per share is computed by dividing net income (loss) by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is computed by dividing net income by the weighted average number of shares of common stock, common stock equivalents and potentially dilutive securities outstanding during the period. Common equivalent shares are excluded from the computation of diluted shares in periods for which they have an anti-dilutive effect. Diluted shares underlying stock options and common stock purchase warrants are included in the determination of diluted earnings per share using the treasury stock method. Diluted shares underlying convertible debt obligations are included in the determination of diluted loss per share using the “if converted” method (Note 14).

 

Recent Accounting Pronouncements

 

In June 2011, the FASB issued ASU No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income. Under the amendments, an entity has the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The presentation option under current GAAP to present the components of other comprehensive income as part of the statement of changes in shareholders’ equity has been eliminated.

 

The amendments in this Update should be applied retrospectively. For public entities, the amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Early adoption is permitted because compliance with amendments is already permitted. The Company already complies with this presentation.

 

In September 2011, the FASB issued guidance on testing goodwill for impairment (ASU 2011-8). The new guidance provides an entity the option to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If an entity determines that this is the case, it is required to perform the currently prescribed two-step goodwill impairment test to identify potential goodwill impairment and measure the amount of goodwill impairment loss to be recognized for that reporting unit (if any). If an entity determines that the fair value of a reporting unit is less than its carrying amount, the two-step goodwill impairment test is not required. The new guidance has already been effective for us from July 1, 2012.

 

15
 

 

In December 2011, the FASB issued guidance on offsetting (netting) assets and liabilities. Entities are required to disclose both gross information and net information about both instruments and transactions eligible for offset in the statement of financial position and instruments and transactions subject to an agreement similar to a master netting arrangement. The new guidance is effective for annual periods beginning after January 1, 2013. Accordingly the Company will adopt this guidance effective July 1, 2013. The Company does not expect this guidance to have a material effect on its condensed consolidated financial statements.

 

4. INVENTORIES

 

Inventories consist of the following:

 

   September 30,   June 30, 
   2012
(unaudited)
   2012 
         
Raw materials  $2,464,483   $2,079,480 
Work in progress   785,480    882,005 
Finished goods   1,044,130    834,430 
Total inventories  $4,294,093   $3,795,915 

 

5. PROPERTY, PLANT AND EQUIPMENT, NET

 

Property, plant and equipment consist of the following:

 

   September 30,   June 30, 
   2012
(unaudited)
   2012 
         
Buildings  $8,911,327   $8,928,545 
Plant equipment   2,531,895    2,490,764 
Office equipment   217,181    208,539 
Motor vehicles   285,060    285,610 
Total   11,945,463    11,913,458 
           
Less: accumulated depreciation   (2,327,226)   (2,188,340)
Construction in progress   1,952,382    1,956,154 
           
Property, plant and equipment, net  $11,570,619   $11,681,272 

 

Depreciation expense for property, plant and equipment for the three months ended September 30, 2012 and 2011 amounted to $143,123 and $148,788, respectively.

 

On June 8, 2010, Yantai Huanghai Construction Co. signed an agreement with Yantai Tianzheng to perform certain portions of a factory construction located at the premises of Yantai Tianzheng. The total contract price is approximately $3.07 million (RMB 19.5 million) and the construction is estimated to be completed by the end of December 2012. The remaining commitment of the contract was approximately $1.25 million (RMB7.9 million) as of September 30, 2012.

 

16
 

 

6. INDEFINITE LIVED INTANGIBLE ASSETS – PHARMACEUTICAL FORMULAS

 

The Company purchased , and currently owns exclusive rights to, a series of pharmaceutical formulas that were approved by the State Food and Drug Administration of China (“SFDA”). This asset includes 14 formulas that are included in the Chinese government’s Essential Drug List (“EDL”) and an additional 5 medicines are included in the National Drug Reimbursement List (“NDRL”). The intellectual property underlying these formulas can be renewed every 5 years without limitation for a nominal fee and are subject to certain protections under PRC drug regulations for an indefinite period of time. These regulations mitigate competition and the ability of other suppliers to replicate the Company’s products or produce comparable substitutes. These intangible assets are measured initially at cost not subject to amortization and are tested for impairment annually or in interim reporting periods if events or changes in circumstances indicate that the carrying amounts of these intangible asset might not be recoverable.

 

Pharmaceutical formulas with indefinite lives consist of the following:

 

  

September 30, 2012

(unaudited)

   June 30, 2012 
         
Pharmaceutical formulas, without amortization, at cost  $25,561,170   $25,610,557 

 

The Company’s active products that are currently generating revenues were derived from formulas that have an aggregate carrying amount of $16,439,373. Product formulas representing a substantial majority of the remaining carrying amount were purchased in December 2010. The Company is currently evaluating new product candidates to be derived from these formulas that it would market in future periods. In addition, drug product formulas are transferrable in the PRC and as such could be sold to approved purchasers as an alternative means of recovery.

 

7. LONG TERM PREPAYMENTS - LAND USE RIGHTS, NET

 

   September 30,   June 30, 
   2012
(unaudited)
   2012 
         
Land use rights, at cost  $20,201,591   $20,240,623 
Less: Accumulated amortization   (1,660,974)   (1,501,326)
Intangible assets – land use rights, net  $18,540,617   $18,739,297 

 

There is no private ownership of land in the PRC. All land is owned by the government, which grants land use rights for specified periods of time. Amortization expense for land use right amounted $162,563 and $148,966 for the three months ended September 30, 2012 and 2011, respectively. Amortization is calculated over a period of 50 years. Amortization of land use rights for fiscal years ending subsequent to September 30, 2012 is as follows:

 

   Amortization 
Remainder of FY2013  $487,689 
2014   650,252 
2015   650,252 
2016   650,252 
2017   650,252 
Thereafter   15,451,920 
Total  $18,540,617 

 

17
 

 

8. OTHER INTANGIBLE ASSETS, NET

 

Other Intangible assets, net includes customer relationships and certain non-prescription drug product formulas that are sold over the counter. The Company acquired these assets in its business combination with YantaiTianzheng. Customer relationships are amortized on a straight line basis over periods of 5 and 8 years. Pharmaceutical formulas are amortized on a straight line basis over periods of 8 years.

 

Other intangible assets – net at September 30, 2012 as follow:

 

   Customer
Relationships
   Drug
Formulas
   Total 
   (unaudited)   (unaudited)   (unaudited) 
Cost  $14,457,599   $10,102,110   $24,559,709 
                
Accumulated Amortization   (2,300,640)   (1,580,830)   (3,881,470)
                
Net carrying amount  $12,156,959   $8,521,280   $20,678,239 

 

Amortization expense for customer relationships amounted $460,186 and $453,906 for the three months ended September 30, 2012 and 2011, respectively. Amortization expense for drug formulas amounted $318,106 and $0 for the three months ended September 30, 2012 and 2011, respectively. Amortization expenses are recorded in general and administrative expenses.

 

Amortization expense for fiscal years ending subsequent to September 30, 2012 is as follows:

 

   Amortization 
Remainder of FY2013  $2,334,878 
2014   3,113,171 
2015   3,113,171 
2016   3,113,171 
2017   3,113,171 
Thereafter   5,890,677 
Total  $20,678,239 

 

9. ACCRUED EXPENSES

 

Accrued expense consists of the following:

 

   September 30,   June 30, 
   2012
(unaudited)
   2012 
         
Accrued expense to sales person  $3,544,087   $3,778,996 
Other taxes payable   1,908,381    1,879,334 
Other accrued expense   1,540,094    2,073,741 
Accrued payroll and welfare   347,892    357,975 
Accrued advertising expense   387,260    388,008 
Total  $7,727,712   $8,478,054 

 

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10. CONVERTIBLE PROMISSORY NOTES IN DEFAULT AND DUE ON DEMAND

 

Convertible Notes

 

On January 5, 2010, pursuant to a Securities Purchase Agreement (the “Securities Purchase Agreement”) with 128 accredited investors (the “Investors”), BPGI sold 6,000,000 units for aggregate gross proceeds of $12,000,000, each unit consisting of an 8% senior convertible promissory note in the principal amount of $2 and one Common Stock purchase warrant (collectively, the “Investor Warrants”). By agreement with the Investors, each investor received: (i) A single Note representing the aggregate number of Notes purchased by them as part of the units (each, a “Note” and collectively, the “Notes”) and (ii) a single Investor Warrant exercisable at $2.40 per share subject to certain anti-dilution provisions. The majority of this debt is guaranteed by third-parties and our CEO, Mr. Qu, and a portion is secured by our inventories and fixed assets.

 

The Notes bear interest at 8% per annum, payable quarterly in arrears on the last day of each fiscal quarter of the Company. Principal is due on January 5, 2012. Each Note, plus all accrued but unpaid interest thereon, is convertible, in whole but not in part, at any time at the option of the holder, into shares of Common Stock at a conversion price of $2.00 per share, subject to adjustments for certain anti-dilution provisions.

 

The Convertible Notes were initially recorded at a discounted carrying amount of zero as a result of having allocated a portion of the proceeds to (i) the fair value of the warrants, which were recorded as liabilities stated at fair value, and (ii) a beneficial conversion feature that was not bifurcated as a free standing derivative at the time of issuance or at subsequent reporting dates based on periodic classification assessments. Accretion of the note discount amounted to $0 and $2,119,387 for the three months ended September 30, 2012 and 2011, respectively. Accretion of the discount was recorded as a component of interest expense in the accompanying statements of income and comprehensive income. Contractual interest expense amounted to $0 and $2,328,387 for the three months ended September 30, 2012 and 2011, respectively. There is an aggregate of 4,702,500 shares of Common Stock issuable under all remaining convertible notes as of September 30, 2012.

 

The Notes contain certain events of default, including non-payment of interest or principal when due, bankruptcy, failure to maintain a listing of the Common Stock or to make required filings on a timely basis. No premium is payable by us if an event of default occurs. However, upon an Event of Default, and provided no more than 50% of the aggregate face amount of the Notes have been converted, the Investors holding Notes have the right to receive a portion, based on their pro-rata participation in the transaction, of 1,000,000 shares of our Common Stock that have been placed in escrow by our principal shareholder. The shares in escrow will be returned to our principal shareholder when 50% of the aggregate face amount of the Notes has been converted or, if later, when the Notes are repaid.

 

On December 31, 2011, the Company’s Chinese operating subsidiary was unable to convert a sufficient number of RMB’s needed to repay the notes on their maturity date of January 5, 2012. As a result, the Company entered into a series of amendments to the Notes with Euro Pacific as representative of the Investors to extend to the maturity date and increase the interest rate on the Notes. Pursuant to the most recent amendment, the maturity date of the notes was extended October 5, 2012 and the interest rate was increased to 12% per annum.

 

On June 27, 2012, Euro Pacific also agreed to release us from certain restrictions on our ability to incur debt, to incur liens or to make capital expenditures as stipulated in the note agreement. The purpose of the Third Amendment is to provide us with enhanced flexibility to seek potential sources of financing.

 

As of the date of this Quarterly Report, the Company continues to work on converting RMB to Dollars on converting RMB to Dollars in order to make payments under the Notes. However, the Company was not able to accomplish this by the October 5, 2012 maturity date under the Notes. The non-payment of the Note in the absence of an extension of the maturity date constituted an event of default under the terms of loan agreement and could have a material adverse effect on the Company.

 

The Company is currently working with Euro Pacific as representative of the Investors on a fourth amendment to the Notes which would further extend the maturity date of the Notes from October 5, 2012 to April 5, 2013. As of the date of this Quarterly Report, no written agreement has been entered into in this regard. The Company cannot predict what the implications of the non-payment of the loan would be other than the continued difficulty of repaying the loan from escrowed funds due to currency conversion restrictions.

 

19
 

 

The Company has, however, paid the quarterly interest due under the Notes as of October 5, 2012 in two installments, with the final payment delivered October 31, 2012. In addition, the Company is currently seeking to repay $0.94 million as a portion of the principal payment before November 30, 2012. Based on its discussions with Euro Pacific, in the event the $0.94 million principal is received before November 30, 2012, the Company and Euro Pacific expect to (i) enter into a Fourth Amendment to the Notes to extend the maturity date thereof from October 5, 2012 to April 5, 2013; and (ii) maintain the interest rate on the Notes at an annual rate of 12% (which was previously increased from the original 8% in consideration of extending the maturity date of the Notes).

 

As of January 5, 2010 and at September 30, 2012 and June 30, 2012, the Company’s principal shareholder, Mr. Qu, is obligated to deliver 1,000,000 shares of Common Stock to the Investors if certain Events of Default occur.

 

11. ACQUISITION PURCHASE PRICE PAYABLE

 

On August 8, 2011, the Company, through WFOE II, acquires 100% of Yantai Tianzheng’s equity interests for total purchase consideration of US$35,000,000 (paid in its RMB equivalent) of which US$6,000,000 was paid as of the Execution Date of the acquisition the remaining $29,000,000 was due in a series of contractual installments.

 

Certain provisions in the acquisition agreement provided the Company with the ability to elect, at its own discretion, to automatically convert any portion or all of the any installment payment due into a two-year term loan, with interest accruing at the rate of six percent (6%) per annum. As of September 30, 2012, $9,700,000 was paid, and the balance of $25,300,000 is payable as follows; $5,000,000 is due on February 8, 2013; $8,300,000 is due on February 8, 2014; and the remaining $12,000,000 is due on August 8, 2014.

 

12. COMMITMENTS, CONTINGENCIES AND OTHER MATTERS

 

(a) Contract Research and Development Arrangement

 

On May 2009, the Company entered into a contract with Yantai Tianzheng Medicine Research and Development Co. to perform research and development on two new pharmaceutical products, namely Fern Injection and Forsythia Capsule. The total contract price is approximately $2,345,509 (RMB 15,000,000). Yantai Tianzheng Medicine Research and Development Co. is committed to complete all research work required for the clinical trial within 3 years. As of September 30, 2012, the Company has paid $1,305,339 (RMB 8,300,000) and the remaining contract amount will be paid progressively in installments. All payments of $1,305,339 (RMB 8,300,000) have been recorded as expenses. The Company has extended the contract with Yantai Tianzheng Medicine Research and Development Co. to May 10, 2017. Total contract price will remain the same. No refund will be received by the Company due to the delay because the delay is caused by the change of the government regulatory requirements instead of Yantai Tianzheng Medicine Research and Development Co.’s mistakes. Research and development costs associated with this contract amounted to $0 and $0 for the three months ended September 30, 2012 and 2011, respectively.

 

(b) Supplier Concentrations

 

We have the following concentrations of business with each supplier constituting greater than 10% of the Company’s purchases of raw materials or other supplies:

 

   Three months   Three months 
   ended   ended 
   September 30,   September 30, 
   2012
(unaudited)
   2011 
          
Shandong Yantai Medicine Procurement and Supply Station   26.9%   *%
Anguo Jinkangdi Chinese Herbal Medicine Co. Ltd   *%   10.3%
Anhui DeChang Pharmaceutical Co. Ltd.   *%   12.9%

 

* Constitutes less than 10% of the Company’s purchases.

 

20
 

 

We had a commitment to purchase certain raw materials totaling $1,537,643 as of September 30, 2012 that was fulfilled upon the delivery of the goods in October 2012.

 

(c) Sales Product Concentrations

 

Five of the Company’s products, namely Tongbi Capsules, Tongbi Tablets, Lung Nourishing Syrup, Zhengxintai Capsules and Fangfengtongsheng Tablets represented approximately 25.6%, 9.6%, 15.0%, 11.7% and 18.5%, respectively, of total sales for the three months ended September 30, 2012.

 

Five of our products, namely Tongbi Capsules, Tongbi Tablets, Lung Nourishing Syrup, Zhengxintai Capsules and Fangfengtongsheng Tablets represented approximately 22.5%, 9.4%, 17.7%, 9.9% and 16.5%, respectively, of total sales for the three months ended September 30, 2011.

 

(d) Economic and Political Risks

 

The Company’s operations are conducted solely in the PRC. There are significant risks associated with doing business in the PRC, which include, among others, political, economic, legal and foreign currency exchange risks. The Company’s results may be adversely affected by changes in political and social conditions in the PRC, and by changes in governmental policies with respect to laws and regulations, anti-inflationary measures, currency conversion, remittances abroad, and rates and methods of taxation, among other things.

 

(e) Concentrations of Credit Risk

 

Financial instruments which potentially subject us to concentrations of credit risk consist principally of cash and trade accounts receivable. Substantially all of the Company’s cash is deposited in state-owned banks within the PRC, and no deposits are covered by insurance. We have not experienced any losses in such accounts and believe that the Company’s loss exposure is insignificant due to the fact that banks in the PRC are state owned and are generally high credit quality financial institutions. A significant portion of the Company’s sales are credit sales which are made primarily to customers whose ability to pay are dependent upon the industry economics prevailing in these areas. We continually monitor the credit worthiness of the Company’s customers in an effort to reduce credit risk.

 

At September 30, 2012 and June 30, 2012, the Company’s cash balances by geographic area were as follows:

 

   September 30,   June 30, 
   2012
(unaudited)
   2012 
Country:                    
United States  $12,772    0.07%  $23,406    0.13%
China   19,366,388    99.93%   18,362,882    99.87%
Total cash and cash equivalents  $19,379,160    100%  $18,386,288    100%

 

21
 

 

(f) Certificate of land use right

 

The Company’s corporate headquarters is located at No. 9 Daxin Road, Zhifu District, Yantai, Shandong Province in China. Under the current PRC laws, land is owned by the state, and parcels of land in rural areas which are known as collective land are owned by the rural collective economic organization. “Land use rights” are granted to an individual or entity after payment of a land use right fee is made to the applicable state or rural collective economic organization. Land use rights allow the holder of the right to use the land for a specified long-term period. We have a land use right, expiring in 2047, for a total of approximately 30,637 square meters of land, on which the Company maintains its manufacturing facility. The Company has not obtained a land use right certificate for a piece of land located in Xingfu Twelve Village of Zhifu District with the area of 11,222 square meters, on which the Company maintains its corporate headquarters. In the process of the planning of Yantai City, the usage of the aforesaid land use right has been changed from “industrial use” to “commercial use” and therefore, the approval process for the land use right certificates on five relevant parcels of land including the land occupied by us is suspended until the completion of the planning. We cannot provide any assurance that the Company will eventually obtain the land use right certificate for this land. If the Company is asked by the local government to relocate the Company’s facility, management believes that estimated relocation and other costs will be reimbursed by the local government. The Company does not believe that a requirement to relocate operations would have a material adverse effect on the business.

 

(g) Business insurance

 

Business insurance is not readily available in the PRC. To the extent that the Company suffers a loss of a type which would normally be covered by insurance in the United States, such as product liability and general liability insurance, the Company would incur significant expenses in both defending any action and in paying any claims that could result from a settlement or judgment.

 

13. NET INCOME PER SHARE

 

Basic earnings per share is computed on the basis of the weighted average number of shares of Common Stock outstanding during the period. Diluted earnings per share is computed on the basis of the weighted average number of shares of Common Stock plus the effect of potentially dilutive common shares outstanding during the period using the if-converted method for the convertible debt and equity securities and the treasury stock method for stock options and common stock purchase warrants. The following table sets forth the computation of basic and diluted net income per common share:

 

   Three months ended   Three months ended 
   September 30, 2012
(unaudited)
   September 30, 2011
(unaudited)
 
         
Net income available to common stockholders-basic  $6,395,512   $2,655,784 
Effective interest on convertible notes and amortization of debt issue costs   -      
Net income available for common shareholders – diluted  $6,395,512   $2,655,784 

 

   Three months ended   Three months ended 
   September 30, 2012
(unaudited)
   September 30, 2011
(unaudited)
 
Weighted average number of common shares outstanding - basic   17,861,085    17,861,085 
Common shares if converted from Convertible Debt   4,702,500      
Weighted average number of common shares outstanding - diluted   22,563,585    17,861,085 
           
Earnings per share:          
Basic  $0.36   $0.15 
Diluted  $0.28   $0.15 

 

Warrants to purchase 6,600,000 shares of Common Stock and stock options to purchase 32,000 shares of Common Stock were outstanding as of September 30, 2012 and 2011 but both 6,600,000 shares of Common Stock and 32,000 shares of options were excluded from the computation of diluted earnings per share where applicable as the exercise prices of these securities exceeded the average stock prices for the three months ended September 30, 2012 and 2011. Further, we excluded 5,225,000 shares issuable upon conversion of the convertible notes from the computation of diluted EPS in 2011 as the effects of these shares are also antidilutive.

 

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14. OPERATING EXPENSE

 

For the three months ended September 30, 2012 and 2011, operating expenses consisted of the following:

 

   Three months ended   Three months ended 
   September 30, 2012
(unaudited)
   September 30, 2011
(unaudited)
 
         
Travel and accommodation  $6,392,974   $3,821,987 
Advertising and promotion   1,613,466    3,590,338 
Audit fees and expenses   69,593    53,175 
Commission   2,166,397    1,048,311 
Conferences   4,191,096    4,421,114 
Depreciation and amortization   958,900    629,599 
Staff costs   498,365    551,715 
           
Other operating expenses   2,275,215    2,118,250 
           
Total Operating expenses  $18,166,006   $16,234,489 

 

15. INCOME TAXES

 

The Company is incorporated under the laws of State of Nevada in the United States of America and has legal subsidiaries in the British Virgin Islands (“BVI”) and the PRC. The Company does not have any employees or assets nor or is it engaged in any income producing activities in the Unites States and in the BVI. The Company is currently filing Federal income tax returns in the United States and applicable franchise tax returns in the state of Nevada. The Company’s net operating losses that may be available to offset future taxable income in the United States, if any, amount to approximately $9,000,000 and expire through 2031. The Company has fully reserved for these and all other deferred tax assets generated in the Company’s US operations since it currently more likely than not that such assets will not be realized in future periods.

 

The Company’s only income producing activities are in the PRC. The statutory corporation income tax rate in the PRC is 25%, which is approximately equal to the effective income tax rate that the Company expects to use when recording income tax expense for financial reporting purposes for the year ending June 30, 2013. Accordingly, the Company is recording a tax provision at interim reporting dates for taxable income earned in the PRC using the effective rate expected to be in effect for the year ending June 30, 2013.

 

23
 

 

16. VIE

 

To satisfy PRC laws and regulations, the Company conducts certain business in the PRC through the VIEs.

 

Resulting from the VIE Agreement signed between YantaiShencaojishi Pharmaceuticals Co., Ltd (“WFOE”) and YantaiBohai Pharmaceuticals Group Co. Ltd (“Bohai”), the Company includes the assets, liabilities, revenues and expenses of YantaiBohai Pharmaceuticals Group Co. Ltd (the “VIE”) in its consolidated financial statements.

 

Substantially all of the Company’s assets, including those of Bohai which is considered the VIE and Yantai Tianzheng, which is an acquired subsidiary of the Company are accessible to Bohai through WFOE II creditors irrespective of the VIE arrangement.

 

The VIE Agreements include:

 

Equity Interest Pledge Agreement. The WFOE and Bohai Shareholders have entered into Equity Interest Pledge Agreements, pursuant to which each Bohai Shareholder has pledged all of his shares of Bohai to the WFOE in order to guarantee cash-flow payments under the applicable Consulting Services Agreement. The Equity Pledge Agreement further entitles the WFOE to collect dividends from Bohai during the term of the pledge.

 

Consulting Service Agreement. Bohai and the WFOE has entered into a Consulting Services Agreement, which provides that the WFOE will be the exclusive provider of technology services to Bohai and Bohai will pay all of its net income based on the quarterly financial statements to the WFOE for such services. Any such payment from the WFOE to the Company would need to comply with applicable Chinese laws affecting payments from Chinese companies to non-Chinese companies. See “Risk Factors – Risks Associated With Doing Business in China.”

 

Operating Agreement. Pursuant to the operating agreement among the WFOE, Bohai and each of Bohai Shareholder, the WFOE provides guidance and instructions on Bohai’s daily operations and financial affairs. The Bohai Shareholders must designate the candidates recommended by the WFOE as their representatives on their respective boards of directors. The WFOE has the right to appoint senior executives of Bohai. In addition, the WFOE agrees to guarantee Bohai’s performance under any agreements or arrangements relating to Bohai’s business arrangements with any third party. Bohai, in return, agrees to pledge its accounts receivable and all of its assets to the WFOE. Moreover, Bohai agrees that without the prior consent of the WFOE, Bohai will not engage in any transactions that could materially affect its assets, liabilities, rights or operations, including, without limitation, incurrence or assumption of any indebtedness, sale or purchase of any assets or rights, incurrence of any encumbrance on any of its assets or intellectual property rights in favor of a third party or transfer of any agreements relating to its business operation to any third party.

 

These contractual arrangements may not be as effective in providing the Company with control over the VIEs as direct ownership. Due to its VIEs structure, the Company has to rely on contract right to effect control and management of the VIEs, which exposes it to the risk of potential breach of contract by the shareholders of Yantai Bohai Pharmaceuticals Group Co. Ltd. Our VIE Agreements are subject to significant risks as set forth in the following risk factors.

 

  £ The PRC government may determine that the VIE Agreements which we utilize to control our operating subsidiary Bohai are not in compliance with applicable PRC laws, rules and regulations and that they are therefore unenforceable.

 

24
 

 

  £ There are risks involved with the operation of Bohai under the VIE Agreements. We have been advised by PRC legal counsel that if the PRC government determines the VIE Agreement used to control the operating company to be unenforceable as they circumvent the PRC restrictions relating to foreign investment restrictions, the relevant regulatory authorities would have broad discretion in dealing with such breach and could have a material adverse impact on our business, financial condition and results of operations.

 

  £ We depend upon the VIE Agreements in conducting our production, manufacturing, and distribution of traditional Chinese herbal medicines in the PRC, which may not be as effective as direct ownership.

 

  £ We conduct our production, manufacturing and distribution of traditional Chinese herbal medicines in the PRC and generate the revenues from our Bohai business through the VIE Agreements. The VIE Agreements may not be as effective in providing us with control over Bohai as direct ownership. The VIE Agreements are governed by PRC laws and provide for the resolution of disputes through arbitration proceedings pursuant to PRC laws. Accordingly, the VIE Agreements will be interpreted in accordance with PRC laws. If Bohai or its Shareholders fail to perform the obligations under the VIE Agreements, we may have to rely on legal remedies under PRC laws, including seeking specific performance or injunctive relief, and claiming damages, and there is a risk that we may be unable to obtain these remedies. The legal environment in China is not as developed as in other jurisdictions. As a result, uncertainties in the PRC legal system could limit our ability to enforce the VIE Agreements.

 

  ¨ The pricing arrangement under the VIE Agreements may be challenged by the PRC tax authorities.

 

  £ We could face adverse tax consequences if the PRC tax authorities determine that the VIE Agreements were not entered into based on arm’s length negotiations. If the PRC tax authorities determine that the VIE Agreements were not entered into on an arm’s length basis, they may adjust the income and expenses of our Company for PRC tax purposes which could result in higher tax liability

 

17. SUBSEQUENT EVENTS

 

In preparing these financial statements, the Company has evaluated events and transactions for potential recognition or disclosure through the reporting date, the date the financial statements were available to be issued.

As of the date of this Quarterly Report, the Company continues to work on converting RMB to Dollars on converting RMB to Dollars in order to make payments under the Notes. However, the Company was not able to accomplish this by the October 5, 2012 maturity date under the Notes. The non-payment of the Note in the absence of an extension of the maturity date constituted an event of default under the terms of loan agreement and could have a material adverse effect on the Company.

 

The Company is currently working with Euro Pacific as representative of the Investors on a fourth amendment to the Notes which would further extend the maturity date of the Notes from October 5, 2012 to January 5, 2013. As of the date of this Quarterly Report, no written agreement has been entered into in this regard. The Company cannot predict what the implications of the non-payment of the loan would be other than the continued difficulty of repaying the loan from escrowed funds due to currency conversion restrictions.

 

The Company has, however, paid the quarterly interest due under the Notes as of October 5, 2012 in two installments, with the final payment delivered October 31, 2012. In addition, the Company is currently seeking to repay $0.94 million as a portion of the principal payment before November 30, 2012. Based on its discussions with Euro Pacific, in the event the $0.94 million principal is received before November 30, 2012, the Company and Euro Pacific expect to (i) enter into a Fourth Amendment to the Notes to extend the maturity date thereof from October 5, 2012 to April 5, 2013; and (ii) maintain the interest rate on the Notes at an annual rate of 12% (which was previously increased from the original 8% in consideration of extending the maturity date of the Notes).

 

 

25
 

 

Item 2. Management’s Discussion and Analysis of Financial Conditions of Operations.

 

The following discussion and analysis of financial condition and results of operations relates to the operations and financial condition reported in our unaudited condensed consolidated financial statements for the three months ended September 30, 2012, and should be read in conjunction with such financial statements and related notes included in this report. Those statements in the following discussion that are not historical in nature should be considered to be forward looking statements that are inherently uncertain. Actual results and the timing of the events may differ materially from those contained in these forward looking statements due to a number of factors, including those discussed in the “Cautionary Note on Forward Looking Statements” set forth elsewhere in this Report.

 

Overview

 

We are engaged in the production, manufacturing and distribution in China of herbal pharmaceuticals based on traditional Chinese medicine, which we refer to herein as Traditional Chinese Medicine, or TCM. We are based in the city of Yantai, Shandong Province, China and our operations are exclusively in China.

 

Our medicines address rheumatoid arthritis, viral infections, gynecological diseases, cardio vascular issues and respiratory diseases. Our initial operating subsidiary Bohai obtained Drug Approval Numbers (or DANs) for 29 varieties of traditional Chinese herbal medicines in 2004, an additional 14 varieties in December 2010. Through our acquisition of Yantai Tianzheng in August 2011, we obtained DANs for another 5 varieties in August 2011. We currently produce 11 varieties of approved traditional Chinese herbal medicines in seven delivery systems: tablets, granules, capsules, formulations, concentrated powder, tincture and medicinal wine. Of these 11 products, 9 are prescription drugs and 2 are over the counter (or OTC) products.

 

Three of Bohai’s lead products, Tongbi Capsules and Tablets and Lung Nourishing Syrup, are eligible for reimbursement under China’s National Medical Insurance Program (or NRDL), which we believe significantly increases the marketability of these products. In addition to these lead products, three of our current products and five of our formulas we acquired in 2010 are eligible for NRDL reimbursement. In addition, one of our current products and four of our newly acquired formulas are currently included on the Chinese government's Essential Drug List (or EDL). Inclusion on either the EDL or NRDL allows for up to 100% insurance coverage by the Chinese government. Yantai Tianzheng owns five prescription products approved by the State Food and Drug Administration of China (which we refer to herein as the SFDA) and currently manufactures four of such products. Among Yantai Tianzheng’s products, Fangfengtongsheng Granule has an exclusive status and is on the EDL and NDRL, and Zhengxintai Capsule is in the process of renewal for its protective status and is currently under the NDRL.

 

Prior to January 5, 2010, we were a public “shell” company operating under the name “Link Resources, Inc.” On January 5, 2010, we consummated a share exchange transaction (the “Share Exchange”) pursuant to which we acquired Chance High, the indirect parent company of Bohai, our principal operating subsidiary, which is a Chinese variable interest entity that we (through a Chinese wholly-owned foreign enterprise subsidiary) control through certain contractual arrangements. On August 8, 2011, WFOE II, a PRC company and a newly formed subsidiary of Chance High, entered into a Share Purchase Agreement pursuant to which we acquired, from the three individual holders thereof, one hundred percent (100%) of the outstanding shares of Yantai Tianzheng, which became our second operating subsidiary effective as of July 1, 2011. Our current organizational structure is summarized below:

 

26
 

 

 

Use of Non-GAAP Financial Measures

 

We make reference to Non-GAAP financial measures in portions of this “Management’s Discussion of Financial Condition and Results of Operations”. Management believes that investors may find it useful to review our financial results that exclude certain non-cash income and expense, namely the aggregate change in the fair value of our warrants, amortization of the beneficial conversion features in our convertible notes and the effective interest charges on our convertible notes, stock-based compensation, and deferred income tax expenses as shown in the chart below in the aggregate net amount of $(391,593) and $2,239,624 income/(expenses) for the three months ended September 30, 2012 and 2011, respectively.

 

Management believes that these Non-GAAP financial measures are useful to investors in that they provide supplemental information to intend to enhance on investors understanding of the underlying business trends and operating performance of our company. We use these Non-GAAP financial measures to evaluate operating performance. However, Non-GAAP financial measures should not be considered as either a substitute or alternative measurement of net income or any other performance measures derived in accordance with GAAP.

 

The following is a summary of reconciliations of such Non-GAAP financial measures to the most directly comparable GAAP financial measures for the three months ended September 30, 2012 and 2011:

 

   Three Months Ended 
   September 30, 
           Increase 
   2012
(unaudited)
   2011
(unaudited)
   (Decrease)
(unaudited)
 
Net Income available to Common shareholders -GAAP  $6,395,512   $2,655,784   $3,739,728 
Add Back (Subtract):               
Change in fair value of warrants   (498,003)   (332,485)   (165,517)
Amortization of beneficial conversion features on convertible notes converted   -    2,328,387    (2,328,387)
Change in Option and Equity Based Compensation   -    22,000    (22,000)
Deferred income tax expenses  - indefinite intangible assets   106,410    221,722    (115,312)
Adjusted Net Income available to Common shareholders -non-GAAP  $6,003,919   $4,895,408   $1,108,512 
Net income margins -non-GAAP   16.98%   16.36%   0.63%
Basic earnings per share – GAAP   $0.36   $0.15   $0.21 
Add back (Subtract):               
Change in fair value of warrants   (0.03)   (0.02)   (0.01)
Amortitized beneficial conversion features on convertible notes converted   -    0.13    (0.13)
Change in Option Based Compensation   -    0.00    0.00 
Deferred tax expenses  - indefinite intangible assets   0.01    0.01    (0.00)
Adjusted basic earnings per share non-GAAP   $0.34   $0.27   $0.07 
                
Diluted earnings per share-GAAP   $0.28   $0.15   $0.23 
Add back (Subtract):               
Change in fair value of warrants   (0.02)   (0.01)   (0.02)
Unamortized beneficial conversion features on convertible notes converted   -    0.10    (0.10)
Change in Option and Equity Based Compensation   -    -    - 
Deferred tax expenses  - indefinite intangible assets   -    0.01    (0.00)
Adjusted diluted earnings per share non-GAAP   $0.26   $0.25   $0.09 
                
Weighted average number of shares               
Basic   17,861,085    17,861,085      
Diluted   22,563,585    23,086,085      

 

27
 

 

Principal Factors Affecting Our Financial Performance

 

We believe that the following factors will continue to affect our financial performance:

 

Sales of Key Products

   For the three months ended 
   September 30, 
   2012
(unaudited)
   2011
(unaudited)
 
         
Tongbi Capsules   25.6%   22.5%
           
Other Products   19.6%   24.0%
Fangfengtongsheng Granule   18.5%   16.5%
Zhengxintai Capsule   11.7%   9.9%
Other Products   9.6%   9.4%
Total Sales   100%   100%

 

Our top selling products as a percentage of total net revenue consist of the following:

 

We expect that a significant portion of our future revenue will continue to be derived from sales of our top five products.

 

We held the Certificates of Protected Variety of Traditional Chinese Medicine (Grade Two) issued by the SFDA for Tongbi Capsules and Anti-flu Granules which gave the Company exclusive or near-exclusive rights to manufacture and distribute these two medicines. Tongbi Capsules’ certificates expired in September 2009. We filed an application for extending the protection period on March 12, 2009 and received certification extension until September 13, 2016. Lung Nourishing Syrup received a patent with duration of 20 years from the State Intellectual Property Office of the PRC and the patent will expire on September 12, 2027.

 

Experienced Management

 

Management’s marketing strategies and business relationships gives us the ability to expand our product market areas, which provides us with leverage to acquire less sophisticated operators, increase production volumes, and implement quality standards. Our future prospects depend substantially on the continued services of our senior management team, especially our President, Chief Executive Officer and Chairman of the Board, Mr. Qu.

 

Price Control of Drugs by PRC Government and SDRC

 

The State Development and Reform Commission of the PRC (“SDRC”) and the price administration bureaus of the relevant provinces of the PRC in which the pharmaceutical products are manufactured are responsible for the retail price control over our pharmaceutical products. The SDRC sets the price ceilings for certain pharmaceutical products in the PRC. All of our products except those under the protection periods are subject to such price controls and could affect our future revenue growth. However, due to the direct support of TCM by the Chinese government, China’s immense market, and our protected drugs, we are optimistic regarding our continuous growth potential for TCM in China.

 

Financial Highlights

 

  · Net revenues for the three months ended September 30, 2012 increased 18.1% to $35.3 million compared to the same period in 2011.

 

  o 67% of net revenues was from Bohai and 33% was from Yantai Tianzheng this first fiscal quarter

 

  o Sales were mostly derived from our lead products, Lung Nourishing Syrup, Tongbi Capsules, Tongbi Tablets, Fangfengtongsheng Granule, and Zhengxintai Capsules, which together represented over 80.4% and 76.0% of our total net revenues for the three months ended September 30, 2012 and 2011, respectively.

 

  o 80% of net revenue was derived from sales of prescription products and 20% was from Over-the-Counter products for the three months ended September 30, 2012.

 

  · Non-GAAP net income for the three months ended September 30, 2012 increased 22.6% to $6.0 million compared to the same period in 2011. The difference was mainly due to increased net income offset by net decrease in effective interest charges on convertible notes of $0 million this first quarter ended September 30, 2012 compared to the same quarter in last year. (See above Use of Non-GAAP Financial Measures). GAAP net income for the three months ended September 30, 2012 increased 140.8% to $6.4 million compared to the same period in 2011. The difference was mainly due to increased net income from Tianzheng and Bohai offset by net decrease in effective interest charges on convertible notes of $0 million during the three quarters ended September 30, 2012 compared to the same quarter in last year. (See above Use of Non-GAAP Financial Measures).

 

  o Income from operations increased 27.3% to $8.6 million this first quarter compared to the same quarter in the last fiscal year.

 

28
 

 

  o Net income margin increased from 8.9% for the three months ended September 30, 2011 to 18.1% for the three months ended September 30, 2012. The increase was mainly due to the net decrease in certain non-cash activities such as effective interest charges from convertible notes and increase in gross profit, offset by increased selling and general and administrative expenses.

 

  o Included in the net income this first fiscal quarter were non-cash charges in effective interest of $0 million, a non-cash charge in deferred income tax expenses of $0.1 million, and a non-cash credit of $0.5 million in changes in fair value of warrants.

 

  · Basic and diluted earnings per share were $0.36 and $0.28 for the three months ended September 30, 2012.

 

  o Non-GAAP Diluted earnings per share increased 2.4% to $0.26 for the three months ended September 30, 2012 compared to the same period in 2011.

 

  o Non-GAAP Basic earnings per share increased 24.5% to $0.34 for the three months ended September 30, 2012 compared to the same period in 2011.

 

  · Including restricted cash, our total cash balance was $28.7 million as of September 30, 2012 and cash flow from operating activities was $1.6 million for the three months ended September 30, 2012.

 

  o Total cash and cash equivalents increased by $1.0 million for the three months ended September 30, 2012 compared to June 30, 2012.

 

Operating Results

 

Comparison of the three months ended September 30, 2012 and 2011

 

Net Revenues

 

Net revenues are comprised of sales of 19 traditional Chinese medicines in China during the three months ended September 30, 2012 (we currently sell 19 medicines following our acquisition of Yantai Tianzheng on August 8, 2011). Net revenues for the three months ended September 30, 2012 increased by $5,420,964, or 18.1%, to $35,348,820 as compared to $29,927,856 for the three months ended September 30, 2011. Net revenues were $23,550,273 and $11,798,547 for Bohai and Yantai Tianzheng, respectively, for the three months ended September 30, 2012. Net revenues were $21,162,188 and $8,765,668 for Bohai and Yantai Tianzheng, respectively, for the three months ended September 30, 2011. The increase in Bohai’s revenue was primarily due to a net increase in revenues of 20.6% from our four lead products in Bohai: Lung Nourishing Syrup, Tongbi Capsules, Tongbi Tablets, and Shantongning Tablets, which together accounted for over 86.0% of our total net revenues for Bohai. All of our lead products from Bohai are listed for coverage and reimbursement under national medical insurance program starting in December 2009. The increase in Tianzheng’s revenue was primarily due to a net increase in revenue of 33.0% of our two lead products in Tianzheng: Zhengxintai Capsul, Fangfengtongsheng Granule. The sale of our prescription drug products for the three months ended September 30, 2012 represented 80% of total net revenue compared to 74 % for the same period in last year. The increase in prescription sales was primary due to increases in sales volume of our two prescription drugs, Tongbi Capsules and Tongbi Tablets as well as prescription product sales from Yantai Tianzheng.

 

Cost of Revenues

 

Cost of revenues is comprised of raw material costs, labor cost, overhead costs associated with the manufacturing processes and related expenses which are directly attributable to our revenues. Our cost of revenues for the three months ended September 30, 2012 was $8,592,104 as compared to $6,943,720 for the three months ended September 30, 2011, representing an increase of $1,648,384, or 23.7%. Cost of revenues were $5,314,633 and $3,277,471 for Bohai and Yantai Tianzheng, respectively, for the three months ended September 30, 2012. Cost of revenues were $4,657,753 and $2,285,967 for Bohai and Yantai Tianzheng, respectively, for the three months ended September 30, 2011. The increase in cost of revenues for the three months ended September 30, 2012, compared to the same period in last year, was mainly due to an increase in total costs of raw materials, labor, and overhead as a result of an increase in overall sales.

 

29
 

 

Gross Profit

 

Gross profit represents the difference between net revenues and cost of revenues. We achieved gross profit of $26,756,716 for the three months ended September 30, 2012, as compared to $22,984,136 for the same period in 2011, representing an increase of $3,772,580, or 16.4%, over the same period in 2011. The increase of the gross profit is mainly due to increased revenues.

 

Our overall gross profit margins as a percentage of net revenues decreased by approximately 1.1% from 76.8% to 75.7% this fiscal quarter at September 30, 2012, as compared to the same period in 2011.The decrease of the gross profit margin is attributable to increases in the cost of raw materials during the three months ended September 30, 2012 compared to the same period last year. Meanwhile, the company also made an effort to improve its cost control to avoid negative inflation effect.

 

Operating Expenses

 

Our operating expenses increased by $1,931,517 or 11.9% to $18,166,006, for the three months ended September 30, 2012, as compared to $16,234,489 for the same fiscal period in 2011. The overall increase in selling, general, and administrative expenses was related to increased selling expenses due to services supporting an overall increase in sales activities. The percentage of operating expenses to net revenues was 51.4% and 54.2% for the three months ended September 30, 2012 and 2011, respectively, representing a decrease of 2.9% as a percentage of net revenues. The decrease of percentage of net revenue is because advertising expense decreased this quarter compared to the same period last year.

 

Total Other Income (Expenses)

 

Total other income (expenses) are comprised of interest income (expenses), changes in fair value of derivative instruments, other income (expenses), and amortization of deferred financing fees. Total other expenses were $13,952 for the three months ended September 30, 2012 compared to total other expenses of $2,275,504 for the period ended September 30, 2011, a decrease of total other expenses of $2,261,552. The decrease in total other expenses were principally due to a net decrease of $2,109,478 for interest expenses and a net decrease in non-cash gain in fair value of warrants for $165,517 for convertible notes in connection with our private placement on January 5, 2010. The effective interest expense for convertible notes is calculated using a constant effective interest rate, applied to the carrying value of the notes each month. As the carrying value increases, so does the interest expense. On December 31, 2011, the Company entered into an amendment to the Notes with Euro Pacific as representative of the Investors (the “Amendment”) which: (i) extended the maturity date of the Notes from January 5, 2012 to April 5, 2012 (such extra three month period, the “Extended Period”); and (ii) increased the interest rate on the Notes to an annual rate of 12% (or 3% for the Extended Period). On May 14, 2012, the Company entered into an amendment to the Notes with Euro Pacific as representative of the Investors (the “Second Amendment”) which: (i) extended the maturity date of the Notes from April 5, 2012 to October 5, 2012 (such extra six month period, the “Second Extended Period”); and (ii) remained the interest rate on the Notes at an annual rate of 12% (or 6% for the Second Extended Period). On June 27, 2012, we and Euro Pacific entered into a Third Amendment to the Notes (the “Third Amendment”) to remove the limitations on our ability to incur debt, to incur liens or to make capital expenditures. The purpose of the Third Amendment is to provide us with enhanced flexibility to seek potential sources of financing. As of September 30, 2012, there were 4,702,500 shares of the Company’s Common Stock issuable upon conversion of the outstanding convertible notes. (See Note 10).

 

Provision for Income Tax

 

Our provision for income taxes for the three months ended September 30, 2012 and 2011 were $2,181,246 and $1,818,359, an increase of $362,887, or 20.0%, from this fiscal quarter to date over the same period last year. The increase in provision for income tax was principally due to an increase in taxable income under the PRC law from Bohai and from Yantai Tianzheng. The effective income tax rates were 25% and 41% for the three months ended September 30, 2012 and 2011, respectively.

 

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Net Income

 

We had a net income of $6,395,512 for the three months ended September 30, 2012, as compared to net income of $2,655,784 for the three months ended September 30, 2011, an increase in net income of $3,739,728, or 140.8%. This translates into basic earnings per common share of $0.36 and $0.15, and diluted earnings per common share of $0.28 and $0.15, for the three months ended September 30, 2012 and 2011, respectively. The increase in net income was primarily attributable to an increase in total gross profit of $3,772,580 and a decrease in total other expenses (resulting from mostly effective interest charges) of $2,261,552, offset by an increase in selling, general and administrative expenses of $1,931,517 and an increase in the tax provision of $362,887 for this fiscal quarter as compared to the same period of prior year.

 

Net income margin was 18.1% for the three months ended September 30, 2012 as compared to net income margin 8.9% for the same period last year, an increase of 9.2%. The increase was mainly due to the net decrease in certain non-cash activities such as effective interest charges from convertible notes and increase in gross profit, offset by increased selling and general and administrative expenses.

 

Total other income included a non-cash charge in effective interest expenses of $0 for the three months ended September 30, 2012 compared to $2,328,387 for the same period in 2011.

 

Total other income for the three months ended September 30, 2012 also comprised of a non-cash credit for fair value of warrants of $498,002.

 

Liquidity and Capital Resources

 

Liquidity is the ability of a company to generate adequate amounts of cash to meet its needs for cash. As of September 30, 2012, we had cash and cash equivalents of $19,379,160 and restricted cash of $9,332,186, substantially almost all of which is located in financial institutions in China. The following table provides detailed information about our net cash flow for financial statement periods presented in this report:

 

Summary of Cash Flow Statements

 

   For the three months ended 
   September 30 
   2012
(unaudited)
   2011
(unaudited)
 
Net cash provided by operating activities  $1,581,692   $3,304,943 
Net cash used in investing activities   (14,834)   (5,226,125)
Net cash provided by financing activities   (528,755)   4,781,444)
Effect of foreign currency translation on cash and cash equivalents   (45,231)   25,612 
Net increase in cash and cash equivalents  $992,872   $2,885,875 

 

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Net Cash Provided by Operating Activities

 

Net cash provided by operating activities totaled $1,581,692 for the three months ended September 30, 2012 as compared to net cash provided by operating activities of $3,304,943 for the three months ended September 30, 2011. The decrease in net cash provided by operating activities, for the three months ended September 30, 2012 compared to the same period 2011, was primarily due to increased net income of $3.7 million, increased accounts payable of $0.8 million, increased depreciation and amortization of $0.3 million, offset by a decrease of $2.1 million in the effective interest on convertible notes, a decrease of $2.6 million in accounts receivables, and a decrease in accrued liabilities of $0.7 million. We expect our cash flow from operating activities to maintain a positive flow due to our continuous cash flow management.

 

Net Cash Used In Investing Activities

 

Net cash used in investing activities was $14,834 for the three months ended September 30, 2012 and $5,226,125 for the three months ended September 30, 2011. The net decrease in cash used in investing activities was due to a cash payment of approximately $6 million for our Yantai Tianzheng acquisition s offset by a cash receipt of $1.4 million from Yantai Tianzheng’s acquisition for the quarter ended September 30, 2012.

 

Net Cash Provided by Financing Activities

 

Net cash used in financing activities totaled $528,755 for the three months ended September 30, 2012 as compared to net cash provided by financing activities of $4,781,444 for the same period in 2011. The reason for the decrease in cash provided by financing activities was due to a cash receipt of $6.3 million from an equity shareholder, Mr. Qu (our Chairman and CEO) the quarter ended September 30, 2011 offset by the repayment of short term bank loans of $1.5 million in the quarter ended September 30, 2011 and repayment of convertible notes of $0.6 million in the quarter ended September 30, 2012. Mr. Qu made a permanent equity capital contribution of approximately $6.3 million (RMB 40,000,000) into Bohai on August 3, 2011 to support its future capital needs.

 

Cash Position

 

As of September 30, 2012, we had cash of $19,379,160 as compared to $18,386,288 as of June 30, 2012, an increase of $992,872. This increase was due primarily to an increase in net income of approximately $6.4 million, offset by increased accounts receivable of $4.1 million, a repayment of convertible note of $0.6 million, purchase of inventories of $0.5 million, payment made for prepaid expenses and other current expenses of $0.6 million, and increased accrued liabilities of $0.7 million.

 

We believe that we can meet our liquidity and capital requirements for our ongoing operations from our currently available working capital and maintain our operations at our current levels.

 

However, during the current fiscal year and thereafter, we will be required to fund two significant obligations (as well as others described under “Obligations under Material Contracts” below):

 

  (i) the completion of the acquisition of Yantai Tianzheng ($5,000,000 million is due within 12 months as of September 30, 2012.  The installment balances can be turned into bank loans with a two-years term at 6% annual interest rate); and

 

  (ii) the repayment our convertible promissory notes due October 5, 2012 ($9.405 million due as of September 30, 2012).

 

As such, we will be required to raise substantial additional capital to fund these obligations, either through the issuance of debt or equity securities, bank loans or other methods. Readers are cautioned that additional funding, capital or loans may be unavailable to us on favorable terms, if at all. If adequate funds are not available, we would likely have to renegotiate the terms of these obligations, which we may be unable to do on favorable terms. We may thus be required to agree to unfavorable terms which could have a material adverse effect on us, our financial condition and our results of operations in 2011 and beyond. Moreover, to the extent that additional capital is raised through the sale of equity or convertible debt securities, the issuance of such securities would result in ownership and potentially economic dilution to existing shareholders.

 

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In addition, if we are faced with worldwide financial and credit crises as occurred in 2008 and 2009 and very recently in 2011, it may make the future cost of raising funds through the debt or equity markets more expensive or make financial markets unavailable to us at times when we require additional financings.

 

Critical Accounting Policies and Estimates

 

As discussed in Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, of our Annual Report on Form 10-K for the fiscal year ended June 30, 2012, we consider our use of estimates, accounts receivable, revenue recognition, inventories, property plant and equipment, and income taxes to be the most critical accounting policies in understanding the judgments that are involved in preparing our condensed consolidated financial statements. There have been no significant changes to these estimates in the three months ended September 30, 2012.

 

Recent Accounting Pronouncements Adopted

 

See Note 3 to the condensed consolidated unaudited financial statements included in Item 1, Financial Information, of this Quarterly Report on Form 10-Q.

 

Recent Accounting Pronouncements Not Yet Adopted

 

See Note 3 to the condensed consolidated unaudited financial statements included in Item 1, Financial Information, of this Quarterly Report on Form 10-Q.

 

Obligations under Material Contracts

 

The following table summarizes our contractual obligations as of September 30, 2012, and the effect these obligations are expected to have on our liquidity and cash flows in future periods.

 

   Payments Due by Period
(unaudited)
 
   Less than   1-3   4-5   5 
   Total   1 year   Years   years   Years+ 
Contractual Obligations:                         
Convertible notes  $9,405,000   $9,405,000   $-   $-   $- 
                          
Construction In Process   1,248,716    1,248,716    -    -    - 
                          
Yantai Tianzheng acquisition   25,300,000    5,000,000    20,300,000    -    - 
                          
Contract Research and Development Arrangement   1,040,170                   1,040,170 
              -    -      
Total Contractual Obligations:  $36,993,886   $15,653,716   $20,300,000   $-   $1,040,170 

 

Other than discussed above, there are no other foreseeable material commitments or contingencies as of September 30, 2012.

 

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Off-Balance Sheet Arrangements

 

We did not engage in any “off-balance sheet arrangements” (as that term is defined in Item 303(a)(4)(ii) of Regulation S-K) during the three months ended September 30, 2012. We have not entered into any financial guarantees or other 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 shareholder’s equity or that are not reflected in our condensed 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.

 

Currency Exchange Risk

 

Our reporting currency is the U.S. dollar and our operations in China use their local currency as their functional currencies. Substantially all of our revenue and expenses are in the Chinese currency, the Renminbi. We are subject to the effects of exchange rate fluctuations with respect to any of these currencies. For example, the value of the Renminbi depends to a large extent on Chinese government policies and China’s domestic and international economic and political developments, as well as supply and demand in the local market. Since 1994, the official exchange rate for the conversion of the Renminbi to the U.S. dollar had generally been stable and the Renminbi had appreciated slightly against the U.S. dollar. In July 2005, the Chinese government changed its policy of pegging the value of the Renminbi to the U.S. dollar. Under this policy, which was halted in 2008 due to the worldwide financial crisis, the Renminbi was permitted to fluctuate within a narrow and managed band against a basket of certain foreign currencies. In June 2010, the Chinese government announced its intention to again allow the Renminbi to fluctuate within the 2005 parameters. It is possible that the Chinese government could adopt an even more flexible currency policy, which could result in more significant fluctuation of Renminbi against the U.S. dollar, or it could adopt a more restrictive policy. We can offer no assurance that the Renminbi will be stable against the U.S. dollar or any other foreign currency.

 

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Our consolidated financial statements are translated into U.S. dollars at the average exchange rates in each applicable period. To the extent the U.S. dollar strengthens against foreign currencies, the translation of these foreign currencies denominated transactions results in reduced revenue, operating expenses and net income for our international operations. Similarly, to the extent the U.S. dollar weakens against foreign currencies, the translation of these foreign currency denominated transactions results in increased revenue, operating expenses and net income for our international operations. We are also exposed to foreign exchange rate fluctuations as we convert the financial statements of our foreign consolidated subsidiaries into U.S. dollars in consolidation. If there is a change in foreign currency exchange rates, the conversion of the foreign consolidated subsidiaries’ financial statements into U.S. dollars will lead to a translation gain or loss which is recorded as a component of other comprehensive income. In addition, we have certain assets and liabilities that are denominated in currencies other than the relevant entity’s functional currency. Changes in the functional currency value of these assets and liabilities create fluctuations that will lead to a transaction gain or loss. We have not entered into agreements or purchased instruments to hedge our exchange rate risks, although we may do so in the future. The availability and effectiveness of any hedging transaction may be limited and we may not be able to hedge our exchange rate risks. Most of our transactions are settled in Renminbi and U.S. dollars. We are not exposed to significant foreign currency risk.

 

Credit Risk

 

Our potential credit risk is mainly attributable to its debtors and bank balances. In respect of debtors, we have policies in place to ensure that it will only accept customers from countries which are politically stable and customers with an appropriate credit history. In addition, all the bank balances were made with financial institutions with high-credit quality. Thus, we are not considered to be subject to significant credit risk.

 

Interest Rate Risk

 

Our interest rate risk is primarily attributable to its short-term borrowings, loan to a third party and loan to equity holders. Our borrowings carry interest at fixed rate. Our management has not used any interest rate swaps to hedge its exposure to interest rate risk.

 

Inflation

 

In recent years, the Chinese economy has experienced periods of rapid expansion and high rates of inflation. During the past ten years, the rate of inflation in China has been as high as 20.7% and as low as -2.2%. These factors have led to the adoption by Chinese government, from time to time, of various corrective measures designed to restrict the availability of credit or regulate growth and contain inflation. While inflation has been more moderate since 1995, high inflation may in the future cause Chinese government to impose controls on credit and/or prices, or to take other action, which could inhibit economic activity in China, and thereby harm the market for our products.

 

Item 3. Quantitative and Qualitative Disclosures about Market Risk

 

Not applicable

 

Item 4. Controls and Procedures

 

Evaluation of Disclosure Controls and Procedures

 

As of September 30, 2012, the quarterly period covered by this report, the management conducted evaluations of the Company’s disclosure controls and procedures. As defined under Sections 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended (the Exchange Act”), the term disclosure controls and procedures” means controls and other procedures of an issuer that are designed to ensure that information required to be disclosed by the issuer in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Exchange Act is accumulated and communicated to the issuer’s management, to allow timely decisions regarding required disclosures.

 

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Based on this evaluation, the management have concluded that our disclosure controls and procedures were, due to certain material weaknesses in internal control and significant deficiencies on financial reporting discussed below, not effective to ensure that material information is recorded, processed, summarized and reported by our management on a timely basis in order to comply with our disclosure obligations under the Exchange Act and the rules and regulations promulgated there under.

 

Material weakness

 

We identified two material weaknesses in the design and operation of our internal controls. The material weakness is related to (i) the failure to retain sufficient qualified accounting personnel to prepare financial statements in accordance with accounting principles generally accepted in the US (including a qualified Chief Financial Officer); and (ii) continue to experience difficulty applying complex accounting principles. The Company’s accounting department personnel have limited knowledge and experience in US GAAP.

 

To remediate the material weaknesses identified in internal control over financial reporting of the Company, we have commenced to: (i) hire additional personnel with sufficient knowledge and experience in US GAAP; and (ii) provide ongoing training courses in US GAAP to existing personnel, including our Financial Controller in China.

 

These new remediation initiatives were put into place in the fourth quarter of 2012 ended June 30, 2012. We will continue to monitor and assess our remediation initiatives to ensure that the aforementioned material weakness is remediated.

 

Significant deficiency

 

A significant deficiency is a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness(within the meaning of PCAOB Auditing Standard No. 5) yet important enough to merit attention by those responsible for oversight of a company’s financial reporting.

 

The significant deficiencies identified by the management continue to be as described in our Annual Report on Form 10-K for the fiscal year ended June 30, 2012, which was filed with the SEC on September 28, 2012. As a result, the Certifying Officers and our board of directors are continuing to evaluate on our internal control over financial reporting and our disclosure controls and procedures in an attempt to address such significant deficiencies.

 

Changes in Internal Control over Financial Reporting

 

The Company currently lacks an audit committee. Thus there is no independent supervision from an audit committee to select and oversee the Company's independent accountant; monitor the procedures for handling complaints regarding the Company's accounting practices; engage advisors; and ensure funding for the independent auditor and any outside advisors engaged by the audit committee.

 

Subject to the foregoing disclosure, there were no other changes in our internal control over financial reporting during the nine months ended March 31, 2011 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

Limitations on the Effectiveness of Internal Controls

 

Readers are cautioned that our management does not expect that our disclosure controls and procedures or our internal control over financial reporting will necessarily prevent all fraud and material error. An internal control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any control design will succeed in achieving its stated goals under all potential future conditions. Over time, control may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.

 

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PART II - OTHER INFORMATION

 

Item 1. Legal Proceedings

 

From time to time, we may become involved in various lawsuits and legal proceedings, which arise in the ordinary course of business. However, litigation is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm business. We are currently not aware of any such legal proceedings or claims that will have, individually or in the aggregate, a material adverse affect on our business, financial condition or operating results.

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

 

None.

 

Item 3. Defaults Upon Senior Securities

 

None.

 

Item 4. Mine Safety Disclosures

 

Not applicable.

 

Item 5. Other Information

 

None.

 

Item 6. Exhibits 

 

(a) Exhibits

 

Exhibit
Number
Description of Exhibit
31.1* Certification of Principal Executive and Financial Officer pursuant to Rule 13a-14 and Rule 15d-14(a), promulgated under the Securities and Exchange Act of 1934, as amended.
32.1* Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Chief Executive Officer and principal financial officer).

 

_________________

 

* Filed herewith

 

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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.

 

  Bohai Pharmaceuticals Group, Inc.
     
November 19, 2012 By: /s/ Hongwei Qu
 

Hongwei Qu

Chief Executive Officer

(Principal Executive Officer and Principal Financial Officer)

  

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