NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
China Yongxin Pharmaceuticals, Inc. and subsidiaries (the “Company” or “We” or “Our”) was originally established in 1993. Yongxin’s business operations consist of wholesale and retail sales of pharmaceuticals, medical equipment, other medical-related products, health products including nutritional and dietary supplements, and cosmetics. Yongxin’s operations are based in Changchun City, Jilin Province, China.We own and control 110 retail pharmacy locations, through our ownership of Yongxin Drugstore and its affiliated entities, Jingyongxin Drugstore and Caoantang Drugstore. Yongxin previously owned a direct 100% equity interest in Yongxin Drugstore as a record owner of all of its outstanding share capital. PRC laws and regulations limit foreign ownership of in excess of 49% of the outstanding share capital of PRC entities that operate more than 30 drugstores in China that sell a variety of branded pharmaceutical products sourced from different suppliers.
In May 2010, in an effort to comply with PRC regulatory requirements regarding foreign ownership of drugstores in the PRC, and in contemplation of future growth of our Company, we conducted a restructuring of Yongxin’s ownership and control of Yongxin Drugstore (the “Restructuring”) in which we changed the method by which we own Yongxin Drugstore. Specifically, we instituted a “variable interest entity” (“VIE”) structure under which Yongxin is a record holder of 49% of the outstanding share capital of Yongxin Drugstore, and Mr. Yongxin Liu (our CEO and Chairman of the Company’s Board of Directors) and Mr. Yongkui Liu (a Company Vice President and former Company director), each of whom are PRC citizens (collectively, the “PRC Shareholders”), serve as nominee record holders of the remaining 51% of the share capital of Yongxin Drugstore. In order to retain the Company’s rights and authority to control, operate and manage Yongxin Drugstore and to continue to receive all of the economic benefits of Yongxin Drugstore’s business operations, concurrent with the equity transfers, Yongxin and the PRC Shareholders also entered into an Entrustment Agreement dated May 17, 2010 (the “Entrustment Agreement”), which effectively grants Yongxin beneficial ownership of the interest attributable to the 51% interest, including but not limited to, the right to exclusively control, operate and manage Yongxin Drugstore, and all of the profits, income, distributions, dividends, compensation, payments, assets property, or other economic benefits from Yongxin Drugstore that the PRC Shareholders now hold or receive or otherwise become entitled to receive in the future by virtue of their 51% record ownership of Yongxin Drugstore’s share capital. As a result of the rights conferred to Yongxin under the Entrustment Agreement, the Company is considered the primary beneficiary of Yongxin Drugstore and Yongxin Drugstore is deemed our variable interest entity (“VIE”). Further, we consolidate 100% of Yongxin Drugstore’s results of operations, assets and liabilities in our financial statements.
Our corporate structure consists of the following consolidated subsidiaries:
| · | Changchun Yongxin Durui Medical Co., Ltd. (“Yongxin”), through which we operate our wholesale pharmaceuticals distribution business and in which the Company owns an 80% equity ownership interest; |
| · | Jilin Province Yongxin Chain Drugstore Ltd. (“Yongxin Drugstore”), through which we operate 42 pharmacy retail drugstores and which we control through Yongxin’s equity ownership interest in Yongxin Drugstore, and through an Entrustment Agreement described more fully below by and between Yongxin, on the one hand, and Yongxin Liu (our CEO and Chairman) and Yongkui Liu (a Company Vice President and former director), on the other hand; |
| · | Tianjin Jingyongxin Chain Drugstore Ltd. (“Jingyongxin Drugstore”), through which we operate 26 pharmacy retail drugstores and in which Yongxin Drugstore owns a 90% equity ownership interest; and |
| · | Baishan Caoantang Chain Drugstore Ltd. (“Caoantang Drugstore”), through which we operate 32 pharmacy retail drugstores and in which Yongxin Drugstore owns 100% of the equity ownership interest. |
Chinese laws and regulations concerning the validity of the contractual arrangements such as the Entrustment Agreement are uncertain, as many of these laws and regulations are relatively new and may be subject to change. Official interpretation and enforcement by the Chinese government involves substantial uncertainty. Additionally, the Entrustment Agreement may not be as effective in providing control over Yongxin Drugstore as direct majority equity interest ownership under the current PRC laws and regulations. Due to such uncertainty, the Entrustment Agreement includes a further assurances provision that allows us to take any additional steps in the future permissible under the then-applicable law to ensure the Company’s complete control over, and the realization of the entirety of all rights and benefits of ownership of Yongxin Drugstore and its assets and business operations, including but not limited to direct ownership of selected assets.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 2 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
| UNAUDITED INTERIM FINANCIAL INFORMATION |
The accompanying unaudited consolidated financial statements have been prepared by the Company, pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) and generally accepted accounting principles for interim financial reporting. The information furnished herein reflects all adjustments (consisting of normal recurring accruals and adjustments) which are, in the opinion of management, necessary to fairly present the operating results for the respective periods. Certain information and footnote disclosures normally present in annual consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted pursuant to such rules and regulations. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and footnotes included in the Company’s Annual Report on Form 10-K. The results of the nine month period ended September 30, 2010 are not necessarily indicative of the results to be expected for the full year ending December 31, 2010.
The accompanying financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America. The functional currency of our operating subsidiary, Changchun Yongxin Dirui Medical Co., Ltd is Chinese Renminbi (“RMB”); however the accompanying financial statements have been translated and presented in United States Dollars (“USD”).
The Company’s functional currency is the Chinese Yuan or Renminbi (“RMB”), which must be translated into US Dollar for financial reporting purposes. All asset and liability accounts were translated at the exchange rate on the balance sheet date; stockholder's equity is translated at historical rates and items in the statements of income and cash flow are translated at the average rate in each applicable period. Translation adjustments resulting from this process are included in accumulated other comprehensive income in the statement of shareholders’ equity. The resulting translation gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the functional currency are included in the results of operations as incurred.
The preparation of financial statements in conformity with generally accepted accounting principles in the United States (“GAAP”) requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates include collectability of accounts receivable, accounts payable, sales returns and recoverability of long-term assets.
| PRINCIPLES OF CONSOLIDATION |
The consolidated financial statements include the accounts of China Yongxin Pharmaceuticals Inc. and its subsidiaries. All material inter-company accounts, transactions and profits have been eliminated in consolidation.
The accompanying consolidated financial statements have been prepared by the Company, pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) and in accordance with GAAP. The Company acquired 80% of Yongxin, and Yongxin Liu and Yongkui Liu own 11% and 9% of Yongxin, respectively. The 20% equity interest held by Yongxin Liu and Yongkui Liu represents non-controlling interest amounting to $6,593,628 as at September 30, 2010 compared to $5,687,633 as at December 31, 2009.
The Company owns a 90% ownership interest in Jinyongxin Drugstore. The remaining 10% interest in Jinyongxin Drugstore is owned by third parties. As at September 30, 2010 and December 31, 2009, the 10% equity interest amounted to $47,006 and 26,917 respectively.
| CASH AND CASH EQUIVALENTS |
Cash and cash equivalents consist primarily of cash in banks and highly liquid investments with original maturities of 90 days or less.
The Company maintains reserves for potential credit losses on accounts receivable. Management reviews the composition of accounts receivable and analyzes historical bad debts, customer concentrations, customer credit worthiness, current economic trends and changes in customer payment patterns to evaluate the adequacy of these reserves. Reserves are recorded primarily on a specific identification basis. As of September 30, 2010 and December 31, 2009, there was no allowance for doubtful debts.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The Company entered into a factoring agreement with China Jilin Bank Corporation Limited (“Jilin Bank”), to transfer accounts receivable with full recourse. The Company is required to repurchase the transferred accounts receivable in the event of default of debtors or in other certain defined events. This transfer was recorded as a secured borrowing with a pledge of collateral in the accounts receivable balances, which are included in the accompanying consolidated financial statements.
Notes receivable represent bankers’ acceptances that have been arranged with third-party financial institutions by certain customers to settle their purchases from us. These bankers’ acceptances are non-interest bearing, guaranteed by a PRC bank, and are collectible within three to six months. Such sales and purchasing arrangements are consistent with industry practices in the PRC.
The Company advances to certain vendors for purchase of its material. The advances to suppliers are interest free and unsecured. As of September 30, 2010 and December 31, 2009, advance to suppliers amounted to $7,226,774 and $6,255,874, respectively.
Inventories are valued on a lower of weighted average cost or market basis. Inventory includes product cost, inbound freight, warehousing costs and vendor allowances not included as a reduction of advertising expense. The management compares the cost of inventories with the market value and allowance is made for writing down their inventories to market value, if lower. Work in process inventories include the cost of raw materials and outsource processing fees.
Property and equipment are recorded at cost. Depreciation is computed using the straight-line method over useful lives ranging from 5 to 20 years. Expenditures for maintenance and repairs are charged to earnings as incurred; additions, renewals and betterments are capitalized. When property and equipment are retired or otherwise disposed of, the related cost and accumulated depreciation are removed from the respective accounts, and any gain or loss is included in operations. Assets held under capital leases are recorded at the lesser of the present value of the future minimum lease payments or the fair value of the leased property. Expenditures for maintenance and repairs are charged to operations as incurred.
Depreciation of property and equipment is provided using the straight-line method for substantially all assets with estimated lives of:
Asset Type | | Depreciable Period |
Buildings | | 20 years |
Infrastructures and leasehold improvements | | 10 years |
Equipment (including electronic facilities, sports, education and recreation facilities) | | 10 years |
Automobiles | | 10 years |
Furniture and fixtures | | 5 years |
Computer hardware and software | | 5 years |
| IMPAIRMENT OF LONG-LIVED ASSETS |
The Company tests long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable through the estimated undiscounted cash flows expected to result from the use and eventual disposition of the assets. In that event, a loss is recognized based on the amount by which the carrying amount exceeds the fair market value of the long-lived assets. Loss on long-lived assets to be disposed of is determined in a similar manner, except that fair market values are reduced for the cost of disposal.
Sales revenue is recognized at the date of shipment to customers when a formal arrangement exists, the price is fixed or determinable, the delivery is completed, no other significant obligations of the Company exist and collectability is reasonably assured. The Company recognizes revenue net of an allowance for estimated returns, at the time the merchandise is sold or services performed. The allowance for sales returns is estimated based on the Company’s historical experience. Sales taxes are presented on a net basis (excluded from revenues and costs). Payments received before all of the relevant criteria for revenue recognition are satisfied are recorded as unearned revenue.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Vendor allowances are principally received as a result of purchase levels, sales or promotion of vendors’ products. Allowances are generally recorded as a reduction of inventory and are recognized as a reduction of cost of sales when the related merchandise is sold. Those allowances received for promoting vendors’ products are offset against advertising expense and result in a reduction of selling, occupancy and administration expenses to the extent of advertising costs incurred, with the excess treated as a reduction of inventory costs.
The Company accounts for income taxes using an asset and liability approach which allows for the recognition and measurement of deferred tax assets based upon the likelihood of realization of tax benefits in future years. Under the asset and liability approach, deferred taxes are provided for the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. A valuation allowance is provided for deferred tax assets if it is more likely than not these items will either expire before the Company is able to realize their benefits, or that future deductibility is uncertain.
| FAIR VALUE OF FINANCIAL INSTRUMENTS |
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Assets and liabilities measured at fair value are categorized based on whether or not the inputs are observable in the market and the degree that the inputs are observable. The categorization of financial assets and liabilities within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.
The Company's financial instruments primarily consist of cash and cash equivalents, accounts receivable, and accounts payable.
As of the balance sheet dates, the estimated fair values of the financial instruments were not materially different from their carrying values as presented on the balance sheet. This is primarily attributed to the short maturities of these instruments.
The costs of all employee stock options, as well as other equity-based compensation arrangements, are reflected in the consolidated financial statements based on the estimated fair value of the awards on the grant date. That cost is recognized over the period during which an employee is required to provide service in exchange for the award—the requisite service period (usually the vesting period). Stock compensation for stock granted to non-employees is determined as the fair value of the consideration received or the fair value of equity instruments issued, whichever is more reliably measured.
Earnings per share data for the three and nine month periods ended September 30, 2010 and 2009 are as follows:
Cash flows from the Company’s operations are calculated based upon the local currencies. As a result, amounts related to assets and liabilities reported on the statement of cash flows will not necessarily agree with changes in the corresponding balances on the balance sheet.
The Company reports segment information using the “management approach” model. The management approach model is based on the way a company’s management organizes segments within the company for making operating decisions and assessing performance. Reportable segments are based on products and services, geography, legal structure, management structure, or any other manner in which management disaggregates a company. The Company allocates its resources and assesses the performance of its sales activities based upon its products and services (see Note 21).
The Company is subject to substantial risks from, among other things, intense competition associated with the industry in general, other risks associated with financing, liquidity requirements, rapidly changing customer requirements, limited operating history, foreign currency exchange rates and the volatility of public markets.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The Company’s operations are carried out in the PRC. Accordingly, the Company’s business, financial condition and results of operations may be influenced by the political, economic and legal environments in the PRC, by the general state of PRC’s economy. The Company’s business may be influenced by changes in governmental policies with respect to laws and regulations, anti-inflationary measures, currency conversion and remittance abroad, and rates and methods of taxation, among other things.
Under current PRC law on foreign investment, foreign companies are allowed to establish or invest in wholly-owned foreign enterprises or joint ventures that engage in wholesale or retail sales of pharmaceuticals in China. These regulations limit the number and size of retail pharmacy outlets that a foreign investor may establish. If a foreign investor owns more than 30 outlets that sell a variety of branded pharmaceutical products sourced from different suppliers, the foreign investor’s ownership interests in the outlets may be limited to 49.0% . The Company currently controls more than 30 retail pharmacy outlets through its 80% equity ownership interest in Yongxin, 100% equity ownership in Caoantang Drugstore and 90% equity ownership interest in Jinyongxin Drugstore. At the time of the establishment of Yongxin, Yongxin already controlled in excess of 30 retail pharmacy outlets and with this structure in place it obtained all required approvals from the relevant governmental agencies in Jilin Province for the joint venture. The Company has been advised by its PRC counsel, that based on their understanding of the current PRC laws, rules and regulations and the Company’s receipt of all relevant government approvals for the equity joint venture, the structure under which it operates and holds equity ownership in its retail pharmacy businesses complies with all applicable PRC laws, rules and regulations. However, there are uncertainties regarding the interpretation and application of PRC laws, rules and regulations by PRC government authorities, and there is a risk that such authorities may later issue a differing interpretation of the law and determine that the Company’s corporate and/or ownership structure does not comply with PRC laws, rules and regulations. In addition, new PRC laws, rules and regulations may be introduced from time to time to impose additional requirements that may be applicable to the Company’s corporate structure or its business operations. If the Company and/or its PRC subsidiaries are determined to be in violation of any existing or future PRC laws, rules or regulations, including laws applicable to foreign investment in retail pharmacy outlets, or fail to obtain or maintain any of the required governmental permits or approvals, the relevant PRC regulatory authorities would have broad discretion in dealing with such violations, including: The imposition of penalties and/or a restructuring of the Company’s holding structure in order to comply with relevant PRC regulations could severely disrupt the Company’s ability to conduct business and could have a material adverse effect on the Company’s financial condition, results of operations and prospects and also could result in:
| · | revocation of the business and operating licenses of the Company’s PRC consolidated entities; |
| · | discontinuation or restriction of the operations of the Company’s PRC consolidated entities; |
| · | imposition of conditions or requirements with which the Company or its PRC consolidated entities may not be able to comply; |
| · | requirements that the Company or its PRC consolidated entities restructure its ownership or operations; |
| · | restriction or prohibition of the Company’s use of the proceeds from its financings to fund its business and operations in China; or |
| CONCENTRATIONS OF CREDIT RISK |
Financial instruments that potentially subject the Company to concentrations of credit risk are cash, accounts receivable and other receivables arising from its normal business activities. The Company places its cash in what it believes to be credit worthy financial institutions. The Company has a diversified customer base, most of which are in China. The Company controls credit risk related to accounts receivable through credit approvals, credit limits and monitoring procedures. The Company routinely assesses the financial strength of its customers and, based upon factors surrounding the credit risk, establishes an allowance, if required, for uncollectible accounts and, as a consequence, believes that its accounts receivable credit risk exposure beyond such allowance is limited.
Certain conditions may exist as of the date the financial statements are issued, which may result in a loss to the Company but which will only be resolved when one or more future events occur or fail to occur. The Company’s management and legal counsel assess such contingent liabilities, and such assessment inherently involves an exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against the Company or unasserted claims that may result in such proceedings, the Company’s legal counsel evaluates the perceived merits of any legal proceedings or unasserted claims as well as the perceived merits of the amount of relief sought or expected to be sought.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
If the assessment of a contingency indicates that it is probable that a material loss has been incurred and the amount of the liability can be estimated, then the estimated liability would be accrued in the Company’s financial statements. If the assessment indicates that a potential material loss contingency is not probable but is reasonably possible, or is probable but cannot be estimated, then the nature of the contingent liability, together with an estimate of the range of possible loss if determinable and material would be disclosed. Loss contingencies considered to be remote by management are generally not disclosed unless they involve guarantees, in which case the guarantee would be disclosed.
| RECENT ACCOUNTING PRONOUNCEMENTS |
In January 2010, FASB issued ASU No. 2010-06 – Improving Disclosures about Fair Value Measurements. This update provides amendments to Subtopic 820-10 that requires new disclosure as follows: 1) Transfers in and out of Levels 1 and 2. A reporting entity should disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers. 2) Activity in Level 3 fair value measurements. In the reconciliation for fair value measurements using significant unobservable inputs (Level 3), a reporting entity should present separately information about purchases, sales, issuances, and settlements (that is, on a gross basis rather than as one net number). This update provides amendments to Subtopic 820-10 that clarifies existing disclosures as follows: 1) Level of disaggregation. A reporting entity should provide fair value measurement disclosures for each class of assets and liabilities. A class is often a subset of assets or liabilities within a line item in the statement of financial position. A reporting entity needs to use judgment in determining the appropriate classes of assets and liabilities. 2) Disclosures about inputs and valuation techniques. A reporting entity should provide disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements. Those disclosures are required for fair value measurements that fall in either Level 2 or Level 3. The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. These disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. The Company is currently evaluating the impact of this ASU, however, the Company does not expect the adoption of this ASU to have a material impact on its consolidated financial statements.
In April 2010, FASB issued ASU No. 2010-13–Stock Compensation. The objective of this Update is to address the classification of an employee share-based payment award with an exercise price denominated in the currency of a market in which the underlying equity security trades. It provides guidance on the classification of a share-based payment award as either equity or a liability. A share-based payment award that contains a condition that is not a market, performance, or service condition is required to be classified as a liability. Under Topic 718, awards of equity share options granted to an employee of an entity's foreign operation that provide a fixed exercise price denominated in (1) the foreign operation's functional currency or (2) the currency in which the employee's pay is denominated should not be considered to contain a condition that is not a market, performance, or service condition.
The amendments in this Update affect entities that issue employee share-based payment awards with an exercise price denominated in the currency of a market in which a substantial portion of the entity's equity securities trades that differs from the functional currency of the employer entity or payroll currency of the employee. The amendments affect entities that have previously considered such awards to be liabilities because of their exercise price.
The amendments in this Update are effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2010. The amendments in this Update should be applied by recording a cumulative-effect adjustment to the opening balance of retained earnings. The Company is currently evaluating the impact of this ASU on its consolidated financial statements.
In July 2010, the FASB issued Accounting Standards Update 2010-20 which amends “Receivables” (Topic 310). ASU 2010 20 is intended to provide additional information to assist financial statement users in assessing an entity’s risk exposures and evaluating the adequacy of its allowance for credit losses. The disclosures as of the end of a reporting period are effective for interim and annual reporting periods ending on or after December 15, 2010. The disclosures about activity that occurs during a reporting period are effective for interim and annual reporting periods beginning on or after December 15, 2010. The amendments in ASU 2010-20 encourage, but do not require, comparative disclosures for earlier reporting periods that ended before initial adoption. However, an entity should provide comparative disclosures for those reporting periods ending after initial adoption. While ASU 2010-20 will not have a material impact on our consolidated financial statements, we expect that it will expand our disclosures related to notes receivables.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 3 BASIC AND DILUTED EARNINGS PER SHARE
Basic earnings per share are computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted net income (loss) per share is based on the assumption that all dilutive convertible shares and stock options were converted or exercised. Dilution is computed by applying the treasury stock method. Under this method, options and warrants are assumed to be exercised at the beginning of the period (or at the time of issuance, if later), and as if funds obtained thereby were used to purchase common stock at the average market price during the period. Earnings per share data for the three and nine month periods ended September 30, 2010 and 2009 are as follows:
| | | For the three-months ended | | | For the nine-months ended | |
| | | September 30 | | | September 30 | |
| | | 2010 | | | 2009 | | | 2010 | | | 2009 | |
Earning (loss) per share | | | | | | | | | | | | |
Basic from continued operations | | $ | (0.03 | ) | | $ | 0.19 | | | $ | 0.15 | | | $ | 0.77 | |
Basic from discontinued operations | | $ | - | | | $ | (0.01 | ) | | $ | 0.38 | | | $ | (0.03 | ) |
Basic | | $ | (0.03 | ) | | $ | 0.18 | | | $ | 0.53 | | | $ | 0.74 | |
| | |
Diluted from continued operations | | $ | (0.03 | ) | | $ | 0.18 | | | $ | 0.12 | | | $ | 0.76 | |
Diluted from discontinued operations | | $ | - | | | $ | (0.01 | ) | | $ | 0.31 | | | $ | (0.03 | ) |
Diluted | | $ | (0.03 | ) | | $ | 0.18 | | | $ | 0.43 | | | $ | 0.73 | |
| | |
Weighted average number of shares | | | | | | | | | | | | | | | | |
outstanding | | | | | | | | | | | | | | | | |
Basic | | $ | 5,377,378 | | | $ | 2,638,922 | | | $ | 5,115,082 | | | $ | 2,607,409 | |
Diluted | | $ | 6,502,378 | | | $ | 2,677,160 | | | $ | 6,240,082 | | | $ | 2,645,647 | |
NOTE 4 OTHER RECEIVABLES
Other receivables are interest free, unsecured, and due on demand (with the exception of loans to un-related parties). These receivables as of September 30, 2010, and December 31, 2009 are summarized as follows:
| | | September 30, 2010 | | | December 31, 2009 | |
Advance to employees | | $ | 225,724 | | | $ | 26,493 | |
Advances to store employees | | | 42,275 | | | | 15,037 | |
Rent receivable | | | 80,838 | | | | 79,218 | |
Deposits | | | 342,753 | | | | 765,925 | |
Sponsorship from customers | | | - | | | | 987,174 | |
Others | | | 192,861 | | | | 57,237 | |
Loans to unrelated parties | | | 3,409,418 | | | | - | |
Total | | $ | 4,293,869 | | | $ | 1,931,084 | |
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Loans to un-related parties as of September 30, 2010 accrue interest at an annual percentage rate (APR) of 4.86% and are summarized as follows:
| | Term of Loan | | | Principal | | | | Principal | | | | Accrued | |
Jilin Province Dingjian Natural Plant Base | July 22 – November 20, 2010 | | $ | 1,991,010 | | | $ | 13,300,000 | | | $ | 18,334 | |
Changchun Golden Century Commodities Concrete Construction Company Limited | June 30, 2010 – October 30, 2010 | | | 898,200 | | | | 6,000,000 | | | | 10,871 | |
Jilin Province Shunda Logistics Company | June 30, 2010 – November 30, 2010 | | | 471,555 | | | | 3,150,000 | | | | 5,707 | |
Changchun City Nanguan District Xingfu Town Heizuizi Village Community | July 1, 2010 –November 30, 2010 | | | 48,653 | | | | 325,000 | | | | 582 | |
| | | | $ | 3,409,418 | | | $ | 22,450,000 | | | $ | 35,494 | |
NOTE 5 PREPAID EXPENSES
The balance of Company prepaid expenses as of September 30, 2010 and December 31, 2009 comprised of the following:
| | | September 30, 2010 | | | December 31, 2009 | |
Prepaid rent | | $ | - | | | $ | 18,088 | |
Rent | | | - | | | | 489,156 | |
Other prepaid expenses | | | - | | | | 27,525 | |
Prepaid debt issue costs | | | 89,487 | | | | - | |
Total | | $ | 89,487 | | | $ | 534,769 | |
NOTE 6 INVENTORIES
As of September 30, 2010 and December 31, 2009, inventory consisted of the following:
| | | September 30, 2010 | | | December 31, 2009 | |
Packaging Materials | | $ | 211,252 | | | $ | 200,007 | |
Finished Goods | | | 10,516,615 | | | | 7,611,621 | |
Total inventory | | $ | 10,727,867 | | | $ | 7,811,628 | |
NOTE 7 PROPERTIES AND EQUIPMENT
As of September 30, 2010 and December 31, 2009 the property and equipment of the Company consisted of the following:
| | | September 30, 2010 | | | December 31, 2009 | |
Office furniture and fixtures | | $ | 997,418 | | | $ | 930,962 | |
Vehicles | | | 383,959 | | | | 392,557 | |
Buildings | | | 8,684,989 | | | | 8,628,714 | |
Total property and equipment | | | 10,066,366 | | | | 9,952,233 | |
Less: Accumulated depreciation | | | (1,682,174 | ) | | | (1,200,420 | ) |
Net value of property and equipment | | $ | 8,384,192 | | | $ | 8,751,813 | |
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The Company had depreciation expense of $481,754 and $198,687 for the nine month periods ended September 30, 2010 and 2009, respectively. Depreciation expense for three months ended September 30, 2010 and 2009 amounted to $135,432 and $92,655, respectively.
NOTE 8 INTANGIBLE ASSETS
As of September 30, 2010 and December 31, 2009, the intangible assets of the Company consisted of the following:
| | | September 30, 2010 | | | December 31, 2009 | |
Software | | $ | 1,129,238 | | | $ | 1,102,893 | |
Less: Accumulated amortization | | | (204,771 | ) | | | (115,561 | ) |
Net value of intangible assets | | $ | 924,467 | | | $ | 987,332 | |
The amortization expense for the nine month periods ended September 30, 2010 and 2009 amounted to $89,210 and $40,424, respectively. Amortization expense for the three month periods ended September 30, 2010 and 2009 amounted to $28,735 and $14,593, respectively.
Amortization expenses for intangible assets for next five years after September 30, 2010 are as follows:
September 30, 2011 | | $ | 115,471 | |
September 30, 2012 | | | 112,917 | |
September 30, 2013 | | | 108,589 | |
September 30, 2014 | | | 108,463 | |
September 30, 2015 | | | 108,463 | |
Thereafter | | | 370,564 | |
Total | | $ | 924,467 | |
NOTE 9 ACCRUED EXPENSES AND OTHER PAYABLE
The other payable represents the deposits made by the sales representatives and sales distributors for the right to sell products for the Company. Other payables and accrued expenses consisted of the following as of September 30, 2010 and December 31, 2009:
| | | September 30, 2010 | | | December 31, 2009 | |
Accrued compensation | | $ | 497,004 | | | $ | 1,091,299 | |
Accrued rent expense | | | 222,831 | | | | 124,874 | |
Accrued professional fees | | | 294,034 | | | | 86,026 | |
Accrued litigation | | | 1,025,544 | | | | 987,515 | |
Accrued interest | | | 39,301 | | | | 8,133 | |
Accrued payable | | | 565,365 | | | | 2,539,032 | |
Other accrued expense | | | | | | | 112,151 | |
Sales agent deposits | | | 55,776 | | | | 113,265 | |
Other payable | | | 6,186 | | | | 108,491 | |
Total | | $ | 2,706,041 | | | $ | 5,170,786 | |
NOTE 10 ADVANCES FROM CUSTOMERS
The advances from customers amounted to $222,480 and $2,055,602 respectively as of September 30, 2010 and December 31, 2009, representing the deposits made by customers to purchase inventory from the Company.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 11 DEFERRED INCOME
A portion of the Company’s net revenue is derived directly from government-sponsored healthcare programs, and the Company is therefore subject to government regulations on reimbursement on the sales made through the healthcare programs. The Jilin Province Social Insurance Bureau and Changchun City Insurance Bureau (“Insurance Bureaus”) reimburse 90% of the sales that the Company’s pharmacy retail stores made through the healthcare program networks in the following month, and retain 10% of the sales until the following year. The amount will be repaid proportionally based on the level of evaluation made by the Insurance Bureaus in the following year. The Company classified 10% of the sales made through the healthcare program networks as deferred income as the collectability of these sales is uncertain. As of September 30, 2010 and December 31, 2009, the Company had deferred income of $328,522 and $419,277, respectively.
NOTE 12 SHARES TO BE ISSUED
The Company classifies all amounts, against which shares have not been issued, as shares to be issued. Once the Company issues shares, the amounts are classified as Common stock. As of September 30, 2010, the Company had a total of 41,667 (post-reverse split) shares to be issued with a balance of $35,000 pursuant to an agreement with a software consultant entered into by the Company in 2005.
During the year ended December 31, 2009, the Company entered into an agreement with an investor relations firm for services. The term of services is one year and the Company is obligated to issue 50,000 shares (post-reverse split) to the investor relations firms. During the three month period ended September 30, 2010, the balance 25,000 shares (post-reverse split), valued at $36,000 were issued.
Tax payable comprised of the following taxes as of September 30, 2010 and December 31, 2009:
| | | September 30, 2010 | | | December 31, 2009 | |
VAT | | $ | 23,676 | | | $ | 7,874 | |
Business Tax | | | 96,723 | | | | 94,785 | |
City Construction Tax | | | 6,966 | | | | 6,658 | |
Education Tax | | | 5,541 | | | | 5,356 | |
Income Tax | | | 1,649,122 | | | | 1,305,906 | |
Others | | | 1,286 | | | | 855 | |
Total | | $ | 1,783,314 | | | $ | 1,421,434 | |
The Company is registered in the State of Delaware and has operations in primarily two tax jurisdictions; the PRC and the United States. For certain operations in the United States, the Company has incurred net accumulated operating losses for income tax purposes. The Company believes that it is more likely than not that these net accumulated operating losses will not be utilized in the future. Therefore, the Company has provided full valuation allowance for the deferred tax assets arising from the losses at these locations as of September 30, 2010. Accordingly, the Company has no net deferred tax assets. The provision for income taxes from continuing operations on income consists of the following as of September 30, 2010 and 2009:
| | | September 30, 2010 | | | September 30, 2009 | |
US Federal | | | - | | | | - | |
US State | | | - | | | | - | |
PRC current income tax expense | | | 1,283,272 | | | | 964,474 | |
Total Provision for Income Tax | | $ | 1,283,272 | | | $ | 964,474 | |
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The following is a reconciliation of the provision for income taxes at the U.S. federal income tax rate to the income taxes reflected in the Statement of Operations:
| | | September 30, 2010 | | | September 30, 2009 | |
Tax expense (credit) at statutory rate – federal | | | 34 | % | | | 34 | % |
State tax expense net of federal tax | | | 6 | % | | | 6 | % |
Changes in valuation allowance | | | -40 | % | | | -40 | % |
Foreign income tax – PRC | | | 25 | % | | | 25 | % |
Temporary difference | | | 1 | % | | | - | |
Non-taxable items - PRC | | | 19 | % | | | 1 | % |
Tax expense at actual rate | | | 45 | % | | | 26 | % |
The Company has significant income tax net operating losses (“NOL”) carried forward from prior years. Due to the change in ownership of more than fifty percent, the amount of NOL which may be used in any one year will be subject to a restriction under section 382 of the Internal Revenue Code. Due to the uncertainty of the realizability of the related deferred tax assets of $2,392,181, a reserve equal to the amount of deferred income taxes has been established at September 30, 2010.
| PEOPLE’S REPUBLIC OF CHINA (“PRC”) |
Pursuant to the PRC Income Tax Laws, the Company’s subsidiary is generally subject to Enterprise Income Taxes (“EIT”) at a statutory rate of 25%. The following table sets forth the significant components of the provision for income taxes for operation in PRC as of September 30, 2010 and 2009:
| | | September 30, 2010 | | | September 30, 2009 | |
Net taxable income | | $ | 5,182,311 | | | $ | 4,489,076 | |
Income tax @ 25% and 22% | | $ | 1,283,272 | | | $ | 964,474 | |
NOTE 14 SHORT-TERM LOANS PAYABLE
The loans payable at September 30, 2010 comprised of the following:
| | | September 30, 2010 | | | December 31, 2009 | |
| Loan payable to Jilin Bank, interest at 4.86% annually, | | | | | | |
due February 16, 2011 (Note a) | | $ | 491,016 | | | | - | |
| Loan payable to Jilin Bank, interest at 4.86% annually, | | | | | | | | |
due October 17, 2010 (Note b) | | | 550,896 | | | | - | |
Loan payable to non-related party, interest at 1.5% annually, | | | | | | | | |
unsecured, due December 23, 2010 (Note c) | | | 449,100 | | | | 237,146 | |
January 22, 2010 | | | - | | | | 733,500 | |
Various loans, interest free, unsecured and due on demand | | | 118,074 | | | | 130,238 | |
Total | | $ | 1,609,086 | | | $ | 1,100,884 | |
| (a) | As of September 30, 2010, short-term borrowings, amounting to USD 491,106, were secured by accounts receivable, amounting to USD 613,784 at interest rates of approximately 4.86%, maturing by February 16, 2011. |
| |
| (b) | As of September 30, 2010, short-term borrowings, amounting to USD 550,869 were secured by accounts receivable, amounting to USD 689,249 at interest rates of approximately 4.86%, maturing by October 17 2010. |
| |
| (c) | As of September 30, 2010, short-term borrowings, amounting to USD 449,100, were secured by accounts receivable, amounting to USD 580,631 at interest rates of approximately 4.86%, maturing by December 23, 2010. |
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 15 LONG-TERM LOAN PAYABLE
The loans are secured by personal properties of a significant stockholder of the Company. The loans payable at September 30, 2010 and December 31, 2009 comprised of the following:
| | | September 30, 2010 | | | December 31, 2009 | |
| Loan Payable to Runfeng Agriculture Credit Union, annual interest | | | | | | |
| at 150% over bank stated rate, due by January 26, 2011 | | | - | | | | 1,320,300 | |
| Loan payable to Jilin Bank, interest at 7.02% annually, | | | | | | | | |
| due by June 24, 2012 | | | 2,245,500 | | | | - | |
Total | | $ | 2,245,500 | | | $ | 1,320,300 | |
NOTE 16 CONVERTIBLE NOTE PAYABLE
During the nine months ended September 30, 2010, the Company consummated three closings of a private placement financing. These issuances have a two year term, bear interest at 10% per annum, and are convertible into common stock of the Company at a conversion price of $2.40 per share (post-reverse split). Further, these notes are subject to adjustment for stock splits, recapitalizations and other similar events and will also be adjusted on a full-ratchet basis to equal the price per share of any subsequent financing below $2.40 per share. The notes are secured by a first priority interest in all current and future assets of the Company, which will be cancelled upon repayment of the notes or upon conversion of at least 50% of the principal amount of the notes into shares of Company common stock. The note may be redeemed, by the Company, at any time for 110% of outstanding principal and interest.
On January 25, 2010, the Company consummated a private placement of its equity securities with certain accredited investors pursuant to a Subscription Agreement for total consideration of $700,000. The notes are convertible into an aggregate of 291,667 shares (post-reverse split) of the Company’s common stock at $6 per share (post reverse split) and are exercisable for a period of three years. The relative fair value of the warrants using the Black-Scholes method assuming a volatility of the stock of 197.3%, term of three years and a discount of 1.75% was determined to be $418,783 and was recorded as debt discount, a reduction of the carrying amount of the debt. The relative fair value of the beneficial conversion feature of the notes was determined to be $281,217 and also recorded as a debt discount. Using the effective interest method the beneficial conversion feature and the value of the warrants will be amortized over the 36 months term of the note and charged to interest expense. In the nine month period ended September 30, 2010 $178,646 was expensed. The Company further incurred broker fees of $56,000 cash and 8,750 warrants (post-reverse split) having fair market value of $50,037, which is recorded as prepaid debt issue cost and is being amortized over the term of the note. $27,062 was amortized as general expense during the nine month period ended September 30, 2009. During the nine month period ended September 30, 2010, notes aggregating to $300,000 and interest accrued of $15,835 on these notes were converted into 131,600 shares of common stock. The balance of beneficial conversion feature and warrants discount related to these notes, on the date of conversion, aggregating to $240,625, was fully amortized as general expense on the conversion of notes. The balance of debt issue costs related to these notes, on the date of conversion, aggregating to $36,450, was fully amortized as general expense on the conversion of notes.
On March 4, 2010, the Company consummated a private placement of its equity securities with certain accredited investors pursuant to a Subscription Agreement for total consideration of $125,000. The notes are convertible into an aggregate of 52,083 shares (post-reverse split) of the Company’s common stock at $6 per share (post reverse split) and are exercisable for a period of three years. The relative fair value of the warrants using the Black-Scholes method assuming a volatility of the stock of 197.3%, term of three years and a discount of 1.75% was determined to be $74,456 and was recorded as debt discount, a reduction of the carrying amount of the debt. The relative fair value of the beneficial conversion feature of the notes was determined to be $50,544 and also recorded as a debt discount. Using the effective interest method the beneficial conversion feature and the value of the warrants will be amortized over the 36 months term of the note and charged to interest expense. In the nine month period ended September 30, 2010 $26,687 was expensed. The Company further incurred broker fees of $10,000 cash and 1,563 warrants (post-reverse split) having fair market value of $9,115, which is recorded as prepaid debt issue cost and is being amortized over the term of the note. During the nine month period ended September 30, 2010, $4,081 was expensed as a general expense. During the nine month period ended September 30, 2010, notes aggregating to $75,000 and interest accrued of $3,822 on these notes were converted into 32,842 shares of common stock. The balance of
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
beneficial conversion feature and warrants discount related to these notes, on the date of conversion, aggregating to $62,092, was fully amortized as general expense on the conversion of notes. The balance of debt issue costs related to these notes, on the date of conversion, aggregating to $9,495, was fully amortized as general expense on the conversion of notes.
On May 3, 2010, the Company consummated a private placement of its equity securities with certain accredited investors pursuant to a Subscription Agreement for total consideration of $250,000. The notes were convertible into an aggregate of 104,167 shares (post-reverse split) of the Company’s common stock at $6 per share (post reverse split) and are exercisable for a period of three years. The relative fair value of the warrants using the Black-Scholes method assuming a volatility of the stock of 197.3%, term of three years and a discount of 1.75% was determined to be $141,284 and was recorded as debt discount, a reduction of the carrying amount of the debt. The relative fair value of the beneficial conversion feature of the notes was determined to be $108,716 and also recorded as a debt discount. Using the effective interest method the beneficial conversion feature and the value of the warrants will be amortized over the 36 months term of the note and charged to interest expense. In the nine month period ended September 30, 2010, $59,524 was expensed. The Company further incurred broker fees of $20,000 paid in cash, legal fees of $10,000 paid in cash and 3,125 warrants (post-reverse split) having a fair market value of $24,367, which is recorded as prepaid debt issue cost and is being amortized over the term of the note. In the nine month period ended September 30, 2010, $12,945 was expensed as a general expense.
| | | | Principal | | | | Converted | | | | Balance | | | | Discount | | | | Net | |
Convertible Note Issue 1 | | $ | 700,000 | | | $ | 300,000 | | | $ | 400,000 | | | $ | (280,729 | ) | | $ | 119,271 | |
Convertible Note Issue 2 | | | 125,000 | | | | 75,000 | | | | 50,000 | | | | (36,221 | ) | | | 13,779 | |
Convertible Note Issue 3 | | | 250,000 | | | | - | | | | 250,000 | | | | (190,476 | ) | | | 59,524 | |
Convertible notes payable | | $ | 1,075,000 | | | $ | 375,000 | | | $ | 700,000 | | | $ | (507,426 | ) | | $ | 192,574 | |
NOTE 17 LOANS FROM RELATED PARTIES
As of September 30, 2010 and December 31, 2009, the loans from related parties were comprised of the following:
| | | September 30, 2010 | | | September 30, 2009 | |
Loans payable to ex-officers, interest free, due on demand, and | | | | | | | | |
| | $ | - | | | $ | 184,662 | |
NOTE 18 STOCK-BASED INCENTIVE PLAN
The Company adopted the China Yongxin Pharmaceuticals Inc. 2010 Equity Incentive Plan (the “Plan”) on June 28, 2010, which was ratified by the stockholders on September 23, 2010. The purpose of the Plan is to provide an incentive to attract and retain directors, officers, consultants, advisors and employees whose services are considered valuable, to encourage a sense of proprietorship and to stimulate an active interest of such persons in the Company’s development and financial success. Under the Plan, the Company is authorized to issue up to 250,000 shares of common stock as awards over the term of the Plan, subject to adjustment to reflect stock splits, reorganizations and other changes in corporate structure affecting the common stock. Under the Plan, the Company is authorized to issue incentive stock options intended to qualify under Section 422 of the Internal Revenue Code of 1986, as amended, non-qualified stock options, restricted stock and other stock or cash awards to eligible directors, officers and employees of, and consultants and advisors to, the Company or subsidiary of the Company. The Plan is initially administered by the Company’s board of directors (the “Board”). The Board determines which employees, directors, officers, consultants and advisors will participate in the Plan, as well as the terms of award grants.
Stock options granted under the Plan may not be exercisable more than 10 years after the date such option is granted. Awards under the Plan may be conditioned on continued employment or the passage of time. Vesting requirements are determined by the Board, provided, however, that stock options shall vest and become exercisable as to one-twelfth (1/12th) of the total number of shares subject to the option every three months following the date of grant.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 19 STOCKHOLDERS’ EQUITY
Effective on May 24, 2010, the Company effected a reverse stock split with a ratio of 1-for-12, whereby each twelve (12) issued and outstanding shares of the common stock of the Company, par value $0.001 per share (“Common Stock”) were combined into one (1) share of Common Stock (the “Reverse Split”), pursuant to the Certificate of Amendment of the Certificate of Incorporation that the Company filed with the State of Delaware’s Secretary of State (“Certificate of Amendment”).
On April 21, 2010, the Company filed a Certificate of Amendment with Delaware’s Division of Corporations to amend and restate our Certificate of Incorporation (the “Restated Certificate of Incorporation”). The revisions in the Restated Certificate of Incorporation included the following: (a) an increase in the Company’s authorized shares of Common Stock from 75,000,000 to 100,000,000 shares; (b) a decrease in the authorized number of shares of both our preferred stock and our Series A Convertible Preferred Stock from 5,000,000 shares to 1,666,667 shares; and (c) additional amendments including changes to the rights of the holders of our Series A Convertible Preferred Stock which included an increase in the number of votes that each share of Series A Preferred Stock is entitled to vote when voting with the common stockholders as a single class which was increased from six (6) to twenty-five (25). As described in the Definitive Information Statement that we filed with the SEC on February 22, 2010 and which we mailed to our stockholders on or about February 24, 2010, our board of directors approved the Restated Certificate of Incorporation by unanimous written consent on February 8, 2010. Further, on February 8, 2010, the holders of a majority of our voting capital stock held by holders of Common Stock and Series A Preferred Stock, voting as a single class, and holders of a majority of our Series A Preferred Stock, voting as a separate class, each approved the Restated Certificate of Incorporation and the adoption thereof.
The Series A Convertible Preferred Stock is convertible over a 3 year period, into up to 30 million shares of common stock on a pre-split basis, adjusted to 2,500,000 shares of common stock on a post-split basis. Holders of Series A Convertible Preferred Stock have the option to convert any such shares of Series A Convertible Preferred Stock into such number of fully paid and nonassessable shares of Common Stock on the basis of one (1) share of Series A Convertible Preferred Stock for every 0.5 shares of common stock (which has been adjusted for the Reverse Split). During the year ended September 30, 2009, holders of preferred shares opted to convert 3,333,333 of preferred shares into 1,666,667 common shares (post reverse split).
Following is a summary of common stock activity for the period ended September 30, 2010:
| | | Shares | |
Balance, December 31, 2009 (pre-stock split) | | | 56,448,923 | |
Balance, December 31, 2009 as adjusted for reverse stock split (1-for-12) | | | 4,704,077 | |
Shares issued in private placements | | | 491,322 | |
Shares issued pursuant to the equity incentive plan | | | 25,001 | |
Shares issued as consideration for services | | | | |
Shares issued for other consideration | | | 75,000 | |
Shares issued on conversion of convertible notes | | | 164,442 | |
Shares receivable | | | 25,000 | |
Balance, September 30, 2010 | | | 5,484,842 | |
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Following is a summary of stock-based compensation activity for the period ended September 30, 2010:
| | | | Weighted |
| | | | Average |
| | | | Grant Date |
| | Shares | | Fair Value |
Nonvested balance, December 31, 2009 | | | |
Granted | 16,667 | | 6.18 |
Vested | 2,778 | | 6.18 |
Forfeited | - | | - |
Nonvested balance, September 30, 2010 | 13,889 | | 6.18 |
Following is a summary of stock-based compensation expense for the period ended September 30, 2010:
| | | For the three-months ended | | | For the nine-months ended | |
| | | September 30 | | | September 30 | |
| | |
| | | 2010 | | | 2009 | | | 2010 | | | 2009 | |
Total stock-based compensation expense | | | 27,264 | | | | - | | | | 54,528 | | | | - | |
Income tax benefits related to compensation | | | 14,995 | | | | - | | | | 29,990 | | | | - | |
NOTE 20 OPTIONS AND WARRANTS
WARRANTS
Following is a summary of the warrant activity for the period ended September 30, 2010:
| | | | | | | | | Average | | | | |
| | | | | | | | | Remaining | | | Average | |
| | | | | | Exercise | | | Contractual | | | Intrinsic | |
| | | Warrants | | | Price(s) | | | Life | | | Value | |
Balance, December 31, 2009 | | | 432,365 | | | $ | 6 - $48 | | | | 2.87 | | | $ | 1,189,016 | |
Granted | | | 952,230 | | | $ | 6 - $48 | | | | | | | | | |
Exercised | | | - | | | | | | | | | | | | | |
Expired | | | - | | | | | | | | | | | | | |
Balance, September 30, 2010 | | | 1,384,595 | | | $ | 6 - $48 | | | 2 years | | | $ | - | |
Exerciseable, September 30, 2010 | | | 8,334 | | | $ | 6.32 | | | | 2 years | | | $ | - | |
The assumptions used in calculating the fair value of warrants granted using the Black-Scholes option-pricing model are as follows:
Risk-free interest rate | | | 1.75% | |
Expected life of the options | | 3 years | |
Expected volatility | | | 197.30% | |
Expected dividend yield | | | - | |
|
| NOTES TO CONSOLIDATED FINANCIAL STATEMENTS |
| (UNAUDITED) |
Following is a summary of the options activity for the period ended September 30, 2010:
| | | | | | | | | Weighted | | | | |
| | | | | | | | | Average | | | | |
| | | | | | Weighted | | | Remaining | | | Average | |
| | | | | | Average | | | Contractual | | | Intrinsic | |
| | | Shares | | | Exercise Price | | | Term | | | Value | |
Balance, December 31, 2009 | | | - | | | $ | - | | | | - | | | $ | - | |
Granted | | | 50,001 | | | | 4.49 | | | | | | | | | |
Exercised | | | - | | | | - | | | | | | | | | |
Cancelled | | | - | | | | - | | | | | | | | | |
Forfeited | | | - | | | | - | | | | | | | | | |
Balance, September 30, 2010 | | | 50,001 | | | $ | 4.49 | | | | 9.75 | | | $ | - | |
Exerciseable, September 30, 2010 | | | 8,334 | | | $ | 4.49 | | | | 9.75 | | | $ | - | |
The assumptions used in calculating the fair value of options granted during the nine month period ended September 30, 2010 using the Black-Scholes option-pricing model are as follows:
Risk-free interest rate | | | 3.50% | |
Expected life of the options | | 10 years | |
Expected volatility | | | 197.30% | |
Expected dividend yield | | | - | |
NOTE 21 COMMITMENTS AND CONTINGENCIES
The Company leases its operating locations. Initial terms are typically 5 to 10 years, followed by additional terms containing priority of renewal options at the maturity of the lease agreements, and may include rent escalation clauses. The Company recognizes rent expense on a straight-line basis over the term of the lease.
Minimum rental commitments at September 30, 2010, under all leases having an initial or remaining non-cancelable term of more than one year are shown:
| | | Amount | |
2010 | | $ | 1,058,624 | |
2011 | | | 959,800 | |
2012 | | | 306,110 | |
2013 | | | 82,426 | |
2014 | | | 17,853 | |
Total minimum lease payments | | $ | 2,424,813 | |
The Company sub-leases its building to an unrelated party. The lease term is one year.
On or about October 17, 2008, a former officer initiated an action in the Superior Court for the State of California, County of Los Angeles, Central District, against the Company alleging claims for damages related to an alleged employment agreement. On December 29, 2008, the Company filed an Answer to the Complaint. The Company defended itself against claims for open account and intentional misrepresentation. The Plaintiff sought past due attorneys’ fees for services rendered in the amount of $193,100. The case was settled in October 2009 for $50,000 cash and 400,000 shares of common stock. The court also ordered interest at the rate of 10% on $50,000 from June 20, 2009 until the date the amount is paid off. The Company accrued an aggregate sum of $127,397 for the cash to be paid and for the fair market value of the shares to be issued. The Company paid $52,500 in cash and issued 200,000 shares of common stock to the former officer, valued at $102,000 for the settlement of debt, during the nine month period ended September 30, 2010.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The Company was involved in a legal proceeding filed in Orange County Superior Court on or about November 9, 2004. In this action, the Cross-Complainant, Terry Koosed, sought to amend a $219,000 judgment he obtained to include a subsidiary of the predecessor-in-interest of the Company, which was not named or a participant in such lawsuit. The Company strongly disputed the lawsuit and aggressively defended such action. The Company accrued $219,000 in the accompanying financials statements. The Company paid $35,000 in cash and 500,000 shares valued at $255,000 for the settlement of the case during the nine month period ended September 30, 2010.
A former employee of the Company, the plaintiff, brought a lawsuit against the Company seeking unpaid wages, bonuses, benefits, penalties and interest. The case went into trial in November 2009 and the trial court thereafter issued a judgment for plaintiff in the amount of $641,018. The Company accrued the amount in 2009. The court entered a revised judgment in the amount of $746,487 against the Company on April 20, 2010 to reflect attorney fees. As of September 30, 2010, the Company has not paid the judgment amount and the revised judgment amount has been accrued in the accompanying financials as accrued litigation. The Company also accrued interest of $37,324 at the rate of 10% on the settlement amount.
On or about March 10, 2009, a former employee of the Company, the plaintiff, brought a lawsuit against the Company seeking unpaid wages that accrued during his employment from 2005 to 2008 as well as penalties, interest and attorney fees. The Company and the former employee entered into a stipulation on May 10, 2010 in the amount of $241,733. The Company accrued the amount in the accompanying financials as accrued litigation as of September 30, 2010.
NOTE 22 SEGMENT INFORMATION |
The Company operates in two business segments: retail drug stores, pharmaceutical medicine wholesales sales. These segments were identified based on their separate and distinct products and services, technology, marketing strategies and management reporting. Management evaluates the segments’ operating performance separately and allocates resources based on their respective financial condition, results of operations and cash flows. Inter-segment transactions and balances are eliminated in consolidation.
The retail drug store segment sells prescription and over-the-counter medications, traditional Chinese medicines, health and beauty products, and other items. As of September 30, 2010, the retail drug store segment operated 110 retail stores with business area of 12,021 square meters in three cities in China.
The wholesale segment provides wholesale distribution of over-the-counter and prescribed medicines to hospitals, clinics, medical institutions, other distributors and retail drug stores.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following table summarizes significant financial information by segment:
| | | September 30, 2010 | | | September 30, 2009 | |
Revenues from unaffiliated customers: | | | | | | |
Retail drug stores | | $ | 11,148,827 | | | $ | 10,252,383 | |
Pharmaceutical medicine wholesales | | | 25,866,500 | | | | 22,603,169 | |
Unallocated | | | | | | | - | |
Revenues from inter-company sales | | | (4,663,781 | ) | | | (3,699,532 | ) |
Consolidated Totals | | $ | 32,351,546 | | | $ | 29,156,020 | |
| | |
Net income: | | | | | | | | |
Retail drug stores | | $ | 1,017,213 | | | $ | 1,185,444 | |
Pharmacy wholesales | | | 2,176,645 | | | | 2,069,823 | |
Unallocated | | | (417,304 | ) | | | (1,014,771 | ) |
Net income from inter-company | | | (74,626 | ) | | | (303,591 | ) |
Consolidated Totals | | $ | 2,701,928 | | | $ | 1,936,905 | |
| | |
Depreciation and amortization: | | | | | | | | |
Retail drug stores | | $ | 197,927 | | | $ | 109,037 | |
Pharmacy wholesales | | | 328,229 | | | | 95,700 | |
Unallocated | | | - | | | | - | |
Consolidated Totals | | $ | 526,156 | | | $ | 204,737 | |
| | |
Interest income: | | | | | | | | |
Retail drug stores | | $ | 1,645 | | | $ | 1,252 | |
Pharmacy wholesales | | | 9,477 | | | | - | |
Unallocated | | | - | | | | - | |
Consolidated Totals | | $ | 11,092 | | | $ | 1,252 | |
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
| | | September 30, 2010 | | | September 30, 2009 | |
Interest expense: | | | | | | |
Retail drug stores | | $ | 449 | | | | - | |
Pharmacy wholesales | | | 195,331 | | | | 186 | |
Unallocated | | | - | | | | - | |
Consolidated Totals | | $ | 195,780 | | | $ | 186 | |
| | |
Capital expenditures: | | | | | | | | |
Retail drug stores | | $ | 556,996 | | | $ | 135,520 | |
Pharmacy wholesales | | | 20,945 | | | | 942,491 | |
Unallocated | | | - | | | | - | |
Consolidated Totals | | $ | 577,941 | | | $ | 1,078,011 | |
| | |
Identifiable assets: | | | | | | | | |
Retail drug stores | | $ | 13,076,079 | | | $ | 11,567,766 | |
Pharmacy wholesales | | | 35,876,397 | | | | 31,862,360 | |
Intercompany | | | (2,190,928 | ) | | | (1,785,673 | ) |
Unallocated | | | 113,196 | | | | 111,211 | |
Consolidated Totals | | $ | 46,874,744 | | | $ | 41,755,664 | |
NOTE 23 STATUTORY RESERVE |
As stipulated by the Company Law of the PRC, net income after taxation can only be distributed as dividends after appropriation has been made for the following:
| i. | Making up cumulative prior years’ losses, if any; |
| |
| ii. | Allocations to the “Statutory Surplus Reserve” of at least 10% of income after tax, as determined under PRC accounting rules and regulations, until the fund amounts to 50% of the Company’s registered capital; and |
| |
| iii. | Allocations to the discretionary surplus reserve, if approved in the stockholders’ general meeting. |
| |
For the nine months ended September 30, 2010 and 2009, the Company transferred $387,904 and $329,564, respectively, representing 10% of the net income generated by the Company’s subsidiaries located within PRC determined in accordance with PRC accounting rules and regulations, to this reserve. As of September 30, 2010, the reserve to fulfill the 50% registered capital requirement has been met.
NOTE 24 DISCONTINUED OPERATIONS |
On September 30, 2005, Software Education of America, Inc., (“SEA”), a subsidiary of Nutradyne Group Inc., filed a petition in bankruptcy under Chapter 7 of the U.S. Bankruptcy Code. The petition was necessitated because SEA was unable to continue to meet its financial obligations. SEA is presented in the accompanying financial statements as discontinued operations.
In November 2009, a subsidiary of the Company, Jilin Dingjian Natural Health Products Co., Ltd, (“Dingjian”), entered into an agreement (the “Agreement”) with Sun Shi Wei (the “Buyer”), an individual, to transfer 90% of ownership with all its assets and liabilities to the Buyer. The 10% minority interest remained unchanged. Both parties agreed that the Buyer would assume the net liability. No other consideration was exchanged. The Agreement also indicated that the Company would be liable for any undiscovered liability. Because the Buyer assumed the net liability, the Company recorded a gain from disposal of assets and liabilities at November 30, 2009. Dingjian is presented in the accompanying financial statements as discontinued operations.
Balance Sheet information for the discontinued subsidiaries as of September 30, 2010 and December 31, 2009 is as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
| | | September 30, 2010 | | | December 31, 2009 | |
Liabilities: | | | | | | | | |
Accounts payable | | $ | - | | | $ | 227,590 | |
Accrued expenses | | | - | | | | 238,581 | |
Loans payable | | | - | | | | 162,666 | |
Net liabilities of discontinued operations | | $ | - | | | $ | 628,837 | |
On March 1, 2010, the Company sold its digital e-learning business including its wholly-owned subsidiary, Digital Learning Institute Inc., a Delaware corporation (“Digital Learning”); and (i) Digital Learning’s wholly-owned subsidiary Software Education of America, Inc., a California corporation; (ii) Digital Learning’s wholly-owned subsidiary McKinley Educational Services, Inc., a California corporation; (iii) Digital Learning’s wholly-owned subsidiary Digital Knowledge Works, Inc., a Delaware corporation; (iv) Digital Learning’s wholly-owned subsidiary Coursemate, Inc., and (v) Digital Learning’s wholly-owned subsidiary Global, Inc., a California corporation (referred to collectively herein as the “Digital E-learning Business”). The Company recorded a gain of $1,948,554.
The following are the assets and liabilities of the disposed entities:
| | | Amount | |
AP | | $ | 728,754 | |
Accrued expenses | | | 435,469 | |
Due to related party | | | 140,456 | |
Loan payable | | | 130,238 | |
Other liabilities | | | 492,837 | |
Current Liabilities Total | | | 1,927,754 | |
Net liability disposed | | | (1,927,754 | ) |
Additional cash received | | | 20,000 | |
Gain on disposal of subsidiaries | | $ | 1,947,754 | |
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of the financial condition and results of operations of China Yongxin Pharmaceuticals Inc. and its consolidated subsidiaries for the three and nine month periods ending September 30, 2010 and September 30, 2009 should be read in conjunction with its financial statements and the related notes, and the other financial information included in this quarterly report on Form 10-Q (“Form 10-Q”).
Forward-Looking Statements
This Form 10-Q contains forward-looking statements. The words “anticipate,” “estimate,” “plan,” “project,” “continuing,” “ongoing,” “expect,” “believe,” “intend,” “may,” “will,” “should,” “could,” and similar expressions are intended to identify forward-looking statements. These statements include, among others, information regarding future operations, future capital expenditures, and future net cash flow. These forward-looking statements reflect our management’s current views with respect to future events and financial performance and involve risks and uncertainties, including, without limitation, general economic and business conditions, changes in domestic and international political, social, and economic conditions, regulatory initiatives and compliance with governmental regulations, the ability to achieve further market penetration and additional customers, and various other matters, many of which are beyond our control. Should one or more of these risks or uncertainties occur, or should underlying assumptions prove to be incorrect, actual results may vary materially and adversely from those anticipated, believed, estimated or otherwise indicated. Consequently, all of the forward-looking statements made in this report are qualified by these cautionary statements and there can be no assurance of actual results or outcomes.
Overview
China Yongxin is a wholesale distributor and retailer of pharmaceuticals and health-related products in Jilin province in the northeastern region of the People’s Republic of China (“PRC” or “China”). We currently own and operate 110 retail locations, most of which are situated in high-traffic residential districts, and eight wholesale distribution facilities throughout Jilin province. We enjoy strong retail brand name recognition in Jilin province, which we believe results from our quality service and reputation. We believe that our customer service orientation, close contact with the local community, competitive price format, and broad product offerings provide a convenient and value-oriented shopping experience for our customers and has allowed us to build customer loyalty. We also utilize our extensive retail network as a channel to provide affordable, quality, health and wellness products and services to our customers. Our business model is based on integration of wholesale and retail operations, an approach that we consider to be relatively new in China.
We began retail operations in China in 2004. The Company has rapidly grown and it currently has a retail chain of 110 drugstores as well as the wholesale distribution operations in Northeastern China. Our corporate headquarters are located in City of Industry, California and the Company’s distribution operations are based in Changchun City, Jilin Province, China. Substantially all of our employees are located in China. As of September 30, 2010, we had 908 employees, including 143 pharmacists with requisite credentials, professional education and training, working at our retail drugstores.
China’s pharmaceutical market is one of the top five in the world in terms of overall size, now valued at over USD $37 billion, and is projected to continue to grow at an annual rate of 15.45% through 2013. According to Business Monitor International, consumers spent $22.42 billion on prescription drugs (including patented and generic) in 2007, another $7.07 billion on OTC generic drugs, and $21 billion on traditional Chinese medicine. By 2013, per capita spending on pharmaceuticals is projected to nearly double (from 2009), and as a percentage of overall GDP, is expected to increase from 0.97% to 1.16%, as universal health coverage is implemented, China’s economy continues to grow, more chronic diseases occur, and the average age of the population continues to increase. The drug pricing and reimbursement environment remains heavily regulated in China, and the market is dominated by lower cost basic drugs. However, we foresee rapid growth in the generic drug sector, and growth in over-the-counter drug sales.
The reform of China’s health care system began in 1997 after the State Council issued the Decision on Reform of the Health Care System, which historically has been dominated by state-run hospitals. Since then, in 2004, the Chinese government initiated new regulations which have profoundly affected the system of drug prescription and dispensation in China, spurring the growth of retail pharmacies. In August 2009, the Ministry of Health released a list of over 300 essential medicines known as the “Essential Drugs List”, including medicines deemed vital to the basic health care needs of the public, to be made available at heavily subsidized prices. These reforms have further prompted the growth of retail pharmacies, as well as consolidation among distributors. We are currently a licensed distributor and retailer in Jilin province. We currently sell 290 out of the 307 Essential Drugs, and over 95% of the drugs included in the Jilin Province Medical Insurance Catalogue which includes over 2,400 drugs (the “Insurance Catalogue”).
Our business consists of two major segments – a wholesale segment and a retail segment. We were one of the first authorized distributors of essential drugs, and now one of fourteen, in Jilin Province. In addition through our eight distribution facilities we act as a distributor for over 7,000 products, which we sell and distribute to over 270 medical institutions, over 200 community health services centers, over 600 hospitals in rural areas, over 100 regional sub-distributors and over 2,600 drugstores or clinics. As for our retail segment, we operate 110 modern retail locations in Changchun, Baishan and Tianjin, serving over 350,000 customers in our registry of members. In 2009 we sold or distributed over 800 types of medicines listed in the provincial insurance catalogue.
The Company considers the following to be its key competitive strengths:
| | 1. | Management team with extensive industry experience. Our management team is comprised of 11 members with an average age of 43. Ninety percent of our management team holds at least a bachelor’s degree and 5 members hold a master’s degree. Most of our management has more than 10 years of experience working in the pharmaceutical industry, and have extensive logistics management experience and knowledge. We also employ 143 pharmacists, accounting for approximately 17% of all of our employees, and we employ a sales force of 150 employees. |
| | 2. | Scalability, reputation, and a wide distribution and retail network. We have an established reputation of providing reliable, quality customer service, modern store design, innovative access to medical care at in-store clinics, and customer access to medical professionals through our EDS system. We are also capable of expanding our business and achieving further economies of scale by extending the reach of our distribution network, acquiring or building more distribution centers and acquiring or opening more retail locations. |
| | 3. | Unique industry position in drug distribution in Jilin province. We have been designated by the Jilin Food and Drug Administration as a “Pilot Pharmaceutical Logistics Enterprise”, and management believes this is due to our modernized approach to logistics management. To our knowledge we are the only firm to have been granted this status to date, which allows us to provide storage and logistics services to other drug distributors and pharmaceutical chain stores. We also act as one of 14 licensed wholesale distributors certified and permitted by the Jilin Health Department to sell and distribute essential drugs in Jilin province. |
| | 4. | Use of modern information technology. We use sophisticated information management systems, such as our Enterprise Resource Planning (“ERP”) third party logistics platform, Warehouse Management System (“WMS”), Warehouse Control System (“WCS”) and Transport Management System (“TMS”), to unify our management of drug distribution, operation of retail outlets and warehouses, transport and delivery, and billing. Our logistics management system can manage real-time online orders, product storage, billing and provide storage information, order status and delivery status. |
| | 5. | Strong financial performance and cash flow generation. We have enjoyed strong historical financial performance and steady cash flow. Our bank credit is rated A+ by local banks in Jilin province. We have been designated as a “AAA Rate Good Standing Enterprise” by the Provincial Business Association. |
Notwithstanding our competitive strengths, we expect to face certain risks and uncertainties, including but not limited to:
| | · | our need for capital in order to expand; |
| | · | the rapid growth of our competitors, and ongoing consolidation in our industry; |
| | · | our ability to locate suitable retail locations at reasonable cost; |
| | · | changes in government policies and regulations in China that may affect pricing and reimbursement patterns as well as the structure of our industry; and |
| | · | change in the economic conditions in China that may affect consumer spending on the products we sell, among various other risks and uncertainties. |
For a full discussion of the risks associated with our securities, please review our “Risk Factors” set forth in our filings with the Securities and Exchange Commission.
Recent Developments
In March 2009, the Chinese government announced certain changes to the national medical policy relating to the extension of medical benefits to rural areas in China (“National Medical Policy”) that will be gradually implemented from 2009 through 2011. These revisions to the National Medical Policy extend medical insurance coverage to people who live in the rural areas of China, which includes approximately 40% of the Chinese population. Management believes the implementation of these revisions to the National Medical Policy would be highly beneficial to our sales and operations because the Company has a retail presence in rural areas and its wholesale distribution sales should also increase because it sells to retailers and hospitals in rural areas. However, until recently the direction and specifics of the National Medical Policy has been unclear. Due to this uncertainty, the Company made changes to its operations in the second half of 2009, including a shift in emphasis from the wholesale to the retail sector. Since we began retail operations in 2004, we have established 110 retail locations. Ten of these locations were opened during 2010 to date.
Specifically, in 2009 we placed greater emphasis on developing and expanding our retail segment in response to emerging market opportunities in retail. Over the past twelve months, the retail sector of our business has begun to generate a superior profit margin compared to our wholesale sector. The growth of our retail and wholesale segments both require significant capital investments. However, we tend to realize more immediate returns from investments in our retail segment. Although overall sales were down in 2009, our gross profit nonetheless continued to increase due to the higher profit margin contributed by the retail segment. In 2009, we significantly increased our investments in retail, while also continuing to develop, operate and maintain our wholesale operations, as each segment enhances the growth and profitability of the other. We plan to further invest in both segments with capital from a combination of bank loans, equity offerings, and our internal cash flow.
During 2009 and up to the present, we have also added products with relatively high profit margins to our retail offerings, including cosmetics and certain health and nutritional products such as vitamins and supplements. We believe that the addition of such products has increased our overall gross profit in 2009 and will continue to increase our gross profit margin over the next few years.
On June 30, 2010, we made an unsecured short term loan in the amount of $898,204 to Changchun Golden Century Commodities Concrete Construction Company Limited, a firm we plan to engage to provide construction material for the construction of a distribution center in Changchun in 2011. The purpose of the loan was to provide working capital to our vendor. The loan matures on November 30, 2010, and bears interest at the rate of 4.86% per annum. A copy of the loan agreement is included as Exhibit 10.35 to this report.
On July 22, 2010, we made an unsecured short term loan in the amount of $1,991,018 to Jilin Province Dingjian Natural Plant Base Company Limited, one of our suppliers. The purpose of the loan was to provide working capital to our supplier, and to strengthen our business relationship with the firm. The loan matures on November 30, 2010, and bears interest at the rate of 4.86% per annum. A copy of the loan agreement is included as Exhibit 10.34 to this report.
In September 2010, we entered into two letters of intent to acquire two separate retail drugstore chains. In the first, we signed a letter of intent with Liwen Tien (an individual) to conduct a consolidation of 12 Baokang retail stores and clinics and establish a new company to be named (in part) Baokang (“New Company”) in order to further develop the drug retail market in Jilin Province. If consummated, we would pay a total of RMB 8,520,000 (approximately USD $1.3 million) in connection with the consolidation of the Business, of which RMB 5,540,000 (approximately USD $800,000) would be paid to Liwen Tien as consideration, and RMB 2,980,000 (approximately USD $440,000) of which would be contributed as capital to the New Company in exchange for a 65% interest in the New Company. Second, we signed a letter of intent with Shan Gao (an individual) to acquire the Changchun Pharmaceutical Distribution Center and its 13 retail stores for a proposed acquisition price of RMB 22,920,000 (approximately USD $3.4 million). Under both letters of intent, upon the payment of a deposit (RMB 500,000 in the case of Liwen Tien and RMB 1,000,000 in the case of Shan Gao, neither of which have been paid to date), the sellers must deal with the Company exclusively, these deposits will be forfeited if we do not consummate the acquisitions within an agreed amount of time after payment of the deposits.
During 2010, the Chinese central government provided additional guidance and clarification on medical reform which has improved confidence among manufacturers, suppliers, distributors, medical service providers and retailers, and this has encouraged business decisions and commitments that previously may have been deferred due to uncertainty surrounding application and interpretation of the new regulations. As evidence of this surge in confidence, in August 2010, we entered into sales agreements with over 500 medical institutions in 17 out of 41 counties in Jilin province. Management believes that this heightened level of contract formation would not have been possible prior to the government’s guidance and clarification on medical reform. As a result of these new sales agreements, management expects to solidify its business relationships with manufacturers and suppliers, providing for greater stability in wholesale revenue.
Also in 2010, the Chinese central government notably extended medical benefits to cover residents living in rural areas of China, where approximately two-fifths of the nation’s population resides. As a result, the Company believes that its operations and sales are poised to benefit due to anticipated increases in sales through the Company’s rural retail locations and increased wholesale distribution sales to drugstores and hospitals in rural areas. Specifically, increased coverage is expected to result in an increase in drug consumption, which would lead to more orders and wholesale volume. Prior to March 2010, we distributed products (especially essential drugs) to other distributors who then handled distribution to hospitals and clinics. Since then, increasingly we have been entering into distribution relationships directly with hospitals and clinics, and have increased the number of our wholesale customers in the rural areas, thus increasing revenue from medical institution while earning a higher profit margin. Currently our sales and distribution network covers all areas of Jilin province.
The Insurance Catalogue was revised in 2009 by the Chinese government to include additional categories and types of pharmaceuticals, and in 2009 we sold or distributed over 95% of the types of drugs listed in the Insurance Catalogue. The revenues attributable to sales of products covered under the Insurance Catalogue during the fiscal years ended December 31, 2009 and 2008 represented 61.7% and 35% respectively, of our total revenues for those periods. However, the Company’s overall revenues for fiscal year 2009 decreased approximately 19.5% compared to 2008. The decrease was attributable to a decrease in sales from the wholesale sector of our business, which included sales to hospitals, medical facilities and other retailers which currently represents approximately 70% of our total net revenues. Sales volume from the wholesale sector of our business decreased in 2009 due to uncertainty of the direction and implementation of health care reform in China, as discussed above. Since December 31, 2009, our wholesale business has rebounded and stabilized, and management believes that growth in our wholesale segment is likely to resume.
We believe that recent developments in medical reform in China pose an unprecedented opportunity for us to expand our business in the pharmaceutical distribution and retail industry. However, we face multiple challenges in achieving our objectives in expanding our business and market share.
Among these challenges:
| | · | We require external capital in order to establish new retail locations and distribution hubs at the rate we plan, and this is dependent on our ability to raise capital on acceptable terms. As part of our strategy we are seeking to list our securities on a U.S. national exchange, and to conduct an underwritten offering of our equity securities. In addition, we are working to secure loans from other capital sources within China. |
| | · | We face growing competition from other distributors and retailers who may pursue the same business opportunities or enter the market in which we compete. Some of these competitors or potential competitors have perhaps greater access to capital resources than we do. In response we are continuing to pursue and develop our wholesale business relationships by negotiating and establishing agreements with suppliers and manufacturers. We have also been actively pursuing acquisition opportunities to capture market share, and have continued to execute on our plan to open new retail locations. We have been continuously working to enhance our customer service by improving our operations management, and by deploying advanced information technologies to provide customers with vital information that they need and require. |
| | · | We face the prospect of rising lease or property-related costs for new retail locations, as urban areas in prized key markets in China become increasingly expensive. We plan to use a portion of the proceeds from our financing activities to acquire existing businesses that have favorable leasing arrangements, or the acquisition of real property to secure favorable arrangements for our retail locations, in an effort to protect against rising rents for preferred locations. |
| | · | We operate in a highly regulated industry in China, and while thus far government policies have been favorable to drug distributors and retailers. However, we cannot make any assurances with regard to how government policies may change in the future. |
| | · | Growth of the overall pharmaceuticals market and our market opportunities depend on continued growth of the Chinese economy and individual spending power, however we cannot predict the prospects for the Chinese economy, particularly following the global recession of 2008 – 2009. |
Despite the above challenges, risks, trends and uncertainties, we see the growth in per capita incomes and life expectancies, an aging population which is shifting the medical needs of the public, a general increase in health care spending per capita, and the gradual expansion of health care coverage, and the gradual de-centralization of the hospital-centric medical care system in China, as continuing trends that now affect and will affect our business. In 2010 and in the foreseeable future, we see no reason for these trends to discontinue.
Corporate Structure
Our corporate structure consists of the following consolidated subsidiaries:
| | 1. | Changchun Yongxin Durui Medical Co., Ltd. (“Yongxin”), through which we operate our wholesale pharmaceuticals distribution business and in which the Company owns an 80% equity ownership interest; |
| | 2. | Jilin Province Yongxin Chain Drugstore Ltd. (“Yongxin Drugstore”), through which we operate 42 pharmacy retail drugstores and which we control through Yongxin’s equity ownership interest in Yongxin Drugstore, and through an Entrustment Agreement described more fully below by and between Yongxin, on the one hand, and Yongxin Liu (our CEO and Chairman) and Yongkui Liu (a Company Vice President and former director), on the other hand; |
| | 3. | Tianjin Jingyongxin Chain Drugstore Ltd. (“Jingyongxin Drugstore”), through which we operate 26 pharmacy retail drugstores and in which Yongxin Drugstore owns a 90% equity ownership interest; and |
| | 4. | Baishan Caoantang Chain Drugstore Ltd. (“Caoantang Drugstore”), through which we operate 32 pharmacy retail drugstores and in which Yongxin Drugstore owns 100% of the equity ownership interest. |
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our management’s discussion and analysis of our financial condition and results of operations are based on our financial statements that have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported net sales and expenses during the reporting periods. On an ongoing basis, we evaluate our estimates and assumptions. We base our estimates on historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
While our latest significant accounting policies are described in Note 2 to the unaudited consolidated financial statements for the period ended September 30, 2010 commencing on page F-1 under the section above titled “Summary of Significant Accounting Policies,” we believe that the following accounting policies are the most critical to aid you in fully understanding and evaluating this management discussion and analysis:
Basis of Presentation
The accompanying financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America. The functional currency of our operating Chinese subsidiaries is Chinese Renminbi (“RMB”); however, the accompanying financial statements have been translated and presented in United States Dollars (“USD”).
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles in the United States (“GAAP”) requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates include collectability of accounts receivable, accounts payable, sales returns and recoverability of long-term assets.
Non-Controlling Interest
The accompanying consolidated financial statements have been prepared by the Company, pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) and in accordance with GAAP. The Company owns an 80% interest in Yongxin, and Yongxin Liu and Yongkui Liu own 11% and 9% of Yongxin, respectively. The 20% equity interest held by Yongxin Liu and Yongkui Liu represents non-controlling interest and the Net Income Attributable to Minority Shareholders amounted to $6,593,539 as of September 30, 2010 compared to $5,687,633 as of December 31, 2009.
The Company owns, through its subsidiary Yongxin Drugstore, a 90% ownership interest in Jinyongxin Drugstore. The remaining 10% interest in Jinyongxin Drugstore is owned by third parties. As of September 30, 2010 and December 31, 2009, the 10% equity interest and net profit to minority stockholders amounted to $47,006 and $26,917, respectively.
Inventories
Inventories are valued on a lower of weighted average cost or market basis. Inventory includes product cost, inbound freight, warehousing costs and vendor allowances not included as a reduction of advertising expense. Management compares the cost of inventory with the market value and allowance is made for writing down their inventory to market value, if lower. Work in process inventory includes the cost of raw materials and outsource processing fees.
Revenue Recognition
The Company’s revenue recognition policies are in compliance with Staff Accounting Bulletin (“SAB”) 104 (ASC 605). Sales revenue is recognized at the date of shipment to customers when a formal arrangement exists, the price is fixed or determinable, the delivery is completed, no other significant obligations of the Company exist and collectability is reasonably assured. The Company recognizes revenue net of an allowance for estimated returns, at the time the merchandise is sold or services performed. The allowance for sales returns is estimated based on the Company’s historical experience. Sales taxes are presented on a net basis (excluded from revenues and costs). Payments received before all of the relevant criteria for revenue recognition are satisfied are recorded as unearned revenue.
Recent Accounting Pronouncements
For a description of new accounting standards that may affect us, see Note 2 in our consolidated financial statements included under Part I, Item 1 of this Form 10-Q.
Reverse Stock Split
Effective May 24, 2010, the Company effected a reverse stock split with a ratio of 1-for-12, whereby each twelve (12) issued and outstanding shares of the common stock of the Company, par value $0.001 per share (“Common Stock”) was combined into one (1) share of Common Stock (the “Reverse Split”), pursuant to the Certificate of Amendment of the Certificate of Incorporation that the Company filed with the State of Delaware’s Secretary of State (“Certificate of Amendment”). The Company’s Common Stock, on a split-adjusted basis, has a new CUSIP number of 16946Y 207.
Throughout this report, each instance which refers to a number of shares of our common stock, refers to the number of shares of common stock after giving effect to the Reverse Split, unless otherwise indicated. The term “pre-reverse split” as used in this report means a number of shares of common stock issued or outstanding prior to May 24, 2010 without giving effect to the Reverse Split. The term “post-reverse split” as used in this report refers to the number of shares of common stock prior to any adjustment for the Reverse Split on May 24, 2010.
Results of Operations
Three and Nine Month Periods Ended September 30, 2010 and 2009.
The following table sets forth the results of our operations for the periods indicated:
| | | Three Months Ended September 30, | | | Nine Months Ended September 30, | |
| | | 2010 | | | 2009 | | | 2010 | | | 2009 | |
| | | (unaudited) | | | (unaudited) | | | (unaudited) | | | (unaudited) | |
| Net Revenues | | $ | 10,515,586 | | | $ | 10,812,529 | | | $ | 32,351,546 | | | $ | 29,156,020 | |
| Cost of Goods Sold | | | (6,829,661) | | | | (7,667,014) | | | | (23,442,133) | | | | (21,060,847) | |
| Gross Profit | | | 3,685,925 | | | | 3,145,515 | | | | 8,909,413 | | | | 8,095,173 | |
| | | | | | | | | | | | | | | | | |
| Operating Expenses: | | | | | | | | | | | | | | | | |
| Selling expenses | | | 1,142,085 | | | | 912,094 | | | | 2,900,904 | | | | 2,495,546 | |
| General and administrative | | | 2,116,908 | | | | 2,350,837 | | | | 3,623,259 | | | | 3,825,981 | |
| Total Operating Expenses | | | 3,258,993 | | | | 3,262,931 | | | | 6,524,163 | | | | 6,321,527 | |
| Income from Operations | | | 426,932 | | | | (117,416) | | | | 2,385,250 | | | | 1,773,646 | |
| Other Income (Expense): | | | | | | | | | | | | | | | | |
| Gain on settlement of debt | | | - | | | | - | | | | 75,000 | | | | - | |
| Other income | | | 1,016,312 | | | | 1,112,309 | | | | 1,231,197 | | | | 1,906,864 | |
| Other expense | | | (13,336) | | | | (19,981) | | | | (57,598) | | | | (40,763) | |
| Interest Income (Expense) | | | (70,726) | | | | (6,919) | | | | (184,239) | | | | 1,066 | |
| Beneficial conversion fee and warrant fee amortization | | | (444,289) | | | | - | | | | (628,153) | | | | - | |
| Total Other Income | | | 487,961 | | | | 1,085,409 | | | | 436,207 | | | | 1,867,166 | |
| | | | | | | | | | | | | | | | | |
| Operating Income Before Tax & Non-controlling Interest | | | 914,893 | | | | 967,993 | | | | 2,821,457 | | | | 3,640,812 | |
| | | | | | | | | | | | | | | | | |
| Provision for Income Tax | | | (658,756) | | | | (233,908) | | | | (1,283,272) | | | | (964,474) | |
| | | | | | | | | | | | | | | | | |
| Net Income Before Non-controlling Interest | | | 256,137 | | | | 734,085 | | | | 1,538,185 | | | | 2,676,338 | |
| | | | | | | | | | | | | | | | | |
| Non-controlling Interest | | | (424,738) | | | | (240,362) | | | | (795,807) | | | | (670,747) | |
| | | | | | | | | | | | | | | | | |
| Net Income / (loss) from continued operations | | | (168,601) | | | | 493,723 | | | | 742,378 | | | | 2,005,591 | |
| | | | | | | | | | | | | | | | | |
| Discontinued operations | | | | | | | | | | | | | | | | |
| Gain on disposal of subsidiaries | | | - | | | | - | | | | 1,948,553 | | | | - | |
| Gain / (loss) from discontinued operations | | | - | | | | (21,610) | | | | 10,997 | | | | (68,685) | |
| Total income / (loss) from discontinued operations | | | - | | | | (21,610) | | | | 1,959,550 | | | | (68,685) | |
| | | | | | | | | | | | | | | | | |
| Net Income | | | (168,601) | | | | 472,113 | | | | 2,701,928 | | | | 1,936,906 | |
| Other Comprehensive Item | | | | | | | | | | | | | | | | |
| Foreign exchange translation gain (loss) | | | 445,180 | | | | (17,742) | | | | 544,710 | | | | 598 | |
| | | | | | | | | | | | | | | | | |
| Net Comprehensive Income | | | 276,579 | | | | 454,371 | | | | 3,246,638 | | | | 1,937,504 | |
| | | | | | | | | | | | | | | | | |
| Earning per share | | | | | | | | | | | | | | | | |
| Basic | | | (0.03) | | | | 0.18 | | | | 0.52 | | | | 0.74 | |
| Diluted | | | (0.03) | | | | 0.17 | | | | 0.43 | | | | 0.73 | |
| | | | | | | | | | | | | | | | | |
| Weighted average number of shares outstanding | | | | | | | | | | | | | | | | |
| Basic | | | 5,377,378 | | | | 2,638,922 | | | | 5,115,082 | | | | 2,607,409 | |
| Diluted | | | 6,502,378 | | | | 2,677,160 | | | | 6,240,082 | | | | 2,645,647 | |
Comparison of Three months Ended September 30, 2010 and 2009.
Net Revenues. For the three month period ended September 30, 2010, net revenues decreased approximately 2.74% from $10,812,529 for the three month period ended September 30, 2009 to $10,515,586 for the same period ended September 30, 2010. For the three months ended September 30, 2010 and 2009, net revenues consisted of the following:
| | | Three Months Ended September 30, | |
| | | 2010 | | | 2009 | |
| Wholesale | | $ | 6,749,435 | | | $ | 7,055,306 | |
| Retail | | | 3,766,151 | | | | 3,757,223 | |
| Total Net revenues | | $ | 10,515,586 | | | $ | 10,812,529 | |
Wholesale net revenues decreased by $305,871, representing a 4.34% change, from $7,055,306 in the three months ended September 30, 2009 to $6,749,435 in the three months ended September 30, 2010. This decrease in net revenue was due to a reduction in sales to other distributors with low gross profit margins, as the Company made a shift toward higher-margin wholesale customers such as medical institutions. In 2010, we strategically targeted the medical institution market to develop sales relationships with hospitals, clinics, and other medical institutions as high-margin wholesale customers. In the three month period ended September 30, 2010, we added 238 new medical institutions and 978 new retailers as wholesale customers. Because of this shift in wholesale strategy, however, sales to other distributors declined by $1,953,945 for the three months ended September 30, 2010 as compared to the prior year, representing a 27.56% decline. However, this decrease was offset by a $1,243,053 increase in sales to medical institutions (representing a 17.54% increase), and a $372,764 increase in sales to other retailers (representing a 5.26% increase) for the three months ended September 30, 2010 as compared to the same period in the prior year. The decrease in sales to other distributors, offset by the increase in sales to medical institutions and other retailers, resulted in a net decrease of $338,128 in revenue from wholesale operations as compared with the three month period ended September 30, 2009.
Retail net revenues slightly increased by 0.24%, from $3,575,223 in the three months ended September 30, 2009 to $3,766,151 in the three months ended September 30, 2010. Retail revenues for the three month period ended September 30, 2010 were higher due to the following factors (1) $425,770 in additional revenue was from the 21 new retail drugstores that we opened from July 1, 2009 to September 30, 2010; (2) $105,225 in additional revenue was deferred and recognized as “accrued revenue” due to the fact that the Jilin Social Security Administration and Changchun Social Security Administration provided reimbursement for only 90% of sales in the latest month pending verification of reimbursements through its medical record system (the remaining 10% is payable in the following year, provided the government finds we are in full compliance with national health program regulations). In 2009, 100% of reimbursement revenue was fully collected with no 10% holdback, thus a holdback that applied in the most recent quarter caused a $105,225 decrease in net retail revenue as compared to the three months ended September 30, 2009. Additionally, in the most recent quarter, city road construction impeded customer traffic to four of our retail stores in Chaungchun and Baishan, which caused our retail revenue to decline by an estimated $329,473. Management believes this construction may continue for one or more quarters, however, once road construction is complete, we expect sales for these locations to resume at a normal level.
Cost of Goods Sold. Cost of goods sold, which mainly consisted of the procurement of drugs from suppliers and manufacturers, was $6,829,661, or approximately 64.95% of net revenues for the three month period ended September 30, 2009, as compared to $7,667,014, or approximately 70.91% of net revenues for the same period in 2010. For the three months ended September 30, 2010 and 2009, cost of goods sold consisted of the following:
| | | Three Months Ended September 30, | |
| | | 2010 | | | 2009 | |
| Wholesale | | $ | 4,711,466 | | | $ | 5,270,706 | |
| Retail | | | 2,118,195 | | | | 2,414,663 | |
| Total Cost of Sales | | $ | 6,829,661 | | | $ | 7,667,014 | |
Wholesale cost of goods sold decreased by $559,240, or approximately 10.3%, from $5,270,706 in the three months ended September 30, 2009 to $4,711,466 for the three months ended September 30, 2010. The decrease in wholesale cost of goods was mainly due to a decrease in wholesale revenue, however, the decrease was partly attributable to efforts to control and reduce procurement costs by selecting suppliers with the most competitive prices for products available from multiple suppliers.
Retail cost of goods sold decreased by $295,468, or approximately 12.3%, from $2,414,663 in the three months ended September 30, 2009 to $2,118,195 in the three months ended September 30, 2010. The decrease is mainly attributable to the Company’s efforts to control and reduce procurement costs for our retail operation.
Gross Profit. Gross profit increased approximately $540,410, from $3,145,515 for the three month period ended September 30, 2009 to $3,685,925 for the three month period ended September 30, 2010, representing a 17.18% increase. Of this increase, approximately $328,218 in additional gross profit was due to increased sales to medical institutional customers. An additional $100,000 in gross profit was added through our 21 new retail drugstores opened from July 1, 2009 to September 30, 2010. Another $66,000 in gross profit was due to the addition of some products we carry to the Essential Drug Catalogue under the national medical insurance program. An additional $32,290 in gross profit was added by increased sales through existing retail drug stores. The increase in our gross profit for the 3 month period ended September 30, 2010 reflected the continuous effort of our management in adding higher margin products to the Company’s wholesale and retail sales mix.
Selling Expenses. Selling expenses increased approximately 25.22% from $912,094 for the three month period ended September 30, 2009 to $1,142,085 for the same period in 2010. The increase in selling expenses was mainly attributable to an increase in headcount and salary expense, which added $219, 228 to selling expenses. This constituted 95% of the total increase of the selling expenses. From the period ended September 30, 2009 to September 30, 2010, we added 162 employees, including 67 sales professionals and staff in wholesale, and 95 employees for our retail segment. These employees were required to meet the demands of our change in strategy for our wholesale business and to staff our new stores in our retail business.
General and Administrative Expenses. General and administrative expenses were $2,350,837 for the three month period ended September 30, 2009, as compared to $2,116,908 for the three month period ended September 30, 2010, representing a decrease of 10%. This decrease was largely due to a decrease in bad debt expenses of $1,056,012, offset by an increase in litigation, service expense and settlement costs amounting to $822,083, for the three month period ended September 30, 2010 as compared to the same three month period in the prior year. The net effect of these two offsetting factors resulted in a reduction in overall general and administrative expenses.
Other Income. Other income decreased 55.04% from $1,085,409 for the three month period ended in September 30, 2009 to $487,961 in the same period in 2010. The decrease of other income was mainly due to a reduction in promotional income for the three month period ended September 30, 2010, as compared to the same period of 2009. For the three month period ended September 30, 2009, we held fewer promotional events for drug makers, which resulted in lower promotional income. Instead, in the three month period ending September 30, 2010 the Company put more efforts into the development of its own medical market instead of undertaking product promotion activities on behalf of drug makers.
Other income was offset by amortization of our financing expenses for our issuance of convertible debt and warrants. The Company issued a total of $1,075,000 in principal amount of convertible notes, along with warrants for the purchase of 952,230 shares of its common stock with an exercise price of $6.00 per share, during the nine months ended September 30, 2010, resulting in the following expenses:
| | | Nine Months Ended September 30, 2010 | |
| Beneficial Conversion Feature | | $ | 601,955 | |
| Fair Value of Warrants | | | 473,045 | |
| Total Value of Securities Issued | | | 1,075,000 | |
| Other Financing Expenses | | | 179,519 | |
| Total Financing Expenses: | | $ | 1,254,519 | |
Total expenses for the note and warrant financing amounted to $1,254,519. In accordance with US GAAP these expenses was amortized within the applicable 36 month vesting period. For the three months ended September 30, 2010, $95,626 of the above financing expenses had been amortized and recorded. An additional $348,663 in expenses recorded represent expenses immediately realized, against $375,000 in principal amount of the convertible notes that were converted as of September 30, 2010. At September 30, 2010, the balance of the unamortized financing expense was $626,366. For details regarding the accounting for our convertible note and warrant financing, please also refer to information disclosed in Notes 15 and 17 of our unaudited financial statements for the nine months ended September 30, 2010.
Net Income. Net income decreased 135.71% from a net income of $472,113 in the three month period ended September 30, 2009 to a net loss of $168,601 in the three month period ended September 30, 2010. For the three months ended September 30, 2010 and 2009, net income consisted of the following:
| | | Three months Ended September 30, | |
| | | 2010 | | | 2009 | |
| Wholesale | | $ | 905,664 | | | $ | 494,131 | |
| Retail | | | 591,806 | | | | 508,627 | |
| Unallocated | | | (1,666,071) | | | | (530,645) | |
| Total Net Income | | $ | (168,601) | | | $ | 472,113 | |
Wholesale net income increased by 83.28% from $494,131 for the three months ended September 30, 2009 to $905,664 for the three months ended September 30, 2010. The increase was attributable to the additional $411,533 in net profit generated from sales to customers with higher margins after the Company adjusted its wholesale strategy.
Retail net income increased 16.4% from $508,627 for the three months ended September 30, 2009 to $591,806 for the three months ended September 30, 2010. The increase was attributable to the net income generated from increased essential drug sales and an increase in sales of covered drugs under the government’s new medical insurance program.
Unallocated net income in the three month period ended September 30, 2010 mainly consisted of net income from net expense attributable to non-controlling interest of $424,738, legal and accounting expenses of 822,083, and financing expenses of $444,289, and certain other items not allocable to a segment. Unallocated net expense increased by 214% from an expense of $530,644 for the three months ended September 30, 2009 to an expense of $1,666,071 for the three months ended September 30, 2010. We categorize the above expenses as unallocated since they are not directly related to our business segments are not allocable to a segment.
Comparison of Nine Months Ended September 30, 2010 and 2009.
Net Revenues. For the nine month period ended September 30, 2010, our net revenues increased by approximately 10.96% from $29,156,020 to $32,351,546 for the nine month period ended September 30, 2010. Net revenues consisted of the following:
| | | Nine Months Ended September 30, | |
| | | 2010 | | | 2009 | |
| Wholesale | | $ | 21,202,719 | | | $ | 18,860,332 | |
| Retail | | | 11,148,827 | | | | 10,295,688 | |
| Total Net revenues | | $ | 32,351,546 | | | $ | 29,156,020 | |
Wholesale net revenues increased by $2,342,387, from $18,903,637 in the nine months ended September 30, 2009 to $21,202,719 in the nine months ended September 30, 2010, representing a 12.42% increase. This increase in net revenue was due to higher sales to medical institutions, as we shifted our wholesale strategy away from selling to lower-margin distributors, and targeted higher-margin hospitals, clinics and other similar institutions. As a result of this shift, net sales to other distributors decreased by $157,656, which was offset by a $1,446,605 increase in sales to medical institutions as well as a $1,053,438 increase in sales to other retailers.
Retail net revenues increased by $853,139, or 8.29%, from $10,295,688 in the nine months ended September 30, 2009 to $11,148,827 in the nine months ended September 30, 2010. Retail revenues for the nine month period ended September 30, 2010 were higher mainly due to $825,442 in incremental sales through 21 new retail drugstores which were added from September 30, 2009 to September 30, 2010.
Cost of Goods Sold. Cost of goods sold, which mainly consisted of the procurement of drugs from suppliers and manufacturers, was $21,060,847, or approximately 72.23% of net revenues for the nine month period ended September 30, 2009, as compared to $23,442,133, or approximately 72.46% of net revenues for the same period in 2010. For the nine months ended September 30, 2010 and 2009, cost of goods sold consisted of the following:
| | | Nine Months Ended September 30, | |
| | | 2010 | | | 2009 | |
| Wholesale | | $ | 16,486,499 | | | $ | 14,327,504 | |
| Retail | | | 6,955,634 | | | | 6,733,343 | |
| Total Cost of Sales | | $ | 23,442,133 | | | $ | 21,060,847 | |
Wholesale cost of goods sold increased by approximately 15.07% from $14,327,504 in the nine months ended September 30, 2009 to $16,486,499 for the nine months ended September 30, 2010. The increase in wholesale cost of goods corresponded with an increase in wholesale net revenues. In addition, an increase in the prices we pay suppliers and manufacturers for certain drugs, such as antibiotics and certain herbal medications, led to an increase in overall wholesale cost of goods. Management also believes that rising labor costs and inflation in China also contributed to the increase in wholesale cost of goods.
Retail cost of goods sold increased by approximately 3.3% from $6,733,343 in the nine months ended September 30, 2009 to $6,955,634 in the nine months ended September 30, 2010. The increase in retail cost of goods sold was mainly related to the increase of the retail sales, however, some of the reduction in retail cost of goods was a result of the Company’s efforts to control and reduce procurement costs for its retail stores.
Gross Profit. Gross profit increased approximately 10.06% from $8,095,173 for the nine month period ended September 30, 2009 to $8,909,413 for the nine month period ended September 30, 2010. This increase in gross profit was mainly attributable to incremental sales through the 21 new retail drugstores that were added through 21 new retail drugstores which were added from September 30, 2009 to September 30, 2010. In addition, incremental sales resulting from the inclusion of products we well in the Essential Drug Catalogue under the national medical insurance program, which are reimbursable to recipients when purchased from authorized pharmacies. The increase in our overall gross profit margin was also due to adjustments in our product mix to include higher margin drugs.
Selling Expenses. Selling expenses increased approximately 16.24% from $2,495,546 for the nine month period ended September 30, 2009 to $2,900,904 for the same period in 2010. The increase of the selling expenses was due to our increase in headcount by 162 employees during the period between September 30, 2009 and 2010. This included 67 sales professionals and staff newly hired to develop and expand our wholesale segment, and an additional 95 employees for the retail business respectively. Salary expense increased by $312,411, which represented 77% of the total increased selling expenses. Additional depreciation expenses of $92,947 were incurred for equipment purchases as well as start-up costs for newly opened retail drugstores in the nine months period ended September 30, 2010.
General and Administrative Expenses. General and administrative expenses were $3,825,987 for the nine month period ended September 30, 2009, as compared to $3,623,259 for the nine month period ended September 30, 2010, representing a decrease of 5.33%. This decrease was largely because we had no bad debt expense in the nine month period ended September 30, 2010, in contrast to a bad debt expense of $1,372,350 in the third quarter of 2009. Also, in the nine months ended September 30, 2010, we had a $1,169,622 increase in litigation and settlement expenses compared to the same period in the prior year. The net effect of these two offsetting factors resulted in the 5.33% reduction in overall general and administrative expenses.
Other Income. Other income decreased by 76.64% from $1,867,166 for the nine month period ended in September 30, 2009 to $436,207 in the same period in 2010. For the nine month period ended September 30, 2009, we held two major promotional events through which we garnered substantial sponsorship and promotional fees from suppliers. These promotional events were held at the request of our suppliers in order to market and promote new products during the market downturn in 2009. In 2010, our suppliers did not hold similar promotional events partly in response to an overall improvement in local economic conditions. For the nine month period ended September 30, 2010, we did not conduct any major promotional events, and accordingly our other income decreased compared to the same period ended September 30, 2009.
Other income was offset by amortization of our financing expenses for our convertible debt and warrant financing. The Company issued a total of $1,075,000 in principal amount in convertible notes, along with warrants for the purchase of 952,230 shares of its common stock with an exercise price of $6.00 per share, during the nine months ended September 30, 2010, resulting in the following expenses:
| | | Nine Months Ended September 30, 2010 | |
| Beneficial Conversion Features | | $ | 601,955 | |
| Fair Value of Warrants | | | 473,045 | |
| Total Value of Securities Issued | | | 1,075,000 | |
| Other Financing Expenses | | | 179,519 | |
| Total Financing Expenses: | | $ | 1,254,519 | |
Total expenses for the note and warrant financing amounted to $1,254,519. In accordance with US GAAP these expenses was amortized within the applicable 36 month vesting period. For the nine months ended September 30, 2010, $279,490 of the above expenses had been amortized and recorded. An additional $348,663 in expenses recorded represent the expenses immediately realized, against $375,000 in principle amount of the convertible notes that were converted as of September 30, 2010. At September 30, 2010, the balance of the unamortized financing expense was $626,366. For details regarding the accounting for our convertible note and warrant financing, please also refer to information disclosed in Notes 15 and 17 of our unaudited financial statements for the nine months ended September 30, 2010.
Net Income. Net income increased 39.5% from a net income of $1,936,906 in the nine month period ended September 30, 2009 to a net income of $2,701,928 in the nine month period ended September 30, 2010. For the nine months ended September 30, 2010 and 2009, net income consisted of the following:
| | | Nine Months Ended September 30, | |
| | | 2010 | | | 2009 | |
| Wholesale | | $ | 2,102,020 | | | $ | 2,069,823 | |
| Retail | | | 1,017,212 | | | | 1,185,445 | |
| Unallocated | | | (417,304) | | | | (1,318,362) | |
| Total Net Income | | $ | 2,701,928 | | | $ | 1,936,906 | |
Wholesale net income declined by 1.56% from $2,069,823 for the nine months ended September 30, 2009 to $2,102,019 for the nine months ended September 30, 2010. The decrease was attributable to an increase in wholesale cost of goods sold, higher legal, financing and accounting expenses, and a decrease in sponsorship and promotional income classified as other income.
Retail net income decreased 14.2% to $1,017,212 for the nine months ended September 30, 2010, compared to $1,185,445 for the same period in the prior year. Even though our retail net revenues increased by 8.29% for the nine months ended September 30, 2010 compared to the same period in 2009, such revenues were offset by expenses related to the opening of 10 additional retail drugstores during the nine months ended September 30, 2010, amounting to approximately $168,233. Excluding these start-up costs, retail net income did not change substantially between the nine months ended September 30, 2010 and 2009.
Unallocated net income (expense) in the nine month period ended September 30, 2010 mainly consisted of income gained from the disposal of the liabilities associated with the e-learning business of $1,948,553, net income attributable to non-controlling interest of $795,807, legal, accounting and service fee expenses of $941,897, financing expenses of $628,153, and certain other expenses not allocable to a segment. We categorize the above income and expenses as unallocated since they are not directly related to our business segments are not allocable to a segment. Unallocated net expense decreased by 68.35% from an expense of $1,318,362 for the nine months ended September 30, 2009 to an expense of $417,304 for the nine months ended September 30, 2010. This decrease in unallocated net expense was mainly due to the sale of our e-learning business during the first quarter of 2010, which was unrelated to our current pharmaceutical operations. As a consequence of this sale, we transferred approximately $1.9 million in liabilities associated with the e-learning business, to the purchaser of the e-learning business.
Liquidity
Cash Flow
Net cash flow used in operating activities was $3,172,770 for the nine month period ended September 30, 2010, as compared to net cash flow provided by operating activities in the amount of $2,626,117 for the nine month period ended September 30, 2009. The decrease in net cash provided by operating activities was primarily attributable to payments which amounted to $2,700,832 for procurement of pharmaceuticals, mainly to build up our inventory for the opening of additional drugstores, and to expand our wholesale operations. In addition, we agreed to accept bank-guaranteed notes with a three to six month maturity, similar to letters of credit, from certain of our customers in lieu of cash for their purchases during the nine month period ended September 30, 2010. Since the notes are bank-guaranteed, risk of non-collectability is considered negligible. Our acceptance of these notes in lieu of cash caused a decrease in net cash flow used in operating activities.
Net cash flow used in investing activities was $577,941 during the nine months ended September 30, 2010, as compared to cash outflow of $1,078,011 for the same period in 2009. For the nine months ended September 30, 2010, the net cash outflow from investing activities decreased mainly because we purchased less property and equipment during the nine month period ended September 30, 2010 as compared to the same period in the prior year.
Net cash flow provided by financing activities increased from a cash outflow of $752,249 for the nine months ended September 30, 2009 to a cash inflow of $3,530,829 for the nine months ended September 30, 2010. The increase was mainly due to an increase in cash from financing activities in the amount of $1,155,323 for the issuance of our securities, and receipt of loans from non-related parties in the amount of $2,375,506.
Capital Resources
At September 30, 2010, we had cash and cash equivalents of $1,631,986, other current assets of $35,258,090 and current liabilities of $11,656,529. We presently finance our operations primarily out of cash flow from operations, and we anticipate that this will continue to be our primary source of funds to finance our short-term cash needs. We expect to generate positive operating cash flow for the remainder of 2010.
In the nine months ended September 30, 2010 we have thus far opened 10 retail drugstores, and we expect to open additional stores for the remainder of 2010 through 2012. In order to finance our growth and expansion, or if we pursue other opportunities for investment, acquisition, or strategic cooperation, however, we may require additional cash resources. If we determine that our cash requirements exceed the amounts of cash on hand, we may rely on proceeds from an equity or other type of financing for additional working capital to complete these projects. We may seek to issue debt or equity securities or obtain short-term or long-term bank financing. Any issuance of equity securities could cause dilution of our stockholders’ interests. However, at this time, other than the above we are not aware of any known demands, commitments, events, or uncertainties that will or may be reasonably likely to result in material changes in our liquidity.
Contractual Obligations and Off Balance-Sheet Arrangements
Off-Balance Sheet Arrangements
We have not entered into any other 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 stockholder’s equity or that are not reflected in our consolidated financial statements. Furthermore, we do not have any retained or contingent interest in assets transferred to an unconsolidated entity that serves as credit, liquidity or market risk support to such entity. We do not have any variable interest in any unconsolidated entity that provides financing, liquidity, market risk or credit support to us or engages in leasing or hedging services with us.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Derivative Financial Instruments. We do not use derivative financial instruments in our investment portfolio and have no foreign exchange contracts. Our financial instruments consist of cash and cash equivalents, trade accounts receivable, accounts payable and long-term obligations. We consider investments in highly-liquid instruments purchased with a remaining maturity of 90 days or less at the date of purchase to be cash equivalents.
Interest Rates. Our exposure to market risk for changes in interest rates relates primarily to our short-term obligations; thus, fluctuations in interest rates would not have a material impact on the fair value of these securities. At September 30, 2010, we had approximately $1,631,986 in cash and cash equivalents. A hypothetical 10% increase or decrease in interest rates would not have a material impact on our earnings or loss, or the fair market value or cash flows of these instruments.
Foreign Exchange Rate. We use the United States Dollar (“U.S. Dollars”) for financial reporting purposes but all of our sales and inputs are transacted in Renminbi (“RMB”). As a result, changes in the relative values of U.S. Dollars and RMB affect our reported levels of revenues and profitability as the results are translated into U.S. Dollars for reporting purposes. However, since we conduct our sales and purchase inputs in RMB, fluctuations in exchange rates are not expected to significantly affect our financial stability, or gross and net profit margins. We do not currently expect to incur significant foreign exchange gains or losses, or gains or losses associated with any foreign operations. During the years ended December 31, 2009 and 2008, we recorded net foreign currency gains of $123,209 and $824,961, respectively. During the three months ended September 30, 2010, we recorded a net foreign currency gain of $445,180 compared to a net foreign currency Loss of $17,742 for the same period in 2009.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Disclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by the Company in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our principal executive and financial officers, as appropriate to allow timely decisions regarding required disclosure.
As of the end of the period covered by this Form 10-Q, we conducted an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of our disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) of the Exchange Act). Based upon this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective.
Changes in Internal Control Over Financial Reporting
Based on the evaluation of our management as required by paragraph (d) of Rule 13a-15 or 15d-15 of the Exchange Act, there were no changes in our internal control over financial reporting that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Part II. Other Information
Item 1. Legal Proceedings
Although China Yongxin is a party in the litigation matters described below, all of these legal proceedings relate to the Company’s predecessor company, Digital Learning Management Corporation and its activities prior to the Reverse Acquisition Transaction, and they are not related to China Yongxin’s current business:
On or about October 17, 2008, in the legal proceeding titled Craig Nagasugi v. Digital Learning Management Corporation, et al., a former officer of the Company (then named Digital Learning) initiated an action in Los Angeles Superior Court, Central District, against Digital Learning Management Corporation alleging claims for damages related to an alleged employment agreement. On December 29, 2008, the Company filed an Answer to the Complaint. The matter went to trial on or about November 2, 2009 and concluded as of November 9, 2009. The case resulted in a judgment against the Company for $641,018. The court entered a revised judgment in the amount of $746,487.37 against the Company on April 20, 2010 to reflect attorney fees. As of the date of this filing, the judgment has not been paid. Presently the Company’s parent corporation holds insufficient funds to pay the judgment.
Under Allaudin Jinnah v. China Yongxin Pharmaceuticals Inc., filed in Los Angeles Superior Court, Central District, on or about June 27, 2008, the Company defended itself against claims for open account and intentional misrepresentation. Prior to the Reverse Acquisition, Plaintiff was an officer of the Company and claimed that the Company breached an employment agreement concerning compensation and that the Company, alleging Umesh Patel and Ning Liu committed fraud by making misrepresentations concerning stock that they promised to give to Plaintiff to settle his claims. The Plaintiff sought past due attorneys’ fees for services rendered in the amount of $193,100. The Plaintiff also sought 67,000 shares (pre-Reverse Split) of the Company’s common stock. The Plaintiff filed a motion to enforce the Company’s settlement to receive up to a $50,000 judgment and 200,000 to 400,000 shares (pre-Reverse Split) of the Company’s common stock. At the hearing to enforce the settlement, the court entered judgment against the Company for $50,000 plus 200,000 shares (pre-Reverse Split) of the Company’s common stock. The court ordered the Company to issue an additional 200,000 shares (pre-Reverse Split) of the Company’s common stock as collateral for the $50,000. The said judgment was paid and satisfied in full by the Company in February 2010.
The Company was also involved in a legal proceeding named Wells Fargo Bank. N.A.. v. Software Education for America Inc. filed in Orange County Superior Court on or about November 9, 2004. Wells Fargo brought an action to collect on a promissory note issued by Software Education and guaranteed by Mr. Koosed. Mr. Koosed then brought a cross-complaint against Digital Learning Corporation (the Company as it was named prior to the Reverse Acquisition) on the grounds that Digital Learning Corporation promised to indemnify him for his guaranty. A stipulated judgment was entered against Digital Learning Corporation. Mr. Koosed then amended the judgment to name the Company as the successor-in-interest to Digital Learning Corporation. The Cross-Complainant, Mr. Koosed, sought to amend a $219,000 judgment he obtained to include a subsidiary of the predecessor-in-interest of the Company, which was not named or a participant in such lawsuit. On May 8, 2009, the Orange County Superior Court rendered a decision to enter a judgment of $219,000 against the Company. This judgment was satisfied in full by the Company in February 2010.
Under Adnan Mann v. China Yongxin Pharmaceuticals Inc. , on or about March 10, 2009, a former employee filed claims for unpaid wages and penalties under the California Labor Code and applicable Industrial Wage Orders. On July 10, 2009, the Company filed an Answer to the Complaint denying liability. The Company and the former employee entered into a stipulation on May 10, 2010 in the amount of $241,733.28.
Item 2. Unregistered Sale of Equity Securities and Use of Proceeds
None.
Item 3. Default Upon Senior Securities
Not applicable.
Item 4. [Removed and Reserved]
Item 5. Other Information
Item 6. Exhibits
The following exhibits are included in this Form 10-Q or incorporated by reference into this Form 10-Q:
| Exhibit Number | | Description | |
| | | | |
| 3.7 | | Amended and Restated Certificate of Incorporation (incorporated by reference to Exhibit 3.7 to the Amendment No. 1 to the Registration Statement on Form S-1 filed with the SEC on August 3, 2010) | |
| | | | |
| 3.9 | | Amended and Restated Bylaws (incorporated by reference to Exhibit 3.9 to the Amendment No. 1 to the Registration Statement on Form S-1 filed with the SEC on August 3, 2010) | |
| | | | |
| 10.32 | | Letter of Intent entered into by and between the Company and Mr. Shan Gao on September 25, 2010 (supersedes Framework Agreement dated July 18, 2010). (English Translation) (incorporated by reference to Exhibit 10.32 to the Amendment No. 2 to the Registration Statement on Form S-1 filed with the SEC on November 4, 2010) |
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| 10.33 | | Letter of Intent entered into by and between the Company and Mr. Liwen Tian on September 25, 2010 (supersedes Framework Agreement dated May 15, 2010). (English Translation) (incorporated by reference to Exhibit 10.33 to the Amendment No. 2 to the Registration Statement on Form S-1 filed with the SEC on November 4, 2010) |
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| 10.34 | | Loan Agreement dated July 22, 2010 (Dingjian Natural Plant Base Co.) |
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| 10.35 | | Loan Agreement dated June 30, 2010 (Changchun Golden Century) |
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| 31.1 | | Certification of Chief Executive Officer Pursuant to Item 601(b)(31) of Regulation S-K, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| 31.2 | | Certification of Chief Financial Officer Pursuant to Item 601(b)(31) of Regulation S-K, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
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| 32.1 | | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
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| 32.2 | | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
SIGNATURES
| | | CHINA YONGXIN PHARMACEUTICALS INC. | |
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| Dated: November 22, 2010 | | /s/ Yongxin Liu | |
| | | Yongxin Liu | |
| | | Chairman of the Board and Chief Executive Officer | |
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| Dated: November 22, 2010 | | /s/ Harry Zhang | |
| | | Harry Zhang | |
| | | Chief Financial Officer | |
