The following chart shows the structure of our control agreements and the affiliated entities consolidated into our group consolidated financial results as a result of the control agreements:
| | * | Control Agreements include: |
| | (a) | Exclusive Consulting and Service Agreement entered into by and between Shengyuan Nutrition and Huimin; |
| | (b) | Business Operating Agreement entered into by and among Shengyuan Nutrition, Huimin, Jibin Zhang (who is our Director of Loans) and Yunpeng Jiang (who is our Director of Strategic Acquisitions); |
| | (c) | Call Option Agreement entered into by and among Shengyuan Nutrition, Huimin, Jibin Zhang and Yunpeng Jiang; |
| | (d) | Pledge Agreement entered into by and among Shengyuan Nutrition, Jibin Zhang and Yunpeng Jiang; and |
| | (e) | Entrustment Agreement entered into by and among Shengyuan Nutrition, Jibin Zhang and Yunpeng Jiang. |
| | ** | Entrustment Agreement entered into by and among Shengyuan Nutrition, Jibin Zhang, Yunpeng Jiang and Honnete. |
For a more detailed description of the control agreements, see “Item 13. Certain Relationships and Related Transactions, and Director Independence.”
Our Brands
We primarily market our products under the Synutra, or Shengyuan, brand which has been associated with infant formula products in China for more than 10 years. In addition to the Synutra, or Shengyuan brand, our products are marketed in China under brands that we have developed through our national sales and marketing efforts.
Brands for Powdered Formula Products
Powdered formula product brands include several of China’s leading infant and adult formula brands, which mainly include Super, U-Smart, My Angel and Dutch Cow. We have positioned these brands as high quality brands, which provide unique, clinically supported health and developmental benefits. Our infant powdered formula products include DHA and ARA, which support brain and immune system development of infants.
Complementary Brands
Building upon the strength of our brands, we are extending into the fast growing prepared baby food and adult food market, using the Huiliduo brand.
We market under the Meitek brand to meet the nutritional needs of the broader consumer population in China. The products of our Meitek brand use raw materials of type II collagen, which are believed to help relieve joint discomfort, and glucosamine and chondroitin, which clinical studies indicate may help slow down the aging of joints.
In addition, we have recently launched Chondro Gold and Chodro Cal brands of chondroitin sulfate sodium and chondroitin sulfate calcium materials intended for the dietary ingredients industry in North America and the rest of the world. We believe these two branded materials lead the industry and differentiate our dietary ingredients from the rest of the field and feature our unique and proprietary manufacturing processes at Meitek that help to ensure material purity and quality with innovation.
Stages of Development
Generally, there are five stages of pediatric development and we produce different products for each of these stages. The general stages of pediatric development are as below:
| Stage 0: | For expectant and nursing mothers |
| Stage 1: | For infants 0-12 months old |
| Stage 2: | For infants 6-18 months old |
| Stage 3: | For children 1-3 years old |
| Stage 4: | For children 3-7 years old |
Our Dutch Cow brand also provides powdered formula products for students, women and older people, to address their special needs.
Our Products
Our products are grouped by category of production process and usage as well as internal resource allocation: (1) Powdered Formula, (2) Foods, (3) Nutritional Ingredients and Supplements, and (4) Other business. Sales of Powdered Formula, Foods, Nutritional Ingredients and Supplements, and Other business comprised 84%, 0%, 3%, and 13% of our net sales for the fiscal year ended March 31, 2013, respectively.
Powdered Formula Products
Infant Formula (Stage 1 and Stage 2)
Our infant formula products include formulas for regular feeding and specialty formula products. The following illustrates our key infant formula brands and products:
Regular Infant Formula
We design regular infant formula as a breast milk substitute for healthy, full-term infants without special nutritional needs, both for use as the infant’s sole source of nutrition and as a supplement to breastfeeding. We endeavor to develop regular infant formula closer to breast milk.
Each product is referred to as a “formula,” as it is formulated for the specific nutritional needs of an infant of a given age. Generally, our regular infant formula has the following four main components: (1) protein from cow’s milk that is processed to have an amino acid profile similar to human milk, (2) a blend of vegetable fats (including DHA/ARA) to replace bovine milk fat in order to better resemble the composition of human milk, (3) a carbohydrate, generally lactose from cow’s milk and (4) a vitamin and mineral “micronutrient” pre-mix that is blended into the product to meet the specific needs of the infant at a given age. Patterned after breast milk, which changes composition to meet the infant’s changing nutritional needs, we produce two stages of formula. Stage 1 formulas are consumed by newborn infants up to twelve months of age. Stage 2 formulas are generally consumed by infants from six to eighteen months.
Specialty Infant Formula
| | l | Formulas for Preterm and Low Birth Weight Infants |
| | l | Formulas addressing Calcium, Iron or Zinc Deficiency |
| | l | Formulas of Partially Hydrolyzed Whey Protein |
In March 2012, we obtained the license to produce specialty infant formulas in five categories from Shandong Bureau of Quality and Technical Supervision and were the first domestic manufacturer in China to receive such a license. Special infant formulas are designed for infants with special conditions who cannot consume regular infant formulas. We market these products under the Shengyuan Specialty Formula brand name.
Lactose free formulas are designed for infants that are lactose intolerant. Lactose is substituted by maltodextrin in this formula, and it is mainly for infants with diarrhea.
Formulas for preterm and low birth weight infants are designed to meet these infants’ unique needs. Typically, such infants need extra assistance obtaining the requisite nutrition. They require a higher density of nutrients and calories because they cannot take in enough volume of breast milk or regular infant formula. We have formula for infants both when they are under intensive care in the hospital, and after they are discharged from the hospital.
We designed formulas addressing calcium, iron or zinc deficiency for infants with special needs from stage 1 to stage 3.
Formulas of partially hydrolyzed whey protein are designed for use by infants that are allergic to the protein in cow’s milk. We introduced this product to the market in April 2013.
We produce medical formula, or formulas for special medical purposes, for nutritional management of infants who are born with rare metabolism disorders. Currently, we have formula for infants under twelve months of age with phenylketonuria (“PKU”). We plan to develop more formulas targeting other specific disorders in the future.
Children’s Formula (Stage 3 and Stage 4)
We market children’s formula products under the Synutra family of brands. Super, U-Smart, My Angel, Dutch Cow and Formulas addressing Calcium, Iron or Zinc Deficiency are produced for stage 3 and 4. We design these products to meet the changing nutrition needs of children at different stages of development. We offer products at stages 3 and 4 that are designed for children’s nutritional needs at one to three years of age and three to seven years of age, respectively. These products are not breast milk substitutes and are not designed for use as the sole source of nutrition but instead are designed to be a part of a child’s appropriate diet. Our use of the Synutra brand allows for a consistent image across our stages 3 and 4 products.
We produce rice cereal products as supplements for children over 6 months. Currently we have ten formulas of rice cereal products which are produced using rice, fruit, vegetable, meat, vitamins and minerals. We believe that rice cereal products are essential supplements to formula milk.
Adult Formula
We produce Stage 0 powdered formulas for expectant and nursing mothers under Super and U-Smart brand. Our products for expectant or nursing mothers provide the developing fetus or breastfed infant with vitamin supplements and/or an increased supply of DHA for brain development. These products also supplement the mother’s diet by providing either DHA or ARA with increased proteins, as well as vitamins and minerals.
We produce powdered formulas for adult, such as formula with multi-vitamin, formula with high calcium, formula for the elderly, formula for women, and formula for students under the Dutch Cow brand. These products are developed to address specific types of consumer profiles and nutritional needs.
Food Products
Food segment covers the sale of prepared pureed food for babies and children and starting fiscal 2014, we plan to expand the segment to include sales of prepared pureed adult food. Baby food products are designed to be part of a child’s healthy diet with enhanced nutritional value. Adult food products will be designed for patients with special nutritional needs after surgical operations.
Nutritional Ingredients and Supplements
Nutritional ingredients and supplements segment covers the production and sale of nutritional ingredients and supplements such as chondroitin sulfate, collagen, microencapsulated DHA and ARA. Chondroitin sulfate and collagen is mainly for industrial sales and export, with a small portion used in our self-developed nutritional products. Microencapsulated DHA and ARA powders are produced mainly for internal use in powdered formula production process.
Other business
Other business principally includes ancillary sales of surplus milk powder and whey protein to industrial customers.
Production
Powdered Formula Processing
In the fiscal year ended March 31, 2013, we import whole milk powder used for our powdered formula products from Fonterra Co-operative Group (“Fonterra”) in New Zealand. We import whey protein and high oil whey protein used for infant powdered formula products from Eurosérum S.A.S (“Eurosérum”) in France. We purchase other ingredients for our formula from domestic suppliers.
If the high oil whey protein purchased from Eurosérum is not enough for our production, we use whey protein and oil to produce high oil whey protein, or engage a third party to produce high oil whey protein using whey protein and oil provided by us. In rare cases, when whey protein powder is in short supply, we use whey protein concentrates and lactose instead in the production.
At our Qingdao facility, milk powder is mixed in large automated mechanical mixers with high oil whey protein powder and other additives in a method known as dry-mixing. Our dry-mixing equipment can automatically adjust the level of ingredients to achieve the complex formulations required by our premium products. The resulting milk powder is then checked to ensure proper granule size before packaging and distribution.
Imported Super product is contract manufactured by Arla, a Danish company, and Dutch Cow infant formula product is contract manufactured by FrieslandCampina, a Dutch company. These products are produced according to our specification and the quality standards of both companies/countries.
Production and Packaging Facilities
Our processing and packaging facilities, which are all owned by us, are located in various locations in China, including Qingdao, Zhangjiakou, Fengzhen and Zhenglanqi. These facilities encompass approximately 137,000 square meters of office, plant, and warehouse space. Our distribution center located in Qingdao includes approximately 25,000 square meters of owned space. All of our production facilities are built based on the GMP standard, with equipment imported from Europe and all of our facilities that have commenced operations have ISO9000 and HACCP series qualifications with some also being ISO14000 certified.
Qingdao, Zhangjiakou and Fengzhen facilities are for our powdered formula production. As of March 31, 2013, we had high oil whey protein processing capacity of approximately 12,000 tons per year for the Zhangjiakou facility and the Fengzhen facility, and had packaging capacity of approximately 108,000 tons per year and dry-mixing processing capacity of approximately 62,000 tons per year for the Qingdao facility.
Our Qingdao facility serves as our dry-mixing and packaging plant. Various ingredients, such as milk powder, high oil whey protein powder and nutritional additives arrive at our Qingdao facility from our production facilities and our suppliers, and are mixed using the dry-mixing method. Qingdao facility packages the mixed ingredients into retail-size tin canisters or stand up/display pouches or sealed packages in boxes. This packaging facility also provides inventory control and logistics management, product quality monitoring and product development assistance.
Our production facility for prepared foods is located in Zhenglanqi. As of March 31, 2013, the Zhenglanqi facility had a processing capacity for prepared foods of 9,000 tons per year.
Our production facility for nutritional ingredients and supplements is located in Qingdao. As of March 31, 2013, this facility had a processing capacity of 500 tons per year for chondroitin sulfate, 500 tons per year for collagen protein, and 700 tons for microencapsulated DHA and ARA powders.
For information with respect to the installed capacity, location and function of our processing and packaging facilities, see “Item 2. Properties”.
Retail Packaging
The bulk of our powdered formula and other nutritional products come in three types of retail packaging: tin canisters, standup/display pouches, or sealed packages in a box. All packaging labels carry product information, nutritional profile, user instructions, product tracing data and shelf life date, product certification status, quality control and assurance remarks, manufacturer contact information, as well as customer service information that comply with PRC labeling requirements. Selected products are also retail-packaged in single-use sizes. Before any product leaves our packaging facility to distributors, we engage in an extensive testing and inspection of the final product.
Raw Materials and Suppliers
Raw Materials
Our business depends on maintaining a regular and adequate supply of high-quality raw materials. In the aftermath of the melamine contamination incident, we decided to use imported milk powder for the production of our powdered formula products. Currently, all of the milk powder used in our production is from New Zealand.
Whey protein powder is the other key ingredient used in the production of our powdered infant formula products. Like all powdered milk producers, we use whey protein powder as the active ingredient to help reconstituted dairy-based formula to mimic the consistency of breast milk, which can constitute approximately 55% of the final powdered infant formula product by weight. Whey protein powder is a byproduct of cheese-making processes, and is difficult and costly to produce as a stand-alone product. Since China is not a large consumer or producer of cheese and cheese products, we typically obtain whey protein powder in volume from overseas sources, such as France.
Based on our experience, prices of milk powder and whey protein powder can fluctuate over relatively short periods of time depending on market conditions. Our sourcing team monitors price movements and makes major purchases at times when prices are attractive, subject to projected customer order flow and other factors.
Our powdered milk products, including our powdered infant formulas, also include additives such as DHA and ARA fatty acids and other nutritional additives. DHA and ARA fatty acids are long-chain poly-unsaturated fatty acids found in breast milk that are believed to aid in the development of an infant’s brain, eyes and nervous system. Studies have suggested that DHA and ARA fortification can replicate some of the nutritional benefits of breast milk in infant formulas. Currently we purchase DHA oil and ARA oil from third parties, and produce microencapsulated DHA and ARA powders at our Meitek facility for internal use.
We use vegetable oils in our spray-drying powder infant formula production processes as a binder for the dry ingredients, helping diminish the occurrence of “lumpiness” or uneven texture when reconstituting powdered infant formula.
We purchase animal cartilage from third-party suppliers for the production of chondroitin sulfate, a substance that provides nutrients for joints, tendon, ligaments and bones, in our Meitek facility.
Suppliers and Supplier Arrangements
Currently, we purchase all of our milk powder from Fonterra in New Zealand. The purchase prices are determined through Fonterra’s online auction process and we do not sign long term contracts with our suppliers.
We purchase all of our whey protein powder from Eurosérum.
On September 17, 2012 we entered into a partnership agreement, a milk supply agreement, a whey supply agreement, a whey powder supply agreement, and a technical assistance agreement with Sodiaal Union, a French agricultural cooperative company (“Sodiaal”), and Euroserum SAS, a French subsidiary of Sodiaal (“Euroserum”). Under these agreements, we intend to build a new drying facility in Carhaix, France, to manufacture powdered milk and fat-enriched demineralized whey (the “French Project”). For details, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources”.
Sales and Distribution
Sales
We generally sell our products to distributors and in limited circumstances directly to retailers such as supermarkets. With the introduction of My Angel series infant powdered formula products in the fourth quarter of fiscal year 2011, we began to sell directly to baby stores. Our sales and marketing approach combines advertising, brand-building and store-level promotions. Our customer relations management team, or CRM, of approximately 140 employees uses our customer relations management database in order to acquire, process, and manage targeted customer information.
We have built a sales network that covers all the provinces and provincial-level municipalities in mainland China. Our sales group is divided into multiple sub-sales regions. Each sub-sales region covers between eight to twenty urban sales areas which act as independent operating units, while each urban sales area covers three to twenty county sales areas. As of March 31, 2013, we had a sales and marketing force of approximately 2,000 employees, complemented by approximately 11,000 full time or part time commissioned field nutrition consultants or retail site promoters employed by our distributors and sub-distributors to promote and sell our products.
Our sales teams work directly with each retail outlet to manage the sales process and to collect customer and purchasing related data. We use multiple criteria to select our distributors, including reviewing each potential distributor’s financial condition. City managers are rotated periodically among various cities. We have set up a sales budget management team to manage our sales expenses and to supervise the execution of our budgeting plan. This team reports directly to the director of marketing and sales.
We compensate our sales personnel through a combination of fixed salaries and bonuses based on sales volume. Our targeted sales incentive programs compensate our sales personnel on a product-specific level, thereby enabling us to incentivize our sales personnel to focus their sales and promotion efforts on certain product lines, such as our premium product lines or larger product packages.
Distribution
We primarily work directly with over 670 independent distributors, who in turn work with over 680 independent sub-distributors, and approximately 27,000 retail outlets. Our dry-mixing and packaging subsidiary, Shengyuan Nutritional Food Co., Ltd., also serves as our national distribution center for our distributors in China. Through the personal digital assistant (“PDA”) devices and cell phone applications we installed for each distributor, we can monitor their inventory level closely. We accept purchase orders each month from the distributors. Our sales personnel also regularly inspect and perform stocktaking on distributors’ inventories to identify and control any potential inventory buildup. We employ trucking companies locally and nationally to distribute retail packaged products to various regional and provincial distributors.
Distributors normally have exclusive distribution rights in their respective regions and cities to distribute our products, and are also responsible for developing the sub-distributors in their own region and cities. We typically enter into a contract with each of our distributors that establishes the range of sales obligations and their respective discount level on top of our standard manufacturer’s prices. However, our obligation to sell and the distributor’s obligation to purchase arise only at the time a purchase order is accepted. We seek to carefully manage our distributors through an evaluation system that monitors and grades each distributor with respect to performance criteria such as monthly sales and investment in promotional activities. We seek to incentivize well-performing distributors by providing larger discounts, larger sales territory and other incentives. While we do not directly manage our sub-distributors, we do track sub-distributor performance through coordinated efforts between our own sales personnel in the field and the distributors. We do not accept product returns except in the event of package damage during delivery and for a limited number of supermarket retailers.
We currently distribute our nutritional products across mainland China. Our logistics center in our Qingdao facilities occupies an area of 25,000 square meters. This logistics center can currently dispatch 6,900 tons of our products for shipment to our distributors per month. Our Qingdao facility also has the capability to respond to urgent requests for product shipments within an average of five days.
We currently work with more than 20 transportation companies that transport our goods directly from our Qingdao facilities to distributors in a timely and efficient manner.
We have an enterprise resource planning system, or ERP system, which is a financial information system with an inventory module that manages and records inventory transactions.
Seasonality
Our business experiences some seasonal fluctuations. Summer time is typically a slow time for the infant formula market because Chinese parents tend to choose the summer time to switch from milk feeding to more concrete food for their babies. As a result, we generally experience weaker sales in our first and second fiscal quarters.
Marketing, Advertising and Promotion
Advertising
We advertise through various media, including television, print media and the Internet. We supplement nationwide television coverage with local television coverage. We also purchase advertising over the Internet. Our advertising spending was $11.9 million, $11.5 million and $22.6 million for the fiscal years ended March 31, 2013, 2012 and 2011, respectively. Our advertising spending has enabled us to secure prime-time placements with China Central Television and other premium regional or satellite television stations.
Marketing and Promotion
As part of our sales and marketing approach, our sales force works with more than 15,000 healthcare facilities across China to provide maternity, infant nutrition and health education programs. We have also established a national customer service call center providing live assistance and a toll-free line to provide consumers with prenatal, nursing, baby care education, product information, and address complaints and dispute resolution.
We provide displays, posters and other printed promotional materials to retail outlets and sales consultants employed by our distributors at each point of sale. We also pay entry fees to various retail outlets to place our products within such outlets. We collect customer information through surveys voluntarily provided by each customer via the point of sale or via mailed forms provided to our customers in each product package. We also have promotional activities with supermarket chains and entertainment companies in order to reach our target market.
Quality Control
We place primary importance on quality. We have established quality control and food safety management systems for the purchasing, acceptance checks, processing, packaging, storage and transportation. All of our processing facilities are equipped with in-house laboratories for quality assurance and quality control purposes. Our quality test laboratory in Qingdao has been qualified as a National Standard Laboratory by the China National Accreditation Service for Conformity Assessment.
In order to ensure the quality and safety of our ingredients and products, we have also installed testing equipment and have implemented control procedures at each stage of production, including at the initial raw material purchase stage. There are over 1,100 quality control points throughout the entire production process. We employ strict internal procedures and monitoring by highly trained employees during production, transportation and storage. Additionally, we have been increasing our investment in quality control equipment and training. All policies relating to quality control are subject to PRC laws and regulations.
In the dietary ingredients and supplements sector, we believe we have led our domestic industry in applying well established standards in production documentation, including those under the U.S. Pharmacopeia (UPS), to help ensure the integrity of the supply chain and to discourage adulteration of chondroitin sulfate materials. In addition to our quality assurance laboratory facilities in Qingdao, we have recently established a wet lab in Rockville, MD dedicated to dietary ingredients material screening and research on supplement products in the US market.
Highlights of our quality control procedures are summarized below, organized by the main stages of production:
Imported Milk Powder and Whey Protein:
| | ● | Procurement staff inspects the Certificate of Analysis to ensure the products are manufactured and tested according to production countries’ national standard; |
| | ● | Entry-Exit Inspection and Quarantine of the People’s Republic of China performs quality test to ensure the products are up to national standard and issue a Sanitary Certificate; and |
| | ● | Quality test staff of the Company performs detailed test on quality and nutritional ingredients of the products before using them in production. |
Powder Formula Production:
| | ● | Compliance with production process control procedure, HACCP Plan implemented at all plants; |
| | ● | All raw materials are subject to prior inspection; |
| | ● | Detailed process designed for all parts of the production process including pretreatment, dry-mixing, powder receiving, and packaging; |
| | ● | Maintain hygiene standards for staff, equipment, environment and any other object; and |
| | ● | Inspection conducted throughout the production process. |
Packaging, Storage and Transport:
| | ● | Establishment and practice of total process management with respect to product identification and traceability; |
| | ● | Inspection before warehousing of products; |
| | ● | Maintain hygiene standards in the course of transport and storage; and |
| | ● | Products must be positioned according to their category during transport and storage. |
Research and Development
Our research and development activities focus on new product formulation, new ingredient development, creation of new methods to incorporate certain nutrients in our products, and improvement in product tastes and ingredient shelf stabilities. We engage in regular product refinement and new product development for our dairy-based formula products, as well as other forms of foods and nutritional supplements.
We utilize our research and development facilities to engage in the development of bringing our infant formula products closer to the quality of breast milk and promote our brand image. We also engage third-party research institutions to research and develop such trial products for us.
We seek to leverage our research and development resources in order to extend our new product pipeline. We believe we can accomplish this goal with new formulations and product concepts in dairy-based formula products as well as other nutritional food products and supplements.
During each of the fiscal years ended March 31, 2013, 2012 and 2011, we spent approximately 1.0%, 0.3% and 0.4% of net sales per year on research and development, respectively.
Competition
The infant formula industry in China is highly competitive. We generally compete with both multinational and domestic infant formula producers. Competitive factors include brand recognition, distribution network, quality, advertising, formulation, packaging and price. Many of our competitors have significant market share in the markets we compete in. Our principal competitors can be classified generally into the following two groups:
Multinational Brands
| | ● | Abbot Laboratories’ Ross Products Division, a U.S. producer and distributor of infant formulas marketed under the brand names of Similac and Enfalac family of formulas; |
| | ● | Mead Johnson Nutrition Co., or Mead Johnson, formerly a Bristol-Myers Squibb Company Division, a U.S. producer and distributor of the Enfamil family of formulas; |
| | ● | Groupe Danone SA’s Numico division, or Numico, a Dutch producer of baby foods, which sells and markets infant formula products in China under the Dumex brand; |
| | ● | Nestlé Suisse SA, or Nestlé, a Swiss producer and distributor of starter and follow-up formulas, milk, cereals, oral supplements and performance foods marketed under Nestlé brands such as Carnation; and |
| | ● | Wyeth, a U.S. producer and distributor of infant formula sold under private label brands. |
Domestic Brands
| | ● | Inner Mongolia Yili Industrial Group Co., Ltd., or Yili, a PRC producer and distributor of liquid and powdered milk under their Yili brand; |
| | ● | Beingmate Group Company Limited, or Beingmate, a PRC producer and distributor of infant formula products under their Beingmate brand; |
| | ● | Guangdong Yashili Group Co., Ltd., or Yashili, a PRC consumer brand marketer which sells a line of infant formula products under their Yashili brand; and |
| | ● | Feihe International, Inc., a PRC producer and distributor of milk formula products under their Feihe brand. |
According to data collected by the PRC National Commercial Information Center, or CIC, an entity affiliated with the PRC General Chamber of Commerce responsible for collecting retail sales data, the top ten brands accounted for 83% of total infant formulas sold in China in calendar year 2012.
Intellectual Property
All of our product formulations have been developed in-house and are proprietary. We have not registered or applied for protections in China for most of our intellectual property or proprietary technologies relating to the formulations of our powdered infant formula. See Item 1A. Risk factors—Risks Related to Our Business—Failure to adequately protect our intellectual property rights may undermine our competitive position, and litigation to protect our intellectual property rights may be costly. Although we believe that, as of today, patents and copyrights have not been essential to maintaining our competitive market position, we intend to assess in the future whether to seek patent and copyright protections for those aspects of our business that provide significant competitive advantages.
As of March 31, 2013, we had 251 registered trademarks in China, and 8 registered trademarks in other districts and countries. Additionally, we had 65 trademark applications pending approval in China.
We rely on trade secret protection and confidentiality agreements to protect our proprietary information and know-how. Our management and each of our research and development personnel have entered into annual employment contracts, each of which includes a confidentiality clause and a clause acknowledging that all inventions, designs, trade secrets, works of authorship, developments and other processes generated by them on our behalf are our property, and assigning to us any ownership rights that they may claim in those works. Despite our precautions, it may be possible for third parties to obtain and use, without our consent, intellectual property that we own or are licensed to use. Unauthorized use of our intellectual property by third parties, and the expenses incurred in protecting our intellectual property rights, may adversely affect our business. See Item 1A. Risk factors—Risks Related to Our Business—Failure to adequately protect our intellectual property rights may undermine our competitive position, and litigation to protect our intellectual property rights may be costly.
Environmental Matters
Our manufacturing facilities are subject to various pollution control regulations in China with respect to noise, water and air pollution and the disposal of waste and hazardous materials. We are also subject to periodic inspections by local environmental protection authorities in China. We are not currently subject to any pending actions alleging any violations of applicable PRC environmental laws.
Our Employees
As of March 31, 2013, we employed approximately 3,400 employees in all of our facilities, with approximately 160 head office management staff and research and development employees, approximately 1,330 production employees, and approximately 1,910 sales and marketing employees. Our employees are not represented by a labor organization or covered by a collective bargaining agreement. We have not experienced any work stoppages.
We offer our employees both a base salary and a performance bonus. As required by PRC regulations, we participate in various employee benefit plans that are organized by municipal and provincial governments, including pension, work-related injury benefits, maternity insurance, medical and unemployment benefit plans. We are required under PRC law to make contributions to the employee benefit plans at specified percentages of the salaries, bonuses and certain allowances of our employees, up to a maximum amount specified by the local government from time to time. The pension amount is determined by a number of factors, including the member’s salary amount at retirement date, contribution period, social average salary level and price index.
Regulation
The food industry, of which nutritional and infant formula products form a part, and medical institutions, are subject to extensive regulations in China. This section summarizes the most significant PRC regulations governing our business in China.
Food Hygiene and Safety Laws and Regulations
As a producer of nutritional products, and particularly dairy-based infant formula products, in China, we are subject to a number of PRC laws and regulations governing the manufacturing (including composition of ingredients), labeling, packaging, safety and hygiene of food products:
| | ● | the PRC Product Quality Law; |
| | ● | the PRC Food Safety Law; |
| | ● | the Implementation Rules on the PRC Food Safety Law; |
| | ● | the Dairy Product Industrial Policies (2009 Version); |
| | ● | the Regulation on the Supervision and Administration of the Quality and Safety of Dairy Products; |
| | ● | The Outlines of the Rectification and Revival of the Dairy Industry; |
| | ● | the Measures of the Administration on the New Food-Additives; |
| | ● | the Measures of the Filing of the Enterprise Standard of the Food Safety; |
| | ● | the Implementation Rules on the Administration and Supervision of Quality and Safety in Food Producing and Processing Enterprises; |
| | ● | the Regulation on the Administration of Production Licenses for Industrial Products; |
| | ● | the General Standards for the Labeling of Prepackaged Foods; |
| | ● | the Implementation Measures on Examination of Dairy Product Production Permits; |
| | ● | the Standardization Law; |
| | ● | the Raw Milk Collection Standard; |
| | ● | the Whole Milk Powder, Skimmed Milk Powder, Sweetened Whole Milk Powder and Flavored Milk Powder Standards; |
| | ● | the General Technical Requirements for Infant Formula Powder and Supplementary Cereal for Infants and Children; |
| | ● | Rules for the Examination of Licensing Criteria for Enterprises Producing Formula Milk Powder of Infant Use (2010 version); and |
| | ● | Rules for the Examination of Licensing Criteria for Enterprises Producing Milk Products (2010 version) |
These laws and regulations set out safety and hygiene standards and requirements for various aspects of food production, such as the use of additives, production, packaging, handling, labeling and storage, as well as facilities and equipment. Failure to comply with these laws and regulations may result in confiscation of our products and proceeds from the sales of non-compliant products, destruction of our products and inventory, fines, suspension of production and operation, product recalls, revocation of licenses, and, in extreme cases, criminal liability.
On October 7, 2008, the State General Administration of Quality Supervision, Inspection and Quarantine (“AQSIQ”) issued a national standard on the detection of melamine in raw milk and dairy based products. On October 9, 2008, the State Council promulgated with immediate effect a Regulation for the Quality and Safety Supervision of Dairy Based Products, which, among other things, imposes more stringent requirements for inspection, production, packaging, labeling and product recall on dairy product producers. This regulation also established a “Black-List” system to ensure that illegal business operators in the dairy production chain are timely disclosed and severely punished.
On April 22, 2010, MOH issued 66 food safety national standards (“New National Standard”), including the national standard for infant powdered formula, which impose strict requirement for production of infant powdered formula.
On November 1, 2010, AQSIQ issued Rules for the Examination of Licensing Criteria for Enterprise Producing Formula Milk Powder of Infant Use (2010 version) and Rules for the Examination of Licensing Criteria for Enterprise Producing Milk Products (2010 version) to tighten the supervision of milk product quality and safety. Under the new rules, milk producers are required to pass higher safety and quality tests in order to have their licenses re-issued.
Environmental Regulations
We are subject to various governmental regulations related to environmental protection. The major environmental regulations applicable to us include:
| | ● | the Environmental Protection Law of the PRC; |
| | ● | the Law of PRC on the Prevention and Control of Water Pollution; |
| | ● | Implementation Rules of the Law of PRC on the Prevention and Control of Water Pollution; |
| | ● | the Law of PRC on the Prevention and Control of Air Pollution; |
| | ● | Implementation Rules of the Law of PRC on the Prevention and Control of Air Pollution; |
| | ● | the Law of PRC on the Prevention and Control of Solid Waste Pollution; and |
| | ● | the Law of PRC on the Prevention and Control of Noise Pollution. |
We are periodically inspected by local environmental protection authorities. Our operating subsidiaries have received certifications from the relevant PRC government agencies in charge of environmental protection indicating that their business operations are in compliance with the relevant PRC environmental laws and regulations.
Dairy Industry Access Conditions and Policies
In June 2009, the PRC National Development and Reform Commission, or the NDRC, and the Ministry of Industry and Information Technology, or the MIIT, jointly promulgated and issued Dairy Industry Policies (2009 Version), or the Policies. The Policies set forth the conditions an entity must satisfy in order to engage, or continue to engage, in the dairy products processing business, including technique and equipment, product quality, energy and water consumption, sanitation and environmental protection, as well as production safety. Any new or continuing dairy products processing projects or enterprises will be required to meet all the conditions and requirements set forth in the Policies. For projects or enterprises that already commenced operations before the promulgation of the Policies, improvements or rectification actions may need to be taken in order to have such projects or enterprises meet the conditions before the end of 2010.
The Policies also set forth some requirements relating to the location, processing capacity and raw milk source for any new or continuing dairy products processing project or enterprise. Any new or continuing dairy products processing projects or enterprises that fail to meet the requirements will not be able to procure land, license, permits, loan facility and electricity necessary for the processing of dairy products, and those projects or enterprises already in operation before the promulgation of the Policies will be deregistered and ordered to shut down if they fail to meet the conditions before the end of 2010. We believe that all of our existing entities and facilities for powdered formula production meet the requirements under the Access Conditions. See Item 1A. Risk Factors—Risks Associated with Doing Business in China—Changes in the regulatory environment for dairy and infant nutrition products in China could negatively impact our business.
Medical Institutions
On February 26, 1994, the State Council promulgated the Regulations of Administration on Medical Institutions which established the regulations for establishing, managing and supervision of medical institutions. In particular, the regulations required a medical institution to be approved by and register with the applicable administrative department of public health prior to establishment. On December 14, 2009, the Ministry of Public Health promulgated the Standards of Medical Inspection Laboratory which set forth the standards for establishing and managing medical inspection laboratories. On August 21, 2012 we received the approval from Beijing Bureau of Health to set up Shengyuan Huimin Medical Inspection Laboratory in Beijing which will be a wholly-owned subsidiary of Beijing Shengyuan Huimin Technology Service Co., Ltd. We are in the process of setting up this lab with commencement of operations expected by the end of calendar year 2013.
Financial Information about Segments and Geographic Areas
We have four reportable segments, which are powdered formula, foods, nutritional ingredients and supplements and other business. Other business includes non-core operations such as ancillary sales of surplus milk powder and whey protein. Please refer to Note 16 to the Consolidated Financial Statements for further discussion about segments and geographic areas.
Available Information
Our Internet website address is www.synutra.com. We make available at this address, free of charge, our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the United States Securities and Exchange Commission, or SEC. Information available on our website is not incorporated by reference in and is not deemed a part of this Form 10-K. The public may read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F. Street, N.E., Washington, DC, 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issues that file electronically with the SEC at www.sec.gov.
Because of the following factors, as well as other factors affecting our financial condition and operating results, past financial performance should not be considered to be a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods.
You should carefully consider the following risks and other information in this Form 10-K before making an investment decision with respect to our common stock. The following risks and uncertainties could materially and adversely affect our business, results of operations and financial condition. The risks described below are not the only ones we face. Additional risks that we are not presently aware of or that we currently believe are immaterial may also impair our business operations.
Risks Related to Our Business
We may face liquidity challenges to meet our debt obligations and may require additional funding in the future.
We had loss before income tax expense of $27.0 million and negative cash flow from operation of $5.7 million for the fiscal year ended March 31, 2013. Our operations rely heavily on debt, and at March 31, 2013, we had short-term debt of $127.4 million, long-term debt due within one year of $82.7 million and long term debt due between one and three years of $102.2 million. The asset liability ratio, which is defined as total liabilities divided by total assets, was 94% at March 31, 2013. Our ability to meet our debt obligations will depend on our future performance, which will be affected by financial, business, domestic and foreign economic conditions and other factors, many of which we are unable to control. As a result, there can be no assurance that our operation will generate sufficient cash flows to meet our liquidity needs, and we therefore may continue have negative cash flows in the future. If our cash flow is not sufficient to service our debt, we may be required to obtain additional financing in the future, and such additional financing may not be available at times, in amounts or on terms acceptable to us or at all. We may not be able to repay such borrowings in full or at all when due and, if we were to default on the repayment of these borrowings, we may not be able to continue our operations as a going concern.
We are highly dependent upon consumers’ perception of the safety and quality of our products. Any ill effects, product liability claims, recalls, adverse publicity or negative public perception regarding particular ingredients or products or our industry in general could harm our reputation, damage our brand and adversely affect our results of operations.
We sell products for human consumption, which involves risks such as product contamination, spoilage and tampering. We may be subject to liability if the consumption of any of our products causes injury, illness or death. Adverse publicity or negative public perception regarding particular ingredients, our products, our actions relating to our products, or our industry in general could result in a substantial drop in demand for our products. This negative public perception may include publicity regarding the safety or quality of particular ingredients or products in general, of other companies or of our products or ingredients specifically. Negative public perception may also arise from regulatory investigations or product liability claims, regardless of whether those investigations involve us or whether any product liability claim is successful against us.
On September 16, 2008, China’s Administration of Quality Supervision, Inspection and Quarantine, or China AQSIQ, announced its finding that the formula products of 22 Chinese formula producers, including certain lots of our U-Smart products, were contaminated by melamine, a substance not approved for use in food and linked to the illness and deaths of infants and children in China. There were six reported deaths and approximately 300,000 children suffered kidney-related illnesses due to the contaminated infant formula of one of our competitors. This contamination incident resulted in significant negative publicity for the entire domestic dairy and formula industries in China and demand for domestically-produced dairy and formula products, including our products, declined significantly since September 2008 until late 2009. We recalled our affected U-Smart products as well as all other products produced at the same facilities in the Hebei and Inner Mongolia regions of China, where we believe the contaminated milk supplies originated. We also suspended production at our facilities in Qingdao, Hebei and Inner Mongolia for two weeks pending government and internal investigations. The total cost of this action was $100.6 million which was recognized as a charge to cost of sales, selling and distribution expenses and general and administrative expenses in our consolidated statement of income mostly in fiscal year 2009.
Although we have not confirmed any cases of kidney-related or other illnesses caused by our products, we cannot assure you that such cases will not surface in the future. The Chinese government has provided medical screening, treatment, and care for consumers affected by melamine contamination in infant formula products. We have contributed a net amount of $2.3 million to a compensation fund set up by China Dairy Industry Association to settle existing and potential claims arising in China from families of infants affected by melamine contamination. We cannot assure you that the Chinese government will not seek further reimbursement from dairy and formula product manufacturers, including us.
We believe the melamine contamination incident negatively impacted our brand and reputation in China. It also affected investor confidence in us as reflected by the significant decrease in our stock price after September 16, 2008. We cannot predict whether there will be similar future incidents and what impact such incidents may have on our operations and reputation.
In August 2010, several media reports alleging our infant formula products caused symptoms of hormone-triggered sexual prematurity in infants in the Hubei province of China. Our business was significantly and negatively impacted since then as a result of these media reports, and our sales volume decreased significantly. We increased the spending on advertising after the prematurity event to repair our reputation and regain market share. As a result, we had a significant net loss for the fiscal year ended March 31, 2011.
In January 2012, several Chinese media outlets reported that a pair of 4-month old twins in Jiangxi province became ill with severe intestinal symptoms. One passed away from hyperthermia and multi-functional organ failure on January 7, 2012. The other has recovered following hospitalization. Both infants were reported to have been consuming our powdered milk formula products for weeks before the sudden onset of their illnesses. In response to this event, the Jiangxi Province Center for Disease Control and Prevention and the Jiangxi Dairy Quality Supervision and Inspection Center conducted tests on samples of our products that were sold in the store where the infants’ family purchased the formula and concluded that there was no link between the infant milk powder products and the death of the baby or the illness of his twin sister. However, it is unclear what adverse impact this event has had on our reputation and results of operations.
In the past, there have also been occurrences of counterfeiting and imitation of products in China that have been widely publicized. We cannot guarantee that contamination or counterfeiting or imitation of our or similar products will not occur in the future or that we will be able to detect it and deal with it effectively. Any occurrence of contamination or counterfeiting or imitation could negatively impact our corporate and brand image or consumers’ perception of our products or similar nutritional products generally, particularly if the counterfeit or imitation products cause injury or death to consumers. For example, in April 2004, sales of counterfeit and substandard infant formula in Anhui, China caused the deaths of 13 infants as well as harming many others. Although this incident did not involve the counterfeiting of our products, it caused significant negative publicity for the entire infant formula industry in China. The mere publication of information asserting that infant formula ingredients or products may be harmful could have a material adverse effect on us, regardless of whether these reports are scientifically supported or concern our products or the raw materials used in our products.
We believe that the melamine contamination incident, the prematurity event and any other adverse news related to formula products in China will also result in increased regulatory scrutiny of our industry, which may result in increased costs and reduce our margins and profitability. The government has enhanced its regulations on the industry aimed to ensure the safety and quality of dairy products, including but not limited to compulsory batch by batch inspection. This is likely to increase our operating costs and capital expenditure.
If we fail to obtain raw materials in the quantity and the quality we need, and at commercially acceptable prices, our results of operations, financial condition and business prospects would be materially and adversely affected.
Our business requires certain key raw materials, such as milk powder and whey protein powder. We may experience a shortage in the supply of certain raw materials in the future, which could materially and adversely affect our production and results of operations. While our agreements with Sodiaal and Euroserum are intended to provide our supplies in the future, the drying facility in Carhaix, France is not expected to be operational until 2015. See “Liquidity and Capital Resources”. Other than these agreements, we currently do not have guaranteed supply contracts with any other raw material suppliers, and some of our suppliers may, without notice or penalty, terminate their relationship with us at any time. We also rely on a small number of suppliers for some of our raw materials, such as whey protein powder and imported milk powder. We now use imported milk powder from New Zealand for all of our powered formula products as consumers have less confidence in domestically-produced milk powder. If any supplier is unwilling or unable to provide us with high quality raw materials in required quantities and at acceptable prices, we may be unable to find alternative sources or at commercially acceptable prices, on satisfactory terms, in a timely manner, or at all. Our inability to find or develop alternative sources could result in delays or reductions in production, product shipments or a reduction in our profit margins. Moreover, these suppliers may delay material shipments or supply us with inferior quality raw materials that may adversely impact the timely delivery or the quality of our products. If any of these events were to occur, our product quality, competitive position, reputation and business could suffer.
In addition, most of the raw materials used in our business are imported, such as whey protein powder and milk powder. Our imported raw materials are subject to various PRC governmental permit requirements, approval procedures and import duties, and may also, from time to time, be subject to export controls and other legal restrictions imposed by foreign countries. Should the PRC government refuse to issue the necessary permits or approvals to us or our suppliers, or take any administrative actions to limit imports of certain raw materials, or if we or our suppliers fail to pay any required import duties, or if governmental agencies or laws of foreign countries prevent the timely export of certain raw materials we require to China, our ability to produce and sell our products in China could be materially and adversely affected. In addition, import duties increase the cost of our products and may make them less competitive.
Finally, certain suppliers of raw materials within our supply chain may contaminate our raw material supplies or provide us with substandard raw material supplies that adversely impact the quality of our products exposing our customers to health risks and damaging our reputation, brand and financial condition. For a more detailed description of this risk, and in particular the impact of the melamine contamination incident in China, see Part 1 - Item 1A. Risk Factors — We are highly dependent upon consumers’ perception of the safety and quality of our products. Any ill effects, product liability claims, recalls, adverse publicity or negative public perception regarding particular ingredients or products or our industry in general could harm our reputation, damage our brand and adversely affect our results of operations.
Any interruption in our supply of milk powder could materially and adversely affect our results of operations, financial condition and business prospects.
We currently import all of the milk powder used in the powdered formula production from New Zealand. The continuity of the milk powder supplies is of critical importance to our business. The importation of milk powder is influenced by numerous factors beyond our control, including, among other: (1) export control policy in the originating countries, (2) China’s government policy and regulation on milk powder importation as well as China’s custom inspection standards and (3) acts of God such as natural disasters. Any interruption in our milk powder supplies could have a material adverse effect on our results of operations, financial condition and business prospects. In addition, we currently source all of our milk powder from one supplier, Fonterra. If Fonterra fails to deliver the milk powder we need on the terms we have agreed, we may not be able to find an alternative source at a comparable price or on other favorable terms, and any delays in securing an alternative source could result in production delays and late shipments of our products to distributors and end customers.
Our results of operations may be affected by fluctuations in availability and price of raw materials.
The raw materials we use are subject to price fluctuations due to various factors beyond our control, including increasing market demand, inflation, severe climatic and environmental conditions, commodity price fluctuations, currency fluctuations, changes in governmental and agricultural regulations and programs and other factors. We also expect that our raw material prices will continue to fluctuate and be affected by inflation in the future. Changes to our raw materials prices may result in increases in production and packaging costs, and we may be unable to raise the prices of our products to offset these increased costs in the short-term or at all. As a result, our results of operations may be materially and adversely affected.
We might face inventory write-downs if we are unable to effectively manage inventory levels and/or prices decline. We maintain inventories of raw materials and finished products, and our inventories may spoil.
Most of our finished products have an average shelf life of 18 to 24 months before the product is opened. Milk powder has a shelf life of 24 months. Whey protein has a shelf life of 12 months. Other additives have a shelf life from several months to several years. Our inventory levels are based, in part, on our expectations regarding future sales. We may in future periods experience inventory buildup if our sales slow for any reason. Any significant shortfall in sales may result in higher inventory levels of raw materials and finished products than we require, thereby increasing our risk of inventory spoilage and corresponding inventory write-downs and write-offs, which may materially and adversely affect our results of operations.
Any major outbreak of illness or disease relating to cows in the regions in which we import milk powder could lead to significant shortfalls in the supply of our milk powder, and could result in consumers avoiding dairy products, which could result in substantial declines in our sales and possibly substantial losses.
We import all of our milk powder from New Zealand, and all of our whey protein powder from France. A major outbreak of any illness or disease in cows globally could lead to a serious loss of consumer confidence in, and demand for, dairy products. A major outbreak of mad cow disease (bovine spongiform encephalopathy), bovine tuberculosis, or bovine TB, or other serious disease in the principal regions supplying milk powder could lead to significant shortfalls in the supply of milk powder. Furthermore, adverse publicity about these types of concerns, whether or not valid, may discourage consumers from buying dairy products or cause production and delivery disruptions. If consumers generally were to avoid our products, our sales would decline substantially and we could suffer substantial losses.
We may experience problems with product quality or product performance, or the perception of such problems, which could materially and adversely affect our reputation or result in a decrease in customers and revenue, unexpected expenses and loss of market share.
Our operating results depend, in part, on our ability to deliver high quality products on a timely and cost-effective manner. Our quality control and food safety management systems are complex. For example, there are over 1,100 quality control points throughout the whole production process. If the quality of any of our products deteriorated, it could result in delays in shipments, cancellations of orders or customer returns and complaints, loss of goodwill, and harm to our brand and reputation. In addition, following the melamine contamination incident, we purchase all of the milk powder used for our powdered formula products from New Zealand. We may be unable to exercise the same degree of quality control over this overseas supplier as we can over our own facilities. Any quality problems associated with the milk powder produced by this supplier would also affect our products’ quality and lead to negative publicity against us, materially and adversely affecting our reputation and brand, and causing a decrease in sales of our products and a loss of market share. For example, the melamine contamination incident in China has resulted in certain of our products being contaminated, impacting our brand and reputation.
Product liability claims against us could result in adverse publicity and potentially significant monetary damages.
As with other infant formula producers, we are also exposed to risks associated with product liability claims if the consumption of infant formula products we sell results in injury or death. We cannot predict what impact such product liability claims or resulting negative publicity would have on our business or on our brand image. The successful assertion of product liability claims against us could result in potentially significant monetary damages, diversion of management resources and require us to make significant payments and incur substantial legal expenses. We do not have product liability insurance for powdered formula products sold in China and have not made provisions for potential product liability claims. Therefore, we may not have adequate resources to satisfy a judgment if a successful claim is brought against us. Even if a product liability claim is not successfully pursued to judgment by a claimant, we may still incur substantial legal expenses defending against such a claim and our brand image and reputation would suffer. Finally, serious product quality concerns could result in governmental actions against us, which, among other things, could result in the suspension of production or distribution of our products, loss of certain licenses, or other governmental penalties.
Our sales, results of operations, brand image and reputation could be materially and adversely affected if we fail to efficiently manage our operations without interruption, or fail to ensure that our products are delivered on time.
Our business requires successful coordination of several sequential and complex processes, the disruption of any of which could interrupt our operations and materially and adversely affect our relationships with our distributors, sub-distributors and end-customers, our brand name and reputation, and our financial performance. Our operations involve the coordination of raw material sourcing from third parties, internal production processes and external distribution processes. We may face difficulties in coordinating the various aspects of our production processes, resulting in downtime and delays.
In addition, we may encounter interruptions in our production processes due to a catastrophic loss or events beyond our control, such as fires, explosions, labor disturbances, earthquakes or other natural disasters. If there is a stoppage in production at any of our facilities, even if only temporary, or delays in deliveries to our customers, our business and reputation could be materially and adversely affected. Along with many other producers of dairy and consumer products in China, we generally rely on third-party logistics companies and distributors for the delivery of our products. Delivery may be disrupted for various reasons, many of which are beyond our control, including natural disasters, weather conditions or social unrest and strikes, which could lead to delayed or lost deliveries. In addition, transportation and related infrastructure conditions are often generally under-developed in some of the regions where we sell our products. We currently do not have business interruption insurance to offset these potential losses, delays and risks, so a material interruption of our business operations could materially damage our business.
We rely primarily on third-party distributors and cannot assure you that their marketing and distribution of our products will be effective or will not harm our brand and reputation. Moreover, if we fail to timely identify and appoint additional or replacement distributors as needed, or are unable to successfully manage our distribution network, our operating results could suffer.
We primarily rely on third-party distributors and sub-distributors for the distribution and sales of our products. We sell our products through an extensive nationwide distribution and sales network covering all of the provinces and provincial-level municipalities in mainland China. As of March 31, 2013, this network comprised over 670 independent distributors and over 680 independent sub-distributors who sell our products in approximately 27,000 retail outlets. Our distributors normally have exclusive distribution rights in their respective regions, and are also responsible for developing the sub-distributors located in their own regions. In addition, our distributors are not required to exclusively distribute our products. We typically do not enter into long-term agreements with distributors and have no control over their everyday business activities. Consequently, our distributors may engage in activities that are prohibited under our arrangements with them, that violate PRC laws and regulations governing the dairy industry or other PRC laws and regulations generally, or that are otherwise harmful to our business or our reputation. Due to our dependence on distributors for the sale and distribution of our products to retail outlets, any one of the following events could cause material fluctuations or declines in our revenue and have a material adverse effect on our financial condition and results of operations:
| | ● | reduction, delay or cancellation of orders from one or more of our distributors; |
| | ● | selection or increased sales by our distributors of our competitors’ products; and |
| | ● | our failure to timely identify and appoint additional or replacement distributors upon the loss of one or more of our distributors. |
The competition for distributors is intense in our industry in China and many of our competitors are expanding their distribution networks in China. We may not be able to compete successfully against the larger and better-funded sales and marketing operations of some of our current or future competitors, especially if these competitors provide more favorable arrangements for distributors. As a result, we may lose some of our distributors to our competitors, which may cause us to lose some or all of our favorable arrangements with such distributors and may even result in the termination of our relationships with some of our distributors. While we do not believe we are substantially dependent upon any individual distributor, finding replacement distributors could be time-consuming and any resulting delay may be disruptive and costly to our business. In addition, we may not be able to successfully manage our distributors and the cost of any consolidation or further expansion of our distribution network may exceed the revenue generated from these efforts. The occurrence of any of these factors could result in a significant decrease in the sales volume of our products and therefore materially harm our financial condition and results of operations.
We initiated a “gold mining” marketing strategy (“Strategy“) in September 2012 to strengthen our management of the sales channel, the goal of which is to use marketing and promotional expenditures more effectively and to improve net profit by centrally monitoring the spending in each retail outlet. We have terminated our relationship with those retail outlets with low sales volume and a low yield rate on the slotting fees, to focus our resources on those retail outlets with high sales volume and a higher yield rate on the slotting fees. As a result, our number of retail outlets reduced from more than 60,000 at June 30, 2012 to approximately 27,000 at March 31, 2013. The Strategy had been substantially completed by March 31, 2013. We cannot be certain that the Strategy will produce the results as planned in the long term.
Our results of operations and business prospects may be impaired by changing consumer preferences if we do not develop and offer products to meet changing preferences.
Consumer preferences evolve over time and the success of our products depends on our ability to identify the tastes and nutritional needs of our customers and to offer products that appeal to their preferences. We introduce new products and improved products from time to time and incur significant development and marketing costs. If our products fail to meet consumer preferences, then our strategy to grow sales and profits with new products will be less successful.
More mothers may breastfeed their babies rather than use our products, resulting in reduced demand for our products and adversely affecting our revenues.
Our results of operations are affected by the number of mothers who choose to use our products rather than breastfeeding their babies. Much publicly available data suggests that breastfeeding has many health benefits for the baby that cannot be replicated by dairy-based infant formula products. Additionally, popular literature, cultural pressure, government policies and medical advice in China generally promote the benefits of breastfeeding. For example, on August 1, 2007, China’s Ministry of Health issued an Infant Feeding Strategy which promoted breastfeeding and requested all local relevant departments to publicize the benefits of breastfeeding through radio broadcasting, television and newspapers during World Breastfeeding Week, which took place in early August 2007. In November 2011, the MOH of China submitted a proposal for public review that could ban promotions and advertising of infant formula for babies younger than six months. Thus, to the extent that private, public and government sources increasingly promote the benefits of breastfeeding, there could be a reduced demand for our products and our revenues could be adversely affected.
A severe and prolonged downturn in the Chinese or global economy or continued disruptions in the financial markets may adversely impact our business and results of operations and may limit our access to additional financing.
The infant formula industry can be affected by macro economic factors, including changes in national, regional, and local economic conditions, employment levels and consumer spending patterns. A prolonged slowdown in the Chinese or global economy could erode consumer confidence which could result in changes to consumer spending patterns, which could be harmful to our financial position and results of operations.
In addition, if the capital and credit markets continue to experience volatility and the availability of funds remains limited, we will incur increased costs associated with equity and/or debt financing. It is possible that our ability to access the capital and credit markets may be limited by these or other factors at a time when we would like, or need, to do so, which could have an adverse impact on our ability to refinance maturing debt and/or react to changing economic and business conditions. In addition, fluctuations in interest rates could impact our floating rate debt negatively and increase our debt obligations.
Failure to execute our future expansion plan could adversely affect our financial condition and results of operations.
We may increase our annual production capacity in the future to meet any expected increase in demand for our products. Our decision to increase our production capacity is based in part on our projections of increases in our sales volume and growth in the size of the infant formula product market in China. If actual customer demand does not meet our projections, we will likely suffer overcapacity problems and have idle capacity, which may materially and adversely affect our financial condition and results of operations. Our future success depends on our ability to expand our business to address expected growth in demand for our current and future products. Our ability to add production capacity and increase output is subject to significant risks and uncertainties, including:
| | ● | the availability and cost of additional funding to expand our production capacity, build new processing and packaging facilities, make additional investments in our subsidiaries, acquire additional businesses or production facilities, purchase additional fixed assets and purchase raw materials on favorable terms or at all; |
| | ● | delays and cost overruns as a result of a number of factors, many of which may be beyond our control, such as problems with equipment vendors and suppliers of raw materials; |
| | ● | failure to maintain high quality control standards; |
| | ● | global or local shortage of raw materials, such as raw milk or whey protein powder; |
| | ● | our inability to obtain, or delays in obtaining, required approvals by relevant government authorities; |
| | ● | diversion of significant management attention and other resources; and |
| | ● | failure to execute our expansion plan effectively. |
As our business grows, we will need to implement a variety of new and upgraded operational and financial systems, procedures and controls, including improvements to our accounting and other internal management systems by dedicating additional resources to our reporting and accounting functions, and improvements to our record keeping and contract tracking system. We will need to respond to competitive market conditions and continue to enhance existing products and develop new products, and retain existing customers and attract new customers. We will also need to recruit more personnel and train and manage our growing employee base. Furthermore, we will need to maintain and expand our relationships with our current and future customers, suppliers, distributors and other third parties, and there is no guarantee that we will succeed.
If we encounter any of the risks described above, or are otherwise unable to establish or successfully operate additional production capacity or to increase production output, we may be unable to grow our business and revenues, reduce our operating costs, maintain our competitiveness or improve our profitability, and our business, financial condition, results of operations and prospects may be adversely affected.
As discussed in “Liquidity and Capital Resources”, we entered into a series of agreements with Sodiaal Union and Euroserum SAS relating to a long-term industrial and commercial partnership. Under the agreements, we are committed to building a new drying facility in Carhaix, France, intended to manufacture powdered milk and fat-enriched demineralized whey. The estimated cost to build the facility is approximately Euro 90 million ($117 million), and we are currently negotiating with certain banks to obtain financing for this project. There is no assurance whether we will be able to obtain financing on satisfactory terms. In addition, we cannot be certain whether there will be delays in the building of the facility. If there is a delay, we are obligated to compensate Sodiaal and Euroserum for any losses that are incurred as a result of such delay. In addition, we cannot be certain whether the facility will produce the quality and quantity of products as planned and whether the facility will encounter any mechanical or other issues in the future. Any of these issues could have a material adverse impact on our future operations and financial results.
Any future expansion into new markets that we are currently not significantly represented may be costly, time-consuming and difficult. If we do not successfully expand into new, high growth markets we have identified, our results of operations and prospects may be materially and adversely affected.
Our future success may depend upon our ability to successfully expand into markets that we currently have low penetration rates. To further promote our brand and generate demand for our products in such markets, we may increase our spending on marketing and promotion in specific geographical areas or channels. We may be unable to attract a sufficient number of distributors or penetrate a sufficient number of retail outlets to justify the spending on marketing and promotion in these markets, or our selected distributors or outlets may not be suitable for selling our products in these markets for other reasons. We may also fail to attract new customers in such markets who may have less familiarity with our brand and products. Furthermore, we may fail to anticipate and address competitive conditions in these new markets that are different from those in our existing primary markets. These competitive conditions may make it difficult or impossible for us to effectively operate in these markets. If our expansion efforts in existing and new markets are unsuccessful, our results of operations and prospects may be materially and adversely affected.
Part of our strategy involves the development of new products and new business segments, and if we fail to timely develop new products or we incorrectly gauge the potential market for new products, our financial results would be adversely affected.
We plan to utilize our in-house research and development capabilities to develop new products that could become new sources of revenue for us in the future and help us to diversify our revenue base. We have also entered into new business segments such as the prepared foods segment, and the nutritional ingredients and supplements segment. Our future research and development efforts will focus on further expanding our product offerings beyond dairy-based nutritional products. If we fail to timely develop these and other new products or if we incorrectly gauge market demand for such new products, we may not be able to grow our sales revenue at expected growth rates and may incur expenses and capital expenditure costs relating to the development of new products that do not generate a positive return on the investment.
We operate in a competitive environment, which may lead to declining revenue growth or other circumstances that would negatively affect our results of operations.
The market for pediatric nutritional products is competitive, and we believe that competition in this market will continue to intensify. We believe that the principal competitive factors in our markets are brand recognition, quality, advertising, formulation, packaging, and price. We face significant competition from a number of competitors, including multinational companies, such as Abbot Laboratories’ Ross Products Division, Mead Johnson, Nestle, Numico and Wyeth, and domestic companies, such as Beingmate, Yashili, Feihe and Yili. See “Item 1. Business—Competition”. Many of our competitors have longer operating histories, greater name recognition, significantly larger market shares, access to larger customer bases and significantly greater financial resources and economies of scale in financial, sales and marketing, production, distribution, technical and other resources than we do. Some of these competitors have used, and we expect will continue to use, more aggressive pricing strategies, greater amounts of incentives and subsidies for distributors, retailers and customers and more advanced processes and technologies. Furthermore, consolidation among industry participants in China may potentially result in stronger domestic competitors that are better able to compete as end-to-end suppliers as well as competitors who are more specialized in particular areas and geographic markets. This could have a material adverse effect on our business, financial condition, results of operations and prospects. In addition, as a result of the melamine contamination incident, customers have lost confidence in infant formula produced by domestic companies for the time being, which gives multinational infant formula companies an advantage over us.
In order to compete successfully in our markets, we will need to continue to restore customer confidence in our brand and products, develop new products and enhance our product offerings while maintaining price competitiveness. Even if we successfully restore customer confidence, if and to the extent we fail to develop new products that differentiate us from our competitors, we may need to compete largely on price, which may cause our operating margins to decline. Our inability to compete successfully against competitors and pricing pressures could result in lost customers, loss of market share and reduced operating margins, which would adversely impact our results of operations.
If we grant employee stock options and other stock-based compensation in the future, we will be required to recognize stock-based compensation expense, which would adversely affect our results of operations.
As of the date of this Form 10-K, we have not granted any stock-based compensation and thus have not been required to reflect any such expenses in our results of operations. We adopted a stock -based compensation plan in June 2008 and may grant certain employees and directors stock-based compensation, which we believe could be important to attract and retain key personnel. We will be required to account for compensation costs for all stock options, including stock options granted to our directors and employees, using the fair value method and recognize the expense in our consolidated statement of operations, which may have a material adverse effect on our results of operations.
We may be exposed to liabilities under the Foreign Corrupt Practices Act, and any determination that we violated the Foreign Corrupt Practices Act could have a material adverse effect on our business.
We are subject to the Foreign Corrupt Practice Act, or the FCPA, and other laws that prohibit improper payments or offers of payments to foreign governments and their officials and political parties by U.S. persons and issuers as defined by the statute for the purpose of obtaining or retaining business. We have operations, agreements with third parties and make sales in China, which may experience corruption. Our activities in China create the risk of unauthorized payments or offers of payments by one of the employees, consultants, sales agents or distributors of our company, because these parties are not always subject to our control. It is our policy to implement safeguards to discourage these practices by our employees. However, our existing safeguards and any future improvements may prove to be less than effective, and the employees, consultants, sales agents or distributors of our Company may engage in conduct for which we might be held responsible. Violations of the FCPA may result in severe criminal or civil sanctions, and we may be subject to other liabilities, which could negatively affect our business, operating results and financial condition. In additions, the government may seek to hold our Company liable for successor liability of FCPA violations committed by companies in which we invest or that we acquire.
If we are unable to maintain an effective system of internal control over financial reporting, we may be unable to accurately report our financial results, or prevent fraud.
We have previously experienced certain material weaknesses and significant deficiencies in our internal control over financial reporting. In connection with our management's assessment of the effectiveness of our internal control over financial reporting as of March 31, 2012, a material weakness was identified. A material weakness is defined by the Public Company Accounting Oversight Board, or PCAOB, as a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis.
We have taken steps to remediate the material weakness in our internal control over financial reporting, and we believe that the material weakness previously identified has been fully remediated as of March 31, 2013, see “Part II. Item 9A. Controls and Procedures”. However, there can be no assurance that any current or future deficiencies will not contribute to, or cause, possible material weaknesses in the future or, that we will be able to implement effectively new or improved controls. In addition, our management or our independent registered public accounting firm may determine that our internal control over financial reporting is not effective in the future.
Moreover, a lack of effective internal control over financial reporting in the future could cause us to fail to provide accurate financial statements or fail to meet our reporting obligations, either of which could cause investors to lose confidence in our reported financial information, and have a negative effect on the trading price of our common stock. Our failure to meet our reporting obligations in a timely fashion may also lead to the delisting of our common stock by the NASDAQ Global Select Market.
Our success depends to a substantial degree upon our senior management and key personnel, and our business operations may be significantly and negatively affected if we fail to attract and retain highly competent senior management and key personnel.
Our future success depends substantially on the continued services of our key personnel including, particularly, Liang Zhang, our chairman and chief executive officer. We rely substantially on their experience in the dairy and nutritional products industry, and on their relationships and ability to work with our suppliers and distributors and other customers. If we lose the services of one or more of these key personnel, we may not be able to replace them readily, if at all, with suitable or qualified candidates, and may incur additional expenses to recruit and retain new officers and key personnel, which could severely disrupt our business and growth. We do not maintain key-man life insurance for any of our key personnel.
In addition, if any of these key personnel joins a competitor or forms a competing company, we may lose some of our distributors. We have entered into employment agreements with each of these key personnel, which contain confidentiality and non-competition provisions. However, if any disputes were to arise between these key personnel and us, it is not clear, in light of uncertainties associated with the PRC legal system, what the court decisions would be and the extent to which these court decisions could be enforced in China, where most of these key personnel reside and hold some of their assets. See “Item 1A. Risk Factors—Risks Associated with Doing Business in China—Uncertainties with respect to the PRC legal system could limit the legal protections available to you and us.” Furthermore, as we expect to continue to expand our operations and develop new products, we will need to continue attracting and retaining experienced management and key research and development personnel.
Competition for experienced management and research and development personnel in China is intense, and the availability of experienced, suitable and qualified candidates is limited. Competition for these individuals may require us to pay higher compensation and other benefits in order to attract and retain them, which could have a material adverse effect on our financial condition and results of operations. We may also be unable to attract or retain the personnel necessary to achieve our business objectives, and any failure in this regard could severely disrupt our business and growth.
Liang Zhang’s association with other businesses could impede his ability to devote sufficient time to our business and could present potential conflicts of interest.
Liang Zhang, our founder, chairman, chief executive officer and principal beneficial stockholder, controls several other companies in China. Liang Zhang devotes most of his time to our affairs and the remainder of his time to the affairs of the other companies. Liang Zhang’s decision-making responsibilities for these other companies are similar in the areas of public relations, risk management and strategic planning. As a result, conflicts of interest may arise from time to time and we cannot assure you that they will be resolved in our favor. Additionally, even though Liang Zhang devotes most of his time to our affairs and is further accountable to us and our stockholders as a fiduciary, which requires that he exercise good faith and due care in handling our affairs, we cannot assure you this will always be the case and his existing responsibilities to other businesses and entities may limit the amount of time he can spend on our affairs.
Our chairman and chief executive officer, Liang Zhang, beneficially owns a substantial amount of our common stock and will have significant influence over our corporate affairs.
Our founder, chairman and chief executive officer, Liang Zhang, beneficially owns approximately 62.8% of our outstanding common stock through a company owned by his wife as of March 31, 2013. Accordingly, Liang Zhang will be able to direct the outcome of matters requiring approval of the stockholders, including the election of our directors and other corporate actions such as:
| | · | our merger with or into another company; |
| | · | a sale of our assets; and |
| | · | amendments to our certificate of incorporation. |
The decisions of Liang Zhang may conflict with our interests or the interests of our other stockholders.
We have committed to certain capacity expansion projects that require significant capital investment. Such capital may not be available on favorable terms or at all.
We have, in the past, obtained loans and sold our common stock to raise additional capital. We have committed to certain capacity expansion projects, in particular the French Project which requires a total investment of Euro 90 million ($117 million). Although we believe that our current cash, and cash flow from operations will be sufficient to meet our present and reasonably anticipated cash needs, there is no assurance that we will be able to generate the required equity portion of the investment in the French Project from our operation cash flow, or raise the required debt portion of the French Project investment. Failure to do so may cause us to delay or abandon the French Project, which in turn will lead to penalties by Euroserum and Sodiaal as permitted under the partnership agreement, the deterioration of our relationship with Euroserum and Sodiaal, and potentially other material adverse impact on our business. Any additional equity financing may be dilutive to stockholders and such additional equity securities may have rights, preferences or privileges that are senior to those of our existing common stock. The incurrence of indebtedness would result in increased debt service obligations and could require us to agree to operating and financial covenants that would restrict our operations. If we are unable to generate sufficient cash flow from operating activities or obtain funds for required payments of interest and principal on such additional indebtedness, or if we fail to comply with our debt covenants, we will be in default. Financing may not be available in amounts or on terms acceptable to us, if at all. Any failure by us to raise additional funds on terms favorable to us, or at all, could limit our ability to expand our business operations and could harm our overall business prospects.
We have limited property insurance coverage and do not carry any business interruption insurance.
Operation of our facilities involves many risks, including equipment failures, natural disasters, industrial accidents, power outages, labor disturbances and other business interruptions. Furthermore, if any of our products are faulty or contaminated, then we may become subject to product liability claims or we may have to engage in a product recall.
We do not carry any business interruption insurance, and have limited property insurance coverage. Therefore, our existing insurance coverage may not be sufficient to cover all risks associated with our business. As a result, we may be required to pay for financial and other losses, damages and liabilities, including those caused by natural disasters and other events beyond our control, out of our own funds, which could have a material adverse effect on our business, financial condition and results of operations. For example, all of the costs we have incurred to date and may incur in the future that are related to our product recall in connection with the melamine contamination incident is not covered by our existing insurance policies.
Failure to adequately protect our intellectual property rights may undermine our competitive position, and litigation to protect our intellectual property rights may be costly.
We rely primarily on trade secrets and other contractual restrictions to protect our intellectual property. We have not registered or applied for protections in China for most of our intellectual property or proprietary technologies relating to the formulations of powdered infant formula that we produce. In order to protect our proprietary technology and processes, we also rely in part on nondisclosure agreements with our employees, licensing partners, third-party producers, consultants, agents and other organizations to which we disclose our proprietary information. The actions we have taken to protect our intellectual property rights may not be adequate to provide us with meaningful protection or commercial advantage. As a result, third parties may use the intellectual property or proprietary technologies that we have developed and compete with us, which could have a material adverse effect on our business, financial condition and operating results.
PRC intellectual property-related laws and their implementation are still under development. Accordingly, intellectual property rights and confidentiality protections in China may not be as effective as in the United States or many other countries. In addition, policing unauthorized use of proprietary technology can be difficult and expensive. Litigation may be necessary to enforce our intellectual property rights and the outcome of any such litigation may not be in our favor. Given the relative unpredictability of China’s legal system and potential difficulties enforcing a court judgment in China, there is no guarantee that we would be able to halt the unauthorized use of our intellectual property through litigation in a timely manner or at all. Furthermore, any such litigation may be costly and may divert management attention away from our business and cause us to expend significant resources. An adverse determination in any such litigation will impair our intellectual property rights and may harm our business, prospects and reputation. In addition, we have no insurance coverage against litigation costs and would have to bear all costs arising from such litigation to the extent we are unable to recover them from other parties. The occurrence of any of the foregoing could have a material adverse impact on our business, financial condition and results of operations.
We may be exposed to infringement or misappropriation claims by third parties, which, if determined adversely against us, could disrupt our business and subject us to significant liability to third parties.
Our success largely depends on our ability to use and develop our know-how and product formulations without infringing upon the intellectual property rights of third parties. We may be subject to litigation involving claims of infringement or violation of other intellectual property rights of third parties. The holders of patents and other intellectual property rights potentially relevant to our product offerings may be unknown to us or may otherwise make it difficult for us to acquire a license on commercially acceptable terms.
There may also be technologies licensed to and relied on by us that are subject to infringement or other corresponding allegations or claims by others which could damage our ability to rely on such technologies. In addition, although we endeavor to ensure that companies that work with us possess appropriate intellectual property rights or licenses, we cannot fully avoid the risks of intellectual property rights infringement created by suppliers of raw materials used in our products, our third-party producers, or by companies with which we work in cooperative research and development activities. Our current or potential competitors, many of which have substantial resources and have made substantial investments in competing technologies, may have obtained or may obtain patents that will prevent, limit or interfere with our ability to make, use or sell our products in China or other countries. The defense of intellectual property claims, including patent infringement suits, and related legal and administrative proceedings can be both costly and time-consuming, and may significantly divert the efforts and resources of our technical and management personnel. Furthermore, an adverse determination in any such litigation or proceeding to which we may become a party could cause us to:
| | · | seek licenses from third parties, which may not be available on reasonable terms or at all; |
| | · | pay additional ongoing royalties, which could decrease our profit margins; |
| | · | redesign our products, which may be costly, if possible at all; or |
| | · | be restricted by injunctions. |
These factors could effectively prevent us from pursuing some or all of our business and result in our customers or potential customers deferring, canceling or limiting their purchase or use of our products, which could have a material adverse effect on our financial condition and results of operations.
Increased IT security threats and more sophisticated and targeted computer crime could pose a risk to our systems, networks, products, solutions and services.
Increased global IT security threats and more sophisticated and targeted computer crime pose a risk to the security of our systems and networks and the confidentiality, availability and integrity of our data. While we attempt to mitigate these risks by employing a number of measures, our systems, networks, products, solutions and services remain potentially vulnerable to advanced persistent threats. Depending on their nature and scope, such threats could potentially lead to the compromising of confidential information, improper use of our systems and networks, manipulation and destruction of data, defective products, production downtimes and operational disruptions, which in turn could materially adversely affect our reputation, competitiveness and results of operations.
Risks Associated With Doing Business in China
Adverse changes in political and economic policies of the PRC government could impede the overall economic growth of China, which could reduce the demand for our products and damage our business.
We conduct our operations and generate all of our revenues in China. Accordingly, our business, financial condition, results of operations and prospects are affected significantly by economic, political and legal developments in China. The PRC economy differs from the economies of most developed countries in many respects, including:
| | · | the higher level of government involvement and regulation; |
| | · | the early stage of development of the market-oriented sector of the economy; |
| | · | the higher rate of inflation; |
| | · | the higher level of control over foreign exchange; and |
| | · | government control over the allocation of many resources. |
As the PRC economy has been transitioning from a planned economy to a more market-oriented economy, the PRC government has implemented various measures to encourage economic growth and guide the allocation of resources. While these measures may benefit the overall PRC economy, they may also have a negative effect on us.
Although the PRC government has in recent years implemented measures emphasizing the utilization of market forces for economic reform, the PRC government continues to exercise substantial control over virtually every sector of the PRC economy through the allocation of resources, controlling payment of foreign currency-denominated obligations, setting monetary policy and imposing policies that impact particular industries or companies in different ways. Our ability to operate in China may be harmed by changes in PRC laws and regulations, including those relating to how we conduct our business, taxation, import and export tariffs, environmental regulations, land use rights, property and other matters. We believe that our operations in China are in material compliance with all applicable legal and regulatory requirements. However, the central or local governments of the jurisdictions in which we operate may impose new, stricter regulations or interpretations of existing regulations that would require additional expenditures and efforts on our part to ensure our compliance with such regulations or interpretations.
Accordingly, government actions in the future, including any decision not to continue to support recent economic reforms and to return to a more centrally planned economy or regional or local variations in the implementation of economic policies, could have a significant adverse effect on economic conditions in China or particular regions thereof and could require us to divest ourselves of any interest we then hold in PRC properties or joint ventures.
PRC food hygiene and safety laws may become more onerous, which may adversely affect our operations and financial performance and lead to an increase in our costs which we may be unable to pass on to our customers.
Operators within the PRC dairy industry and infant formula sector are subject to compliance with PRC food hygiene and safety laws and regulations. Such laws and regulations require all enterprises engaged in the production of dairy and infant formula products to obtain a hygiene license. They also set out hygiene standards with respect to food and food additives, packaging and containers, and labeling on packaging as well as hygiene requirements for food production and sites, facilities and equipment used for the transportation and the sale of food. Failure to comply with PRC food hygiene and safety laws may result in fines, suspension of operations, loss of hygiene license and, in certain cases, criminal proceedings against an enterprise and its management. Although we are in compliance with current PRC food hygiene and safety laws and regulations, in the event that such laws and regulations become more stringent or widen in scope, we may fail to comply with such laws, or if we comply, our production and distribution costs may increase, and we may be unable to pass these additional costs on to our customers. For example, in response to the melamine contamination incident, the PRC State Council abolished the regulations on inspection exemptions for food on September 18, 2008 so that our products were to be subject to batch by batch inspection going forward. In addition, the PRC State Council promulgated with immediate effect the Regulation on Supervision and Administration of Quality and Safety of Dairy Products on October 9, 2008 which, among other things, imposes more stringent requirements for inspection, production, packaging, labeling and product recall on dairy product producers. These measures have increased our costs in the past and are likely to continue to contribute to our costs in the future, which costs we may be unable to pass on to our customers.
Changes in the regulatory environment for dairy and infant nutrition products in China could negatively impact our business.
The dairy and infant nutrition product industries in China are regulated and regulatory changes may affect both our customers and us. Any changes in regulations that impose additional requirements for construction of new production lines and facilities or expansion of existing facilities will require us to secure additional government approvals for our current production expansion projects. Similarly, additional safety and quality control regulations could impact our costs of production. For example, on June 26, 2009, NDRC and MIIT jointly, promulgated the Dairy Industry Policies (2009 Version), or the Policies. The Policies impose new conditions that an entity must satisfy in order to engage, or continue to engage, in the dairy products processing business. For a more detailed description of these requirements, see “Item 1. Business—Regulation”. Although we believe our existing entities and facilities meet the Policies requirements, it is possible that our future expansion plans or the establishment of new entities may fail to meet one or more of the requirements under the Policies in the future. Failure to comply with these or any other changes in regulations affecting our business could have a material adverse effect on our business and our results of operations. In addition, the indirect impact of any such changes could adversely affect our business even if the specific regulations do not directly apply to our products or us.
Uncertainties with respect to the PRC legal system could limit the legal protections available to you and us.
We conduct our business through our operating subsidiaries in China. Our operating subsidiaries are generally subject to laws and regulations applicable to foreign investments in China and, in particular, laws applicable to foreign-invested enterprises. The PRC legal system is based on written statutes, and prior court decisions may be cited for reference, but have limited precedential value. Over the past several decades, a series of new PRC laws and regulations have significantly enhanced the protections afforded to various forms of foreign investments in China. However, since the PRC legal system continues to rapidly evolve, the interpretations of many laws, regulations and rules are not always uniform and enforcement of these laws, regulations and rules involve uncertainties, which may limit legal protections available to you and us. In addition, any litigation in China may be protracted and result in substantial costs and diversion of resources and management attention.
If we are found to have failed to comply with applicable laws, we may incur additional expenditures or be subject to significant fines and penalties.
Our operations are subject to PRC laws and regulations applicable to us. However, many PRC laws and regulations are uncertain in their scope, and the implementation of such laws and regulations in different localities could have significant differences. In certain instances, local implementation rules and/or the actual implementation are not necessarily consistent with the regulations at the national level. Although we strive to comply with all the applicable PRC laws and regulations, we cannot assure you that the relevant PRC government authorities will not later determine that we have not been in compliance with certain laws or regulations. For example, there is a PRC regulation requiring all employees to make contributions to a housing fund based on their salary level and their employers to match such contributions. However, many employees are reluctant to make such contributions as they do not perceive such contribution will benefit them, and this regulation has generally not been rigorously enforced. We have allowed our employees to make contributions on a voluntary basis and then match their contributions. However, we cannot assure you that in the future the PRC government will not start to enforce this regulation more rigorously. Although there are no material penalties stipulated in this regulation, if we are found not to be in compliance, we may be required to bring current any past deficiencies, which could adversely affect our financial condition and results of operations.
In addition, our facilities and products are subject to many laws and regulations administered by the PRC State Administration for Industry and Commerce, the PRC State Administration of Taxation, the PRC Ministry of Health and Hygiene Permitting Office, the PRC General Administration of Quality Supervision, Inspection and Quarantine, and the PRC State Food and Drug Administration Bureau relating to the processing, packaging, storage, distribution, advertising, labeling, quality, and safety of food products. Our failure to comply with these and other applicable laws and regulations in China could subject us to administrative penalties and injunctive relief, as well as civil remedies, including fines, injunctions and recalls of our products. It is possible that changes to such laws, more rigorous enforcement of such laws or with respect to our current or past practices, could have a material adverse effect on our business, operating results and financial condition. Further, additional environmental, health or safety issues relating to matters that are not currently known to management may result in unanticipated liabilities and expenditures.
Restrictions on currency exchange may limit our ability to receive and use our sales revenue effectively.
All of our sales revenue is denominated in Renminbi. Under PRC law, the Renminbi is currently convertible under the “current account,” which includes dividends and trade and service-related foreign exchange transactions, but not under the “capital account,” which includes foreign direct investment and loans. Currently, our PRC operating subsidiaries may purchase foreign currencies for settlement of current account transactions, including payments of dividends to us, without the approval of the PRC State Administration of Foreign Exchange, or SAFE, by complying with certain procedural requirements. However, the relevant PRC government authorities may limit or eliminate our ability to purchase foreign currencies in the future.
The PRC government imposes controls on the convertibility of the RMB into foreign currencies and, in certain cases, the remittance of currency out of China. We receive substantially all of our revenues in RMB. Under existing PRC foreign exchange regulations, payments of current account items, including profit distributions, interest payments and trade and service related foreign exchange transactions, can be made in foreign currencies without prior SAFE approval by complying with certain procedural requirements. Therefore, after complying with certain procedural requirements, our PRC subsidiaries are able to pay dividends in foreign currencies to us without prior approval from SAFE. However, approval from or registration with appropriate government authorities is required where RMB is to be converted into foreign currency and remitted out of China to pay capital expenses such as the repayment of loans denominated in foreign currencies. The PRC government may also at its discretion restrict access to foreign currencies for current account transactions in the future. If the foreign exchange control system prevents us from obtaining sufficient foreign currencies to satisfy our foreign currency demands, we may not be able to pay dividends in foreign currencies to our shareholders.
Recent PRC regulations relating to investment activities by, and holdings in entities outside of China of, PRC residents and citizens, may subject our PRC resident and citizen stockholders to personal liability and limit our ability to acquire PRC companies or to inject capital into our PRC subsidiaries, limit our PRC subsidiaries’ ability to distribute profits to us or otherwise materially and adversely affect us.
In October 2005, SAFE issued a public notice, the Notice on Relevant Issues in the Foreign Exchange Control over Financing and Return Investment Through Special Purpose Companies by Residents Inside China, or Notice 75. In May 2007, SAFE issued the Notice of the State Administration of Foreign Exchange on Operating Procedures Concerning Issues Relating to the Administration of Foreign Exchange in Fund Raising and Return Investment Activities of Domestic Residents Conducted via Offshore Special Purpose Companies, or Notice 106. According to Notice 75 and Notice 106, prior registration with the local SAFE branch is required for PRC residents to establish or to control an offshore company for the purposes of financing that offshore company with assets or equity interests in an onshore enterprise located in the PRC. An amendment to registration or filing with the local SAFE branch by such PRC resident is also required for the injection of equity interests or assets of an onshore enterprise in the offshore company or overseas funds raised by such offshore company, or any other material change involving a change in the capital of the offshore company. Moreover, Notice 75 and Notice 106 apply retroactively. As a result, PRC residents who have established or acquired control of offshore companies that have made onshore investments in the PRC in the past were required to complete the relevant registration with the local SAFE branch. If any PRC stockholder of any offshore special purpose company fails to make the required SAFE registration and amendment, the PRC subsidiaries of that offshore special purpose company may be prohibited from distributing their profits and the proceeds from any reduction in capital, share transfer or liquidation to the offshore special purpose company. Moreover, failure to comply with the SAFE registration and amendment requirements described above could result in liability under PRC laws for evasion of applicable foreign exchange restrictions.
Many of the terms and provisions in Notice 75 and Notice 106 remain unclear and implementation by central SAFE and local SAFE branches of Notice 75 and Notice 106 have been inconsistent since their adoption. Based on the advice of our PRC counsel, De Heng Law Offices, and after consultation with relevant SAFE officials, our PRC resident stockholders and the PRC resident beneficial stockholders of Meitek may be required to complete their respective SAFE registrations pursuant to Notice 75 and Notice 106. The local SAFE branch may not accept their applications for SAFE registration until more detailed rules or announcements concerning the penalties for those who failed to make their SAFE registrations are implemented. Moreover, because of uncertainty over how Notice 75 and Notice 106 will be interpreted and implemented, and how or whether SAFE will apply it to us, we cannot predict how it will affect our business operations or future strategies. For example, our present and prospective PRC subsidiaries’ ability to conduct foreign exchange activities, such as the remittance of dividends and foreign currency-denominated borrowings, may be subject to compliance with Notice 75 and Notice 106 by our PRC resident beneficial holders. In addition, such PRC residents may not always be able to complete the necessary registration procedures required by Notice 75 and Notice 106. We also have little control over either our present or prospective direct or indirect stockholders, the PRC resident beneficial stockholders of Meitek, or the outcome of such registration procedures. A failure by our PRC resident beneficial holders or future PRC resident stockholders to comply with the SAFE notice, if SAFE requires it, could subject us to fines or legal sanctions, restrict our overseas or cross-border investment activities, limit our subsidiary’s ability to make distributions or pay dividends or affect our ownership structure, which could adversely affect our business and prospects.
Fluctuations in exchange rates could adversely affect our business and the value of our common stock.
The value of our common stock will be indirectly affected by the foreign exchange rate between the U.S. dollar and the Renminbi and between those currencies and other currencies in which our sales may be denominated. Because our earnings and cash assets are denominated in Renminbi, appreciation or depreciation in the value of the Renminbi relative to the U.S. dollar would affect our financial results reported in U.S. dollar terms without giving effect to any underlying change in our business or results of operations. Fluctuations in the exchange rate will also affect the relative value of any dividend we issue that will be exchanged into U.S. dollars and earnings from, and the value of, any U.S. dollar-denominated investments we make in the future.
Since July 2005, the Renminbi has no longer been pegged to the U.S. dollar. Although the People’s Bank of China, or PBOC, regularly intervenes in the foreign exchange market to prevent significant short-term fluctuations in the exchange rate, the Renminbi may appreciate or depreciate significantly in value against the U.S. dollar in the medium to long-term. Moreover, it is possible that in the future the PRC authorities may lift restrictions on fluctuations in the Renminbi exchange rate and lessen intervention in the foreign exchange market.
Very limited hedging transactions are available in China to reduce our exposure to exchange rate fluctuations. To date, we have not entered into any hedging transactions in an effort to reduce our exposure to foreign currency exchange risk. While we may enter into hedging transactions in the future, the availability and effectiveness of these transactions may be limited, and we may not be able to successfully hedge our exposure at all. In addition, our foreign currency exchange losses may be magnified by PRC exchange control regulations that restrict our ability to convert Renminbi into foreign currencies.
Currently, some of our raw materials and major equipment are imported. In the event that the U.S. dollar appreciated against the Renminbi, our costs may increase. If we cannot pass the resulting cost increases on to our customers, our profitability and operating results will suffer. In addition, to the extent we enter markets outside China in the future, we may be increasingly subject to the risk of foreign currency fluctuations.
Restrictions under PRC law on our PRC subsidiaries’ ability to make dividends and other distributions could materially and adversely affect our ability to grow, make investments or acquisitions that could benefit our business, pay dividends to our shareholders, and otherwise fund and conduct our businesses.
Our revenues are earned by our PRC subsidiaries. However, PRC regulations restrict the ability of our PRC subsidiaries to make dividends and other payments to their offshore parent company. PRC legal restrictions permit payments of dividend by our PRC subsidiaries only out of their accumulated after-tax profits, if any, determined in accordance with PRC accounting standards and regulations. Each of our PRC subsidiaries is also required under PRC laws and regulations to allocate at least 10% of our annual after-tax profits determined in accordance with the generally accepted accounting principles in the PRC (“PRC GAAP”) to a statutory general reserve fund until the amounts in such fund reaches 50% of our registered capital. Allocations to these statutory reserve funds can only be used for specific purposes and are not transferable to us in the form of loans, advances or cash dividends. As of March 31, 2013, the common stock, additional paid-in capital and statutory reserve of PRC subsidiaries were RMB 1017.4 million, which were equivalent to $162.3 million using the exchange rate as of March 31, 2013. Any limitations on the ability of our PRC subsidiaries to transfer funds to us could materially and adversely limit our ability to grow, make investments or acquisitions that could be beneficial to our business, pay dividends and otherwise fund and conduct our business.
Under China’s New Enterprise Income Tax Law (“EIT Law”), we may be classified as a “resident enterprise” of China. This classification could result in unfavorable tax consequences to us and our non-PRC shareholders.
The New EIT Law provides that enterprises established outside of China whose “de facto management bodies” are located in China are considered “resident enterprises” and are generally subject to the uniform 25% enterprise income tax rate on their worldwide income. In addition, a circular issued by the State Administration of Taxation regarding the standards used to classify certain Chinese-invested enterprises established outside of China as “resident enterprises” clarified that dividends and other income paid by such “resident enterprises” will be considered to be PRC source income, subject to PRC withholding tax, currently at a rate of 10%, when recognized by non-PRC shareholders. This circular also subjects such “resident enterprises” to various reporting requirements with the PRC tax authorities. Under the implementation regulations to the enterprise income tax, a “de facto management body” is defined as a body that has material and overall management and control over the manufacturing and business operations, personnel and human resources, finances and treasury, and acquisition and disposition of properties and other assets of an enterprise. In addition, the circular mentioned above details that certain Chinese-invested enterprises will be classified as “resident enterprises” if the following are located or reside in China: senior management personnel and departments that are responsible for daily production, operation and management; financial and personnel decision making bodies; key properties, accounting books, company seal, and minutes of board meetings and shareholders’ meetings; and half or more of the directors or senior management having voting rights. If the PRC tax authorities determine that Synutra, Inc. or Synutra International, Inc. are “resident enterprises,” we may be subject to enterprise income tax at the rate of 25% on our worldwide income and dividends paid by us to our non-PRC shareholders and, while less clear, capital gains recognized by them with respect to the sale of our stock, may be subject to a PRC withholding tax. This will have an impact on our effective tax rate, a material adverse effect on our net income and results of operations, and may require us to withhold tax on our non-PRC shareholders. We are actively monitoring the “resident enterprise” classification rules and are evaluating appropriate organizational changes to avoid this treatment, to the extent possible.
If we were treated as a “resident enterprise” by PRC tax authorities, we would be subject to tax in both the U.S. and China, and our PRC tax may not be creditable against our U.S. tax.
Our shareholders may have difficulty enforcing judgments against us.
We are a Delaware holding company and most of our assets are located outside of the United States. All of our current operations are conducted in the PRC. In addition, most of our directors and officers are nationals and residents of countries other than the United States. A substantial portion of the assets of these persons is located outside the United States. As a result, it may be difficult for our shareholders to effect service of process within the United States upon these persons. It may also be difficult for our shareholders to enforce in U.S. courts judgments on the civil liability provisions of the U.S. federal securities laws against us and our officers and directors. In addition, there is uncertainty as to whether the courts of the PRC would recognize or enforce judgments of U.S. courts. DeHeng Law Offices, our counsel as to PRC law, has advised us that the recognition and enforcement of foreign judgments are provided for under the PRC Civil Procedures Law. Courts in China may recognize and enforce foreign judgments in accordance with the requirements of the PRC Civil Procedures Law based on treaties between China and the country where the judgment is made or on reciprocity between jurisdictions. China does not have any treaties or other arrangements that provide for the reciprocal recognition and enforcement of foreign judgments with the United States. In addition, according to the PRC Civil Procedures Law, courts in the PRC will not enforce a foreign judgment against us or our directors and officers if they decide that the judgment violates basic principles of PRC law or national sovereignty, security or public interest. So it is uncertain whether a PRC court would enforce a judgment rendered by a court in the United States.
The PRC government’s recent measures to curb inflation rates could adversely affect our future results of operations.
In recent years, the Chinese economy has experienced periods of rapid expansion and high rates of inflation. Rapid economic growth can lead to growth in the money supply and rising inflation. For example, in April 2013, the change in China’s Consumer Price Index increased 2.4% from the prior year according to the National Bureau of Statistics of China, or the NBS. If prices for our products rise at a rate that is insufficient to compensate for the rise in the costs of supplies, it may have an adverse effect on our profitability. In addition, our labor costs could increase as a result of inflationary pressures. An increase in our labor costs will increase our operating costs, which we may not be able to pass through to our customers. These factors have led to the adoption by the Chinese government, from time to time, of various corrective measures designed to restrict the availability of credit or regulate growth and constrain inflation. High inflation may in the future cause the Chinese government to impose controls on credit and/or prices, or to take other actions, which could inhibit economic activity in China, and thereby harm the market for our products.
In the last few years, the government of China has undertaken various measures to alleviate the effects of inflation, including imposing national price controls on various products, including milk. The government of China may conclude that the prices of infant formula or our other products are too high and may institute price controls that would limit our ability to set prices for our products. The government of China has also encouraged local governments to institute price controls on similar products. Such price controls could adversely affect our future results of operations and the price of our common stock.
The PRC government may deem the control agreements between us and certain of our consolidated affiliated entities to be non-compliant with restrictions on foreign investment and as a result we may be subject to penalties or required to perform a costly restructuring of these entities.
PRC laws and regulations currently restrict foreign entities from establishing clinical business in China. Foreign entities that wish to establish medical clinical businesses in China must have domestic entities as partners. In order to comply with PRC law and avoid restrictions on foreign investment in medical clinical operations, we operate our medical treatment services (mostly pre-natal diagnostics services) through several entities (the “Several Entities”) that are not directly owned by us. These Several Entities included Nanjing Shengyuan Huiren Clinical Examination Co., Ltd. which was disposed of in May 2013, Heilongjiang Shengyuan Huiren Clinical Examination Co., Ltd which was in pre-operating status and had not been equipped with necessary equipment, Taiyuan Shengyuan Huiren Clinical Examination Co., Ltd. and Shijiazhuang Shengyuan Huiren Clinical Examination Co., Ltd. which were disposed of in January 2013, and will include the Shengyuan Huimin Medical Inspection Laboratory which is expected to commence operations by the end of calendar year 2013. We control and consolidate these entities into our group consolidated results through a series of contractual arrangements. See “Item 1, Business—Our Corporate Structure and History” and “Item 13. Certain Relationships and Related Transactions, and Director Independence.”
The contractual arrangements we have in place are governed by PRC law. There are substantial uncertainties regarding the interpretation and application of current and future PRC laws and regulations on these contractual agreements and it is possible that the PRC authorities may in the future find these arrangements unlawful. If these arrangements were to be deemed unlawful, the PRC authorities have broad discretion to penalize us, including:
| | · | revoking the business and operating licenses of our PRC subsidiaries and affiliates; |
| | · | discontinuing or restricting our PRC subsidiaries’ and affiliates’ operations; |
| | · | imposing fines or confiscating the income of our PRC subsidiaries or affiliates; |
| | · | requiring us or our PRC subsidiaries and affiliates to restructure the relevant ownership structure or operations; or |
| | · | taking other regulatory or enforcement actions that could be harmful to our clinic examination business. |
Furthermore, we have no assurance that Jibin Zhang and Yunpeng Jiang, parties to these control agreements, will continue to cooperate with us and honor these control agreements. There is a risk that they will not always act in our best interests. If we cannot resolve any conflicts of interest or dispute that may arise between them and us, we may have to take legal action to compel them to fulfill their contractual obligations and there is substantial uncertainty as to the outcome of any such legal proceedings. It may be difficult for us to change our corporate structure or to bring claims against the Several Entities if they do not perform their obligations under these contractual arrangements.
The audit reports included in this annual report are prepared by auditors who are not inspected by the U.S. Public Company Accounting Oversight Board and, as such, investors may be deprived of the benefits of such inspection.
As an auditor of companies that are publicly traded in the United States and a firm registered with the U.S. Public Company Accounting Oversight Board, or the PCAOB, our independent registered public accounting firm is required by the laws in the United States to undergo regular inspections by the PCAOB to assess its compliance with the laws of the United States and the professional standards of the PCAOB. However, because our auditor is located in the PRC, a jurisdiction where the PCAOB is currently unable to conduct inspections without the approval of the Chinese authorities, our auditor is not currently inspected by the PCAOB.
Inspections of other auditors conducted by the PCAOB outside of China have at times identified deficiencies in those auditor’s audit procedures and quality control procedures, which may be addressed as part of the inspection process to improve future audit quality. The lack of PCAOB inspections in China prevents the PCAOB from regularly evaluating our auditor's audits and its quality control procedures. In addition, the inability of the PCAOB to conduct auditor inspections in China makes it more difficult to evaluate the effectiveness of our auditor's audit procedures or quality control procedures as compared to auditors located outside of China that are subject to regular PCAOB inspections. As a result, investors may be deprived of the benefits of PCAOB inspections, and may lose confidence in our reported financial information and procedures and the quality of our financial statements.
We may be adversely affected by the outcome of the administrative proceedings brought by the SEC against five accounting firms in China.
Recently, the SEC commenced administrative proceedings under Rule 102(e) of its Rules of Practice and also under the Sarbanes-Oxley Act of 2002 against the Chinese affiliates of the ‘‘big four’’ accounting firms, including our auditors, and also against BDO China Dahua. The Rule 102(e) proceedings initiated by the SEC relate to these firms’ failure to produce documents, including audit workpapers, to the request of the SEC pursuant to Section 106 of the Sarbanes-Oxley Act of 2002, as the auditors located in the PRC are not in a position lawfully to produce documents directly to the SEC because of restrictions under PRC law and specific directives issued by the China Securities Regulatory Commission. As the administrative proceedings are ongoing, it is impossible to determine their outcome or the consequences thereof to us. The issues raised by the proceedings are not specific to our auditors. or to us, but affect equally all audit firms based in China and all China-based businesses with securities listed in the United States.
However, if the administrative judge were to find in favor of the SEC under the proceeding and depending upon the remedies sought by the SEC, these audit firms could be barred from practicing before the SEC. As a result, listed companies in the United States with major PRC operations may find it difficult or impossible to retain auditors in respect of their operations in the PRC, which may result in their delisting. Moreover, any negative news about the proceedings against these audit firms may erode investor confidence in China-based, United States listed companies and the market price of our shares may be adversely affected.
Risks Related to Our Common Stock
The market price of our common stock is volatile, and its value may be depressed at a time when our stockholders want to sell their holdings.
The market price of our common stock is volatile, and this volatility may continue. For instance, between July 1, 2008 and March 31, 2013, the price of our common stock, as reported on the NASDAQ on which our common stock has traded, ranged between $3.99 and $52.24. Though we believe this dramatic fluctuation resulted mainly from volatility in our earnings, which is attributable to various events including, but not limited to the melamine contamination incident, the prematurity event and the worldwide market disruption, numerous factors, many of which are beyond our control, may cause the market price of our common stock to fluctuate significantly.
In addition to market and industry factors, the price and trading volume for our common stock may be highly volatile for specific business reasons. Factors such as variations in our revenues, earnings and cash flow, announcements of new investments, cooperation arrangements or acquisitions, and fluctuations in market prices for our products could cause the market price for our shares to change substantially. In addition, our stock price may be impacted by the performance, reputation, or stock prices of other Chinese companies that are listed in the U.S.
Securities class action litigation is often instituted against companies following periods of volatility in their stock price. This type of litigation could result in substantial costs to us and divert our management’s attention and resources.
The trading market for our common stock will also be influenced by research or reports that industry or securities analysts publish about us or our business. If one or more analysts who cover us downgrade our common stock, the market price for our common stock would likely decline. If one or more of these analysts cease coverage of us or fail to regularly publish reports on us, we could lose visibility in the financial markets, which, in turn, could cause the market price for our common stock or trading volume to decline.
Furthermore, securities markets may from time to time experience significant price and volume fluctuations for reasons unrelated to operating performance of particular companies. These market fluctuations may adversely affect the price of our common stock and other interests in our company at a time when our stockholders want to sell their interest in us.
Although publicly traded, the trading market in our common stock has been substantially less liquid than the common stock of many companies quoted on the NASDAQ Global Select Market, and this low trading volume may adversely affect the price of our common stock.
Although our common stock is traded on the NASDAQ Global Select Market, the trading volume of our common stock has generally been very low. Reported average daily trading volume in our common stock for the twelve month period ended March 31, 2013 was approximately 30,372 shares. Limited trading volume will subject our shares of common stock to greater price volatility and may make it difficult for our stockholders to sell their shares of common stock at a price that is attractive to them.
Provisions in our charter documents and under Delaware law could discourage a change-of-control that our stockholders may consider favorable.
Provisions in our amended and restated certificate of incorporation and bylaws may have the effect of delaying or preventing a change of control or changes in our management. These provisions include the following:
| | · | our board of directors is divided into three classes, with approximately one-third of our directors elected each year; |
| | · | our board of directors has the right to elect directors to fill a vacancy created by the expansion of the board of directors or the resignation, death or removal of a director, which prevents stockholders from being able to fill vacancies on our board of directors; |
| | · | our stockholders must provide timely notice for any stockholder proposals and director nominations; |
| | · | we have adopted provisions that eliminate the personal liability of directors for monetary damages for actions taken as a director, with certain exceptions; and |
| | · | our board of directors may issue, without stockholder approval, shares of undesignated preferred stock, which makes it possible for our board of directors to issue preferred stock with voting or other rights or preferences that could impede the success of any attempt to acquire us. |
As a Delaware corporation, we are also subject to certain Delaware anti-takeover provisions. Under Delaware law, a corporation may not engage in a business combination with any holder of 15% or more of its capital stock unless the holder has held the stock for three years or, among other things, the board of directors has approved the transaction. Our board of directors could rely on Delaware law to prevent or delay an acquisition of us.
None.
Our headquarters are currently located in Beijing with around 45,500 square meters of leased office space and with 31,300 square meters of leased land as our management, marketing, and research and development headquarter. Synutra Illinois leases an executive office in Rockville, Maryland, USA. Our processing and packaging facilities are located in various locations in China, including Qingdao, Zhangjiakou, Fengzhen and Zhenglanqi. These facilities encompass approximately 137,000 square meters of office, plant, and warehouse space. Our distribution center located in Qingdao includes approximately 25,000 square meters of owned office space. All of our production facilities are built based on the GMP standard, with equipment imported from Europe and all of our facilities that have commenced operation have ISO9000 and HACCP series qualifications with some also being ISO14000 certified.
The following table sets forth certain information with respect to our production, processing and packaging facilities.
Subsidiary | | Province/Region | | Installed Capacity as of March 31, 2013 | | Description | | Property Right |
| | | | | (tons per year) | | | | |
| Shengyuan Nutrition | | Shandong, Qingdao | | 62,000 | | | Dry-mixing of powdered formula products | | Land Use Right |
| | | | | 108,000 | | | Packaging of powdered formula products | | Land Use Right |
| Zhangjiakou | | Hebei, Zhangjiakou | | 8,000 | | | High oil whey protein powder processing | | Land Use Right |
| Mengyuan | | Inner Mongolia, Fengzhen | | 4,000 | | | High oil whey protein powder processing | | Land Use Right |
| Inner Mongolia Huiliduo | | Inner Mongolia, Zhenglanqi | | 9,000 | | | Production of prepared foods | | Land Use Right |
| Meitek | | Shandong, Qingdao | | 1,700 | | | Production of nutritional ingredients and supplements | | Land Use Right |
There is no private land ownership in China. Individuals and companies are permitted to acquire land use rights for specific purposes and for limited periods. Each period may be renewed at the expiration of the initial and any subsequent terms. Granted land use rights are transferable and may be used as security for borrowings and other obligations.
We believe that our facilities are adequate for our current operations and any increase in production in the near term will not require additional space.
As of March 31, 2013, the end of the period covered by this report, the Company was subject to various legal proceedings and claims that have not been fully resolved and that have arisen in the ordinary course of business. In the opinion of management, the Company does not have a potential liability related to any current legal proceedings and claims that would individually or in the aggregate have a material adverse effect on its financial condition or operating results. However, the results of legal proceedings cannot be predicted with certainty. The Company intends to contest each lawsuit vigorously but should the Company fail to prevail in any of these legal matters or should several of these legal matters be resolved against the Company in the same reporting period, the operating results of a particular reporting period could be materially and adversely affected.
Not applicable.
PART II
Price Range of our Common Stock
Our common stock has been trading on the NASDAQ Global Select Market under the symbol “SYUT” since November 8, 2007. Our common stock was previously quoted on the Over-The-Counter Bulletin Board, or OTCBB, under the trading symbol “SYUT.OB” until April 11, 2007. On April 12, 2007, our common stock was listed on the NASDAQ Global Market and subsequently approved for listing on the NASDAQ Global Select Market on November 8, 2007.
The high and low bid prices reflect inter-dealer prices, without retail mark-up, mark-down or commission, and may not represent actual transactions.
| | | The NASDAQ Global/Global Select Market Price per Share | |
| | | High | | | Low | |
| Fiscal Year Ended March 31, 2012 | | | | | | | | |
| First Quarter | | $ | 11.73 | | | $ | 9.14 | |
| Second Quarter | | | 10.02 | | | | 4.54 | |
| Third Quarter | | | 7.49 | | | | 4.05 | |
| Fourth Quarter | | | 6.62 | | | | 4.24 | |
| | | | | | | | | |
| Fiscal Year Ended March 31, 2013 | | | | | | | | |
| First Quarter | | $ | 6.20 | | | $ | 4.50 | |
| Second Quarter | | | 6.27 | | | | 4.61 | |
| Third Quarter | | | 5.15 | | | | 3.99 | |
| Fourth Quarter | | | 4.94 | | | | 4.36 | |
As of June 10, 2013, we had 14 registered stockholders of our common stock on record. This number does not include shares held by brokerage clearing houses, depositories or otherwise in unregistered form or shares held by a custodian for the benefit of our employees.
Dividend Policy
We have never declared or paid any dividends on shares of our common stock. We intend to retain any future earnings to fund the development and growth of our business, and we do not anticipate paying any dividends in the foreseeable future.
Our revenues are earned by our PRC subsidiaries. However, PRC regulations restrict the ability of our PRC subsidiaries to make dividends and other payments to their offshore parent company. PRC legal restrictions permit payments of dividend by our PRC subsidiaries only out of their accumulated after-tax profits, if any, determined in accordance with PRC accounting standards and regulations. Each of our PRC subsidiaries is also required under PRC laws and regulations to allocate at least 10% of our annual after-tax profits determined in accordance with PRC GAAP to a statutory general reserve fund until the amounts in such fund reaches 50% of our registered capital. Allocations to these statutory reserve funds can only be used for specific purposes and are not transferable to us in the form of loans, advances or cash dividends. In addition, there are restrictions on the distribution of share capital from the Company’s PRC subsidiaries. As of March 31, 2013, the common stock, additional paid-in capital and statutory reserve of PRC subsidiaries were RMB 1017.4 million, which were equivalent to $162.3 million using the exchange rate as of March 31, 2013.
For information on securities authorized for issuance under our equity compensation plans, see “Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.”
Recent Sales of Unregistered Securities
None.
The following selected consolidated financial data for the fiscal years ended March 31, 2013, 2012 and 2011 are derived from our audited consolidated financial statements included elsewhere in this Form 10-K. The financial data for the years ended March 31, 2010 and 2009 are derived from audited consolidated financial statements which are not included in this Form 10-K. The results of operations for past accounting periods are not necessarily indicative of the results to be expected for any future accounting period.
The financial data set forth below should be read in conjunction with, and are qualified in their entirety by reference to “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and our consolidated financial statements and related notes included elsewhere in this Form 10-K.
| | | Fiscal Year Ended March 31, | |
| | | 2013 | | | 2012 | | | 2011 | | | 2010 | | | 2009 | |
| | | (in thousands except earnings per share data) |
| Selected Consolidated Statement of Income Data: | | | | | | | | | | | | | | | |
| Net sales | | $ | 265,770 | | | $ | 342,539 | | | $ | 248,516 | | | $ | 291,886 | | | $ | 312,528 | |
| Cost of sales | | | 171,211 | | | | 201,618 | | | | 170,769 | | | | 208,476 | | | | 259,086 | |
| Gross profit | | | 94,559 | | | | 140,921 | | | | 77,747 | | | | 83,410 | | | | 53,442 | |
| Selling and distribution expenses | | | 53,607 | | | | 51,221 | | | | 48,409 | | | | 43,989 | | | | 44,178 | |
| Advertising and promotion expenses | | | 32,574 | | | | 28,442 | | | | 41,420 | | | | 33,854 | | | | 115,478 | |
| General and administrative expenses | | | 30,220 | | | | 23,948 | | | | 28,261 | | | | 24,509 | | | | 25,455 | |
| Impairment of goodwill | | | — | | | | — | | | | 1,440 | | | | — | | | | — | |
| Impairment loss from assets disposal | | | — | | | | — | | | | — | | | | 5,894 | | | | — | |
| Gain on disposal and liquidation of subsidiaries | | | 3,625 | | | | — | | | | — | | | | — | | | | — | |
| Government subsidies | | | 4,217 | | | | 5,484 | | | | 1,441 | | | | 894 | | | | 5,790 | |
| Income (loss) from operations | | | (14,000 | ) | | | 42,794 | | | | (40,342 | ) | | | (23,942 | ) | | | (125,879 | ) |
| Interest expense | | | 15,018 | | | | 14,276 | | | | 10,321 | | | | 8,603 | | | | 4,857 | |
| Interest income | | | 2,326 | | | | 1,870 | | | | 820 | | | | 1,850 | | | | 341 | |
| Other income (expense), net | | | (343 | ) | | | 146 | | | | 277 | | | | (1,081 | ) | | | (580 | ) |
| Income (loss) before income tax expense (benefit) | | | (27,035 | ) | | | 30,534 | | | | (49,566 | ) | | | (31,776 | ) | | | (130,975 | ) |
| Income tax expense (benefit) | | | 37,186 | | | | 13,510 | | | | (9,306 | ) | | | (6,904 | ) | | | (30,386 | ) |
| Net income (loss) | | | (64,221 | ) | | | 17,024 | | | | (40,260 | ) | | | (24,872 | ) | | | (100,589 | ) |
| Net income (loss) attributable to the noncontrolling interest | | | (333 | ) | | | 287 | | | | (192 | ) | | | (257 | ) | | | (40 | ) |
| Net income (loss) attributable to common stockholders | | $ | (63,888 | ) | | $ | 16,737 | | | $ | (40,068 | ) | | $ | (24,615 | ) | | $ | (100,549 | ) |
| Earnings (loss) per share-basic and diluted | | $ | (1.11 | ) | | $ | 0.29 | | | $ | (0.71 | ) | | $ | (0.46 | ) | | $ | (1.86 | ) |
| | | | | | | | | | | | | | | | | | | | | |
| | | March 31, | |
| | | 2013 | | | 2012 | | | 2011 | | | 2010 | | | 2009 | |
| | | (in thousands) | |
| Selected Balance Sheets Data: | | | | | | | | | | | | | | | |
| Cash and cash equivalents | | $ | 79,050 | | | $ | 64,793 | | | $ | 48,741 | | | $ | 48,693 | | | $ | 37,736 | |
| Working capital (deficit) | | | (40,006 | ) | | | 10,565 | | | | (479 | ) | | | (27,593 | ) | | | (80,432 | ) |
| Inventory | | | 87,707 | | | | 75,499 | | | | 67,372 | | | | 52,134 | | | | 114,724 | |
| Total assets | | | 476,144 | | | | 447,913 | | | | 398,704 | | | | 349,357 | | | | 472,571 | |
| Short-term debt | | | 127,449 | | | | 86,614 | | | | 124,281 | | | | 98,069 | | | | 224,647 | |
| Long-term debt due within one year | | | 82,663 | | | | 40,831 | | | | 38,131 | | | | 61,194 | | | | — | |
| Long-term debt | | | 102,164 | | | | 92,745 | | | | 62,722 | | | | 41,018 | | | | 8,777 | |
| Capital lease obligation | | | 7,848 | | | | 4,726 | | | | 5,540 | | | | 5,372 | | | | 5,254 | |
| Total long-term liabilities | | | 120,476 | | | | 104,243 | | | | 74,310 | | | | 52,497 | | | | 20,468 | |
| Total equity | | $ | 29,207 | | | $ | 97,092 | | | $ | 75,926 | | | $ | 52,931 | | | $ | 76,859 | |
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes that appear elsewhere in this Form 10-K. In addition to historical consolidated financial information, the following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this Form 10-K, particularly in “Item 1A. Risk Factors.”
Overview
We are a leading infant formula company in China. We principally engage in the production, distribution and sale of dairy based nutritional products under the “Shengyuan” or “Synutra” line of brands in the PRC. We focus on selling powdered formula products for infant and adult, which are supplemented by other nutritional products, such as prepared foods and certain nutritional ingredients and supplements. We sell most of our products through an extensive nationwide sales and distribution network covering all provinces and provincial-level municipalities in mainland China. As of March 31, 2013, this network comprised over 670 independent distributors and over 680 independent sub-distributors who sell our products in approximately 27,000 retail outlets.
We currently have four reportable segments which are:
| ● | Powdered formula segment: Powdered formula segment covers the sale of powdered infant and adult formula products. Major brands include Super, U-Smart, My Angel and Dutch Cow; |
| | |
| ● | Foods segment: Foods segment covers the sale of prepared baby foods for babies and children under the brand of Huiliduo. In fiscal year 2014, we plan to introduce prepared adult foods for patients with special nutritional needs after surgical operations; |
| | |
| ● | Nutritional ingredients and supplements segment: Nutritional ingredients and supplements segment covers the production and sale of nutritional ingredients and supplements such as chondroitin sulfate, and microencapsulated Docosahexanoic Acid (“DHA”) and Arachidonic Acid (“ARA”). |
| | |
| ● | Other business segment: our other business includes the ancillary sale of surplus milk powder, whey protein and raw milk to industrial customers. |
Executive Summary
For the fiscal year ended March 31, 2013, net sales of powdered formula segment decreased 26% compared to fiscal year 2012. Earnings per share decreased from $0.29 to a loss per share of $1.11, which was primarily attributable to the decrease in sales and the valuation allowance provided for deferred tax assets.
In order to reduce the pressure from rising costs and bench mark our products with our competitors, we announced a price increase effective on April 1, 2012 on major infant products. Due to advance inventory purchases by our distributors in anticipation of the price increase, the price increase had a negative short-term impact on our sales volume, particularly for the first and second quarters of fiscal 2013.
We initiated a “Goldmining” marketing strategy (the “Strategy“) in September 2012 to strengthen our management of the sales channel, the goal of which is to use marketing and promotional expenditures more effectively and to improve net profit. In the past, we provided sales discounts and rebates to distributors to offset part of the marketing and promotional expenditures incurred at retail outlets. As part of the Strategy, we are now centrally monitoring the spending in each retail outlet to ensure more efficient allocation of marketing and promotional expenditures. We have terminated our relationship with those retail outlets with low sales volume and a low yield rate on the slotting fees to focus our resources on those retail outlets with higher sales volume and a higher yield rate on the slotting fees. In order to strengthen our management of sales channel, we have also set up an inventory tracking system to track our products from the factory to the retail outlets in an effort to prevent distributors from selling out of their designated area. As of March 31, 2013, the number of active retail outlets the Company monitors closely was approximately 27,000.
We started to communicate the Strategy to our distributors in August 2012. While most distributors welcomed the Strategy as it strengthened our supervision on the sales channel and promotes more orderly competition among distributors, some have reduced their orders, as they believed the implementation of the Strategy could have a negative short term impact on their performance. As a result, we had lower sales volume in the third and fourth quarters of fiscal 2013 compared to the prior year periods. We believe the successful implementation of the Strategy is vital to the efficiency of our sales channel system.
Factors Affecting Our Results of Operations
Our operating results are primarily affected by the following factors:
Perceptions of Product Quality and Safety
Rising consumer wealth in China has contributed to a greater acceptance by consumers in China of and desire for higher-priced products with perceived quality advantages associated with such products. Thus, we believe that infant formula producers with a reputation for quality and safety should be able to command higher average selling prices and thereby generate higher gross margins than competitors that do not possess the same perceived reputation for quality and safety. Conversely, any decrease in consumer perceptions of quality and safety could adversely impact such producers’ sales and gross margins, even if the perception is from misinformation or disinformation. Moreover, a decrease in the quality and safety of any particular product could trigger wider negative perception of the decrease in the quality and safety of all producers, thereby affecting the industry generally. For example, the melamine contamination incident had resulted in a significant reduction in the sales of a number of major dairy product companies in China, including us, and the prematurity event resulted in a significant decline in our sales. If a future market crisis involving any of our products should occur, especially if management failed to respond to such crisis in a timely and effective manner, our brand recognition and reputation could be severely damaged, which could adversely affect our results of operations. See Part I - Item 1A. Risk Factors—Risks Related to Our Business—We are highly dependent upon consumers’ perception of the safety and quality of our products. Any ill effects, product liability claims, recalls, adverse publicity or negative public perception regarding particular ingredients or products or our industry in general could harm our reputation, damage our brand and adversely affect our results of operations.
Brand Recognition and Customer Loyalty
In recent years, there has been growing demand in China for premium infant formula products due to increasing consumer awareness of brand image and nutritional value of the products offered by leading producers. Although the market is still highly competitive, we believe that companies with strong national brands and customer loyalty will increasingly capture market share from regional brands with less brand recognition. Moreover, we believe brand recognition and customer loyalty are predominantly influenced by customer perceptions of the quality and safety of branded products. We believe the melamine contamination incident involving 22 infant formula producers has increased the importance of consumer perception of quality and safety and the need to maintain and increase brand recognition and customer loyalty.
Competition and Market Position
While China’s infant formula market is expected to grow significantly, competition is intense. We face significant competition from domestic and multinational producers. A small number of multinational players enjoy significant market share in China, particularly in the more affluent major urban areas, based on greater brand name recognition among Chinese consumers. In addition, competition from domestic producers has become more intense in recent years, especially from large national milk companies, such as Yili, Yashili, Beingmate and Feihe, which have entered the infant formula market.
We focus on developing and marketing premium products for the infant formula market in China. By leveraging our focused marketing strategy, our brand name and our sales and marketing infrastructure, we have been able to sell infant formula products to consumers in China’s small to mid-size cities and rural areas and aside from the prematurity event, had been perceived to deliver premium quality that justifies our premium prices.
Product Offering and Pricing
Infant formula has been, and is expected to remain, our primary product. Due to rising economic affluence in China, infant formula products have become more affordable, resulting in the rapid growth of the overall market for infant formula in China. Despite the recent rapid growth, we believe much of the market is still underserved with respect to infant formula. We believe this growth in demand will help drive sales for many PRC infant formula producers, but companies with strong brand loyalty and extensive distribution networks in China will have greater ability to capitalize on such growth as well as to increase prices and pass on higher raw material costs to customers. This can be accomplished through launching higher-priced new infant formula product lines or re-launching older product lines with higher prices and improved product features.
Raw Material Supply and Prices
The per unit costs of producing our infant formula are subject to the supply and price volatility of milk powder and other raw materials, which are affected by the PRC and global markets. Increases in the price of milk powder and whey protein powder would negatively impact our gross margins if we are not able to offset such price increases through increases in our selling price or change in product mix. See Part I - Item 1A. Risk Factors—Risks Related to Our Business—Our results of operations may be affected by fluctuations in availability and price of raw materials.
Advertising and Sales Promotion Costs
We have historically relied on our extensive distribution network, our consumer education programs and customer relation services to market and sell our products. We spent aggressively on advertising and promotions to rebuild our brand image and to recover customers and market share after the prematurity event. As our market share has stabilized, we reduced our spending on advertising and promotion, and refocused our efforts to achieve effective market pull-through with new customers by supporting increased activities on the consumer-end and beyond the distribution channels by our field promoters in the communities and our nutrition education professionals at the medical and healthcare facilities. For example, we trained our in-store promoters to approach potential consumers more proactively, including conducting more home visits, phone communications and educational programs. We do not expect significant increase in advertising and promotion expenses in near future.
Taxation
We file separate tax returns in the United States, Hong Kong, Netherlands and China. Income taxes of our subsidiaries are calculated in accordance with taxation principles currently effective in the PRC. For Synutra Illinois and Synutra Delaware, applicable U.S. tax laws are followed. For Synutra International (HK) Company Limited, applicable Hong Kong tax laws are followed. For Unisono, applicable Holland tax laws are followed.
On March 16, 2007, the National People’s Congress of the PRC approved and promulgated a new tax law, which took effect beginning January 1, 2008. The Company’s PRC subsidiaries then measure and pay enterprise income tax pursuant to the new tax law. Under the new tax law, foreign investment enterprise and domestic companies are subject to a uniform income tax rate of 25%. The new tax law provides a five-year transition period from its effective date for those enterprises which were established before the promulgation date of the new tax law and which were entitled to a preferential lower tax rate under the then effective tax laws or regulations.
We operate under tax holidays in PRC, which are effective through December 2012. The impact of these tax holidays decreased PRC tax benefit by $307,000 for the fiscal year ended March 31, 2013, decreased PRC tax benefit by $71,000 for fiscal year ended March 31, 2012 and decreased PRC tax expense by $42,000 for fiscal year ended March 31, 2011. The benefit of the tax holidays on both basic and diluted loss per share was $0.01, nearly zero and nearly zero for fiscal years ended March 31, 2013, 2012 and 2011, respectively.
Some of the Company’s PRC subsidiaries are eligible under the transition rules to continue enjoying tax holidays or reduced tax rate until expiration. The following table illustrates the applicable tax rate and tax holidays of major PRC subsidiaries under the new EIT Law:
Name of Subsidiaries | | Statutory Tax Rate Beginning January 1, 2008 | | Tax Holiday (based on calendar year) |
| Shengyuan Nutritional Food Co., Ltd. | | 25% | | No tax holiday |
| Zhangjiakou Chahaer Dairy Co., Ltd. | | 25% | | 3 years tax at 12.5% (2008-10) |
| Inner Mongolia Huiliduo Food Co., Ltd. | | 25% | | 2 years tax exempt (2008, 2009); 3 years tax at 12.5% (2010-12) |
| Inner Mongolia Mengyuan Food Co., Ltd. | | 25% | | No tax holiday |
| Meitek Technology (Qingdao) Co., Ltd. | | 25% | | 2 years tax exempt (2008, 2009); 3 years tax at 12.5% (2010-12) |
| Beijing Shengyuan Huiliduo Food Technology Co., Ltd. | | 25% | | No tax holiday |
| Beijing Shengyuan Huimin Technology Service Co., Ltd. | | 25% | | No tax holiday |
| Global Food Trading (Shanghai) Co., Ltd. | | 25% | | 20% (2009), 22% (2010), 24% (2011), 25% (2012) |
Our income will be derived from dividends we receive from our PRC operating subsidiaries described above. The New EIT Law and its implementing rules generally provide that a 10% withholding tax applies to China-sourced income derived by non-resident enterprises for PRC enterprise income tax purposes. We expect that such 10% withholding tax will apply to dividends paid to us by our PRC subsidiaries but this treatment will depend on our status as a non-resident enterprise. For detailed discussion of PRC tax issues related to resident enterprise status, see Part-I - Item 1A. Risk Factors—Risks Associated with Doing Business in China—Under China’s New Enterprise Income Tax Law (“EIT Law”), we may be classified as a “resident enterprise” of China. This classification could result in unfavorable tax consequences to us and our non-PRC shareholders.
Each of our PRC subsidiaries files stand-alone tax returns and we do not file a consolidated tax return.
Critical Accounting Policies and Estimates
We prepare our financial statements in accordance with US GAAP. The preparation of these financial statements requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Management periodically evaluates the estimates and judgments made. Management bases its estimates and judgments on historical experience and on various factors that are believed to be reasonable under the circumstances. Actual results may differ materially from these estimates as a result of different assumptions or conditions.
The following critical accounting policies involve more significant judgments and estimates used in the preparation of our financial statements.
Revenue
We recognize revenue when title and risk and rewards for the products are transferred to the customer, price is fixed and determinable and collectability is reasonably assured. At the time of the sale, we also record estimates for a variety of sales deductions, including rebates, discounts and incentives, trade promotions and product returns. Sales deductions are reported as a reduction of revenue. Most of our nutritional product sales are made through distributors. Under the distributor arrangement, evidenced by purchase order together with advance payment, sales revenue is realized and earned upon acceptance of delivery of products by the distributors. The revenue recognition of My Angel series, which is directly sold to baby stores, is similar to that of our sales through distributors, and the sales revenue is realized and earned upon acceptance of the delivered of products by the baby stores. We apply this revenue recognition policy uniformly to all nutritional products, including all dairy-based pediatric and adult nutritional products.
A small fraction of our nutritional product sales are through supermarket retailers directly. Our revenue arrangement with some of these retailers includes a right of return clause. Our price to the supermarkets is fixed. The supermarkets’ obligation to us would not be changed in the event of theft or physical destruction or damage of the product. We recognize revenue when the supermarkets have paid us.
Our gross sales are subject to various deductions, primarily comprised of rebates and discounts to distributors and retailers. These deductions represent estimates of the related obligations, requiring the use of judgment when estimating the impact of these sales deductions on gross sales for a reporting period. We report these adjustments as a reduction of gross sales to arrive at net sales.
The Company provides discounts or rebates to customers in the following ways:
| | ● | The Company offers product discounts to compensate certain distributors for promotional expenses and slotting fees paid by them. These distributors are responsible for organizing local promotional activities and paying slotting fees to retail outlets within their sales territory, and providing the Company with documentation of their expenditures, which would be recorded as product discounts and a reduction of the receivable from distributors in the applicable month. |
| | ● | The Company offers rebates to other distributors and supermarket retailers as sales incentives. These rebate programs provide that distributors and supermarket retailers receive a rebate after attaining certain amount of orders relating to specific products. Since rebates are contractually agreed upon, the Company estimates rebates based on the specific terms in each agreement and anticipated performance for the current year. The Company considers the sales performance of products subject to rebates and applicable rebate rate, and adjusts the provision periodically to reflect actual experience. Actual amounts may differ if actual performance varies from estimates. The Company records rebates as a reduction of revenues in the year in which these programs are offered. |
Slotting fees and estimated sales returns due to package damage are also deductions from gross sales:
| | ● | For product sales made directly to supermarket retailers, certain slotting fees, such as shelf display, end-cap placement, bar-coding, banner advertising, are paid to the supermarket retailers. These slotting fees are deducted from revenues. |
| | ● | The Company records a provision for estimated sales returns due to package damage. The sales return amount represents management’s best estimates based on the available information at the time of estimate. The provision for estimated sales returns due to package damage was not material as of March 31, 2013 and 2012. |
Allowance for Doubtful Accounts
We maintain allowances for doubtful accounts primarily based on the age of receivables and factors surrounding the credit risk of specific customers. An estimate for doubtful accounts is made when collection of the full amount is no longer probable. We perform a risk assessment for each customer, and provide specific allowance for those deemed to have a high risk of uncollectibility. We also record a provision for other customers without specific risks based on a review of the receivables aging and our historical experience. Bad debts are written off as incurred.
Inventories
Our inventories are stated at the lower of cost or market. The valuation of inventory requires us to estimate excess and slow moving inventory. The determination of the value of excess and slow moving inventory is based upon assumptions of future demands and market conditions. If actual market conditions are less favorable than those projected by management, inventory write-downs may be required. We routinely evaluate quantities and value of our inventories in light of current market conditions and market trends. We record write-downs against the cost of inventories for a decline in market, which establishes a new cost basis for inventory. In estimating obsolescence, we utilize our backlog information and forecasts of future demand. Market conditions are subject to change and actual consumption of inventories could differ materially from forecasted demand. Furthermore, the price of milk powder is subject to fluctuations based on global supply and demand. If actual market conditions are less favorable or other factors arise that are significantly different from those anticipated by management, additional inventory write-downs or increases in obsolescence reserves may be required.
Income Taxes
The provision for income taxes has been determined using the asset and liability approach of accounting for income taxes. Under this approach, deferred taxes represent the future tax consequences expected to occur when the reported amounts of assets and liabilities are recovered or paid. The provision for income taxes represents income taxes paid or payable for the current year plus the change in deferred taxes during the year. Deferred taxes result from differences between the financial and tax bases of our assets and liabilities and are adjusted for changes in tax rates and tax laws when changes are enacted. Valuation allowances are recorded to reduce deferred tax assets when it is more likely than not that a tax benefit will not be realized. The assessment of whether or not a valuation allowance is required often requires significant judgment including the long-range forecast of future taxable income and the evaluation of tax planning initiatives. Adjustments to the deferred tax valuation allowances are made to earnings in the period when such assessments are made.
Our tax rate is based on expected income, statutory tax rates and tax planning opportunities available in the various jurisdictions in which we operate. For interim financial reporting, we estimate the annual tax rate based on projected taxable income for the full year and record a quarterly income tax provision in accordance with the anticipated annual rate. As the year progresses, we refine the estimates of the year’s taxable income as new information becomes available, including year-to-date financial results. This continual estimation process often results in a change to our expected effective tax rate for the year. When this occurs, we adjust the income tax provision during the quarter in which the change in estimate occurs so that the year-to-date provision reflects the expected annual tax rate. Significant judgment is required in determining our effective tax rate and in evaluating our tax positions.
We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax basis of assets and liabilities. Deferred tax assets represent items to be used as a tax deduction or credit in future tax returns for which we have already properly recorded the tax benefit in the income statement. At least quarterly, we assess the likelihood that the deferred tax asset balance will be recovered from future taxable income. We consider positive and negative evidence when determining whether a portion or all of our deferred tax assets will more likely than not be realized. We take into account such factors as prior earnings history, expected future earnings, carry-back and carry-forward periods, the duration of statutory carry forward periods and tax strategies that could potentially enhance the likelihood of a realization of a deferred tax asset. To the extent recovery is unlikely, a valuation allowance is established against the deferred tax asset and increasing our income tax expense in the year such determination is made. As of March 31, 2013, we had deferred tax assets of $55.8 million, mainly generated from net loss carryforward before valuation allowance. We accrued a full valuation allowance since it is more likely than not that the operating loss will not be utilized before expiration. Tax benefits relating to future reversals of the valuation allowance on deferred tax assets, if any, will be recognized as a reduction of income tax expense.
We periodically evaluate our investment strategies with respect to each foreign tax jurisdiction in which we operate to determine whether foreign earnings will be indefinitely reinvested offshore and, accordingly, whether U.S. income taxes should be provided when such earnings are recorded. As of March 31, 2013, we believed all earnings generated in China and Hong Kong would be permanently reinvested and as a result, we did not record any income taxes on such earnings.
We recognize a tax benefit associated with an uncertain tax position when, in our judgment, it is more likely than not that the position will be sustained upon examination by a taxing authority. For a tax position that meets the more-likely-than-not recognition threshold, we initially and subsequently measure the tax benefit as the largest amount that we judge to have a greater than 50% likelihood of being realized upon ultimate settlement with a taxing authority. Our liability associated with unrecognized tax benefits is adjusted periodically due to changing circumstances, such as the progress of tax audits, case law developments and new or emerging legislation. Such adjustments are recognized entirely in the period in which they are identified. Our effective tax rate includes the net impact of changes in the liability for unrecognized tax benefits and subsequent adjustments as considered appropriate by management. As of March 31, 2013, we had recorded liabilities of $506,000 for our PRC subsidiaries.
We classify interest and penalties recognized on the liability for unrecognized tax benefits as income tax expense. For the fiscal year ended March 31, 2013, the unrecognized tax benefit did not change significantly and the amount of interest and penalties related to uncertain tax position is immaterial.
Impairment of Long-lived Assets
We evaluate our long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable. Factors that we consider in deciding when to perform an impairment review include, but are not limited to significant under-performance of a business or product line in relation to expectations, and significant changes or planned changes in the use of the assets. An impairment analysis is performed at the lower level of identifiable independent cash flows for an asset or asset group. We assess the recoverability of long-lived assets by comparing the carrying amount of the asset group to the estimate of the related total future undiscounted cash flow. If an asset group’s carrying value is not recoverable through the related undiscounted cash flows, the impairment loss is measured by comparing the difference between the asset group’s carrying value and its fair value. We determine the fair value of an asset or asset group utilizing estimated future discounted cash flows and incorporate assumptions that it believes marketplace participants would utilize.
The impairment tests involve the use of accounting estimates and assumptions that management believed to be reasonable, the result of which form the basis for our conclusions. While the current analysis suggested that no impairment was recognized, significant changes to these estimates and assumptions could adversely impact our conclusion to these impairment tests. We will continue to closely monitor our financial performance and projections for the asset groups and the economic conditions of the product end markets. Any significant change in market conditions and estimates of judgments could give rise to impairment in the period that the change becomes known.
Results of Operations
Fiscal Year Ended March 31, 2013 Compared to Fiscal Year Ended March 31, 2012
Below is a summary of selected comparative results of operations for the fiscal year ended March 31, 2013 and 2012:
| | | Fiscal Years Ended March 31, | | | | |
| (In thousands, except per share data) | | 2013 | | | 2012 | | | % Change | |
| Net sales | | $ | 265,770 | | | $ | 342,539 | | | | -22% | |
| - Powdered formula segment | | | 224,423 | | | | 301,664 | | | | -26% | |
| Cost of sales | | | 171,211 | | | | 201,618 | | | | -15% | |
| - Powdered formula segment | | | 122,175 | | | | 159,189 | | | | -23% | |
| Gross profit | | | 94,559 | | | | 140,921 | | | | -33% | |
| - Powdered formula segment | | | 102,248 | | | | 142,475 | | | | -28% | |
| Gross Margin | | | 36% | | | | 41% | | | | | |
| - Powdered formula segment | | | 46% | | | | 47% | | | | | |
| Income (loss) from operations | | | (14,000 | ) | | | 42,794 | | | | * | |
| Interest expense, net | | | 12,692 | | | | 12,406 | | | | 2% | |
| Income (loss) before income tax expense | | | (27,035 | ) | | | 30,534 | | | | * | |
| Income tax expense | | | 37,186 | | | | 13,510 | | | | * | |
| - Effective tax rate | | | -137.5% | | | | 44.2% | | | | | |
| Net income (loss) | | | (64,221 | ) | | | 17,024 | | | | * | |
| Net income (loss) attributable to common stockholders | | $ | (63,888 | ) | | $ | 16,737 | | | | * | |
| Weighted average common stock outstanding – basic and diluted | | | 57,301 | | | | 57,301 | | | | | |
| Loss per share – basic and diluted | | $ | (1.11 | ) | | $ | 0.29 | | | | * | |
* not meaningful
Net Sales
Our net sales by reportable segments are shown in the table below:
| | | Fiscal Years Ended March 31, | | | | | | % Change in | |
| (In thousands, except percentage data) | | 2013 | | | 2012 | | | % Change | | | Volume | | | Price | |
| Powdered formula | | $ | 224,423 | | | $ | 301,664 | | | | -26% | | | | -25% | | | | 0% | |
| Foods | | | 350 | | | | 255 | | | | 37% | | | | | | | | | |
| Nutritional ingredients and supplements | | | 6,836 | | | | 907 | | | | 654% | | | | | | | | | |
| All other | | | 34,161 | | | | 39,713 | | | | -14% | | | | | | | | | |
| Net sales | | $ | 265,770 | | | $ | 342,539 | | | | -22% | | | | | | | | | |
Net sales of our powdered formula segment include powdered formula products for infants, children and adults. The decrease in net sales of our powdered formula products was mainly due to the following factors:
| | ● | Sales volume of powdered formula products for the fiscal year ended March 31, 2013 was 20,521 tons, as compared to 27,526 tons for the prior fiscal year, due primarily to significant purchases of our products by distributors prior to our retail price increase effective on April 1, 2012, and reduced orders from distributors as we implemented the Strategy discussed above. |
| | ● | The average selling price of our powdered formula products for the fiscal year ended March 31, 2013 was $10,936 per ton, compared to $10,959 per ton for the prior fiscal year. Average selling price is calculated as net sales, after deducting sales discounts and rebates, divided by sales volume. The relatively unchanged average selling price was the result of the combined effect from the retail price increase we instituted on April 1, 2012, and the result of increased sales discounts and rebates per ton. We provided sales discounts and rebates to offset part of the marketing and promotional expenditures incurred at retail outlets. The sales discounts and rebates do not fluctuate directly with current period sales because they are based on a prorated fiscal year basis before the initiation of the Strategy. |
The sales volume and average selling price exclude the amount of free products provided to customers, which is recorded as cost of sales in the period.
The product mix in the foods segment is comprised of prepared baby food, such as cooked meat and vegetables. We have focused our efforts on the powdered formula segment since the melamine incident in 2008, followed by the prematurity event in 2010, and have not developed the foods segment as we originally planned, however we plan to launch a new product category under this segment in fiscal 2014 for adults with special nutritional needs, and expect to revitalize this segment going forward.
The product mix in nutritional ingredients and supplements segment is comprised of external sales of chondroitin sulfate to third parties. Our sales of chondroitin sulfate materials to certain international customers increased significantly in fiscal year 2013, however, our production cost remained high and we incurred gross loss on our chondroitin sulfate sales as we produced much less quantity than our nominal capacity.
Our Other business mainly included sales of raw milk powder of $21.5 million and whey protein of $8.8 million for the fiscal year ended March 31, 2013. Our Other business mainly included sales of raw milk powder of $27.7 million and raw milk of $3.3 million for the fiscal year ended March 31, 2012. Since we use the dry-mixing production method, we require a higher quality standard for the milk powder than a wet-mixing production method would require. As a result, we screen the milk powder we purchased for excessive micro-organism content, or milk powder that is over-burnt or lacks the ideal consistency. While we do not make use of this raw material, such product meets the quality standard for raw milk powder that can be used in other products such as dairy drinks or bakery. The amount of this ancillary raw milk powder identified through the screening process is approximately 15% of the total material we purchase. In addition, we may also replace older inventory with new orders when the cost of doing so is low, causing higher sales of milk powder and whey protein powder.
Cost of Sales
Our cost of sales by reportable segments is shown in the table below:
| | | Fiscal Years Ended March 31, | | | | |
| (In thousands, except percentage data) | | 2013 | | | 2012 | | | % Change | |
| Powdered formula | | $ | 122,175 | | | $ | 159,189 | | | | -23% | |
| Foods | | | 3,211 | | | | 2,354 | | | | 36% | |
| Nutritional ingredients and supplements | | | 9,646 | | | | 3,265 | | | | 195% | |
| All other | | | 36,179 | | | | 36,810 | | | | -2% | |
| Cost of sales | | $ | 171,211 | | | $ | 201,618 | | | | -15% | |
The decrease in the cost of sales of the powdered formula segment was mainly due to the decrease in sales volume and extent of promotions involving free product giveaways, partially offset by the increased cost of whey protein powder.
The increase in the cost of sales of nutritional ingredients and supplements segment was mainly due to the sales of chondroitin sulfate to certain international pharmaceutical companies as discussed above.
Cost of our Other business mainly included cost of milk powder of $23.0 million and whey protein of $7.6 million for the fiscal year ended March 31, 2013. Cost of our Other business mainly included cost of raw milk powder of $27.1 million and raw milk of $3.3 million for the fiscal year ended March 31, 2012.
Gross Profit and Gross Margin
| | | Fiscal Years Ended March 31, | | | | |
| (In thousands, except percentage data) | | 2013 | | | 2012 | | | % Change | |
| Gross profit | | $ | 94,559 | | | $ | 140,921 | | | | -33% | |
| - Powdered formula | | | 102,248 | | | | 142,475 | | | | -28% | |
| Gross margin | | | 36% | | | | 41% | | | | | |
| - Powdered formula | | | 46% | | | | 47% | | | | | |
The decrease in gross margin was mainly due to the margin decrease in Other business. The decrease in gross margin of the powdered formula segment was mainly due to increased cost of whey protein powder in the fiscal year ended March 31, 2013.
Expenses
| | | Fiscal Years Ended March 31, | | | | |
| (In thousands, except percentage data) | | 2013 | | | 2012 | | | % Change | |
| Selling and distribution expenses | | $ | 53,607 | | | $ | 51,221 | | | | 5% | |
| Advertising and promotion expenses | | | 32,574 | | | | 28,442 | | | | 15% | |
| - Advertising expenses | | | 11,928 | | | | 11,515 | | | | 4% | |
| - Promotion expenses | | | 20,646 | | | | 16,927 | | | | 22% | |
| General and administrative expenses | | | 30,220 | | | | 23,948 | | | | 26% | |
| Government subsidies | | | 4,217 | | | | 5,484 | | | | -23% | |
Selling and distribution expenses primarily include compensation expense for sales staff, freight charges, travel expense and service charge for our customer loyalty program. The increase in selling and distribution expenses in the fiscal year ended March 31, 2013 from the prior fiscal year was mainly due to the increase in a service charge for our consumer loyalty program administered by a third party since the fourth quarter of fiscal year 2012, and the increase in selling expense as we introduced our specialty infant formulas, which are designed for infants with special conditions who cannot use regular infant formulas, to our market.
Advertising expenses primarily include media expenses paid to national and local TV stations, and e-commerce providers. Promotion expenses primarily include promotional products to end customers. The increase in promotion expenses in the fiscal year ended March 31, 2013 was mainly due to more consumer loyalty program expenses for end customers, and increased service fee to on-site promotion staff.
General and administrative expenses primarily include salaries for staff and management, depreciation, office rental and office supplies in the fiscal year ended March 31, 2013. The increase was mainly due to the increased depreciation expense, office rental and office supplies related to our new headquarter in use.
Government subsidies represented the receipt of general purpose subsidies from local governments.
Gain on Disposal and Liquidation of Subsidiaries
Gain on disposal of subsidiaries is primarily comprised of net foreign currency translation gains of $3.1 million reclassified from accumulated other comprehensive income as a result of the liquidation and disposal of certain subsidiaries, none of which had significant ongoing operations.
Interest Expense and Interest Income
| | | Fiscal Years Ended March 31, | | | | |
| (In thousands, except percentage data) | | 2013 | | | 2012 | | | % Change | |
| Interest expense | | $ | 15,018 | | | $ | 14,276 | | | | 5% | |
| Interest income | | | 2,326 | | | | 1,870 | | | | 24% | |
The increase in interest expense was mainly due to an increase in average borrowing balance, partially offset by a decreased average interest rate as we used more trade financing to purchase inventory with lower interest rates.
The increase in interest income was mainly due to an increase in average restricted cash balance, which earned a higher interest rate than cash and cash equivalents.
Income Tax Expense
The increase in income tax expense was primarily due to the $36.5 million charge from the increase in the valuation allowance for deferred tax assets of certain PRC subsidiaries for the fiscal year ended March 31, 2013.
Net Income (Loss) Attributable to Noncontrolling Interest
Net income (loss) attributable to noncontrolling interest mainly represents the interest held by third parties in Meitek Technology (Qingdao) Co., Ltd.
Net Income (Loss) Attributable to Common Stockholders
As a result of the foregoing, net loss attributable to common stockholders for the fiscal year was $63.9 million, compared to a net income of $16.7 million for the prior fiscal year.
Fiscal Year Ended March 31, 2012 Compared to Fiscal Year Ended March 31, 2011
Below is a summary of selected comparative results of operations for the fiscal year ended March 31, 2012 and 2011:
| | | Fiscal Years Ended March 31, | | | | |
| (In thousands, except per share data) | | 2012 | | | 2011 | | | % Change | |
| Net sales | | $ | 342,539 | | | $ | 248,516 | | | | 38% | |
| - Powdered formula segment | | | 301,664 | | | | 185,569 | | | | 63% | |
| Cost of sales | | | 201,618 | | | | 170,769 | | | | 18% | |
| - Powdered formula segment | | | 159,189 | | | | 107,258 | | | | 48% | |
| Gross profit | | | 140,921 | | | | 77,747 | | | | 81% | |
| - Powdered formula segment | | | 142,475 | | | | 78,311 | | | | 82% | |
| Gross Margin | | | 41% | | | | 31% | | | | | |
| - Powdered formula segment | | | 47% | | | | 42% | | | | | |
| Income (loss) from operations | | | 42,794 | | | | (40,342 | ) | | | * | |
| Interest expense, net | | | 12,406 | | | | 9,501 | | | | 31% | |
| Income (loss) before income tax expense | | | 30,534 | | | | (49,566 | ) | | | * | |
| Income tax expense (benefit) | | | 13,510 | | | | (9,306 | ) | | | * | |
| - Effective tax rate | | | 44.2% | | | | 18.8% | | | | | |
| Net income (loss) | | | 17,024 | | | | (40,260 | ) | | | * | |
| Net income (loss) attributable to common stockholders | | $ | 16,737 | | | $ | (40,068 | ) | | | * | |
| Weighted average common stock outstanding – basic and diluted | | | 57,301 | | | | 57,301 | | | | | |
| Income (loss) per share – basic and diluted | | $ | 0.29 | | | $ | (0.71 | ) | | | * | |
* not meaningful
Net Sales
Our net sales by reportable segments are shown in the table below:
| | | Fiscal Years Ended March 31, | | | | | | % Change in | |
| (In thousands, except percentage data) | | 2012 | | | 2011 | | | % Change | | | Volume | | | Price | |
| Powdered formula | | $ | 301,664 | | | $ | 185,569 | | | | 63% | | | | 10% | | | | 47% | |
| Foods | | | 255 | | | | 495 | | | | -48% | | | | | | | | | |
| Nutritional ingredients and supplements | | | 907 | | | | 1,001 | | | | -9% | | | | | | | | | |
| All other | | | 39,713 | | | | 61,451 | | | | -35% | | | | | | | | | |
| Net sales | | $ | 342,539 | | | $ | 248,516 | | | | 38% | | | | | | | | | |
Net sales of our powdered formula segment include powdered formula products for infants, children and adults. The increase of net sales of our powdered formula products was mainly due to the following factors:
| | ● | Sales volume of powdered formula products for the fiscal year ended March 31, 2012 was 27,526 tons, as compared to 24,927 tons for the prior fiscal year, due primarily to the recovery from the prematurity event since the second quarter of fiscal year 2012. As we announced to implement an approximately 15% price increase beginning on April 1, 2012, distributors increased their orders placed in the second half of fiscal 2012, which also contributed to the sales volume increase comparing with fiscal year 2011. |
| | ● | The average selling price of our powdered formula products for the fiscal year ended March 31, 2012 was $10,959 per ton, compared to $7,444 per ton for the prior fiscal year. The increase in average selling price is mainly due to a reduction in our fixed discounts per ton, which mainly represents fixed compensation for the promotional activities undertaken by our distributors. Since our sales volume increased, primarily attributable to our recovery from the prematurity event, the discounts we were required to offer have decreased as a percentage of sales. Also, our average selling price has been improving and has returned to the level before the prematurity event. |
The product mix in foods segment is comprised mainly of prepared baby food, such as cooked meat and vegetables. As part of our sustained response to the prematurity event, we continued to focus our efforts on the recovery of the powdered formula segment in fiscal year 2012, and did not develop the foods segment as planned.
The product mix in nutritional ingredients and supplements segment is comprised mainly of chondroitin sulfate sold to third parties. The inter-segment sales for the fiscal year ended March 31, 2012 was $12.2 million, compared to $8.3 million for the prior fiscal year. The inter-segment sales represent sales of microencapsulated DHA and ARA, which were used in the production of powdered infant formula products.
We sold surplus imported milk powder of $27.7 million to industrial customers this year as compared to $45.9 million in the prior year. The rest of Other business sales mainly include sales of self-produced milk powder, raw milk and whey protein.
Cost of Sales
Our cost of sales by reportable segments is shown in the table below:
| | | Fiscal Years Ended March 31, | | | | |
| (In thousands, except percentage data) | | 2012 | | | 2011 | | | % Change | |
| Powdered formula | | $ | 159,189 | | | $ | 107,258 | | | | 48% | |
| Foods | | | 2,354 | | | | 1,744 | | | | 35% | |
| Nutritional ingredients and supplements | | | 3,265 | | | | 3,102 | | | | 5% | |
| All other | | | 36,810 | | | | 58,665 | | | | -37% | |
| Cost of sales | | $ | 201,618 | | | $ | 170,769 | | | | 18% | |
The increase in the cost of sales for the powdered formula segment is mainly due to the increase in sales volume, and the increase in promotional product cost.
Cost of surplus imported milk powder sold was $27.1 million for the fiscal year ended March 31, 2012, as compared to $43.0 million for the prior fiscal year.
Gross Profit and Gross Margin
| | | Fiscal Years Ended March 31, | | | | |
| (In thousands, except percentage data) | | 2012 | | | 2011 | | | % Change | |
| Gross profit | | $ | 140,921 | | | $ | 77,747 | | | | 81% | |
| - Powdered formula | | | 142,475 | | | | 78,311 | | | | 82% | |
| Gross margin | | | 41% | | | | 31% | | | | | |
| - Powdered formula | | | 47% | | | | 42% | | | | | |
The increase in gross margin was mainly due to the margin increase in powdered formula segment and Other business. The increase in gross profit was the result of the recovery of powdered formula segment, which was primarily attributable to our recovery from the prematurity event.
Expenses
| | | Fiscal Years Ended March 31, | | | | |
| (In thousands, except percentage data) | | 2012 | | | 2011 | | | % Change | |
| Selling and distribution expenses | | $ | 51,221 | | | $ | 48,409 | | | | 6% | |
| Advertising and promotion expenses | | | 28,442 | | | | 41,420 | | | | -31% | |
| - Advertising expenses | | | 11,515 | | | | 22,562 | | | | -49% | |
| - Promotion expenses | | | 16,927 | | | | 18,858 | | | | -10% | |
| General and administrative expenses | | | 23,948 | | | | 28,261 | | | | -15% | |
| Impairment of goodwill | | | 0 | | | | 1,440 | | | | -100% | |
| Government subsidies | | | 5,484 | | | | 1,441 | | | | 281% | |
Selling and distribution expenses primarily include compensation expense, freight charges, and travel expense. The increase was mainly due to the increase in compensation expenses, which was led by the increase in powdered formula segment sales. Total compensation expense for the fiscal year ended March 31, 2012 increased to $32.8 million from $30.4 million for the prior fiscal year.
The decrease in advertising expenses was mainly due to that we spent significantly on media advertising immediately after the prematurity event to improve our brand image in prior fiscal year.
The decrease in general and administrative expenses was mainly due to $1.5 million to finance prematurity-related research and related public education in the prior fiscal year, $1.5 million decrease in rental expense as we modified the lease agreement of our Beijing headquarter, and $1.1 million decrease in bad debt expense.
Goodwill of $1.4 million was fully impaired during the fiscal year ended March 31, 2011, as a result of conditions surrounding the foods business.
Government subsidies represented the receipt of a general purpose subsidy from a local government.
Interest Expense and Interest Income
| | | Fiscal Years Ended March 31, | | | | |
| (In thousands, except percentage data) | | 2012 | | | 2011 | | | % Change | |
| Interest expense | | $ | 14,276 | | | $ | 10,321 | | | | 38% | |
| Interest income | | | 1,870 | | | | 820 | | | | 128% | |
The increase in interest expense was mainly due to the increase in weighted average interest rate of borrowings from PRC banks, as China’s central bank raised the benchmark lending rate several times since October 2010.
The increase in interest income was mainly due to the increased weighted average restricted cash balance, which earns a higher interest rate than cash and cash equivalents, and the increase in the rate of interest paid on deposits, as China’s central bank raised the benchmark deposit rate several times since October 2010.
Income Tax Expense (Benefit)
The increase in the effective tax rate from 18.8% for fiscal year 2011 to 44.2% for fiscal year 2012 was driven primarily by the effect of a tax refund for overpaid income taxes recognized in the fiscal year ended March 31, 2011 and the valuation allowance established for net operating loss carryforwards of certain subsidiaries in the fiscal year ended March 31, 2012.
Net Income (Loss) Attributable to Common Stockholders
As a result of the foregoing, net income attributable to common stockholders for the fiscal year ended March 31, 2012 was $16.7 million, compared to a net loss of $40.1 million for the prior fiscal year.
Liquidity and Capital Resources
Overview
Our primary sources of liquidity are cash on hand, cash from operations and available borrowings. Cash flows from operating activities represent the inflow of cash from our customers and the outflow of cash for inventory purchases, manufacturing, operating expenses, interest and taxes. Cash flows used in investing activities primarily represent capital expenditures for equipment and buildings, and restricted cash used as security against letter of credits and short-term and long-term borrowings. Cash flows from financing activities primarily represent proceeds and repayments of borrowings, and for the fiscal year ended March 31, 2011, it also includes the issuance of 3.3 million shares of common stock, with net proceeds of approximately $58.8 million. In addition, while there can be no assurance that the Company will be able to refinance its short-term bank borrowings as they become due, historically, the Company has renewed or rolled over most of our short-term bank loans upon the maturity date of the loans and believes we will continue to be able to do so.
Cash and cash equivalents totaled $79.1 million at March 31, 2013, of which $77.9 million was held outside of the United States.
As of March 31, 2013, the Company's current liabilities exceed its current assets by $40.0 million and the Company has an asset liability ratio of 94%, which is defined as total liabilities divided by total assets. In addition, the Company suffered a loss before income tax expense of $27.0 million and incurred negative cash flows from operations of $5.7 million for the fiscal year ended March 31, 2013. However, the Company regards the going concern assumption as appropriate considering the following mitigating factors:
| · | The Company believes that the loss from operations for the year ended March 31, 2013 is primarily attributable to the short term effect of a substantial increase in the retail price of the Company’s powdered formula products beginning April 1, 2012 and management’s rationalization of the Company's sales channel which was initiated in September 2012 and was substantially completed by March 2013. The Company managed to reverse the losses incurred in the six months ended September 30, 2012, with breakeven results from operations in the third quarter and an income from operations in the fourth quarter. In addition, the Company had positive cash flows from operations for the second half of fiscal 2013 of $41.8 million. The Company has performed a review of its cash flow forecast for the twelve months ending March 31, 2014 and believes that its cash flows from operations will be sufficiently positive for fiscal year 2014 to satisfy its obligations when they fall due. |
| · | For the two months ended May 31, 2013, the Company had repaid short-term bank loans of $28.1 million and current portion of long-term bank loans of $16.1 million, had borrowed short-term bank loans of $28.3 million and long-term bank loans of $19.6 million. |
| · | As of May 31, 2013, the Company had unused committed credit facility of $18.3 million at its disposal. |
Based on the above factors, management believes that adequate sources of liquidity will exist to fund the Company’s working capital and capital expenditure requirements, and to meet its short term debt obligations, other liabilities and commitments as they become due. Accordingly, management believes the Company will continue as a going concern.
On September 17, 2012, the Company entered into a partnership framework agreement, a milk supply agreement, a whey supply agreement, a whey powder supply agreement, and a technical assistance agreement with Sodiaal Union, a French agricultural cooperative company (“Sodiaal”), and/or Euroserum SAS (“Euroserum”), a French subsidiary of Sodiaal, relating to a long-term industrial and commercial partnership between Sodiaal and the Company. Under these agreements, the Company undertakes to build a new drying facility in Carhaix, France, intended to manufacture powdered milk and fat-enriched demineralized whey. Pursuant to the partnership framework agreement, the operational commissioning of the new drying facility will take place no later than January 2, 2015. In the event of a delay beyond January 2, 2015 and save for limited exceptions, the Company undertakes to compensate, according to the circumstance, Sodiaal or Euroserum for the loss incurred as a result of such delay. The loss incurred by Sodiaal or Euroserum in case of a delay of the operational commissioning of the new drying facility beyond January 2, 2015 shall amount to the loss of profits actually suffered, as the case may be, by Sodiaal or Euroserum under the milk supply agreement or the whey supply agreement. The estimated cost to build the facility is € 90 million (approximately $117 million). The Company plans to finance a majority of the cost with long-term project financing, and the remaining part of the project with cash on hand and operating cash flow. The Company committed to purchase, and Sodiaal and Euroserum committed to sell, 288 million liters of milk per year for ten years, an amount of whey equivalent to 24,000 tons of 70% demineralized pre-concentrated dry whey extract per year for ten years, and 6,000 tons of 70% demineralized whey powder per year, or an equivalent quantity of liquid whey, for ten years, at market based prices at the time of purchase, to satisfy the production needs of the new drying facility. If the Company purchases less than the agreed amount, the Company would compensate Sodiaal or Euroserum for the loss suffered. On March 20, 2013, the Company received the required approvals from China's National Development and Reform Commission and Ministry of Commerce for the project. As of June 13, 2013, the Company is in the process of obtaining approval from the French government in connection with this project and negotiating borrowing terms with certain banks. The Company expects the construction will start in fiscal 2014.
Cash Flows
The following table sets forth, for the periods indicated, certain information relating to our cash flows:
| | | Fiscal Year Ended March 31, | |
| (In thousands) | | 2013 | | | 2012 | | | 2011 | |
| Cash flow provided by/(used in): | | | | | | | | | | | | |
| Operating activities | | | | | | | | | | | | |
| Net income (loss) | | $ | (64,221 | ) | | $ | 17,024 | | | $ | (40,260 | ) |
| Depreciation and amortization | | | 14,976 | | | | 11,751 | | | | 10,671 | |
| Bad debt expense | | | 2,423 | | | | 3,386 | | | | 4,209 | |
| Deferred income tax | | | 36,550 | | | | 13,834 | | | | (9,441 | ) |
| Gain on disposal and liquidation of subsidiaries | | | (3,625 | ) | | | 0 | | | | 0 | |
| Other | | | 337 | | | | 398 | | | | 2,647 | |
| Changes in assets and liabilities | | | 7,816 | | | | 19,276 | | | | (41,549 | ) |
| Total operating activities | | | (5,744 | ) | | | 65,669 | | | | (73,723 | ) |
| Investing activities | | | (70,012 | ) | | | (38,314 | ) | | | (1,910 | ) |
| Financing activities | | | 89,546 | | | | (12,872 | ) | | | 73,684 | |
| Effect of foreign currency translation on cash and cash equivalents | | | 467 | | | | 1,569 | | | | 1,997 | |
| Net change in cash and cash equivalents | | $ | 14,257 | | | $ | 16,052 | | | $ | 48 | |
Cash Flows from Operating Activities
Cash flow used in operating activities was a result of the net loss incurred, as adjusted for non-cash expense and income items, and changes in working capital. The changes in working capital for the fiscal year ended March 31, 2013 were primarily related to $18.4 million increase in other liabilities, $9.6 million decrease in due from related parties, $6.7 million decrease in accounts receivable, $7.0 million increase in advance from customers, partially offset by $16.1 million decrease in accounts payable, $12.0 million increase in inventories and $5.8 million increase in other assets. In the fiscal year ended March 31, 2013, we spent $270.1 million to purchase raw materials and other production materials, $48.7 million in staff compensation and social welfare, $30.8 million in taxes, $57.5 million in operating expenses, $13.2 million in interest, received $410.7 million from our customers, and received a $3.9 million subsidy from the local government.
The changes in working capital for the fiscal year ended March 31, 2012, were primarily related to a $17.1 million increase in other liabilities, and $10.9 million increase in accounts payable, partially offset by $5.5 million increase in prepaid expense and other current assets, and $5.7 million increase in inventories. In the fiscal year ended March 31, 2012, we spent $265.9 million to purchase raw materials and other production materials, $44.7 million in staff compensation and social welfare, $18.1 million in other taxes, $37.4 million in operating expenses, $13.5 million in interest, and received $446.0 million from our customers.
The changes in working capital for the fiscal year ended March 31, 2011, were primarily related to a $22.9 million increase in accounts receivable due to our support to distributors to help their recovery, and $13.0 million increase in goods in transit of inventories caused by the long lead time to import raw materials. In the fiscal year ended March 31, 2011, we spent $224.9 million to purchase raw materials and other production materials, $42.1 million in staff compensation and social welfare, $23.9 million in other taxes, $79.0million in operating expenses, $166,000 in income taxes, $9.3 million in interest, and received $304.6 million from our customers.
Cash Flows from Investing Activities
Cash flow used in investing activities in the fiscal year ended March 31, 2013 represents $16.1 million payment for purchase of property, plant and equipment, $56.5 million outflow for restricted cash deposited with banks as security against the issuance of letters of credit for the import of raw materials and as pledges for certain short-term and long-term borrowings, $1.6 million in proceeds from disposed assets, and $1.0 million proceeds from disposal of certain PRC subsidiaries.
Cash flow used in investing activities in the fiscal year ended March 31, 2012 mainly represents $27.3 million payment for purchase of property, plant and equipment, and $11.7 million outflow in restricted cash. Restricted cash represents cash deposited with banks as security against the issuance of letters of credit for the import of raw materials and as pledges for certain short-term and long-term borrowings.
Cash flow used in investing activities in the fiscal year ended March 31, 2011 mainly represents $8.2 million payment for purchases of property and equipment, $9.2 million proceeds from disposal of two PRC subsidiaries’ assets, and $2.9 million outflow in restricted cash. Restricted cash represents cash deposited with banks as security against the issuance of letters of credit for the import of raw materials and as pledges for certain short-term borrowings.
Cash Flows from Financing Activities
Cash flow used in financing activities in the fiscal year ended March 31, 2013 mainly represents net cash inflow of $40.2 million from short-term loans and net cash inflow of $50.8 million from long-term loans, $1.0 million payment for assets under capital leases and $0.4 million payment to holders of non-controlling interest.
Cash flow used in financing activities in the fiscal year ended March 31, 2012 mainly represents net cash outflow of $44.0 million of short-term loans and net cash inflow of $31.5 million of long-term loans, and $0.3 million payment for capital leased assets.
Cash flow used in financing activities in the fiscal year ended March 31, 2011 mainly represents net cash inflow of $26.6 million of short-term loans and net cash outflow of $9.7 million of long-term loans, $58.8 million net proceeds from issuance of common stock, and $2.0 million payment for capital leased assets.
Outstanding Indebtedness
For information on our short-term and long-term borrowings, see “Item 8. Financial Statements and Supplementary Data – Note Debt to Consolidated Financial Statements.”
Tabular Disclosure of Contractual Obligations
Below is a table setting forth our contractual obligations as of March 31, 2013.
| | | Total | | | Less than 1 year | | | 1-3 years | | | 3-5 years | | | More than 5 years | |
| | | (in thousands) | |
| Long-term debt and related interest payment obligations | | $ | 199,398 | | | $ | 93,182 | | | $ | 106,216 | | | $ | 0 | | | $ | 0 | |
| Capital lease obligations | | | 19,737 | | | | 263 | | | | 1,224 | | | | 1,224 | | | | 17,026 | |
| Operating lease obligations | | | 58,205 | | | | 1,758 | | | | 3,372 | | | | 3,366 | | | | 49,709 | |
| Purchase commitments | | | 18,409 | | | | 18,409 | | | | 0 | | | | 0 | | | | 0 | |
| Capital expenditure commitments | | | 380 | | | | 380 | | | | 0 | | | | 0 | | | | 0 | |
| Total | | $ | 296,129 | | | $ | 113,992 | | | $ | 110,812 | | | $ | 4,590 | | | $ | 66,735 | |
As discussed in Liquidity and Capital Resources – Overview, we intend to build a new drying facility in Carhaix, France, to manufacture powdered milk and fat-enriched demineralized whey. The estimated cost to build the facility is € 90 million (approximately $117 million). We committed to purchase, and Sodiaal and Euroserum committed to sell, 288 million liters of milk per year for ten years, an amount of whey equivalent to 24,000 tons of 70% demineralized pre-concentrated dry whey extract per year for ten years, and 6,000 tons of 70% demineralized whey powder per year, or an equivalent quantity of liquid whey, for ten years, at market based prices at the time of purchase, to satisfy the production needs of the new drying facility. As the cost to build the facility in the next several years and the price of raw milk and whey in the next ten years cannot be predicted with precision, the building cost and purchase commitment of the new drying facility was not included in the table above.
We computed the long-term debt-related interest based on the interest rate as of March 31, 2013.
As of March 31, 2013, our uncertain income tax liability was $506,000. We are unable to reasonably estimate the timing of the effective settlement of this tax position.
Capital Expenditures
Our capital expenditures were $11.4 million and the corresponding cash outflow was $16.4 million for the fiscal year ended March 31, 2013, which mainly represented expenditure for our new headquarters’ renovation and purchase of equipment.
Off-Balance Sheet Arrangements
We do not have off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.
Recent Accounting Pronouncements
In July 2012, the Financial Accounting Standards Board, or FASB, has issued an authoritative pronouncement related to testing indefinite-lived intangible assets, other than goodwill, for impairment. Under the pronouncement, entities testing indefinite-lived intangible assets for impairment would have the option of performing a qualitative assessment before calculating the fair value of the asset. If an entity determines, on the basis of qualitative factors, that the indefinite-lived intangible asset is not more likely than not impaired, a quantitative fair value calculation would not be needed. The amendments are effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012 with early adoption permitted. We do not expect the adoption of this ASU will have a significant effect on our consolidated financial statements.
In February 2013, the FASB issued ASU No. 2013-02, “Reporting Amounts Reclassified Out of Accumulated Other Comprehensive Income”. ASU No. 2013-02 requires companies to provide additional information about the amounts reclassified out of accumulated other comprehensive income by component. In addition, companies are required to present, either on the face of the financial statements or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income. The amendments are effective prospectively for reporting periods beginning after December 15, 2012. This ASU does not change the requirements for reporting net income or other comprehensive income. Because the standard only affects the presentation of comprehensive income and does not affect what is included in comprehensive income, the adoption of this ASU is not expected to have a material effect on our consolidated financial statements.
