PINX:BOPH Bohai Pharmaceuticals Group, Inc. Quarterly Report 10-Q Filing - 3/31/2012

Effective Date 3/31/2012

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

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

 

For the quarterly period ended March 31, 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 May 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  
     
Item 1. Financial Statements (unaudited)  
     
  Condensed Consolidated Balance Sheets as of March 31, 2012 and June 30, 2011 4
     
  Condensed Consolidated Statements of Operations and Comprehensive Income (Loss) for the Three and Nine Months ended March 31, 2012 and 2011 5
     
  Condensed Consolidated Statements of Equity for the Years Ended June 30, 2011and for the Nine Months Ended March 31, 2012 6
     
  Condensed Consolidated Statements of Cash Flows for the Nine Months ended March 31, 2012 and 2011 7
     
  Notes to Condensed Consolidated Financial Statements 8
     
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 24
     
Item 3. Quantitative and Qualitative Disclosures About Market Risk 34
     
Item 4. Controls and Procedures 35
   
PART II - OTHER INFORMATION  
   
Item 1. Legal Proceedings 37
Item 1A. Risk Factors 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 38
   
SIGNATURES 39

 

1
 

 

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” sections of our Annual Report for the fiscal year ended June 30, 2011 and our Quarterly Report on Form 10-Q for the period ended December 31, 2011. 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, which acquisition was consummated in August 2011 (currently $25,300,000 is due within 12 months. As described in Note 4, the Company has the ability to convert each of the remaining payments that are due into two year term loans bearing interest at 6% per annum); (ii) satisfy our obligations under our convertible notes which were due April 5, 2012 (currently $10.45 million 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 Chinese government granted rights to exclusively manufacture or co-manufacture our products;

 

·the availability of Chinese 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;

 

2
 

 

·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 ability to integrate any future acquisitions;

 

·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” sections of our Annual Report on Form 10-K for the fiscal year ended June 30, 2011 and our Quarterly Report on Form 10-Q for the fiscal period ended December 31, 2011. 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

 

 

   March 31,   June 30, 
   2012   2011 
   (unaudited)     
ASSETS          
Current assets:          
Cash  $23,044,256   $13,344,426 
Restricted cash   328,823    11,043 
Accounts receivable   27,733,858    15,891,642 
Inventories   3,664,864    1,511,021 
Prepaid expenses and other current assets   900,783    1,060,138 
           
Total current assets   55,672,584    31,818,270 
           
Property, plant and equipment, net   11,757,905    5,214,962 
Prepayment for property, plant and equipment   594,113    - 
Intangible assets - pharmaceutical formulas   35,708,434    25,019,377 
Long term prepayments - land use right, net   18,944,336    17,577,271 
Customer relationships, net   13,093,772    - 
           
Goodwill   4,649,283    - 
Debt issue costs   -    485,039 
           
TOTAL ASSETS  $140,420,427   $80,114,919 
           
LIABILITIES AND STOCKHOLDERS’ EQUITY          
           
Current liabilities:          
Convertible notes, net of discount of $0 and $9,317,897 as of March 31, 2012 and June 30, 2011, respectively  $10,450,000   $1,132,103 
Accounts payable   2,913,463    1,291,907 
Accrued expenses   7,024,717    4,312,333 
Income taxes payable   2,434,668    721,771 
Short-term borrowings   -    920,554 
Acquisition price payable - current portion   17,000,000    - 
Derivative liabilities - investor and agent warrants   479,143    937,867 
Due to Related Party   23,166    11,980 
           
Total current liabilities   40,325,157    9,328,515 
           
Acquisition price payable - non-current portion   8,300,000    - 
Deferred tax liability   8,677,042    2,878,397 
           
TOTAL LIABILITIES   57,302,199    12,206,912 
           
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 March 31, 2012 and June 30, 2011, respectively   17,861    17,861 
Additional paid-in capital   24,615,353    18,345,574 
Accumulated other comprehensive income   5,835,597    3,559,355 
Statutory reserves   2,201,817    2,201,817 
Retained earnings   50,447,600    43,783,400 
           
Total stockholders’ equity   83,118,228    67,908,007 
           
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY  $140,420,427   $80,114,919 

 

See accompanying notes to the unaudited condensed consolidated financial statements

 

4
 

 

BOHAI PHARMACEUTICALS GROUP, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)

(UNAUDITED)

 

   For the Three Months Ended
March 31,
   For the Nine Months Ended
March 31,
 
   2012
(unaudited)
   2011   2012
(unaudited)
   2011 
                 
Net revenues  $36,237,847   $21,793,631   $101,002,589   $60,351,029 
                     
Cost of revenues   8,180,762    4,853,768    23,106,879    12,402,897 
                     
Gross profit   28,057,085    16,939,863    77,895,710    47,948,132 
                     
Selling, general and administrative expenses   19,787,628    12,845,962    54,748,109    32,565,981 
                     
Income from operations   8,269,457    4,093,901    23,147,601    15,382,151 
                     
Other income (expenses):                    
Other income   -    1,783    -    99,901 
Interest income   13,039    11,176    51,205    40,673 
Interest expenses   (1,120,273)   (554,428)   (10,694,346)   (2,203,775)
Other (expenses) income, net of   (2,163)   (546)   (10,205)   (2,468)
Amortization of deferred financing fees   -    (232,200)   -    (736,224)
Change in fair value of derivative liabilities   317,986    263,118    458,724    3,181,603 
                     
Total other income (expenses)   (791,411)   (511,097)   (10,194,622)   379,710 
                     
Income before provision for income taxes   7,478,046    3,582,804    12,952,979    15,761,861 
                     
Provision for income taxes   (2,174,128)   (897,458)   (6,288,779)   (3,523,145)
                     
Net income  $5,303,918   $2,685,346   $6,664,200   $12,238,716 
                     
Comprehensive income :                    
Net income   5,303,918    2,685,346    6,664,200    12,238,716 
Other comprehensive income                    
Unrealized foreign currency translation gain   620,662    400,224    2,276,242    2,061,028 
Comprehensive income :  $5,924,580   $3,085,570   $8,940,442   $14,299,744 
                     
Net income per common share                    
                     
Basic  $0.30   $0.15   $0.37   $0.72 
Diluted  $0.28   $0.14   $0.37   $0.59 
                     
Weighted average common shares outstanding                    
                     
Basic   17,861,085    17,544,163    17,861,085    16,988,489 
Diluted   23,086,085    22,808,885    23,086,085    22,439,202 

 

See accompanying notes to the unaudited condensed consolidated financial statements

 

5
 

 

BOHAI PHARMACEUTICALS GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY

FOR THE NINE MONTHS ENDED MARCH 31, 2012

(UNAUDITED)

 

   Common stock                     
   Shares
outstanding
   Amount   Additional 
paid-in 
capital
   Accumulated 
other 
comprehensive 
income
   Statutory 
reserves
   Retained 
Earnings
   Total 
Stockholders’ 
Equity
 
                             
Balance at June 30, 2011   17,861,085   $17,861   $18,345,574   $3,559,355   $2,201,817   $43,783,400   $67,908,007 
                                    
Capital contribution from shareholder   -    -    6,225,779    -    -    -    6,225,779 
Stock based compensation   -    -    44,000    -    -    -    44,000 
Foreign currency translation adjustment   -    -    -    2,276,242    -    -    2,276,242 
Net income   -    -    -    -    -    6,664,200    6,664,200 
                                    
Balance at March 31, 2012   17,861,085   $17,861   $24,615,353   $5,835,597   $2,201,817   $50,447,600   $83,118,228 

 

See accompanying notes to the unaudited condensed consolidated financial statements

 

6
 

 

BOHAI PHARMACEUTICALS GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE NINE MONTHS ENDED MARCH 31, 2012 AND 2011

(UNAUDITED)

 

   For the Nine Months Ended 
   March 31, 
   2012
(unaudited)
   2011 
         
Cash flows from operating activities:          
Net income  $6,664,200   $12,238,716 
Adjustments to reconcile net income to net cash provided by operating activities:          
           
Depreciation and amortization   2,211,065    260,577 
Gain on disposal of property, plant and equipment   -    1,908 
Accretion of beneficial conversion feature   -    1,029,487 
Amortization of deferred fees on convertible notes   485,039    736,224 
Interest expense on convertible notes   9,317,898    339,842 
Change in fair value of warrants   (458,724)   (3,181,603)
Stock based compensation   44,000    184,344 
Deferred income taxes   700,734    - 
           
Changes in operating assets and liabilities:          
Accounts receivable   (4,421,640)   (3,946,124)
Prepaid expenses and other current assets   494,576    (496,515)
Inventories   (771,500)   (1,201,923)
Accrued liabilities   439,028    158,949 
Accounts payable   (843,544)   686,541 
Other payable   1,064,107    1,633,817 
Income taxes payable   943,207    216,325 
Advance from customers   (172,885)   - 
Restricted cash   75,141    355,976 
           
Net cash provided by operating activities   15,770,702    9,016,541 
           
Cash flows used in investing activities:          
Purchases of property, plant and equipment   (509,118)   (14,619)
Proceeds from disposal of property, plant and equipment   26,719    4,491 
Prepaid land use rights   (100,850)   (7,111,204)
Purchase of formulas   -    (7,186,059)
Prepaid for property, plant and equipment   (594,113)   - 
Cash received in acquisition of business   1,358,078    - 
Cash paid for acquisition of subsidiary   (9,700,000)   - 
           
Net cash used in investing activities   (9,519,284)   (14,307,391)
           
Cash flows from financing activities:          
Proceeds from short term borrowings   -    890,772 
Repayment of short term borrowings   (3,056,926)   (4,483,801)
Repayment from related party   11,109    53,147 
Capital contribution from shareholder   6,286,738    - 
Proceeds from issuance of common stock   -    1,870,955 
           
Net cash flows used in financing activities   3,240,921    (1,668,927)
           
Effect of foreign currency translation on cash and cash equivalents   207,491    476,212 
           
Net increase (decrease) in cash and cash equivalent   9,699,830    (6,483,565)
           
Cash and cash equivalents at beginning of period   13,344,426    17,149,082 
           
Cash and cash equivalents at end of period  $23,044,256   $10,665,517 
           
Cash paid during the period for:          
Interest  $540,094   $811,582 
Income taxes  $4,705,358   $3,306,820 
           
Supplemental cash flow information          
           
Non-cash investing and financing activities:          
Common stock issued upon conversion of convertible notes and accrued interest  $-   $948,832 
           
Acquisition payable  $25,300,000   $- 

 

See accompanying notes to the unaudited condensed consolidated financial statements

 

7
 

 

BOHAI PHARMACEUTICALS GROUP, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE THREE AND NINE MONTHS ENDED MARCH 31, 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 Agreement completed between BPGI (then known as Link Resources, Inc.) and the shareholders of Chance High (as defined below) (the “Share Exchange Agreement” and the transactions contemplated hereby, the “Share Exchange”) on January 5, 2010.

 

The Company is currently 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 two operating subsidiaries:

 

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

 

(ii)  Yantai Tianzheng Pharmaceuticals Company, Ltd., a PRC company (“Yantai Tianzheng”) which the Company acquired in August 2011 (with an effective date of July 1, 2011) through a newly formed PRC wholly-foreign owned enterprise subsidiary, Yantai Nirui Pharmaceuticals, Ltd. (“WFOE II”).

 

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

 

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 Yantai Shencaojishi Pharmaceuticals Co., Ltd. (the “WFOE”). On December 7, 2009 (prior to the date of the Share Exchange), 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. As used herein, the term “Common Stock” means the common stock of BPGI, $0.001 par value per share.

  

2. LIQUIDITY AND FINANCIAL CONDITION

 

The Company’s net income amounted to $5,303,918 and $6,664,200 for, respectively, the three and nine month periods ended March 31, 2012. The Company’s cash flows from operations amounted to approximately $15,700,000 for the nine months ended March 31, 2012. The Company had working capital of approximately $15,347,427 as of March 31, 2012, including a $10,450,000 convertible note obligation, which pursuant to an amendment thereto was set to mature on April 5, 2012 (see below and Note 11) but excluding a $479,143 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.

 

8
 

 

As described further in Note 4, the Company completed its acquisition of Yantai Tianzheng on August 8, 2011 (the “Execution Date”), with an effective control date of July 1, 2011, for aggregate purchase consideration of US$35,000,000, originally payable in four installments in the equivalent of Chinese Renminbi, the functional currency of the PRC (“RMB”). $6,000,000 of the aggregate purchase price was paid prior to the tenth calendar day after the Execution Date of the acquisition; $12,000,000 was due to be paid on or before the sixth month anniversary of the Execution Date; $12,000,000 is due to be paid on or before the 12 month anniversary of the Execution Date; and the remaining $5,000,000 is due to be paid on or before the 18 month anniversary of the Execution Date.  As described in Note 4, the Company has the ability to convert each of the remaining payments that are due into two year term loans bearing interest at 6% per annum.  The Company has paid $9,700,000 and deferred $8,300,000 as of March 31, 2012. As of March 31, 2012, the amount of outstanding payments was $25,300,000, among which $12,000,000 is due to August 8, 2012, $5,000,000 is due to February 8, 2013, $8,300,000 is due to February 8, 2014. Like Bohai, Yantai Tianzheng is a TCM manufacturer based in Yantai, Shandong Province, China, and conducts business operations exclusively in the PRC.

 

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 June 2012. The remaining commitment of the contract was approximately $0.46 million (RMB 2.9 million) as of March 31, 2012.

 

In August 2011, Mr. Qu made a permanent equity capital contribution of $6,225,779 (RMB 40,000,000) into Bohai to support the Company’s future capital needs.

 

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 January 1, 2013.

 

Notwithstanding, the Company still has substantial obligations described below 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 $10,450,000 balance due on the Company’s convertible notes on the contractual maturity date of April 5, 2012 (the “Notes”). On December 31, 2011, the Company entered into an amendment to the Notes with Euro Pacific as representative of the Note holders (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).  For a description of the Notes, see Note 11.  

 

 As further described in Note 18, the Company’s Chinese operating entity was unable to convert a sufficient amount of RMB’s into US Dollars for the US Holding Company to repay the remaining principal balance due on the convertible notes by the extended maturity of April 5, 2012. The Company and Euro Pacific as representative of the convertible note holders are currently negotiating a second amendment to the Convertible Notes that would further extend the maturity date thereof to October 5, 2012 (see Note 18). The proposed extension of the maturity date is subject to the satisfaction of certain conditions described in Note 18 and the completion of negotiations. The Company believes it has sufficient liquidity to repay the convertible notes; however, the Company will still be required to converting sufficient currency into US Dollars in order to avoid a declaration of default.

 

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.

  

3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Principles of Consolidation

 

The unaudited condensed consolidated financial statements furnished herein has been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and reflects all adjustments, consisting only of normal recurring adjustments, which in the opinion of management, are necessary for a fair statement of the financial position and results of operations for the periods presented.

 

The preparation of the condensed consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and the accompanying notes. Actual results could differ from those estimates and such differences may be material to the condensed consolidated financial statements. This Quarterly Report on Form 10-Q should be read in conjunction with the Company’s Annual Report on Form10-K for the Company’s fiscal year ended June 30, 2011. The results of operations for the nine months ended March 31, 2012 are not necessarily indicative of the results of the full year 2012 ending June 30, 2012.

 

9
 

 

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 unaudited condensed consolidated balance sheets are as follows:

 

   March 31,   June 30, 
   2012
(unaudited)
  

2011

 

 
         
Total current assets*  $55,594,484   $32,711,620 
Total assets*   104,108,601    80,523,230 
Total current liabilities**   20,167,277    18,674,129 
Total liabilities**  $23,588,857   $21,552,525 

 

*           Includes intercompany accounts in the amounts of $19,818,026 and $1,896,933 in current assets as of March 31, 2012 and June 30, 2011, respectively, that were eliminated in consolidation.

 

**         Includes intercompany accounts in the amounts of $11,826,531 and $11,660,222 in current liabilities as of March 31, 2012 and June 30, 2011, 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. The condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation. 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 March 31, 2012 and the results of operations and cash flows for the periods presented. The results of operations for the nine months ended March 31, 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, 2011. 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, 2011, filed on September 28, 2011, and updated, as necessary, in this Quarterly Report on Form 10-Q.

 

10
 

 

Business Combinations

 

The Company uses the acquisition method of accounting for business combinations which requires that the assets acquired and liabilities assumed be recorded at the date of the acquisition at their respective fair values. Assets acquired and liabilities assumed in a business combination that arise from contingencies are recognized at fair value if fair value can reasonably be estimated. If the acquisition date fair value of an asset acquired or liability assumed that arises from a contingency cannot be determined, the asset or liability is recognized if probable and reasonably estimable; if these criteria are not met, no asset or liability is recognized. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Any excess of the purchase price (consideration transferred) over the estimated fair values of net assets acquired is recorded as goodwill. Transaction costs and costs to restructure the acquired company are expensed as incurred. The operating results of acquired business are reflected in the acquirer’s consolidated financial statements and results of operations after the date of the acquisition.

 

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.

 

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 nine months ended March 31, 2012 and 2011.

 

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:

 

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.

 

11
 

The following table reflects gains and losses for the three and nine months ended March 31, 2012 for all financial assets and liabilities categorized as Level 3.

 

Liabilities:  Three months
(unaudited)
 
     
Balance of derivative liabilities as of December 31, 2011  $797,129 
Change in the fair value of derivative liabilities   (317,986)
Balance of derivative liabilities as of March 31, 2012  $479,143 

 

Liabilities:  Nine months
(unaudited)
 
     
Balance of derivative liabilities as of June 30, 2011  $937,867 
Change in the fair value of derivative liabilities   (458,724)
Balance of derivative liabilities as of March 31, 2012  $479,143 

 

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 11. 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. 

 

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:

 

   Nine months ended
March 31, 2012
   Year ended 
June 30, 2011
   Nine months ended
March 31, 2011
 
Period end US$: RMB exchange rate   6.3185    6.4635    6.5701 
Average periodic US$: RMB exchange rate   6.3626    6.6278    6.6796 

 

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 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.

 

12
 

 

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 and nine months ended March 31, 2012 and 2011, the Company’s sales return rate is low and deemed immaterial and accordingly, no provision for sales returns was recorded.

 

Research and Development Costs

 

Research and development costs are charged to expense as incurred and included in operating expenses. We have only one full-time employee who is engaged in research and development, so the Company is mainly dependent on a third-party, Yantai Tianzheng Medicine Research and Development Co., Ltd., to perform the limited amount of research and development that the Company undertakes. Primarily incurred by Yantai Tianzheng Medicine Research and Development Co., Ltd., the research and development costs were $0 and $190,440 for the three months ended March 31, 2012 and 2011, and were $0 and $562,261 for the nine months ended March 31, 2012 and 2011, respectively.

 

Shipping costs

 

Shipping costs are included in selling, general and administrative expense. Shipping costs amounted to $336,813 and $230,938 for the three months ended March 31, 2012 and 2011, respectively. Shipping costs amounted to $970,542 and $598,525 for the nine months ended March 31, 2012 and 2011, respectively.

 

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 $1,931,103 and $3,962,454 for the three months ended March 31, 2012 and 2011, respectively. As part of the selling, general and administrative expenses, the advertising and promotion expenses amounted to $8,789,884 and $10,461,435 for the nine months ended March 31, 2012 and 2011, respectively.

 

Recent Accounting Pronouncements

 

In May 2011, the FASB issued ASU No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS. The amendments change the wording used to describe the requirements in U.S. GAAP for measuring fair value and for disclosing information about the fair value measurements. The amendments include the following:

 

  · Those that clarify the intent of the Company’s Board of Directors regarding the application of existing fair value measurement and disclosure requirements.
     
  · Those that change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements.

 

The amendments in this Update are to be applied prospectively. For public entities, the amendments are effective during interim and annual periods beginning after December 15, 2011.  Early application by public entities is not permitted.  

   

The Company is currently evaluating the impact of this standard and do not expect its adoption have a material impact on the Company’s condensed consolidated financial statements.

 

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 will be effective for us beginning July 1, 2012.

 

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4. BUSINESS ACQUISITION

 

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 of Yantai Tianzheng to acquire 100% of Yantai Tianzheng’s equity interests for total purchase consideration of US$35,000,000 (paid in its RMB equivalent), payable in four installments: US$6,000,000 was paid on or before the calendar day of the Execution Date of the acquisition; $12,000,000 was due to be paid on or before February 8, 2012 the sixth month anniversary of the Execution Date; $12,000,000 is due to be paid on or before August 8, 2012 the 12 month anniversary of the Execution Date; and the remaining $5,000,000 is due to be paid on or before February 8, 2013 the 18 month anniversary of the Execution Date.

Payment schedule required by the contract is as follows:

 

In the event that the Company fails to pay any of the installments when due, such outstanding installment will be automatically converted into a two-year term loan, with interest accruing on any unpaid portion of such loan from its due date until such installment is paid in full at the rate of six percent (6%) per annum. As of March 31, 2012, $9.7 million was paid, and the balance is $25.3 million. $8,300,000 outstanding installment was automatically converted into a two-year term loan. Interest is accrued on any default loan from the first day after the applicable payment date (the “Conversion Date”) until such default loan is paid in full (with interest) at the rate of six percent (6%) per annum.

 

The acquisition expands the Company’s product lines and should allow the Company to leverage the sales and distribution channels of Bohai and Yantai Tianzheng by introducing new products. Yantai Tianzheng's current sales network spans over 16 major provinces as well as over 16 Tier 2 and Tier 3 cities, with products sold in over 1,100 hospitals across China.  In addition, Yantai Tianzheng brings excess manufacturing capacity which meets GMP standards and will allow Bohai to further expand its production.  Bohai is currently consolidating and integrating the two companies' operations, which creates the potential for significant improvement in the operating efficiency of the combined companies.

  

The Company accounted for its acquisitions of Yantai Tianzheng using the acquisition method of accounting. Accordingly, the results of operations for the three and nine months ended March 31, 2012, include the revenues and expenses of the acquired businesses since the effective control date of acquisition on July 1, 2011, which is the date the Company assumed control of Yantai Tianzheng pursuant to the terms of the share transfer agreement between WFOE II and the shareholders of Yantai Tianzheng.

 

The fair value of the purchase consideration issued to the sellers of Yantai Tianzheng was allocated to fair value of the net tangible assets acquired, with the resulting excess allocated to separately identifiable intangibles including customer relationships that have a finite life, pharmaceutical formulas that have an indefinite life and the remainder recorded as goodwill.

 

Goodwill recognized from the transactions mainly represented the expected operational synergies upon acquisition of the subsidiary and intangibles not qualifying for separate recognition.  Goodwill is nondeductible for income tax purpose in the tax jurisdiction of the acquisition transactions incurred.

 

The preliminary purchase price allocation is as follows*:

 

Purchase Consideration:     
Cash paid to sellers immediately following the closing  $6,000,000 
Acquisition installment obligation payable to sellers   29,000,000 
Less cash acquired   (1,358,078)
Net purchase consideration   33,641,922 
      
Tangible assets acquired:     
Restricted cash   386,787 
Accounts receivable   6,893,730 
Other receivable and advance to suppliers   208,240 
Inventories   1,312,170 
Property, plant and equipment   6,151,206 
Long term prepayments - land use rights   1,394,291 
Accounts payable   (2,386,576)
Other payable and accrued expenses   (1,081,425)
Income taxes payable   (729,796)
Advance from customers   (170,186)
Short-term borrowings   (2,088,652)
Deferred tax liabilities   (5,261,605)
Net tangible assets acquired   4,628,185 
      
Purchase consideration in excess of fair value of net tangible assets   29,013,737 
      
Allocated to:     
Customer relationships   14,151,156 
Pharmaceutical product formulas   9,887,986 
Goodwill   4,974,595 
   $0 

 

  * Using the exchange rate of the acquisition date

 

14
 

 

The purchase price allocation is preliminary and was based, in part, on management’s knowledge of Yantai Tianzheng’s business and the results of a third party appraisal commissioned by management. The purchase price allocation is subject to possible changes as additional facts and information about Yantai Tianzheng’s business come to the Company’s attention.

  

Yantai Tianzheng’s results of operations are consolidated with the Company effective July 1, 2011. The following table presents the unaudited pro-forma financial results, as if the acquisition of Yantai Tianzheng had been completed as of the beginning of the reporting periods and also includes the adjustments for the business combination effect of the amortization charges from acquired intangible assets and the related tax effects.

 

   Three Months Ended   Nine Months Ended 
   March 31, 2011   March 31, 2011 
Net Sales  $33,884,173   $98,492,387 
Net income  $4,684,583   $18,154,118 
Earnings per share- basic  $0.27   $1.07 
Earnings per share- diluted  $0.21   $0.81 

 

   Three Months Ended   Nine Months Ended 
   March 31, 2012   March 31, 2012 
Net Sales  $36,237,847   $101,002,589 
Net income  $5,303,918   $6,664,200 
Earnings per share- basic  $0.30   $0.37 
Earnings per share- diluted  $0.28   $0.37 

 

The unaudited pro-forma results of operations are presented for information purposes only. The unaudited pro-forma results of operations are not intended to present actual results that would have been attained had the acquisition been completed as of the dates presented or to project potential operating results as of any future date or for any future periods.

 

5. INVENTORIES

 

Inventories consist of the following:

 

   March 31,   June 30, 
   2012
(unaudited)
   2011 
         
Raw materials  $2,085,737   $739,363 
Work in progress   368,592    423,202 
Finished goods   1,210,535    348,456 
Total inventories  $3,664,864   $1,511,021 

 

6. PROPERTY, PLANT AND EQUIPMENT, NET

 

Property, plant and equipment consist of the following:

 

   March 31,   June 30, 
   2012
(unaudited)
   2011 
         
Buildings  $8,922,610   $5,122,557 
Plant equipment   2,429,341    1,348,819 
Office equipment   207,342    107,520 
Motor vehicles   285,421    258,720 
Total   11,844,713    6,837,616 
           
Less: accumulated depreciation   (2,041,662)   (1,622,654)
Construction in progress   1,954,854    - 
           
Property, plant and equipment, net  $11,757,905   $5,214,962 

 

15
 

 

Depreciation expense for property, plant and equipment for the three months ended March 31, 2012 and 2011 amounted to $142,733 and $87,847, respectively. Depreciation expense for property, plant and equipment for the nine months ended March 31, 2012 and 2011 amounted to $379,124 and $260,577, respectively.

  

Substantially all of Bohai’s assets are pledged on a collective basis to secure the Company’s convertible notes obligation. As of June 30, 2011, the Company has specifically pledged certain plant equipment and machinery having a carrying amount of approximately $390,000 to secure a bank loan on behalf of Bohai.

 

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 June 2012. The remaining commitment of the contract was approximately $0.46 million (RMB2.9 million) as of March 31, 2012.

 

7. LONG TERM PREPAYMENTS - LAND USE RIGHTS, NET

 

   March 31,   June 30, 
   2012
(unaudited)
   2011 
         
Land use rights, at cost  $20,227,169   $17,999,002 
Less: Accumulated amortization   (1,282,833)   (421,731)
Intangible assets – land use rights, net  $18,944,336   $17,577,271 

 

Amortization expense amounted $154,252 and $19,775 for the three months ended March 31, 2012 and 2011, respectively. Amortization expense amounted to $ 427,133 and $59,325 for the nine months ended March 31, 2012 and 2011, respectively. Amortization of land use rights for fiscal years ending subsequent to March 31, 2012 is as follows:

 

   Amortization 
Remainder of FY2012  $142,378 
2013   569,511 
2014   569,511 
2015   569,511 
2016   569,511 
Thereafter   16,523,914 
Total  $18,944,336 

 

8. INTANGIBLE ASSETS – CUSTOMBER RELATIONSHIPS, NET

 

Intangible assets –customer relationships, net represents customer relationships related to the Yantai Tianzheng workforce acquired during the Yantai Tianzheng acquisition as described in Note 4. Customer relationships are amortized on a straight line basis over periods of 5 and 8 years.

 

Intangible assets – customer relationship, net at March 31, 2012 is as follow:

 

   March 31, 2012
(unaudited)
 
Customer relationships, at cost  $14,475,904 
Accumulated amortization   (1,382,132)
      
Intangible assets – customer relationships, net  $13,093,772 

 

16
 

  

Amortization expense amounted $ 460,711 and $0 for the three months ended March 31, 2012 and 2011, respectively. Amortization expense amounted to $ 1,382,132 and $0 for the nine months ended March 31, 2012 and 2011, respectively.

 

9. ACCRUED EXPENSES

 

Accrued expense consists of the following:

 

   March 31,   June 30, 
   2012
(unaudited)
   2011 
         
Accrued expense to sales person  $3,617,183   $2,605,375 
Other taxes payable   1,973,541    1,056,691 
Other accrued expense   766,459    389,123 
Accrued payroll and welfare   381,865    261,144 
Accrued advertising expense   285,669    - 
Total  $7,024,717   $4,312,333 

 

10. SHORT-TERM BORROWINGS

 

The Company has short-term loan facilities from financial institutions in the PRC. Short-term borrowings as of March 31, 2012 and June 30, 2011 consist of the following:

 

Loan from     Annual   March 31,   June 30, 
financial institution  Loan period  interest rate   2012   2011 
                   
China Citic Bank  February 23, 2011 to February 23, 2012   7.57%  $-   $- 
Yantai Laishan Rural Credit Union  September 21, 2010 to September 20, 2011   9.03%   -    618,860 
Yantai Laishan Rural Credit Union  September 21, 2010 to September 20, 2011   6.90%   -    301,694 
Total short-term borrowings          $-   $920,554 

 

The loan from China Citic Bank is from Yantai Tianzheng and is guaranteed by Yantai Tianzheng’s CEO, Chi Jiangbo and his wife Jiang Chunying. Interest expense for short-term borrowings for the three months ended March 31, 2012 and 2011 amounted to $21,843 and $19,659, respectively. Interest expense for short-term borrowings for the nine months ended March 31, 2012 and 2011 amounted to $107,261 and $187,446, respectively.

 

11. CONVERTIBLE PROMISSORY NOTES AND WARRANTS

 

Convertible notes, net of unamortized original issuance discounts are as follows:

 

   March 31,   June 30, 
   2012
(unaudited)
   2011 
         
Convertible notes payable, at full principal value  $10,450,000   $10,450,000 
Less: unamortized beneficial conversion feature and warrants discount on convertible notes   -    (9,317,897)
Convertible notes, net  $10,450,000   $1,132,103 

 

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 representing the aggregate number of Investor Warrants purchased by them as part of the units.

 

17
 

  

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 adjustment as set forth in the Note.

 

On December 31, 2011, the Company entered into an amendment to the Notes with Euro Pacific as representative of the Investors 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).  As described in notes 2 and 18, the Company’s Chinese operating entity was unable to convert the currency needed by the US Holding to repay the notes on the extended maturity date of April 5, 2012. The Company and Euro Pacific were seeking to negotiate a second amendment to the Notes to further extend the maturity date thereof. See Notes 2 and 18. 

 

Warrants

 

The Investor Warrants expire on January 5, 2013 and may be exercised by the holder at any time to purchase one share of Common Stock at an exercise price of $2.40 per share (subject to adjustment as set forth in the Investor Warrants). The exercise price of the Investor Warrants is subject to adjustment in the same manner as the conversion price of the Notes described above, except that the exercise price will not be adjusted to less than $1.20, as adjusted for any stock dividend, stock split, stock combination, reclassification or similar transaction. The Investor Warrants may only be exercised for cash and do not permit the holder to perform a cashless exercise.

 

In connection with the sale of the units, BPGI paid the placement agents a cash fee of $1,200,000. In addition, the placement agents received warrants (the “Placement Agent Warrants” and, together with the Investor Warrants, the “Warrants”) to purchase 600,000 shares of Common Stock, which Placement Agent Warrants are substantially identical to the Investor Warrants.

 

At March 31, 2012, the fair values of the Investor Warrants and Placement Agent Warrants amounted $435,584 and $43,558, respectively, using a binomial model, based on the closing market price on that date of $0.25, a term equal to the remaining life of the Warrants which is 0.77 years, an expected dividend yield of 0%, a risk-free interest rate of 0.17% based on constant maturity rates published by the U.S. Federal Reserve applicable to the remaining life of the Warrants and estimated volatility of 55%, based on a review of the historical volatility of companies considered by management to be comparable to the Company. The effect of the down-round anti-dilution protection was not considered to be material and no adjustment was made for it in the estimated fair value of the Investor Warrants and the Placement Agent Warrants.

 

The aggregate change in fair value of the Investor and Placement Agent Warrants for the three months ended March 31, 2012 and 2011 of $317,986 and $263,118, respectively, has been recorded as loss, respectively, on condensed consolidated statements of operation. The aggregate change in fair value of the Investor and Placement Agent Warrants for the nine months ended March 31, 2012 and 2011 of $458,724 and $3,181,603, respectively, has been recorded as a component of other income (expense), respectively, on the condensed consolidated statements of income.

 

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 $720,196and $229,376 for the three month periods ended March 31, 2012 and 2011, respectively. Accretion of the note discount amounted to $9,317,898and $339,842 for the nine month periods ended March 31, 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 $731,808 and $438,376 for the three months ended March 31, 2012 and 2011, respectively. Contractual interest expense amounted to $9,747,509 and $986,842 for the nine months ended March 31, 2012 and 2011, respectively. There is an aggregate of 5,225,000 shares of Common Stock issuable under all remaining convertible notes as of March 31, 2012.

  

Escrowed Shares

 

As of January 5, 2010 and at March 31, 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 (as defined in the Notes).

 

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 March 31, 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 $190,440 for the three months ended March 31, 2012 and 2011, respectively. Research and development costs associated with this contract amounted to $0 and $562,261 for the nine months ended March 31, 2012 and 2011, respectively.

 

18
 

 

(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     Nine months     Nine months  
    ended     ended     ended     ended  
    March 31,     March 31,     March 31,     March  
   

2012

(unaudited)

   

2011

 

   

2012

(unaudited)

   

31, 2011

 

 
                                 
Shandong Yantai Medicine Procurement and Supply Station     16.2 %     18.8 %     13.4 %     18.6 %
Anguo Jinkangdi Chinese Herbal Medicine Co. Ltd     * %     10.6 %     * %     11.3 %
Anhui DeChang Pharmaceutical Co. Ltd.     14.5 %     *     16.1 %     *

 

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

 

We have short term raw material purchase obligations from various unrelated third parties in the amount of $2,986,618 (RMB 18,990,408) and the contractual obligation was fulfilled in October 2011.

 

(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 22.3%, 8.8%, 16.0%, 11.1% and 20.5%, respectively, of total sales for the three months ended March 31, 2012.

  

Five of the Company’s products, namely Tongbi Capsules, Tongbi Tablets, Lung Nourishing Syrup, Zhengxintai Capsules and Fangfengtongsheng Tablets represented approximately 22.6%, 9.1%, 16.8%, 10.4% and 18.3%, respectively, of total sales for the nine months ended March 31, 2012.

 

Three of the Company’s products, namely Tongbi Capsules, Tongbi Tablets and Lung Nourishing Syrup, represented approximately 27.4%, 14.2% and 26.1%, respectively, of total sales for the three months ended March 31, 2011. 

 

Three of the Company’s products, namely Tongbi Capsules, Tongbi Tablets and Lung Nourishing Syrup represented approximately 27.4%, 14.6% and 26.4%, respectively, of total sales for the nine months ended March 31, 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.

 

19
 

 

At March 31, 2012 and June 30, 2011, the Company’s cash balances by geographic area were as follows:

 

   March 31,   June 30, 
   2012
(unaudited)
   2011 
Country:                    
United States  $7,120    0.03%  $198,521    1%
China   23,037,136    99.97%   13,145,905    99%
Total cash and cash equivalents  $23,044,256    100%  $13,344,426    100%

 

(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 at approximately 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) Purchase obligation

 

We had a commitment to purchase certain raw materials $3,252,539 as of March 31, 2012 that was fulfilled upon the delivery of the goods in April 2012.

 

(h) 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 (LOSS) 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
   Nine months
ended
   Nine months
ended
 
   March
31, 2012
(unaudited)
   March
31, 2011
   March
31, 2012
(unaudited)
   March
31, 2011
 
                 
Net income (loss) available to common stockholders-basic  $5,303,918   $2,685,346   $6,664,200   $12,238,716 
Effective interest on convertible notes and amortization of debt issue costs   1,064,707    438,376    10,552,548    986,842 
Net income available for common shareholders – diluted  $6,368,625   $3,123,722   $17,216,748   $13,225,558 

 

   Three months
ended
   Three months
ended
   Nine months
ended
   Nine months
ended
 
   March
31, 2012
(unaudited)
   March
31, 2011
   March
31, 2012
(unaudited)
   March
31, 2011
 
Weighted average number of common shares outstanding - basic   17,861,085    17,544,163    17,861,085    16,988,489 
Options - incremental shares based on  assumed proceeds & repurchases   -    -    -    75 
Restricted stock   -    14,722    -    9,398 
Common shares if converted from Convertible Debt   5,225,000    5,250,000    5,225,000    5,441,240 
Weighted average number of common shares outstanding - diluted   23,086,085    22,808,885    23,086,085    22,439,202 
                     
Earnings (loss) per share:                    
Basic  $0.30   $0.15   $0.37   $0.72 
Diluted  $0.28   $0.14   $0.37   $0.59 

 

20
 

  

Warrants to purchase 6,600,000 shares of Common Stock and stock options to purchase 32,000 shares of Common Stock were outstanding during the three and nine months ended March 31, 2012 but were excluded from the computation of diluted earnings per share where applicable as these exercise prices of these securities exceeded the average stock price for the three and nine months ended March 31, 2012. In addition, 5,225,000 shares of stock representing shares issuable upon the conversion of convertible notes were excluded from the loss per share calculation for the three and nine months ended March 31, 2012 because their effect would be anti-dilutive, after adjusting the net loss to exclude contractual interest expense, accretion of note discount and the amortization of debt issue cost in the aggregate amount of $10,232,548.

 

14. STOCK OPTIONS

 

Restricted Stock Awards

 

On June 4, 2010, we granted 120,000 shares of Restricted Common Stock to our Chief Financial Officer for three years of service. The Restricted Common Stock vests in three equal annual installments over the related service period. We issued 40,000 shares of Restricted Common Stock with an aggregate fair value of $95,000 under this agreement during the year ended June 30, 2011. $22,000 and $44,000 stock compensation expenses were accrued for the three and nine months ended March 31, 2012, respectively. There were no shares issued for the nine months ended March 31, 2012. $22,000 and $73,000 stock compensation expenses were accrued for the three and nine months ended March 31, 2011, respectively. Our Chief Financial Officer resigned on December 31, 2011

 

15. SELLING, GENERAL AND ADMINISTRATIVE EXPENSE

 

For the three and nine months ended March 31, 2012 and 2011, selling, general and administrative expenses consisted of the following:

 

   Three months
ended
   Three months
ended
   Nine months
ended
   Nine months
ended
 
   March 31,
2012
(unaudited)
   March 31,
2011
   March 31,
2012
(unaudited)
   March 31,
2011
 
                 
Travel and accommodation  $5,339,055   $3,197,894   $13,079,622   $7,215,635 
Advertising and promotion   1,931,104    3,962,454    8,789,884    10,461,435 
Audit fees and expenses   8,226    12,483    74,477    101,534 
Commission   2,188,762    1,155,155    4,952,778    2,628,125 
Conferences   5,190,607    1,269,264    15,328,133    4,161,191 
Depreciation and amortization   634,116    10,421    1,881,177    30,427 
Staff costs   827,459    966,557    1,922,393    2,106,130 
Research and development cost   -    190,440    -    562,261 
Other operating expenses   3,668,299    2,081,292    8,719,645    5,299,241 
                     
Total selling, general and administrative expenses  $19,787,628   $12,845,962   $54,748,109   $32,565,981 

 

16.  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, 2012. 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, 2012.

 

21
 

 

17. VIE

 

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

 

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

 

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 arrangement may not be as effective in the providing the Company with control over the VIEs as director 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.

 

  · 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

 

22
 

 

18. 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.

 

Proposed Second Extension to Note Maturity Date

 

On April 3, 2012, the Company announced that it was in active discussions with Euro Pacific to (i) extend the maturity date of the Notes from April 5, 2012 to October 5, 2012 (such proposed extra six month period, the “Second Extended Period”); and (ii) maintain the interest rate on the Notes as an annual rate of 12% (or 6% for the Second Extended Period) (such amendments to the Note, the “Second Amendment”). In such announcement, the Company disclosed that to demonstrate the Company’s efforts to repay the Notes, the Company expected to repay 10% of the $10.45 million then due under the Notes by April 13, 2012 (the “Repayment”). In addition, as part of the contemplated Second Amendment, the Company was expected to establish an RMB denominated escrow account in China and to deposit into such escrow account the remaining outstanding amount of the Notes, which the Company will have no right to dispose of or use except for (i) conversion into US Dollars for the purpose of repayment of the Notes or (ii) releases from such Escrow Account from time to time in amounts equal to the decreases in the outstanding amount of the Notes, either by payments made by the Company or conversion of the Notes by Note holders.

 

On May 8, 2012, a Three Parties Fund Escrow Agreement (“Escrow Agreement”) was entered into among Yantai Shencaojishi Pharmaceuticals Co., Ltd., the wholly-owned subsidiary of the Company (“Yantai Shencaojishi”), Euro Pacific and Rural Credit Cooperative of Laishan District, Yantai City (the “Bank”). Pursuant to the Escrow Agreement, an RMB-denominated escrow account (the “Escrow Account”) was established with Bank and RMB 59 million (approximately $10.45 million) was deposited by Yantai Shencaojishi into the Escrow Account. On May 9, 2012, a Supplemental Agreement to the Escrow Agreement with details of the Escrow Account was entered into by the Company, Euro Pacific and the Bank. The Escrow Agreement provides that the Escrow Account will be managed by both the Company and Euro Pacific and that withdrawal of cash from the Escrow Account cannot be done without prior written consent from both the Company and Euro Pacific.

 

As of the date of this Quarterly Report on Form 10-Q, the Repayment is being processed and the Company expects to repay a portion of the Repayment by May 15, 2012 in the amount of approximately $314,000, which is equivalent to the amount of the first quarter 2012 interest payment on the Notes (calculated based on an annual rate of 12% as discussed above). In addition, the Company will make its best efforts to repay the reminder of the Repayment in the amount of approximately $731,000 as soon as possible but no later than June 30, 2012.

 

After the first payment of $314,000 described above is distributed to Note holders, the Company is expected to enter into the Second Amendment with Euro Pacific. A provision will be included in the Second Amendment that the Second Extended Period will automatically expire on June 30, 2012 and the outstanding balance of the Notes will become immediately due and payable if the reminder of the Repayment is not received and distributed to Note holders on June 30, 2012.

 

23
 

 

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 and nine months ended March 31, 2012 and 2011, 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 19 varieties of approved traditional Chinese herbal medicines in seven delivery systems: tablets, granules, capsules, formulations, concentrated powder, tincture and medicinal wine. Of these 19 products, 12 are prescription drugs and 7 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:

 

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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 $654,371 and $(85,725) income/(expenses) for the three months ended March 31, 2012 and 2011, respectively, and $10,033,519 and $(1,967,772) for the nine months ended March 31, 2012 and 2011, respectively.

 

Management believes that these Non-GAAP financial measures are useful to investors in that they provide supplemental information to intended 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 and nine months ended March 31, 2012 and 2011:

 

   Three Months Ended   Nine Months Ended 
   March 31,   March 31, 
           Increase           Increase 
   2012
(unaudited)
   2011   (Decrease)   2012
(unaudited)
   2011   (Decrease) 
Net Income (loss) available to Common shareholders -GAAP  $5,303,918   $2,685,346   $2,618,572   $6,664,200   $12,238,716   $(5,574,516)
Add Back (Subtract):                              
Change in fair value of warrants   (317,986)   (263,118)   (54,868)   (458,724)   (3,181,603)   2,722,879 
Amortization of beneficial conversion features on convertible notes converted   731,808    96,393    635,415    9,747,509    1,029,487    8,718,022 
Change in Option and Equity Based Compensation   0    81,000    (81,000)   44,000    184,344    (140,344)
Deferred income tax expenses  - indefinite intangible assets   240,549    -    240,549    700,734    -    700,734 
Adjusted Net Income available to Common shareholders -non-GAAP  $5,958,289   $2,599,621   $3,358,668   $16,679,719   $10,270,944   $6,426,775 
                               
Net income margins -non-GAAP   16.44%   11.70%   4.74%   16.53%   16.80%   (0.27)%
Basic earning (loss) per share – GAAP  $0.30   $0.15   $0.15   $0.37   $0.72   $(0.35)
Add back (Subtract):                              
Change in fair value of warrants   (0.02)   (0.01)   (0.01)   (0.03)   (0.19)   0.16 
Amortitized beneficial conversion features on convertible notes converted   0.04    0.01    0.03    0.55    0.06    0.49 
Deferred tax expenses  - indefinite intangible assets   0.01    -    0.01    0.04    -    0.04 
Adjusted basic earning per share non-GAAP  $0.33   $0.15   $0.18   $0.93   $0.60   $0.33 
                               
Diluted earning (loss) per share-GAAP  $0.30   $0.14   $0.16   $0.37   $0.59   $(0.22)
Add back (Subtract):                              
Change in fair value of warrants   (0.02)   (0.01)   (0.01)   (0.03)   (0.14)   0.11 
Unamortized beneficial conversion features on convertible notes converted   0.04    0.00    0.04    0.55    0.05    0.50 
Change in Option and Equity Based Compensation   0.00    0.00    (0.00)   0.00    0.01    (0.01)
Deferred tax expenses  - indefinite intangible assets   0.01    -    0.01    0.04    -    0.04 
Adjusted diluted earning per share non-GAAP  $0.33   $0.14   $0.19   $0.93   $0.50   $0.43 
                               
Weighted average number of shares                              
Basic   17,861,085    17,544,163         17,861,085    16,988,489      
Diluted   17,861,085    22,808,885         17,861,085    22,439,202      

 

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Principal Factors Affecting Our Financial Performance

 

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

 

Sales of Key Products

 

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

  

   For the three months ended   For the nine months ended 
   March 31,   March 31, 
   2012
(unaudited)
   2011   2012
(unaudited)
   2011 
Lung Nourishing Syrup   16.0%   26.1%   16.8%   26.6%
Tongbi Capsules   22.3%   27.4%   22.6%   27.4%
Tongbi Tablets   8.8%   14.2%   9.1%   14.8%
Zhengxintai Capsule   11.1%   -    10.4%    -
Fangfengtongsheng Granule   20.5%   -    18.3%    -
Other Products   21.3%   32.3%   22.8%   31.2%
Total Sales   100%   100%   100%   100%

  

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.

 

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Financial Highlights

 

  · Net revenues for the three months ended March 31, 2012 increased 66.3% to $36.2 million compared to the same period in 2011. Net revenues for the nine months ended March 31, 2012 increased 67.4% to $101.0 million compared to the same period in 2011.

 

  o 65% of net revenues was from Bohai and 35% was from Yantai Tianzheng this third fiscal quarter compared to the same quarter last fiscal year. 68% of net revenues was from Bohai and 32% was from Yantai Tianzheng this first three fiscal quarters compared to the same quarter last fiscal year.

  

  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 78.7% and 77.2% of our total net revenues for the three and nine months ended March 31, 2012, respectively.

 

  o 78% of net revenue was derived from sales of prescription products and 22% was from Over-the-Counter products for the three months ended March 31, 2012. 77% of net revenue was derived from sales of prescription products and 23% was from Over-the-Counter products for the nine months ended March 31, 2012.

 

  · Non-GAAP net income for the three months ended March 31, 2012 increased 129.2% to $5.9 million compared to the same period in 2011. The difference was mainly due to net income from Tianzheng acquisition offset by net increase in effective interest charges on convertible notes of $0.73 million this third quarter ended March 31, 2012 compared to the same quarter in last year. (See above Use of Non-GAAP Financial Measures). Non-GAAP net income for the nine months ended March 31, 2012 increased 62.6% to $16.7 million compared to the same period in 2011. GAAP net income for the three months ended March 31, 2012 increased 97.5% to $5.3 million compared to the same period in 2011. GAAP net income for the nine months ended March 31, 2012 decreased 45.5% to $6.7 million compared to the same period in 2011. The difference was mainly due to net income from Tianzheng acquisition offset by net increase in effective interest charges on convertible notes of $9.7 million during the three quarters ended March 31, 2012 compared to the same quarter in last year. (See above Use of Non-GAAP Financial Measures).

 

  o Income from operations increased 102.0% to $8.3 million this third quarter compared to the same quarter in the last fiscal year. Income from operations increased 50.5% to $23.1 million this first three quarter compared to the same quarter in the last fiscal year.

 

  o Net income margin increased from 12.3% for the three months ended March 31, 2011 to 14.6% for the three months ended March 31, 2012. Net income margin decreased from 20.3% for the nine months ended March 31, 2011 to 6.6% for the nine months ended March 31, 2012. The decrease was mainly due to the net increase in certain non-cash activities such as effective interest charges from convertible notes and deferred income tax expenses as well as increase in selling related expenses.

 

  o Included in the net income this third fiscal quarter were non-cash charges in effective interest of $0.7 million, a non-cash charge in deferred income tax expenses of $0.2 million, and a non-cash credit of $(0.3) million in changes in fair value of warrants. Included in the net income the first three fiscal quarters ended March 31, 2012 were non-cash charges in effective interest of $9.7 million, a non-cash charge in deferred income tax expenses of $0.7 million, and a non-cash credit of $(0.5) million in changes in fair value of warrants.

 

  · Basic and diluted earnings per share were $0.37 for the nine months ended March 31, 2012.

 

  o Non-GAAP Diluted earnings per share increased 87.0% to $0.93 for the nine months ended March 31, 2012 compared to the same period in 2011.

 

  o Non-GAAP Basic earnings per share increased 55.8% to $0.93 for the nine months ended March 31, 2012 compared to the same period in 2011.

  

  · Including restricted cash, our total cash balance was $23.4 million as of March 31, 2012 and cash flow from operating activities was $16.0 million for the nine months ended March 31, 2012.

 

  o Total cash and cash equivalents increased by $9.7 million for the nine months ended March 31, 2012 compared to June 30, 2011.

 

  o Major cash payment activities for the nine months ended March 31, 2012 included $3.1 million for the repayment of short term bank loans.

 

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Operating Results

 

Comparison of the three months ended March 31, 2012 and 2011

 

Net Revenues

 

Net revenues are comprised of sales of 19 traditional Chinese medicines in China during the three months ended March 31, 2012 (we currently sell 19 medicines following our acquisition of Yantai Tianzheng on August 8, 2011).  Net revenues for the three months ended March 31, 2012 increased by $14,444,216, or 66.3%, to $36,237,847 as compared to $21,793,631 for the three months ended March 31, 2011. Net revenues were $23,601,089 and $12,636,758 for Bohai and Yantai Tianzheng, respectively, for the three months ended March 31, 2012. The increase in Bohai’s revenue was primarily due to a net increase in revenues of 12.0% from our four lead products in Bohai: Lung Nourishing Syrup, Tongbi Capsules, Tongbi Tablets, and Shantongning Tablets, which together accounted for over 82.0% of our total net revenues for Bohai. All of our lead products are listed for coverage and reimbursement under national medical insurance program starting in December 2009. The sale of our prescription drug products for the three months ended March 31, 2012 represented 78% of total net revenue compared to 61 % for the same period in last year. The increase in prescription sales was primary due to increases in sales volume from 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 March 31, 2012 was $8,180,762 as compared to $4,853,768 for the three months ended March 31, 2011, representing an increase of $3,326,994, or 68.5%. Cost of revenues were $4,751,410 and $3,429,352 for Bohai and Yantai Tianzheng, respectively, for the three months ended March 31, 2012.  The increase in cost of revenues for the three months ended March 31, 2012, compared to the same periods in last year, was mainly attributable to cost of revenues of $3.4 million of Tianzheng which was acquired on July 1, 2011 and due to an increase in total cost of raw material, labor, and overhead as a result of an increase in overall sales from Bohai.

 

Gross Profit

 

Gross profit represents the difference between net revenues and cost of revenues. We achieved gross profit of $28,057,085 for the three months ended March 31, 2012, compared to $16,939,863 for the same period in 2011, representing an increase of $11,117,222, or 65.6%, over the same periods in 2011. The increase of the gross profit is due to gross profit from Tianzheng, which was acquired on July 1, 2011, as well as due to increased revenues from Bohai.

  

Our overall gross profit margins as a percentage of net revenues decreased by approximately 0.3% from 77.7% to 77.4% this fiscal quarter at March 31, 2012 compared to the same period in 2011.The decrease of the gross profit margin is because of increased raw material cost for the nine months ended March 31, 2012 compared to the same period last year. Meanwhile, the company also makes the effort to improve the cost control to avoid negative inflation effect.

  

Selling, General and Administrative Expenses

 

Our selling, general and administrative expenses increased by $6,941,666 to $19,787,628, for the three months ended March 31, 2012 compared to $12,845,962 for the same fiscal periods in 2011. The overall increase in selling, general, and administrative expenses was related to services supporting an overall increase in sales activities and new product promotions as well as increased activities arising from our acquisition of Yantai Tianzheng. Selling, general and administrative expenses amounted to $7,017,616 from Yantai Tianzheng for the three months ended March 31, 2012. The percentage of selling, general, and administrative expenses to net revenues was 54.6% and 58.9% for the three months ended March 31, 2012 and 2011, respectively, representing a decrease of 4.3% as a percentage of net revenues.

 

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 $791,411 for the three months ended March 31, 2012 compared to total other expenses of $511,097 for the period ended March 31, 2011, an increase of total other expenses of $280,314. The increase in total other expenses were principally due to a net increase of $635,415 for non-cash effective interest charges offset by decreased $232,200 amortization of deferred financing cost. The effective interest expense for convertible note 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).  Number of outstanding convertible notes was 5,225,000 as of March 31, 2012 (See Note 11).

 

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Provision for Income Tax

 

Our provisions for income taxes for the three months ended March 31, 2012 and 2011 were $2,174,128 and $897,458, an increase of $1,276,670, or 142.3%, 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 as well as income tax provision from Yantai Tianzheng.

 

Net Income

 

We had a net income of $5,303,918 for the three months ended March 31, 2012, as compared to net income of $2,685,346 for the three months ended March 31, 2011, an increase in net income of $2,618,572, or 97.5%. This translates into basic earnings (loss) per common share of $0.30 and $0.15, and diluted earnings (loss) per common share of $0.30 and $0.14, for the three months ended March 31, 2012 and 2011, respectively. The increase in net income was primarily attributable to an increase in total gross profit of $11,117,221, offset by an increase in selling, general and administrative expenses of $6,914,666, an increase in total other expenses of $280,314 resulting from mostly effective interest charges, and an increase in the tax provision of $1,276,670 this fiscal quarter compared to the same period in prior year.

 

Net income margin was 14.6% for the three months ended March 31, 2012 compared to net income margin 12.3% for the same period last year, an increase of 18.8%. The increase in net income margin for the three months ended March 31, 2012 over the same period in the previous fiscal year was principally due to a net increase in certain non-cash related activities such as effective interest charges and unamortized beneficial conversion features on convertible notes converted for a total of $731,808 as well as a non-cash net difference in deferred tax expense of $240,549. If we excluded such net gains, the net income margin would be 17.3% this fiscal quarter.

 

We had Non-GAAP net income of $5,980,289 for the three months ended March 31, 2012, as compared to Non-GAAP net income of $2,599,621 for the three months ended March 31, 2011, an increase in Non-GAAP net income of $3,358,668, or 129.2%. This translates into basic Non-GAAP net income per common share of $0.33 and $0.15, and Non-GAAP diluted net income per common share of $0.33 and $0.14, for the three months ended March 31, 2012 and 2011, respectively (See Use of Non-GAAP Financial Measures above).

 

Total other income included a non-cash charge in effective interest expenses of $731,808 for the three months ended March 31, 2012 compared to $96,393 for the same period in 2011.

 

Total other income for the three months ended March 31, 2012 also comprised of a non-cash credit for fair value of warrants of $317,986.

 

Comparison of the nine months ended March 31, 2012 and 2011

 

Net Revenues

 

Net revenues are comprised of sales of 19 traditional Chinese medicines in China during the nine months ended March 31, 2012 (we currently sell 19 medicines following our acquisition of Yantai Tianzheng on August 8, 2011).  Net revenues for the nine months ended March 31, 2012 increased by $40,651,561, or 67.4%, to $101,002,589 as compared to $60,351,028 for the nine months ended March 31, 2011. Net revenues were $68,818,996 and $32,183,593 for Bohai and Yantai Tianzheng, respectively, for the nine months ended March 31, 2012. The increase in Bohai’s revenue was primarily due to a net increase in revenues of 10.4% from our four lead products in Bohai: Lung Nourishing Syrup, Tongbi Capsules, Tongbi Tablets, and Shantongning Tablets, which together accounted for over 78.4% of our total net revenues for Bohai.  All of our lead products are listed for coverage and reimbursement under national medical insurance program starting in December 2009. The sale of our prescription drug products for the nine months ended March 31, 2012 represented 77.3% of total net revenue compared to 60.9% for the same period in last year.  The increase in prescription sales was primary due to increases in sales volume from our two prescription drugs, Tongbi Capsules and Tongbi Tablets as well as prescription product sales from Yantai Tianzheng. Yantai Tianzheng was acquired on July 1, 2011.

 

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 nine months ended March 31, 2012 was $23,106,879 as compared to $12,402,897 for the nine months ended March 31, 2011, representing an increase of $10,703,982, or 86.3%. Cost of revenues were $14,440,286 and $8,666,593 for Bohai and Yantai Tianzheng, respectively, for the nine months ended March 31, 2012.  The increase in overall cost of revenue was also due to cost of revenues of approximately $8.7 million from Yantai Tianzheng which was acquired on July 1, 2011. The increase in cost of revenues was also attributable to an increase in total cost of raw material, labor, and overhead as a result of an increase in overall sales from Bohai for the nine months ended March 31, 2012 and attributable to increased unit cost mainly caused by increase raw material cost compared to the same period in last year.

 

29
 

 

Gross Profit

 

Gross profit represents the difference between net revenues and cost of revenues. We achieved gross profit of $77,895,710 for the nine months ended March 31, 2012, compared to $47,948,132 for the same period in 2011, representing an increase of $29,947,578, or 62.5%, over the same periods in 2011. The increase of the gross profit is due to gross profit from Tianzheng, which was acquired on July 1, 2011, as well as due to increased revenues from bohai.

 

Our overall gross profit margins as a percentage of net revenues decreased by approximately 2.4% from 79.4% to 77.1% the nine months ended March 31, 2012 compared to the same period in 2011. The decrease of the gross profit margin is because of increased raw material cost for the nine months ended March 31, 2012 compared to the same period last year. Meanwhile, the company also makes the effort to improve the cost control to avoid negative inflation effect.

 

Selling, General and Administrative Expenses

 

Our selling, general and administrative expenses increased by $22,182,128 to $54,748,109, for the nine months ended March 31, 2012 compared to $32,565,981 for the same fiscal period in 2011. The overall increase in selling, general, and administrative expenses was related to services supporting an overall increase in sales activities and new product promotions as well as increased activities arising from our acquisition of Yantai Tianzheng. Selling, general and administrative expenses amounted to $18,522,447 from Yantai Tianzheng for the nine months ended March 31, 2012. The percentage of selling, general, and administrative expenses to net revenues was 54.2% and 54.0% for the nine months ended March 31, 2012 and 2011, respectively, representing an increase of 0.2% as a percentage of net revenues.

 

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 $10,194,622 for the nine months ended March 31, 2012 compared to total other income of $379,710 for the period ended March 31, 2011, an increase of total other expenses of $10,574,332. The increase in total other expenses were principally due to a net increase of $8,490,571 for non-cash effective interest charges offset by a net increase in non-cash gain in fair value of warrants for $2,722,879 for convertible notes in connection with our private placement on January 5, 2010. The effective interest expense for convertible note 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). Number of outstanding convertible notes was 5,225,000 as of March 31, 2012 (See Note 11).

  

Provision for Income Tax

 

Our provisions for income taxes for the nine months ended March 31, 2012 and 2011 were $6,288,779 and $3,523,145, an increase of $2,765,634, or 78.5%, 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 as well as income tax provision from Yantai Tianzheng (see Note 15 to the accompanying unaudited financial statements).

 

Net Income

 

We had a net income of $6,664,200 for the nine months ended March 31, 2012, as compared to net income of $12,238,716 for the nine months ended March 31, 2011, a decrease in net income of $5,574,516, or 45.5%. This translates into basic net income per common share of $0.37 and $0.72 and diluted net income per common share of $0.37 and $0.59, for the nine months ended March 31, 2012 and 2011, respectively. The decrease in net income was primarily attributable to an increase in total gross profit of $29,947,578 offset by an increase in selling, general and administrative expenses of $7,765,450, an increase in total other expenses of $10,574,332 resulting from mostly effective interest charges, and an increase in the tax provision of $2,765,634 this fiscal quarter compared to the same period in prior year.

 

Net income margin was 6.6% for the nine months ended March 31, 2012 compared to 20.3% for the same period last year, a decrease of 67.5%. The decrease in net income margin for the nine months ended March 31, 2012 over the same period in the previous fiscal year was principally due to a net increase in certain non-cash related activities such as effective interest charges and unamortized beneficial conversion features on convertible notes converted for a total of $8,718,722, as well as a non-cash net difference in deferred tax expense of $70,734. If we excluded such net gains, the net income margin would be 16.9% this fiscal quarter.

 

We had Non-GAAP net income of $16,679,719 for the nine months ended March 31, 2012, as compared to Non-GAAP net income of $10,270,944 for the nine months ended March 31, 2011, an increase in Non-GAAP net income of $6,426,775, or 62.6%. This translates into basic Non-GAAP net income per common share of $0.93 and $0.60, and Non-GAAP diluted net income per common share of $0.93 and $0.50, for the nine months ended March 31, 2012 and 2011, respectively (See Use of Non-GAAP Financial Measures above).

 

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Total other income included a non-cash charge in effective interest expenses of $9,747,509 for the nine months ended March 31, 2012 compared to $1,029,487 for the same period in 2011.

 

Total other income for the nine months ended March 31, 2012 also comprised of a non-cash credit for fair value of warrants of $458,724.

 

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 March 31, 2012, we had cash and cash equivalents of $23,044,256 and restricted cash of $328,823, 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 nine months ended 
   March 31 
   2012
(unaudited)
   2011 
Net cash provided by operating activities  $15,770,702   $9,016,541 
Net cash used in investing activities   (9,519,284)   (14,307,391)
Net cash provided by financing activities   3,240,921    (1,668,927)
Effect of foreign currency translation on cash and cash equivalents   207,491    476,212 
Net increase (decrease) in cash and cash equivalent  $9,699,830   $(6,483,565)

 

On January 5, 2010, pursuant to a Securities Purchase Agreement with 128 accredited investors, we 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 $2.0, or the Notes, and one common stock purchase warrant, or the Warrants. The Notes bear interest at 8% per annum, payable quarterly in arrears on the last day of each of our fiscal quarters. No principal payments are required until maturity of the Notes 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 the Company’s common stock at a conversion price of $2.00 per share, subject to adjustment as set forth in the Note. If the convertible note holders did not convert their notes by their maturity date (January 5, 2012), we will need to redeem those convertible notes at $2.0 per each note. Number of outstanding convertible notes was 5,225,000 as of March 31, 2012.  (See Note 11 to the accompanying unaudited financial statements).

 

Effective as of June 30, 2010, we entered into an Amendment and Agreement (the “A&A”) with the representative of the investors pursuant to which we agreed to make certain amendments to the Notes and the Warrants.  Pursuant to the A&A, the anti-dilution protection provisions in the Notes and the Warrants were eliminated and a provision specifically precluding net cash settlement by the Company of the Notes and the Warrants was added. In return, and subject to certain non-financing exceptions, we agreed not to issue any new equity securities at a price per share below $2.20 until the earlier of (i) January 5, 2013 or (ii) the date on which, collectively with any prior conversions or exercises of Notes and Warrants, 75% of the principal face value of the Notes in the aggregate has been converted into shares of Company common stock and Warrants representing, in the aggregate, 75% of the aggregate shares of the Company’s common stock underlying the Warrants have been exercised. On March 30, 2011, we entered into a Termination Agreement pursuant to which we and the representative of the investors agreed to terminate the A&A because, after further study, we concluded that the original purpose of the A&A (to mitigate the impact of certain non-cash embedded derivative liabilities associated with the Notes, Warrants and certain placement agent warrants) would not be achieved. Therefore, we determined and agreed with the representative of the investors to terminate the A&A and to thereby restore the Notes, Warrants and such placement agent warrants to their original terms.

 

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). 

 

See “Comparison of Nine months ended March 31, 2012 and 2011 – Cash Position” and “Obligations under Material Contracts” below for further discussion of our liquidity needs.

 

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On April 3, 2012, the Company announced that it was in active discussions with Euro Pacific to (i) extend 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) maintain the interest rate on the Notes as an annual rate of 12% (or 6% for the Second Extended Period) (such amendments to the Note, the “Second Amendment”). In such announcement, the Company disclosed that to demonstrate the Company’s efforts to repay the Notes, the Company expected to repay 10% of the $10.45 million then due under the Notes by April 13, 2012 (the “Repayment”). In addition, as part of the contemplated Second Amendment, the Company was expected to establish an RMB denominated escrow account in China and to deposit into such escrow account the remaining outstanding amount of the Notes, which the Company will have no right to dispose of or use except for (i) conversion into US Dollars for the purpose of repayment of the Notes or (ii) releases from such Escrow Account from time to time in amounts equal to the decreases in the outstanding amount of the Notes, either by payments made by the Company or conversion of the Notes by Note holders.

 

On May 8, 2012, a Three Parties Fund Escrow Agreement (“Escrow Agreement”) was entered into among Yantai Shencaojishi Pharmaceuticals Co., Ltd., the wholly-owned subsidiary of the Company (“Yantai Shencaojishi”), Euro Pacific and Rural Credit Cooperative of Laishan District, Yantai City (the “Bank”). Pursuant to the Escrow Agreement, an RMB-denominated escrow account (the “Escrow Account”) was established with Bank and RMB 59 million (approximately $10.45 million) was deposited by Yantai Shencaojishi into the Escrow Account. On May 9, 2012, a Supplemental Agreement to the Escrow Agreement with details of the Escrow Account was entered into by the Company, Euro Pacific and the Bank. The Escrow Agreement provides that the Escrow Account will be managed by both the Company and Euro Pacific and that withdrawal of cash from the Escrow Account cannot be done without prior written consent from both the Company and Euro Pacific.

 

As of the date of this Quarterly Report on Form 10-Q, the Repayment is being processed and the Company expects to repay a portion of the Repayment by May 15, 2012 in the amount of approximately $314,000, which is equivalent to the amount of the first quarter 2012 interest payment on the Notes (calculated based on an annual rate of 12% as discussed above). In addition, the Company will make its best efforts to repay the reminder of the Repayment in the amount of approximately $731,000 as soon as possible but no later than June 30, 2012.

 

After the first payment of $314,000 described above is distributed to Note holders, the Company is expected to enter into the Second Amendment with Euro Pacific. A provision will be included in the Second Amendment that the Second Extended Period will automatically expire on June 30, 2012 and the outstanding balance of the Notes will become immediately due and payable if the reminder of the Repayment is not received and distributed to Note holders on June 30, 2012.

 

Comparison of nine months ended March 31, 2012 and 2011

 

Net Cash Provided by Operating Activities

 

Net cash provided by operating activities totaled $15,770,702 for the nine months ended March 31, 2012 as compared to net cash provided by operating activities of $9,016,541 for the nine months ended March 31, 2011. The increase in net cash provided by operating activities, for the nine months ended March 31, 2012 compared to the same period 2011, was primarily due to decreased net income of $5.6 million, an increase of $9.0 million in the effective interest on convertible notes, increased $2.7 million in change in fair value of warrants, increased depreciation and amortization of $2.0 million, decreased accounts payable of $1.5 million, and increased prepayments of $1.0 million. We expect our cash flow from operating activities to maintain a positive flow due to our acquisition of Yantai Tianzheng and our continuous cash flow management.

 

Net Cash Used In Investing Activities

 

Net cash used in investing activities was $9,519,284 for the nine months ended March 31, 2012 and $14,307,391 for the nine months ended March 31, 2011. The net increase in cash used in investing activities was due to a cash payment of approximately $9.7 million for our Yantai Tianzheng acquisition this first three quarter, offset by a cash receipt of $1.4 million from Yantai Tianzheng’s acquisition, prepayment of $0.6 million for property, plant and equipment and a cash payment of $0.5 million for property, plant and equipment.

 

Net Cash Provided by Financing Activities

 

Net cash provided by financing activities totaled $3,240,921 for the nine months ended March 31, 2012 as compared to net cash used in financing activities of $1,668,927 for the same period in 2011. The reason for the increase 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), offset by payments of $3.1 million for short-term bank loans.  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 March 31, 2012, we had cash of $23,044,256 as compared to $13,344,426 as of June 30, 2011, an increase of $9,699,830. This increase was due primarily to an increase in cash from operating activities of approximately $6.8 million, capital contribution from an equity holder of $6.3 million, and cash receipt of $1.4 million from our acquisition of Yantai Tianzheng offset by a cash payment of approximately $9.7 million for the Yantai Tianzheng acquisition, cash payments for the purchase of property, plant, and equipment of $0.5 million, and cash payments of $3.1 million for short term bank loans.

 

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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 (currently $25.3 million is due within 12 months.  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 April 5, 2012 (currently $10.45 million due).

 

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.

 

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, 2011, 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 nine months ended March 31, 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 March 31, 2012, and the effect these obligations are expected to have on our liquidity and cash flows in future periods.

  

   Payments Due by Period 
       Less than   1-3   4-5   5 
   Total   1 year   Years   years   Years+ 
Contractual Obligations:                         
Convertible notes  $10,450,000   $10,450,000   $-   $-   $- 
              -    -    - 
Yantai Tianzheng acquisition   25,300,000    25,300,000    -    -    - 
              -    -    - 
Total Contractual Obligations:  $35,750,000   $35,750,000   $-   $-   $- 

   

Other than discussed above, there are no other foreseeable material commitments or contingencies as of March 31, 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 nine months ended March 31, 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. 

    

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

 

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Item 4. Controls and Procedures

 

Evaluation of Disclosure Controls and Procedures

 

As of March 31, 2011, 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.

 

35
 

 

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) 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 be put into place in the fourth quarter of 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, 2011, which was filed with the SEC on September 28, 2011. 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.

 

36
 

 

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 1A.     Risk Factors

 

The Company is hereby updating the following risk factor from its Annual Report on Form 10-K for the fiscal year ended June 30, 2011:

 

We have significant payment obligations associated with the Yantai Tianzheng acquisition and the Notes, and our cash flow may not be sufficient to meet such obligations when due.

 

As of March 31, 2012, we have outstanding balances of $12,000,000 due within 12 months in connection with the Yantai Tianzheng acquisition and $10.45 million due in connection with the Notes, which Notes had a maturity date of April 5, 2012. We currently believe that our available cash and funds we expect to generate from operations will enable us to operate our business and satisfy short term obligations through at least January 1, 2013. However, we are currently late in our Note payments, and although we are seeking to extend the maturity date of the Notes again to October 5, 2012, there is a significant risk that we will be unable to meet our payment requirements under the Yantai Tianzheng acquisition and the Notes given that we may not generate sufficient cash flow from operations or otherwise have access to outside financing on favorable terms, or at all. Moreover, we have experienced significant difficulty in converting Chinese RMB held by our subsidiaries into US Dollars which can be utilized to repay the Notes. If we are unable to meet our material financial obligations for these or other reasons, our business, financial condition or operating results would be materially affected.

 

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.

  

37
 

 

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. 
   
May 14, 2012 By: /s/ Hongwei Qu
    Hongwei Qu
    Chief Executive Officer
    (Principal Executive Officer and Principal Financial Officer)

 

39

PINX:BOPH Bohai Pharmaceuticals Group, Inc. Quarterly Report 10-Q Filling

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PINX:BOPH Bohai Pharmaceuticals Group, Inc. Quarterly Report 10-Q Filing - 3/31/2012
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