Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
There were 19,679,400 shares outstanding of the issuer’s common stock, par value $.0001 per share, as of November 18, 2008.
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
NOTE 1 – BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements of China Shenghuo Pharmaceutical Holdings, Inc., (formerly known as SRKP 8, Inc.) (the “Company” or the “Parent” or the “Group”) were prepared pursuant to the rules and regulations of the United States Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. Management of the Company (“Management”) believes that the following disclosures are adequate to make the information presented not misleading. These condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto included in the Company’s Form 10-KSB for the year ended December 31, 2007, as amended.
These unaudited condensed consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) that, in the opinion of Management, are necessary to present fairly the consolidated financial position and results of operations of the Company for the periods presented. Operating results for the three and nine months ended September 30, 2008 are not necessarily indicative of the results that may be expected for the year ending December 31, 2008.
Translating Financial Statements– The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The functional currency of the operating subsidiaries in the People’s Republic of China (“PRC”) is the Chinese Yuan Renminbi (“CNY”); however, the condensed consolidated financial statements have been expressed in United States Dollars (“USD”). The accompanying condensed consolidated balance sheets have been translated into USD at the exchange rates prevailing at each balance sheet date. The condensed consolidated statements of operations have been translated using the weighted average exchange rates prevailing during the operating periods of each statement.
Restatement of Financial Statements – During August 2008, the Company was informed by its auditing firm that the December 31, 2007 consolidated financial statements needed to be revised to correct certain errors related to accounts and notes receivable and advances to employees. The Audit Committee of the Board of Directors commenced an internal investigation which focused on the reported errors.
As a result, the Company has restated its consolidated balance sheet for December 31, 2007 to correct the errors related to accounts and notes receivable and advances to employees. See Note 10. The errors also affected the realization of the deferred tax asset creating a valuation allowance that was caused by unsettled circumstances that, if unfavorably resolved, would adversely affect future operations and profit levels on a continuing basis in future years.
The effects of the restatement were as follows:
| | | As Previously | | Effect of | | | |
| | | Reported | | Restatement | | As Restated | |
Consolidated Balance Sheet | | | | | | | | | | |
As of December 31, 2007 | | | | | | | | | | |
| Accounts and notes receivable, net | | $ | 9,651,304 | | $ | 916,368 | | $ | 10,567,672 | |
| Employee advances, net | | | 10,147,415 | | | (1,897,609 | ) | | 8,249,806 | |
| Total Current Assets | | | 27,581,623 | | | (981,241 | ) | | 26,600,382 | |
| Deferred Income Taxes | | | 1,593,159 | | | (1,593,159 | ) | | - | |
| TOTAL ASSETS | | | 37,910,118 | | | (2,574,400 | ) | | 35,335,718 | |
| Minority Interest in Net Assets of Subsidiaries | | | 655,962 | | | (176,644 | ) | | 479,318 | |
| Stockholders' Equity: | | | | | | | | | | |
| Retained earnings | | | 6,335,590 | | | (2,296,253 | ) | | 4,039,337 | |
| Accumulated other comprehensive income, | | | | | | | | | | |
| Foreign currency translation | | | 1,031,146 | | | (101,503 | ) | | 929,643 | |
| Total Stockholders' Equity | | | 13,709,654 | | | (2,397,756 | ) | | 11,311,898 | |
| TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY | | | 37,910,118 | | | (2,574,400 | ) | | 35,335,718 | |
NOTE 2 – ORGANIZATION AND NATURE OF OPERATIONS
Nature of Business– The Company and its subsidiaries designs, develops, markets, exports and sells pharmaceutical, nutritional supplements and cosmetic products throughout PRC and abroad. The Company also conducts research and development for third parties as well as for itself using the medicinal herb Panax notoginseng, also known as Sanqi, Sanchi, or Tienchi and sells pharmaceutical, nutritional supplements and cosmetic products that contain this herb, which is grown in two provinces in the PRC. Sales from the cosmetic products represent less than 10% of total Company sales and revenue. The Company does not maintain accounting records by line of business as the Company’s subsidiaries sell products from multiple lines of business and management evaluates each subsidiary as a separate entity.
Organization – The Company was organized under the laws of the State of Delaware on May 24, 2005. On August 31, 2006, the Company consummated a share exchange agreement, as amended (the “Agreement”), with Lan’s Int’l Medicine Investment Co., a Hong Kong corporation, and a shareholder holding 93.75% of the equity interest of Kunming Shenghuo Pharmaceuticals Co., Ltd. (“Shenghuo”) whereby the Company, in exchange for 15,213,000 shares of its common stock, acquired 93.75% of Shenghuo’s shares.
In addition, the Company agreed to cancel 2,036,000 shares of its common stock; issue 1,242,400 shares of its common stock and warrants to purchase 100,000 shares of its common stock (the “Warrants”) for services rendered, and issue 2,000,000 shares for $1,800,000 cash (less costs of $535,304).
There was no written agreement for the services to be performed in connection with the 1,242,400 shares of common stock or the 100,000 warrants. The shares issued for services were valued at $0.90 per share. This value was taken from the value of the shares issued for cash on the same day. In accordance with FAS 123(R), as the fair value of the common shares could more reliably be measured than the fair value of the services, the fair value of the shares was used to measure the transaction. In accordance with EITF 96-18, the measurement date was determined to be the date of the Agreement as there was no contract that specifically outlined the commitment date or the performance date for the shares issued for services. Further, in accordance with the guidance given in EITF 00-18, the shares were expensed on the date of the agreement as all shares vested immediately.
As part of several agreements, the Company agreed to register the 1,242,400 shares of its common stock and the Warrants. The Company also agreed to register the 2,000,000 shares of common stock that were to be issued for cash and the 664,000 shares of common stock that were held by the Company’s shareholders immediately prior to the Agreement.
Because the shares issued by the Company to Shenghuo’s shareholders in the aforementioned transaction represented a controlling interest, the transaction has been accounted for as a recapitalization or reverse merger with Shenghuo being considered the acquirer. The accompanying consolidated financial statements have been restated on a retroactive basis to present the capital structure of Shenghuo as though it were the reporting entity.
In October 1995, Shenghuo was formed under the laws of the PRC and subsequently acquired an 80% interest in both Kunming Shenghuo Medicine Co., Ltd. (“Medicine”) and Kunming Pharmaceutical Importation and Exportation Co., Ltd. (“Import/Export”), and a 98.18% interest in Kunming Shenghuo Cosmetics Co., Ltd. (“Cosmetic”). All of these entities were also formed in and operate within the PRC. Stockholder’s equity was represented by share capital and no shares were outstanding prior to August 31, 2006. Share capital of Shenghuo prior to the consummation of the Agreement was $2,660,760. On August 30, 2006, the minority shareholders of Medicine agreed to transfer 19% of their 20% interest to Shenghuo for $249,800. Also on August 30, 2006, the minority shareholders of Import/Export agreed to transfer 19% of their 20% interest to Shenghuo for $24,980. Subsequent to these transfers, Shenghuo owns 99% of the equity interests in Medicine and Import/Export.
In September 2006, Shenghuo, which is the 93.75%-owned subsidiary of the Company, formed Kunming Beisheng Science and Technology Development Company, Ltd. (“Beisheng”), under the laws of the PRC as its partially owned subsidiary for the purpose of doing research and development on bio-tech products, health-care products and cosmetics, the importation and exportation of medicines and equipment and the development of pharmaceutical technologies. Upon formation, Shenghuo owned 70% of Beishing. In August 2007, Shenghuo established a new subsidiary named Pingbian Shenghuo Nanyao Development Co., LTD. (“Pingbian Shenghuo”). Pingbian Shenghuo was organized under the laws of the PRC, has a registered capital of RMB 1,000,000 and Shenghuo holds 100% of the equity interest of Pingbian Shenghuo. The scope of operation of Pingbian Shenghuo is to produce and refine the raw materials, such as Sanchi, that are needed to produce our products. There were no material operations for Beisheng or Pingbian Shenghuo for the nine months ended September 30, 2008.
NOTE 3 – SELECTED SIGNIFICANT ACCOUNTING POLICIES
Cash and Cash Equivalents– The Company’s cash and cash equivalents are maintained in bank deposit accounts. The Company has not experienced any losses with respect to these deposits. Cash and cash equivalents include interest bearing and non-interest bearing bank deposits, money market accounts, and short-term certificates of deposit with original maturities of three months or less. The Company did not enter into any hedge contracts during any of the periods presented.
Employee Advances– Employee advances are presented net of an estimated allowance for doubtful advances. As time passes from when advances are made to employees for travel and related expenses, the Company will create an allowance for these older receivables as the likelihood of collection from each particular employee decreases as their respective advances age. Long-term employee advances are not expected to be realized in the current operating period.
Advances to Suppliers and Advances from Customers– As is customary in the PRC, the Company will often make advanced payments to suppliers for materials, which may include provisions that set the purchase price and delivery date of raw materials, or receive advance payments from customers.
Basic and Diluted Earnings(Loss) per Share - Basic and diluted earnings (loss) per share are calculated by dividing net earnings attributable to common stockholders by the weighted-average number of shares of common stock outstanding during the year. Diluted earnings per share are calculated to give effect to potentially issuable dilutive common shares. Potentially dilutive securities as of September 30, 2008 are comprised of warrants to purchase 40,000 shares of common stock at an exercise price of $4.20 and warrants to purchase 6,000 shares of common stock at an exercise price of $3.50. The effect of these warrants is excluded from the computation as of September 30, 2008 as the effect is antidilutive due to the exercise price exceeding the market price. Dilutive securities as of September 30, 2007 are comprised of warrants to purchase 100,000 shares of common stock at an exercise price of $2.50 per share., warrants to purchase 40,000 shares of common stock at an exercise price of $4.20 and warrants to purchase 6,000 shares of common stock at an exercise price of $3.50.
Comprehensive Income (Loss)– Other comprehensive income (loss) presented in the condensed consolidated financial statements consists of cumulative foreign currency translation adjustments.
Advertising Expense – The Company expenses advertising costs as incurred. Advertising costs for the nine months ended September 30, 2008 and 2007 were $1,442,095 and $22,538, respectively.
Business Condition and Liquidity– Although the Company has a history of positive income, working capital and retained earnings, the Company incurred losses during the nine months ended September 30, 2008 of $2,235,843 which has resulted in a use of cash from operations of $232,648. The Company has expended significant efforts to expand its revenues by assisting its sales representatives and increasing its marketing in fiscal 2008. In addition, the Company has been forced to give significant attention to the internal investigation conducted by the Audit Committee and may have to address class action lawsuits that have been commenced due to the Company’s restatement discussed above and the related delay in filing its Form 10-Q for the second quarter of 2008 with the Securities and Exchange Commission. The Company believes that it will remedy these matters and will be able to return to its normal operations in the near future, including being in full compliance with the Securities and Exchange Commission filing requirements and the rules of the NYSE Alternext US LLC (formerly the American Stock Exchange) but the Company can not give any assurance that this will be the case.
Recently Enacted Accounting Standards - In September 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. In February 2008, the FASB issued FASB Staff Position (FSP FIN) No. 157-2 which extended the effective date for certain nonfinancial assets and nonfinancial liabilities to fiscal years beginning after November 15, 2008. The adoption of the portions of SFAS No. 157 that were not postponed by (FSP FIN) No. 157-2 did not have a material impact on our consolidated financial statements. The Company does not expect the adoption of the postponed portions of SFAS No. 157 to have a material impact on our consolidated financial statements.
In December 2007, the FASB issued SFAS No. 141(R), Business Combinations, and SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements. SFAS No. 141(R) requires an acquirer to measure the identifiable assets acquired, the liabilities assumed and any non-controlling interest in the acquiree at their fair values on the acquisition date, with goodwill being the excess value over the net identifiable assets acquired. SFAS No. 160 clarifies that a non-controlling interest in a subsidiary should be reported as equity in the consolidated financial statements, consolidated net income shall be adjusted to include the net income attributed to the non-controlling interest and consolidated comprehensive income shall be adjusted to include the comprehensive income attributed to the non-controlling interest. The calculation of earnings per share will continue to be based on income amounts attributable to the Parent. SFAS No. 141(R) and SFAS No. 160 are effective for financial statements issued for fiscal years beginning after December 15, 2008. Early adoption is prohibited. SFAS No. 141(R) and SFAS No. 160 are not expected to have a material impact on our results of operations or financial position.
On January 1, 2008, we adopted SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities – Including an Amendment of FASB Statement No. 115” (“FAS 159”). FAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. Entities that elect the fair value option will report unrealized gains and losses in earnings at each subsequent reporting date. The fair value option may be elected on an instrument-by-instrument basis, with few exceptions. FAS 159 also establishes presentation and disclosure requirements to facilitate comparisons between companies that choose different measurement attributes for similar assets and liabilities. The adoption of FAS 159 did not have an effect on our financial condition or results of operations as we did not elect this fair value option, nor is it expected to have a material impact on future periods as the election of this option for our financial instruments is expected to be limited.
In March 2008, the FASB issued SFAS No. 161, "Disclosures about Derivative Instruments and Hedging Activities", an amendment of SFAS No. 133. SFAS 161 applies to all derivative instruments and non-derivative instruments that are designated and qualify as hedging instruments pursuant to paragraphs 37 and 42 of SFAS 133 and related hedged items accounted for under SFAS 133. SFAS 161 requires entities to provide greater transparency through additional disclosures about how and why an entity uses derivative instruments, how derivative instruments and related hedged items are accounted for under SFAS 133 and its related interpretations, and how derivative instruments and related hedged items affect an entity's financial position, results of operations, and cash flows. SFAS 161 is effective as of the beginning of an entity's first fiscal year that begins after November 15, 2008. The Company does not expect SFAS 161 to have a material impact on its results of operations or financial position.
In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles.” SFAS 162 will provide framework for selecting accounting principles to be used in preparing financial statements that are presented in conformity with U.S. generally accepted accounting principles (GAAP) for nongovernmental entities. SFAS 162 will be effective 60 days following the Securities and Exchange Commission’s approval of the Public Company Accounting Oversight Board (PCAOB) amendments to AU Section 411. The Company does not expect the adoption of SFAS 162 will have a material impact on its financial condition or results of operation.
NOTE 4 – INVENTORY
Inventory is stated at weighted average cost and consisted of the following:
| | | September 30, | | December 31, | |
| | | 2008 | | 2007 | |
| | | | | | |
| Raw materials | | $ | 1,146,836 | | $ | 871,425 | |
| Work-in-process | | | 1,300,734 | | | 1,797,379 | |
| Finished goods | | | 709,358 | | | 786,235 | |
| Product on consignment | | | 1,034,085 | | | 806,513 | |
| Total Inventory | | | 4,191,013 | | | 4,261,552 | |
| Less: Provision for obsolescence | | | (130,088 | ) | | (136,359 | ) |
| Net Inventory | | $ | 4,060,925 | | $ | 4,125,193 | |
NOTE 5 – RELATED PARTY TRANSACTIONS
At September 30, 2008 and December 31, 2007, the Company had payables due to related parties in the amount of $236,632 and $94,939, respectively. These amounts are due on demand and do not accrue interest.
NOTE 6 – INCOME TAXES
The Company is not subject to any income taxes in the United States, but is subject to corporate income tax in the PRC. The Parent is located in a special region and has a 15% corporate income tax rate and has been granted a “tax holiday” during which it will pay no income taxes through December 31, 2008. On March 16, 2007, the National People’s Congress of China passed the new Enterprise Income Tax Law, (“EIT Law”), and on December 6, 2007, the State Council of China issued the Implementation Regulations for the EIT Law which took effect on January 1, 2008. The EIT Law and Implementation Regulations Rules impose a unified EIT of 25% on all domestic-invested enterprises and Foreign Invested Entities, or FIEs, unless they qualify under certain limited exceptions.
As a result of the above change in the income tax laws, the Parent will continue to have a 15% rate with a tax holiday for 2008 and will have a favorable rate of 50% of the tax rates in effect during fiscal 2009 through 2011 as determined by the PRC government and the regional tax authorities. Medicine, Import/Export, Cosmetics, Beisheng and Pingbian Shenghuo are taxed at the new 25% rate effective January 1, 2008.
The Company recognizes deferred tax assets and liabilities for future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and the respective tax bases and any tax credit carry forwards available. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company has established a valuation allowance for all deferred income tax assets of Cosmetics and Medicine due to the uncertainty of their realization. Income taxes payable are included in taxes and related payables on the accompanying balance sheets. Income taxes are not required to be paid to the PRC until after the end of the Company’s fiscal year.
Undistributed earnings of the Company’s foreign subsidiaries since acquisition amounted to approximately $3.2 million at September 30, 2008. Those earnings, as well as the investment in the subsidiaries of approximately $6.1 million are considered to be indefinitely reinvested and, accordingly, no U.S. federal and state income taxes have been provided thereon. Upon distribution of those earnings in the form of dividends or otherwise, the Company would be subject to both U.S. income taxes (subject to an adjustment for foreign tax credits) and withholding taxes payable to the PRC. The Company has U.S. net operating loss carryforwards of approximately $2.4 million that, if unused, begin to expire in 2026. Determination of the amount of unrecognized deferred U.S. income tax liability is not practical because of the complexities associated with its hypothetical calculation; however, unrecognized foreign tax credits may be available to reduce a portion of the U.S. tax liability.
NOTE 7 – NOTES PAYABLE
The Company’s notes payable consist of short and long-term debt that is payable to banks, governmental financial bureaus, municipalities and a company.
The following schedule summarizes the Company’s debt obligations and respective balances:
| | | September 30, | | December 31, | |
| | | 2008 | | 2007 | |
| Short-term note payable to a municipality, interest at 1.8%, due on demand, unsecured | | $ | 72,938 | | $ | 68,360 | |
| Short-term note payable to a finance bureau, interest at 4.5%, matured January 2003, unsecured | | | 75,173 | | | 70,455 | |
| Short-term note payable to a bank, interest at 7.47%, matures April 2009, secured by property | | | 3,646,920 | | | - | |
| Short-term note payable to a bank, interest at 6.57%, matures November 2008, secured by property | | | 729,384 | | | - | |
| Short-term note payable to a bank, interest at 6.12%, matured March 2008, secured by land use rights | | | - | | | 1,367,222 | |
| Short-term note payable to a bank, interest at 6.39%, matures April 2009, secured by property | | | - | | | 3,418,056 | |
| Short-term note payable to a government development zone interest at 2.43%, matured November 2007, secured by property | | | 218,815 | | | 410,167 | |
| Total short-term notes payable | | $ | 4,743,230 | | $ | 5,334,260 | |
| | | September 30, | | December 31, | |
| | | 2008 | | 2007 | |
| Long-term note payable to a bank, interest at 7.72%, matures August 2009, secured by shareholder | | $ | 6,710,333 | | $ | 6,836,111 | |
| Long-term note payable to a bank, interest at 8.316%, matures April, 2010, secured by property | | | 1,458,768 | | | - | |
| Long-term note payable to a bank, interest at 6.57%, matures March 2010, secured by property | | | 2,917,535 | | | 4,101,667 | |
| Total long-term debt | | | 11,086,636 | | | 10,937,778 | |
| Less current maturities of long-term debt | | | 8,460,854 | | | 4,101,667 | |
| Long-term notes payable, net of current portion | | $ | 2,625,782 | | $ | 6,836,111 | |
| | | | | | | | |
| Past due notes payable | | $ | 293,988 | | $ | 480,622 | |
NOTE 8 – COMMITMENTS AND CONTINGENCIES
Economic environment– Since all of the Company’s operations are conducted in the PRC, the Company is subject to special considerations and significant risks not typically associated with companies operating in the United States of America. These risks include, among others, the political, economic and legal environments and foreign currency exchange rate fluctuations. The Company’s operational results may be adversely affected by changes in the political and social conditions in the PRC, and by changes in governmental policies with respect to medical reforms, environmental reforms and other laws and regulations, anti-inflationary measures, currency conversion and remittance abroad, and rates and methods of taxation, among other things. In addition, all of the Company’s revenue is denominated in the PRC’s currency CNY, which must be converted into other currencies before remittance out of the PRC. Both the conversion of CNY into foreign currencies and the remittance of foreign currencies abroad require approval of the PRC government. Due to changes in current worldwide economic conditions, the Company’s ability to raise capital or borrow funds may be limited.
Dependence on a single raw material– The primary ingredient in all of the Company’s products is Sanchi, an herb grown in two provinces of the PRC. The Company relies on its in-house purchasing department to acquire sufficient Sanchi at reasonable prices and may on occasion make advance payments to suppliers that include provisions setting the purchase price and delivery date. However, the Company is not reliant on a single source or supplier in order to obtain the Sanchi.
NOTE 9 – STOCKHOLDERS EQUITY
Statutory Reserves - The Company is required to transfer a certain portion of its net profits to Statutory Reserves, as determined under PRC accounting regulations, from net income to both the surplus reserve fund and the public welfare fund. Accordingly, the Company has recorded an aggregate of $147,023 in the Statutory Reserves account in the equity section of the accompanying balance sheet as of September 30, 2008 and December 31, 2007.
The following summarizes the outstanding warrants as of September 30, 2008:
| | | | | Weighted-Average | | | |
Exercise | | Warrants | | Remaining Contractual | | Number | |
Price | | Outstanding | | Life (Years) | | Exercisable | |
| $ 3.50 | | | 6,000 | | | 4.0 | | | 6,000 | |
| $ 4.20 | | | 40,000 | | | 3.8 | | | 40,000 | |
| | | | 46,000 | | | | | | 46,000 | |
NOTE 10 – SUBSEQUENT EVENTS
As a result of the independent investigation by the Audit Committee of the Board of Directors of the errors in the accounting for accounts and notes receivable and employee advances as discussed in Note 1, the Company failed to timely file its Quarterly Report on Form 10-Q for the quarter ended June 30, 2008 with the Securities and Exchange Commission. On August 21, 2008 the Company received a deficiency letter from the American Stock Exchange (now the NYSE Alternext US LLC) (the “Exchange”) stating that the Company was no longer in compliance with their listing standards and suspending trading of the Company’s common stock on the Exchange. In order to maintain its Exchange listing, the Company had to submit a plan by September 12, 2008, outlining actions the Company had taken, or will take, to regain compliance with the continued listing standards of the Exchange, including submission of all required Securities and Exchange Commission filings, by no later than November 19, 2008. The Plan was timely submitted by the Company and accepted by the Exchange on November 5, 2008. If the Company did not make adequate progress and complete the actions outlined in the Plan by November 19, 2008, the Exchange would have initiated delisting proceedings against the Company.
To date, and as required by the Plan, the Company has filed an amendment to its Annual Report on Form 10-KSB for the fiscal year ended December 31, 2007 and an amendment to its Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 2008 to reflect the correction of the accounting errors in those periods, and it has filed its Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 2008. The Company believes that the filing on November 19, 2008 of this Quarterly Report on Form 10-Q for the fiscal quarter ended September 30, 2008 completes the Company’s actions required under the Plan. The Company is awaiting confirmation from the Exchange that it has regained compliance with the Exchange’s listing standards. The Company will request the Exchange to permit its common stock to resume trading as soon as possible. However, the Company can provide no assurances that it has regained compliance with the Exchange’s continued listing requirements, and its failure to do so could result in the suspension or delisting of the Company’s common stock from the Exchange.
Class Action Lawsuits – Putative class action lawsuits have been asserted against the Company and certain of its officers and directors in the United States District Court for the Southern District of New York (the “Court”). Only one complaint, Beni Varghese v. China Shenghuo Pharmaceutical Holdings, Inc., Gui Hua Lan, Qiong Hua Gao, Gene Michael Bennett, And Yunhong Guan, Index No. 08 CIV. 7422 (the “Varghese Action”) has been served on the Company thus far.
The complaints allege, among other things, that certain of the Company’s SEC filings and other public statements contained false and misleading statements which resulted in damages to the plaintiffs and the members of the purported class when they purchased the Company’s securities. On the basis of those allegations, plaintiffs in each of the actions seek an unspecified amount of damages under Sections 10(b) and 20(a) of the Exchange Act.
On October 20, 2008, the Company and counsel to the plaintiff in the Varghese Action filed a stipulation with the Court in which the parties agreed that the plaintiff may file a consolidated, amended complaint within 60 days after the entry of an order appointing and approving lead counsel, and that the Company’s time to answer that complaint is extended until 60 days after the filing of the consolidated complaint.
The Company believes the allegations in the complaint are without merit, and intends to vigorously defend the lawsuits. The Company does not believe that the outcome of these suits will have a material, adverse effect on the Company.
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Forward-Looking Statements
The following discussion of our financial condition and results of operations should be read in conjunction with our financial statements and the related notes, and the other financial information included in this quarterly report.
This filing contains forward-looking statements. The words “anticipated,” “believe,” “expect, “plan,” “intend,” “seek,” “estimate,” “project,” “could,” “may,” and similar expressions are intended to identify forward-looking statements. These statements include, among others, information regarding future operations, future capital expenditures, and future net cash flow. Such statements reflect our management’s current views with respect to future events and financial performance and involve risks and uncertainties, including, without limitation, dependence on a single major product, reliance on a small number of suppliers of Sanchi, the possible removal of Xuesaitong Soft Capsules from China’s Insurance Catalogue, the possible need for and inability to raise additional capital, dependence on a few major customers, general economic and business conditions, changes in foreign, political, social, and economic conditions, regulatory initiatives and compliance with governmental regulations, the ability to achieve further market penetration and additional customers, and various other matters, many of which are beyond our control. Should one or more of these risks or uncertainties occur, or should underlying assumptions prove to be incorrect, actual results may vary materially and adversely from those anticipated, believed, estimated or otherwise indicated. Consequently, all of the forward-looking statements made in this quarterly report are qualified by these cautionary statements and there can be no assurance of the actual results or developments. Refer to the sections entitled “Risk Factors” in our Annual Report on Form 10-KSB for the year ended December 31, 2007, as amended, and “Risk Factors” and “Special Note Regarding Forward-Looking Statements” contained in this quarterly report on Form 10-Q.
Overview
We are primarily engaged in the research, development, manufacture, and marketing of pharmaceutical, nutritional supplement and cosmetic products. Almost all of our products are derived from the medicinal herb Panax notoginseng, also known as Sanqi, Sanchi or Tienchi. Panax notoginseng is the root of a greyish-brown or greyish-yellow plant that only grows in a few geographic locations on Earth, among which is the Yunnan Province in southwest China, where we are located; this province accounts for 90% of the total global production. The main roots of Panax notoginseng are cylindrical shaped and are most commonly one to six centimeters long and one to four centimeters in diameter. Panax notoginseng saponins (PNS), the active ingredients in Panax notoginseng, are extracted from the plant using high-tech equipment and in accord with Good Manufacturing Practice (GMP) standards. Our main product, Xuesaitong Soft Capsules, accounted for more than 77% and 70% of our sales for the three and nine months ended September 30, 2008.
We earn revenues mainly from the production and sale of our products and external processing. We hope to increase profits as a result of making new products and increasing sales, since the sale of products is our main source for generating cash. Our business involves a significant degree of risk as a result of the opportunities and challenges we face in selling our products. We have traditionally focused on research and development of products serving cardiovascular and cerebrovascular disease, peptic ulcer disease and health products markets, but we intend to devote additional resources to research and development and to continue to evaluate and develop additional product candidates to expand our pipeline where we perceive an unmet need and commercial potential, and to improve existing products to enhance their efficacy.
With intense price competition among many similar or identical products in the industry, we believe that building brand equity is the primary means to generate and sustain profitable growth in the future. Our brand strategy is centered on “Lixuwang”—the brand under which most of our products are sold. We believe that our relationships within the Chinese pharmaceutical industry are key to building brand equity, and we believe we can benefit from developing and maintaining relationships with professionals within the industry, especially physicians and hospitals.
Xuesaitong Soft Capsules, which are subject to wholesale and retail price controls by the Chinese government, are primarily sold in China, but the product is also sold in various developing countries, including Malaysia, Indonesia and Kyrgyzstan. Sales of the product in China are regulated by the State Food and Drug Administration of the People’s Republic of China as a prescription drug and therefore must be sold to consumers through hospital pharmacies and cannot be advertised, thus limiting the ability of the Company to market the brand. During the first nine months of 2008, less than 5% of our sales of Xuesaitong Soft Capsules were made to military hospitals through China’s military procurement system, while over 95% of sales were made to non-military hospitals through distributors. Our three largest distributors are Yunnan Province Pharmaceutical, LTD., Beijing Ai’xin Weiye Medicine, LTD, and Nanyang Jikang Medicine LTD, each of which accounted for between 5% and 7% of our sales for the three and nine months ended September 30, 2008.
Our marketing team maintains sales offices or agents in approximately 20 provinces throughout China. The sales network covers approximately 186 cities and is staffed by approximately 410 sales representatives. We intend to grow our internal marketing and sales function and increase our relationships with other national distributors to expand the distribution and presence of our non-prescription brands and cosmetics.
We hope to further expand sales beyond China into other countries where our products could be affordable treatment options. We intend to focus on the expansion of our cosmetics product line and devote additional marketing and sales resources to that end with the aim that our cosmetics products will account for a larger percentage of our revenue in the future.
We believe that among the most important economic or industry-wide factors relevant to our growth in the short term are reform of the medical system in China and the adjustment of medicine prices, which will affect the sale of our main product, Xuesaitong Soft Capsules, in hospitals. In order to increase long-term growth, we applied for the designation of Xuesaitong Soft Capsules as a medicine with “good quality worthy of high price,” which we received in February 2007. We believe this designation may help prevent future price reductions and possibly offset revenue decreases in case of declining future sales. Currently, the Chinese government supports the medical system in urban and rural communities. We hope to stabilize the sales channel into hospitals and widen the reach of sales in urban and rural communities at the same time. We believe that large increases in medicine sales, even at an average lower price, will ensure the growth of general medical sales over the next few years.
We do face certain challenges and risks, including our relatively high debt ratio, which is one of our main risks. If we fail to raise capital in overseas markets, we will encounter great difficulties as a result of the shortage of working capital. There is potential for growth in production and sales, due to the growth of new products and expansion of new channels into urban and rural communities. However, it will be uncertain which of our new products will pass the applicable tests and get clinical approval without difficulty because of the uncertainty of test results and clinical approvals, which relates only to our new products. Over the last three years, the price of the main raw material we use - sanchi - has stabilized and is declining slightly. We will benefit from this trend if it continues.
Recent Events
During August 2008, the Company was informed by its auditing firm that the December 31, 2007 and March 31, 2008 consolidated financial statements needed to be revised to correct certain errors related to accounts and notes receivable and advances to employees. The Audit Committee of the Board of Directors (the “Audit Committee”) commenced an internal investigation which focused on the reported errors.
On August 22, 2008 and September 12, 2008, the Company issued Current Reports on Form 8-K and Form 8-K/A, respectively, announcing a pending internal investigation being conducted by the Audit Committee based on preliminary information received from Hansen, Barnett & Maxwell, P.C. (“HBM”), the independent registered public accounting firm of the Company, regarding errors in the accounting for certain sales representative commission advances and trade receivables, the Company’s internal controls, the Company’s personnel involved and related matters. The errors concern cash transaction journal entries in which uncollected trade accounts and notes receivables were credited (i.e., deemed paid) and corresponding cash debits (i.e., cash deemed received) were recorded, and in connection therewith, corresponding cash credits (deemed decreases) and debits (deemed increases) to other receivables from sales representatives were recorded. The effect of the incorrect entries was to improperly reflect the aging of the Company’s trade accounts and notes receivables and to understate the Company’s bad debt allowance. These errors resulted in the understatement of general and administrative expenses (the line item that includes bad debt allowance) and the resultant overstatement of net income and earnings per share. The errors also resulted in an overstatement of the deferred tax asset, which could adversely affect future operations and profit levels on a continuing basis.
As a result of the investigation by the Audit Committee of the errors in the accounting for accounts receivable and employee advances, the Company failed to timely file its Quarterly report on Form 10-Q for the quarter ended June 30, 2008 with the Securities and Exchange Commission. On August 21, 2008, the Company received a deficiency letter from the American Stock Exchange (now the NYSE Alternext US LLC) (the “Exchange”) stating that the Company was no longer in compliance with their listing standards, and suspending trading of the Company’s common stock on the Exchange. In order to maintain its Exchange listing, the Company had to submit a plan by September 12, 2008, outlining actions the Company had taken, or will take, to regain compliance with the continued listing standards of the Exchange, including submission of all required Securities and Exchange Commission filings, by no later than November 19, 2008. The Plan was timely submitted by the Company and the Exchange accepted the Plan on November 5, 2008. If the Company did not make adequate progress and complete the actions outlined in the Plan by November 19, 2008, the Exchange would have initiated delisting proceedings against the Company.
On September 4, 2008, the Audit Committee engaged independent counsel to assist in the investigation and to ascertain whether these errors were attributable to inadequate training and supervision and lack of familiarity with GAAP on the part of the Company’s financial staff, or whether improper conduct contributed to recording the incorrect journal entries.
In early October 2008, HBM concluded that it had not identified any additional errors or concerns regarding the Company’s journal entries other than those outlined above. On October 8, 2008 and October 10, 2008, the Audit Committee met with its independent legal counsel and HBM, and following these meetings, the Audit Committee concluded that the accounting errors in the Company’s journal entries were made at the direction of two supervisors in the Company’s financial department (who have been dismissed), in an incorrect attempt by such supervisors to follow the Company’s policy that regional managers and sales representatives should be responsible for the collection of trade receivables, as well as to simplify the financial department’s process of generating related data regarding trade receivables and sales representative advances. The Audit Committee found no evidence to suggest that the accounting errors were made at the direction of, or with the knowledge or involvement of, the Company’s executive officers and management, and the Audit Committee determined that the actions of the two supervisors were not intended to manipulate the Company’s reported results or financial statements.
The Company has restated its financial statements for the fiscal year ended December 31, 2007 and the fiscal quarter ended March 31, 2008 to correct the accounting errors. The fiscal year ended December 31, 2007 and the fiscal quarter ended March 31, 2008 were the only periods found to have been impacted by the accounting errors. HBM has advised that there would be no need for the Company to restate its previously filed financial statements for the interim periods contained in the Company’s Forms 10-QSB for the fiscal quarters ended June 30, 2007 and September 30, 2007 (as originally indicated by HBM) and that those statements may be relied upon. For further information regarding the effect of the restatement of the financial statements for the fiscal year ended December 31, 2007 and the fiscal quarter ended March 31, 2008, see the Company’s Form 10-KSB/A and Form 10-Q/A filed with the SEC on November 14, 2008.
To date, and as required by the Plan, the Company has filed an amendment to its Annual Report on Form 10-KSB for the fiscal year ended December 31, 2007 and an amendment to its Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 2008 to reflect the correction of the accounting errors in those periods, and it has filed its Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 2008. The Company believes that the filing on November 19, 2008 of this Quarterly Report on Form 10-Q for the fiscal quarter ended September 30, 2008 completes the Company’s actions required under the Plan. The Company is awaiting confirmation from the Exchange that it has regained compliance with the Exchange’s listing standards. The Company will request the Exchange to permit its common stock to resume trading as soon as possible. However, the Company can provide no assurances that it has regained compliance with the Exchange’s continued listing requirements, and its failure to do so could result in the suspension or delisting of the Company’s common stock from the Exchange.
Critical Accounting Policies and Estimates
The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States of America, or U.S. GAAP. We believe the following are the critical accounting policies that impact the financial statements, some of which are based on management’s best estimates available at the time of preparation. Actual experience may differ from these estimates.
Basis of Presentation and Translating Financial Statements - The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The functional currency of the operating subsidiaries in the People’s Republic of China (“PRC”) is the Chinese Yuan Renminbi (“CNY”); however, the condensed consolidated financial statements have been expressed in United States Dollars (“USD”). The accompanying condensed consolidated balance sheets have been translated into USD at the exchange rates prevailing at each balance sheet date. The consolidated statements of operations have been translated using the weighted average exchange rates prevailing during the operating periods of each statement.
Cash and Cash Equivalents - Our cash and cash equivalents are maintained in bank deposit accounts. We have not experienced any losses with respect to these deposits. Cash and cash equivalents include interest bearing and non-interest bearing bank deposits, money market accounts and short-term certificates of deposit with original maturities of three months or less. We do not have any restricted cash as of September 30, 2008. We did not enter into any hedge contracts during any of the periods presented.
Accounts Receivable and Allowance for Doubtful Accounts - Trade receivables and employee advances are carried at original invoiced amounts less an allowance for doubtful accounts. An allowance for uncollectible accounts receivable is established by charges to operations for amounts required to maintain an adequate allowance, in management’s judgment, to cover anticipated losses from customer accounts and sales returns. Such accounts are charged to the allowance when collection appears doubtful. Any subsequent recoveries are credited to the allowance account. Employee advances consist of business advances to employees for travel and related expenses and various prepaid expenses mainly for market development. As time passes from when advances are made to employees for travel and related expenses, we will create an allowance for these older receivables as the likelihood of collection from each particular employee decreases as their respective advances age. We believe that the allowance for doubtful accounts is consistent with industry standards in the PRC based on the products that are being sold.
Advances to Suppliers and Advances from Customers - As is customary in the PRC, we will often make advanced payments to suppliers for materials, which may include provisions that set the purchase price and delivery date of raw materials, or receive advance payments from customers.
Advertising Expense - We expense advertising costs as incurred.
Research and Development Expense - We expense research and development expenses as incurred.
Basic and Diluted Earnings (Loss) per Share - Basic and diluted earnings (loss) per share are calculated by dividing net earnings attributable to common stockholders by the weighted-average number of shares of common stock outstanding during the year. Diluted earnings per share are calculated to give effect to potentially issuable dilutive common shares. Potentially dilutive securities as of September 30, 2008 are comprised of warrants to purchase 40,000 shares of common stock at an exercise price of $4.20 and warrants to purchase 6,000 shares of common stock at an exercise price of $3.50. The effect of these warrants is excluded as the effect is antidilutive due to the exercise price exceeding the market price. Dilutive securities as of September 30, 2007 are comprised of warrants to purchase 100,000 shares of common stock at an exercise price of $2.50 per share, warrants to purchase 40,000 shares of common stock at an exercise price of $4.20 and warrants to purchase 6,000 shares of common stock at an exercise price of $3.50.
Comprehensive Income (Loss) - Other comprehensive income (loss) presented in the consolidated financial statements consists of cumulative foreign currency translation adjustments.
Recently Adopted Accounting Standards - In September 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. In February 2008, the FASB issued FASB Staff Position (FSP FIN) No. 157-2 which extended the effective date for certain nonfinancial assets and nonfinancial liabilities to fiscal years beginning after November 15, 2008. The adoption of the portions of SFAS No. 157 that were not postponed by (FSP FIN) No. 157-2 did not have a material impact on our consolidated financial statements. The Company does not expect the adoption of the postponed portions of SFAS No. 157 to have a material impact on our consolidated financial statements.
In December 2007, the FASB issued SFAS No. 141(R), Business Combinations, and SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements. SFAS No. 141(R) requires an acquirer to measure the identifiable assets acquired, the liabilities assumed and any non-controlling interest in the acquiree at their fair values on the acquisition date, with goodwill being the excess value over the net identifiable assets acquired. SFAS No. 160 clarifies that a non-controlling interest in a subsidiary should be reported as equity in the consolidated financial statements, consolidated net income shall be adjusted to include the net income attributed to the non-controlling interest and consolidated comprehensive income shall be adjusted to include the comprehensive income attributed to the non-controlling interest. The calculation of earnings per share will continue to be based on income amounts attributable to the Parent. SFAS No. 141(R) and SFAS No. 160 are effective for financial statements issued for fiscal years beginning after December 15, 2008. Early adoption is prohibited. SFAS No. 141(R) and SFAS No. 160 are not expected to have a material impact on our results of operations or financial position.
On January 1, 2008, we adopted SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of FASB Statement No. 115” (“FAS 159”). FAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. Entities that elect the fair value option will report unrealized gains and losses in earnings at each subsequent reporting date. The fair value option may be elected on an instrument-by-instrument basis, with few exceptions. FAS 159 also establishes presentation and disclosure requirements to facilitate comparisons between companies that choose different measurement attributes for similar assets and liabilities. The adoption of FAS 159 did not have an effect on our financial condition or results of operations as we did not elect this fair value option, nor is it expected to have a material impact on future periods as the election of this option for our financial instruments is expected to be limited.
In March 2008, the FASB issued SFAS No. 161, "Disclosures about Derivative Instruments and Hedging Activities", an amendment of SFAS No. 133. SFAS 161 applies to all derivative instruments and non-derivative instruments that are designated and qualify as hedging instruments pursuant to paragraphs 37 and 42 of SFAS 133 and related hedged items accounted for under SFAS 133. SFAS 161 requires entities to provide greater transparency through additional disclosures about how and why an entity uses derivative instruments, how derivative instruments and related hedged items are accounted for under SFAS 133 and its related interpretations, and how derivative instruments and related hedged items affect an entity's financial position, results of operations, and cash flows. SFAS 161 is effective as of the beginning of an entity's first fiscal year that begins after November 15, 2008. The Company does not expect SFAS 161 to have a material impact on its results of operations or financial position.
In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles.” SFAS 162 will provide the framework for selecting accounting principles to be used in preparing financial statements that are presented in conformity with U.S. generally accepted accounting principles (GAAP) for nongovernmental entities. SFAS 162 will be effective 60 days following the Securities and Exchange Commission’s approval of the Public Company Accounting Oversight Board (PCAOB) amendments to AU Section 411. The Company does not expect the adoption of SFAS 162 to have a material impact on its financial condition or results of operation.
Results of Operations
Three Months Ended September 30, 2008 and 2007
The following table sets forth our statements of operations for the three months ended September 30, 2008 and 2007 in U.S. dollars (unaudited):
| | | For the three months | | Change | | Variance | |
| | | ended September 30, | | | | | |
| | | 2008 | | 2007 | | | | | |
| | | (in thousands, except earnings per share and share amounts) | |
| | | | | | | | | | |
Sale of Products | | $ | 7,281 | | $ | 4,202 | | $ | 3,079 | | | 73.27 | % |
Cost of Products Sold | | | 1,974 | | | 1,040 | | | 934 | | | 89.81 | % |
Gross profit | | | 5,307 | | | 3,162 | | | 2,145 | | | 67.84 | % |
| | | | | | | | | | | | | | |
Operating Expenses: | | | | | | | | | | | | | |
| Selling expenses | | | 2,989 | | | 1,546 | | | 1,443 | | | 93.34 | % |
| General and administrative expenses | | | 1,820 | | | 341 | | | 1,479 | | | 434 | % |
| Research and development expenses | | | 66 | | | 5 | | | 61 | | | 1,220 | % |
Total Operating Expenses | | | 4,875 | | | 1,892 | | | 2,983 | | | 158 | % |
| | | | | | | | | | | | | | |
Income (Loss) from operations | | | 432 | | | 1,270 | | | (838 | ) | | -65.98 | % |
| | | | | | | | | | | | | | |
Other Income (expenses): | | | | | | | | | | | | | |
| Interest income | | | 1 | | | 5 | | | (4 | ) | | -80.00 | % |
| Non-operating income | | | 5 | | | 0 | | | 5 | | | N/A | |
| Interest expense | | | (272 | ) | | (275 | ) | | 3 | | | -1.09 | % |
| Non-operating expenses | | | 0 | | | (0 | ) | | 0 | | | N/A | |
Net Other Income (Expense) | | | (266 | ) | | (270 | ) | | 4 | | | -1.48 | % |
| | | | | | | | | | | | | | |
Income (Loss) Before Income Taxes | | | 166 | | | 1,000 | | | (834 | ) | | -83.40 | % |
| Benefit from (provision for) income taxes | | | (4 | ) | | (87 | ) | | 83 | | | -95.40 | % |
| Minority interest in income of subsidiaries | | | (8 | ) | | (45 | ) | | 37 | | | -82.22 | % |
Net Income (Loss) | | | 154 | | | 868 | | | (714 | ) | | -82.26 | % |
| Foreign currency translation adjustments | | | 54 | | | 174 | | | (120 | ) | | -68.97 | % |
Comprehensive Income (Loss) | | $ | 208 | | $ | 1,042 | | $ | (834 | ) | | -80.04 | % |
| | | | | | | | | | | | | | |
Earnings (Loss) Per Share | | | | | | | | | | | | | |
| Basic | | $ | 0.01 | | $ | 0.04 | | $ | (0.03 | ) | | -75.00 | % |
| Diluted | | $ | 0.01 | | $ | 0.04 | | | (0.03 | ) | | -75.00 | % |
| | | | | | | | | | | | | | |
Weighted-average Shares Outstanding | | | | | | | | | | | | | |
| Basic | | | 19,679,400 | | | 19,579,400 | | | 100,000 | | | 0.51 | % |
| Diluted | | | 19,679,400 | | | 19,635,898 | | | 43,502 | | | 0.22 | % |
Sale of products: Sale of products for the three months ended September 30, 2008 was approximately $7.2 million, an increase of approximately $3 million, or 73%, from $4.2 million for the three months ended September 30, 2007. The increase in sale of products was primarily due to the increase of $2.8 million in the sales of our primary product, Xusaitong Soft Capsules, augmented by $0.2 million of increased sales of our non-prescription pharmaceuticals, cosmetic products, and increased export of our products.
Cost of products sold: Our costs of products sold for the three months ended September 30, 2008 was approximately $1.97 million, an increase of $0.93 million, or 89%, from approximately $1.04 million for the three months ended September 30, 2007. The increase of cost of products sold is primarily due to the increase in the sales volume of our product and the increase in cost of the raw material, Sanqi, for our primary product, Xusaitong Soft Capsules.
Gross profit: Our gross profit for the three months ended September 30, 2008 was approximately $5.31 million as compared with approximately $3.16 million for the three months ended September 30, 2007. Gross profit as a percentage of revenues was approximately 73% for the three months ended September 30, 2008, a decrease from 75% for the three months ended September 30, 2007. The decrease in gross margin percentage was primarily due to the increase in the cost of the raw material, Sanqi, for our primary product, Xusaitong Soft Capsules.
Selling expense: Selling expenses were approximately $2.99 million for the three months ended September 30, 2008, an increase of $1.44 million, or 93%, from $1.55 million for the three months ended September 30, 2007. The primary reasons for the increase were the increase in the commission paid to sales representatives due to increased sales of our primary product and the increase in marketing expenses for our cosmetic product.
General and administrative expense: General and administrative expenses were approximately $1.82 million for the three months ended September 30, 2008, an increase of $1.48 million, or 434%, from approximately $0.34 million for the three months ended September 30, 2007. The increase was primarily due to the increase in expenses related to our status as a public company with its securities traded on a U.S. national exchange (including accounting and legal expenses in connection with the restatement of the Company’s financial statements for the fiscal year ended December 31, 2007 and the fiscal quarter ended March 31, 2008), and the increase in expenses related to business expansion of cosmetic products.
Research and development expense: Research and development expense for the three months ended September 30, 2008 was $66,052 as compared to $5,371 for the period ended September 30, 2007. The increase was primarily to enhance new product development.
Net other expense: Net other expense, which includes interest income, income from research and development activities, interest expense and non-operating expenses, was $265,999 for the three months ended September 30, 2008 and $269,684 for the three months ended September 30, 2007. The decrease in net other expenses was primarily due to a decrease in interest income as a result of lower cash balances in the bank, offset by an increase in the income from research and development activities which partially offset other expenses.
Net income: Net income decreased to $154,286 for the three months ended September 30, 2008 as compared to net income of $867,641 for the three months ended September 30, 2007. Considering the foreign currency translation adjustments of $54,116 and $174,392, for the three months ended September 30, 2008 and 2007, respectively, comprehensive income of $208,402 and $1.04 million was realized for the three months ended September 30, 2008 and 2007, respectively.
Nine Months Ended September 30, 2008 and 2007
The following table sets forth our statements of operations for the nine months ended September 30, 2008 and 2007 in U.S. dollars (unaudited):
| | | For the nine months | | Change | | Variance | |
| | | ended September 30, | | | | | |
| | | 2008 | | 2007 | | | | | |
| | | (in thousands, except earnings per share and share amounts) | |
| | | | | | | | | | |
Sale of Products | | $ | 21,359 | | $ | 14,885 | | $ | 6,474 | | | 43.49 | % |
Cost of Products Sold | | | 7,061 | | | 3,762 | | | 3,299 | | | 87.69 | % |
Gross profit | | | 14,298 | | | 11,123 | | | 3,175 | | | 28.54 | % |
| | | | | | | | | | | | | | |
Operating Expenses: | | | | | | | | | | | | | |
| Selling expenses | | | 8,667 | | | 5,180 | | | 3,487 | | | 67.32 | % |
| General and administrative expenses | | | 7,001 | | | 2,703 | | | 4,298 | | | 159 | % |
| Research and development expenses | | | 255 | | | 11 | | | 244 | | | 2,218 | % |
Total Operating Expenses | | | 15,923 | | | 7,894 | | | 8,029 | | | 102 | % |
| | | | | | | | | | | | | | |
Income (Loss) from operations | | | (1,625 | ) | | 3,229 | | | (4,854 | ) | | -150 | % |
| | | | | | | | | | | | | | |
Other Income (expenses): | | | | | | | | | | | | | |
| Interest income | | | 6 | | | 15 | | | (9 | ) | | -60 | % |
| Non-operating income | | | 344 | | | 81 | | | 263 | | | 325 | % |
| Interest expense | | | (963 | ) | | (665 | ) | | (298 | ) | | 44.81 | % |
| Non-operating expenses | | | (139 | ) | | | | | (139 | ) | | N/A | |
Net Other Income (Expense) | | | (752 | ) | | (569 | ) | | (183 | ) | | 32.16 | % |
| | | | | | | | | | | | | | |
Income (Loss) Before Income Taxes | | | (2,377 | ) | | 2,660 | | | (5,037 | ) | | -189 | % |
| Benefit from (provision for) income taxes | | | (5 | ) | | 1,223 | | | (1,228 | ) | | -100 | % |
| Minority interest in income of subsidiaries | | | 146 | | | (224 | ) | | 370 | | | -165 | % |
Net Income | | $ | (2,236 | ) | $ | 3,659 | | $ | (5,895 | ) | | -161 | % |
| Foreign currency translation adjustments | | | 744 | | | 449 | | | 295 | | | 65.70 | % |
Comprehensive Income (Loss) | | $ | (1,492 | ) | $ | 4,108 | | $ | (5,600 | ) | | -136 | % |
| | | | | | | | | | | | | | |
Earnings (Loss) Per Share | | | | | | | | | | | | | |
| Basic | | $ | (0.11 | ) | $ | 0.19 | | $ | (0.30 | ) | | -160 | % |
| Diluted | | $ | (0.11 | ) | $ | 0.19 | | $ | (0.30 | ) | | -160 | % |
| | | | | | | | | | | | | | |
Weighted-average Shares Outstanding | | | | | | | | | | | | | |
| Basic | | | 19,679,400 | | | 19,292,953 | | | 386,447 | | | 2.00 | % |
| Diluted | | | 19,679,400 | | | 19,345,401 | | | 333,999 | | | 1.73 | % |
Sale of products: Sale of products for the nine months ended September 30, 2008 was approximately $21.35 million, an increase of approximately $6.47 million, or 43.49 %, from approximately $14.88 million for the nine months ended September 30, 2007. The increase in sale of products was primarily due to the increase of the sales of our primary product, other brand’s non-prescription pharmaceuticals, and cosmetic products, and the increase in the export of our products.
Cost of products sold: Our costs of products sold for the nine months ended September 30, 2008 was approximately $7.06 million, an increase of approximately $3.30 million, or 87.69%, from approximately $3.76 million for the nine months ended September 30, 2007. The increase of cost of products sold is primarily due to the increase in the sales volume of our product and the increase in the purchasing price of the raw material, Sanqi, of our primary product, Xusaitong Soft Capsules. Moreover, the higher purchasing price of other brand’s non-prescription pharmaceuticals caused the total cost of products sold to increase at a rate higher than the increase in sales.
Gross profit: Our gross profit for the nine months ended September 30, 2008 was approximately $14.3 million as compared with approximately $11.1 million for the nine months ended September 30, 2007. Gross profit as a percentage of revenues was approximately 67% for the nine months ended September 30, 2008, a decrease from 75% for the nine months ended September 30, 2007. The decrease in gross margin percentage was primarily because in the first and second quarter of 2008, there were sales of other brand’s products which have a higher purchasing price and thus generated a smaller profit margin.
Selling expense: Selling expenses were approximately $8.67 million for the nine months ended September 30, 2008, an increase of $3.49 million, or 67%, from approximately $5.18 million for the nine months ended September 30, 2007. The primary reasons for the increase were the increase in marketing and advertising of our cosmetic product and the increase in commission paid to sales representatives.
General and administrative expense: General and administrative expenses were $7 million for the nine months ended September 30, 2008, an increase of $4.3 million, or 159%, from approximately $2.7 million for the nine months ended September 30, 2007. The increase was primarily due to the increase of the expenses related to our status as a public company with its securities traded on a U.S. national exchange, the expenses relating to business expansion, and the allowance for doubtful accounts due to the increase of trade receivables aging over one to two years for the nine months ended September 30, 2008.
Research and development expense: Research and development expense for the nine months ended September 30, 2008 was $255,241 as compared to $10,720 for the nine months ended September 30, 2007. The increase was primarily due to enhance new product development.
Net other expense: Net other expense, which includes interest income, income from research and development activities, interest expense and non-operating expenses, was approximately $751,939 for the nine months ended September 30, 2008 as compared to approximately $569,055 for the nine months ended September 30, 2007. The increase in net other expense was primarily due to an increase in the interest expenses on the long term loans and an increase in non-operating expenses due to donations to hospitals and other parties and losses on damaged pharmaceuticals purchased from other brands, offset by increased income from research and development activities.
Benefits from (Provision for) income taxes: There is $4,484 provision for income taxes for the nine months ended September 30, 2008 as compared to a benefit from income tax of approximately $1.2 million for the nine months ended September 30, 2007. On March 15, 2007, one of our major subsidiaries, Shenghuo Medicine Co., Ltd., was granted an approval of their application by the PRC government for relief of income taxes for the years ended December 31, 2006 and 2005. As a result, Shenghuo Medicine Co., Ltd. recognized an aggregate of $1,099,401 in income taxes that are no longer payable as of March 15, 2007. The amount has been recognized under the caption “Benefit from (provision for) income taxes” in the accompanying Condensed Consolidated Statement of Operations and Comprehensive Income for the nine months ended September 30, 2007.
Net income (loss): Net loss was $2.24 million for the nine months ended September 30, 2008 as compared to approximately $3.66 million net income for the nine months ended September 30, 2007. Considering the foreign currency translation adjustments of $744,189 and $449,189, for the nine months ended September 30, 2008 and 2007, respectively, comprehensive loss of $1.49 million and comprehensive income of $4.11 million was realized for the nine months ended September 30, 2008 and 2007, respectively.
Liquidity and Capital Resources
General - As of September 30, 2008, we had cash and cash equivalents of $1.08 million. We have historically financed our business operations through bank loans. As of September 30, 2008, we had borrowed from banks and other institutions and had approximately $4.7 million in short-term notes payable outstanding. As of September 30, 2008, we had also borrowed $8.5 million which is reflected in our current portion of long-term debt. All loans are secured by land, buildings and machinery as collateral except the loan from the Agricultural Bank of China mentioned below, which is secured by a pledge by Lan's International Medicine Investment Co Ltd. (“LIMI”) of its shareholding in China Shenghuo (KUN). For the nine months ending September 30, 2008, the net decrease in cash and cash equivalents was $1.72 million as compared to December 31, 2007.
Our notes payable consist of short and long-term debt that is payable to banks, governmental financial bureaus, municipalities and a company. If we are unable to repay or renegotiate our debt when due, we may default on our obligations. In view of the current credit market conditions, we may be unable to renegotiate our current obligations or obtain additional financing on favorable terms, if at all, which would have a material adverse effect on our financial condition. The following schedule summarizes our debt obligations and respective balances:
| | | September 30, | | December 31, | |
| | | 2008 | | 2007 | |
| Short-term note payable to a municipality, interest at 1.8%, due on demand, unsecured | | $ | 72,938 | | $ | 68,360 | |
| Short-term note payable to a finance bureau, interest at 4.5%, matured January 2003, unsecured | | | 75,173 | | | 70,455 | |
| Short-term note payable to a bank, interest at 7.47%, matures April 2009, secured by property | | | 3,646,920 | | | - | |
| Short-term note payable to a bank, interest at 6.57%, matures November 2008, secured by property | | | 729,384 | | | - | |
| Short-term note payable to a bank, interest at 6.12%, matured March 2008, secured by land use rights | | | - | | | 1,367,222 | |
| Short-term note payable to a bank, interest at 6.39%, matures April 2009, secured by property | | | - | | | 3,418,056 | |
| Short-term note payable to a government development zone interest at 2.43%, matured November 2007, secured by property | | | 218,815 | | | 410,167 | |
| Total short-term notes payable | | $ | 4,743,230 | | $ | 5,334,260 | |
| | | September 30, | | December 31, | |
| | | 2008 | | 2007 | |
| Long-term note payable to a bank, interest at 7.72%, matures August 2009, secured by shareholder | | $ | 6,710,333 | | $ | 6,836,111 | |
| Long-term note payable to a bank, interest at 8.316%, matures April, 2010, secured by property | | | 1,458,768 | | | - | |
| Long-term note payable to a bank, interest at 6.57%, matures March 2010, secured by property | | | 2,917,535 | | | 4,101,667 | |
| Total long-term debt | | | 11,086,636 | | | 10,937,778 | |
| Less current maturities of long-term debt | | | 8,460,854 | | | 4,101,667 | |
| Long-term notes payable, net of current portion | | $ | 2,625,782 | | $ | 6,836,111 | |
| | | | | | | | |
| Past due notes payable | | $ | 293,988 | | $ | 480,622 | |
On August 17, 2007, we received a loan for $6,651,094 (RMB 50 million) from Shuang Long Branch of Agricultural Bank of China with a term of two years. The loan bears interest at a rate of 7.722%, which is due quarterly. Principal payments for the loan are as follows:
| 2007 | | $ | 665,109 | |
| 2008 | | | 1,995,328 | |
| 2009 | | | 3,990,657 | |
| | | | 6,651,094 | |
The loan is for working capital and is guaranteed by Lan’s International Medicine Investment Co Ltd. (“LIMI”). Gui Hua Lan, our Chief Executive Officer; Feng Lan, our President; and Zheng Yi Wang, our Executive Director of Exports, are directors and have voting and investment control over the shares owned by LIMI, which beneficially owns or controls approximately 77.3% of our outstanding shares. In addition, Gui Hua Lan, Feng Lan and Zheng Yi Wang owns 62.42%, 5.15% and 1.45%, respectively, of LIMI’s issued and outstanding shares. LIMI is not receiving any compensation for the guarantee of our loan.
In April 2008, we obtained a loan of $1,424,455 from Shuang Long Branch of Agricultural Bank of China at an interest rate of 8.316% secured by property. A total of $248,811 is due on May 20, 2009 with the remaining balance of $1,139,244 due on March 31, 2010.
Also in April 2008, we obtained a loan of $3,560,138 from Heping Branch of Construction Bank of China at an interest rate of 7.47% secured by property. The loan is due and payable on April 3, 2009.
Proceeds from the above mentioned April 2008 loans were used to retire existing loans that had matured.
The following table provides summary information about net cash flow for the nine months ended September 30, 2008 and 2007:
| | | Cash Flow | |
| | | Nine months ended September 30, | |
| | | 2008 | | 2007 | |
| | | (unaudited, in thousands) | |
| | | | | | |
| Net cash provided by (used in) operating activities | | $ | (233 | ) | $ | (3,924 | ) |
| | | | | | | | |
| Net cash provided by (used in) investing activities | | | (223 | ) | | 283 | |
| | | | | | | | |
| Net cash provided by (used in) financing activities | | | (1,413 | ) | | 3,398 | |
| | | | | | | | |
Cash and Cash Equivalents at End of Period | | $ | 1,081 | | $ | 3,585 | |
Operating Activities: Net cash used in operating activities for the nine months ended September 30, 2008 was $232,648, as compared to cash used in operating activities of $3,924,389 for the nine months ended September 30, 2007. These results are mainly comprised of: (i) cash flow generated from a decrease in accounts and notes receivable and inventory, and an increase in accounts payable and advances from customers; (ii) a decrease in cash used in employee advances, accrued expenses and taxes and related payables; (iii) an increase in cash used because of net loss, excluding non-cash and other reconciling items, which include the add-back of depreciation and amortization, deferred income taxes, and other non-cash items (primarily the minority interest in (loss) income of subsidiaries).
Investing Activities: Net cash used in investing activities was $222,737 for the nine months ended September 30, 2008, as compared to net cash provided of $282,850 for the nine months ended September 30, 2007. The increase in net cash used was primarily a result of increase in capital expenditure and a decrease in restricted cash.
Financing Activities: Net cash used in financing activities was $1.41 million for the nine months ended September 30, 2008 compared to net cash $3.40 million provided by financing activities for the nine months ended September 30, 2007. The decrease in cash provided by financing activities was primarily due to decreased proceeds from short and long-term loans and issuance of common stock offset by lower payments on short and long-term loans during the nine months ended September 30, 2008.
Working Capital
As of September 30, 2008, our accounts receivable were $ 8.54 million (net of allowance for doubtful accounts of $6.81 million), a decrease of $3.76 million, or 36% from accounts receivable of $10.57 million (net of allowance for doubtful accounts of $3.22 million) as of December 31, 2007. The collection period typically runs from six months to one year, considering the relatively long collection period in our industry.
Our company normally requires one to two months to deliver products once the order is placed. Inventory has slightly decreased by $333,486 for the nine months ended September 30, 2008. Our payment cycle is considerably shorter than our receivable cycle, since we typically pay our suppliers all or a portion of the purchase price in advance and for some suppliers we must maintain a deposit for future orders. We require our customers to pay a certain percentage of the sales price as deposit before we ship products to them. The percentage varies from customer to customer. During the course of business, we reduce the deposit requirement for some customers with good credit.
To the extent that we cannot satisfy our cash needs, whether from operations or from a financing source, our business would be impaired in that it may be difficult for us to obtain products which could, in turn, impair our ability to generate sales. We have implemented new policies aimed at improving collection of accounts receivable in the future, including more detailed reporting from and increased control over provincial sales offices and representatives, incentives for sales representatives more closely tied to timely collection and more stringent enforcement of payment terms with distributors.
In addition, in the course of our business, we must make significant deposits to our suppliers when we place an order. As of September 30, 2008, our advance payments to our suppliers totaled approximately $776,438. We are confident that our available funds and cash generated from operations will provide us with sufficient capital for a sustainable operation; however, we may require additional capital for acquisitions or for the operation of the combined companies. We cannot assure that such funding will be available. As of September 30, 2008, we had no material commitments for capital expenditures other than for those expenditures incurred in the ordinary course of business.
We make significant cash advances to our sales representatives to assist and encourage them to expand the marketing and sales of our products into new markets and gain new customers. We believe the sales representatives are more able to expand into new markets and obtain new customers if they have advanced funds for their travel, meals and other incidental expenses that arise over the time they perform their functions as sales representatives. Prior to September 2006, we did not ask sales representatives to pay off advances immediately because the Chinese economy has grown quickly and because competition in the pharmaceutical industry is intense. Instead, we encouraged sales representatives to expand their markets and gain more customers. However, beginning in September of 2006, we began to more vigorously pursue collection of all employee advances. Nonetheless, there are some employee advances that have aged so significantly that, based on prior experience, we do not expect to collect on every outstanding advance and have estimated the uncollectible balance based on the age of the advances. When we make advances to sales representatives, we require that our selling offices sign advance agreements with sales representatives to arrange the specific purpose of the advance, the amount of the advance and the term of the advance. Our finance department records the detail of advances and checks the remaining balance with sales representatives every month. We also supervise the repayment of the advances. For sales representatives who refuse to pay off the advances, we attempt to collect on the advances and decrease the risk of bad debt as much as possible by withholding sales commissions, prosecuting delinquent sales representatives, and by other valid means of collection. Current and long-term employee advances (net of allowances for doubtful accounts) were approximately $10.85 million at September 30, 2008 and $8.76 million as of December 31, 2007, an increase of approximately $2.09 million or 24%. The increase was due to us advancing more money to sales representatives to encourage them to expand their markets and increase sales. As of September 30, 2008, the gross amount of employee advances was approximately $11.75 million and as of December 31, 2007 it was approximately $11.21 million, an increase of approximately $0.54 million in that nine month period. Beginning in September 2006, we began to employ more sales representatives and, as a result, we made more advances to sales representatives in an attempt to encourage and assist sales representatives to expand into new selling markets and gain new customers. Because of the increase in the balance of employee advances, we, in compliance with our established policy to reserve an allowance for specific percentages of our aged receivables, accrued a larger allowance for the increased employee advances in order to consistently apply our established allowance policy.
The table below sets forth the outstanding gross and net amount of outstanding balances of current and long-term employee advances for the years ended December 31, 2007 and 2006 and the nine months ended September 30, 2008.
| | | For the year ended December 31, 2006 | | For the year ended December 31, 2007 | | For the nine months ended September 30, 2008 | |
| | | | | | | | |
| Gross amount of employee accounts | | $ | 4,559,471 | | $ | 11,210,921 | | $ | 11,752,280 | |
| Allowance for doubtful accounts | | | 1,429,426 | | | 2,447,073 | | | 905,082 | |
| Net amount | | $ | 3,130,045 | | $ | 8,763,848 | | $ | 10,847,198 | |
Off-Balance Sheet Arrangements
None.
Foreign Currency Risk
Since all of our operations are conducted in the PRC, we are subject to special considerations and significant risks not typically associated with companies operating in the United States of America. These risks include, among others, the political, economic and legal environments and foreign currency exchange rate fluctuations. Our operational results may be adversely affected by changes in the political and social conditions in the PRC, and by changes in governmental policies with respect to medical reforms and other laws and regulations, anti-inflationary measures, currency conversion and remittance abroad, and rates and methods of taxation, among other things. Exchange rate fluctuations may adversely affect the value, in U.S. dollar terms, of our net assets and income derived from its operations in the PRC. In addition, all of our revenue is denominated in the Chinese Yuan Renminbi (“CNY”), which must be converted into other currencies before remittance out of the PRC. Both the conversion of CNY into foreign currencies and the remittance of foreign currencies abroad require approval of the PRC government. The effect of the fluctuations of exchange rates is not considered to be material to our business operations.
Interest Rate Risk
We do not have significant interest rate risk, as our debt obligations are primarily fixed interest rates.
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
The information contained in this quarterly report, including in the documents incorporated by reference into this quarterly report, includes some statements that are not purely historical and that are “forward-looking statements.” Such forward-looking statements include, but are not limited to, statements regarding our company’s and our management’s expectations, hopes, beliefs, intentions or strategies regarding the future, including our financial condition, and results of operations. In addition, any statements that refer to projections, forecasts or other characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements. The words “anticipates,” “believes,” “continue,” “could,” “estimates,” “expects,” “intends,” “may,” “might,” “plans,” “possible,” “potential,” “predicts,” “projects,” “seeks,” “should,” “will,” “would” and similar expressions, or the negatives of such terms, may identify forward-looking statements, but the absence of these words does not mean that a statement is not forward-looking.
The forward-looking statements contained in this quarterly report are based on current expectations and beliefs concerning future developments and the potential effects on the Company. There can be no assurance that future developments actually affecting us will be those anticipated. These forward-looking statements involve a number of risks, uncertainties (some of which are beyond our control) or other assumptions that may cause actual results or performance to be materially different from those expressed or implied by these forward-looking statements, including the following:
| | · | our reliance on one product for over 70% of our revenues; |
| | · | our reliance on a few suppliers for Sanchi, a scarce plant that is the primary ingredient in almost all of our products; |
| | · | our ability to develop and market new products; |
| | · | our increasing employee advances; |
| | · | our ability to establish and maintain a strong brand; |
| | · | costs and expenses related to expansion of retail distribution of products; |
| | · | continued maintenance of certificates, permits and licenses required to conduct business in China; |
| | · | protection of our intellectual property rights; |
| | · | market acceptance of our products; |
| | · | changes in the laws of the PRC that affect our operations; |
| | · | any recurrence of severe acute respiratory syndrome or avian flu; |
| | · | our ability to obtain all necessary government certifications and/or licenses to conduct our business; |
| | · | development of a public trading market for our securities; |
| | · | cost of complying with current and future governmental regulations and the impact of any changes in the regulations on our operations; |
| | · | other factors referenced in this quarterly report, including, without limitation, under the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations”; and |
| | · | other factors listed from time to time in our filings with the Securities and Exchange Commission, including, without limitation, our Annual Report on Form 10-KSB for the year ended December 31, 2007, as amended, and subsequent reports on Form 8-K. |
The risks included above are not exhaustive. Other sections of this quarterly report may include additional factors that could adversely impact our business and operating results. Moreover, we operate in a very competitive and rapidly changing environment. New risk factors emerge from time to time and we cannot predict all such risk factors, nor can we assess the impact of all such risk factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward looking statements.
You should not rely upon forward-looking statements as predictions of future events. We cannot assure you that the events and circumstances reflected in the forward-looking statements will be achieved or occur. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Moreover, neither we nor any other person assume responsibility for the accuracy and completeness of the forward-looking statements. Except as required by law, we undertake no obligation to update publicly any forward-looking statements for any reason after the date of this quarterly report to conform these statements to actual results or to changes in our expectations.
You should read this quarterly report, and the documents that we reference in this quarterly report and have filed as exhibits to this quarterly report with the Securities and Exchange Commission, completely and with the understanding that our actual future results, levels of activity, performance and achievements may materially differ from what we expect. We qualify all of our forward-looking statements by these cautionary statements.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Smaller reporting companies are not required to provide the information required by this Item.
ITEM 4T. CONTROLS AND PROCEDURES
Evaluation of disclosure controls and procedures
As of September 30, 2008, our Chief Executive Officer (CEO) and our Chief Financial Officer (CFO) performed an evaluation of the effectiveness of and the operation of our disclosure controls and procedures as defined in Rule 13a-15(e) or Rule 15d-15(e) under the Exchange Act. Based on that evaluation, our CEO and CFO concluded that our disclosure controls and procedures as of September 30, 2008 had significant deficiencies that caused our controls and procedures to be ineffective. These deficiencies consisted of inadequate staffing and supervision that could lead to the untimely identification and resolution of accounting and disclosure matters and failure to perform timely and effective reviews. In addition, our CEO concluded that there are deficiencies in the recording and classification of accounting transactions and a lack of personnel with expertise in U.S. GAAP and Securities and Exchange Commission rules and regulations such as those deficiencies that resulted in the accounting errors for trade receivables and employee advances that caused us to restate our financial statements for the year ended December 31, 2007 and the quarter ended March 31, 2008. Although our accounting staff is basically professional and experienced in accounting requirements and procedures generally accepted in the PRC, our CEO has determined that they require additional training and assistance in U.S. GAAP matters.
We are in the process of improving our controls and procedures in an effort to remediate these deficiencies through improving supervision, education and training of our accounting staff. In order to correct the foregoing material weaknesses, as previously reported, we have taken the following remediation measures prior to the beginning of the third quarter of 2008: (1) we now maintain a separate, independent set of accounting records for the parent company to record all U.S. GAAP audit adjustments along with the local GAAP accounting records so as to reconcile our records according to U.S. GAAP; (2) we have commenced necessary training and engaged external professional accounting and consultancy firms to assist us in the preparation of the U.S. GAAP financial statements; and (3) we have established an internal audit function to strengthen the overall internal control environment and the current skill and experience mix of the internal audit staff. To ensure that the internal audit function becomes an effective monitoring component of our internal control framework, we are in the process of preparing an internal audit manual, and implementing enhanced audit planning and the sufficient training and development of the internal audit team. Moreover, we have begun the recruitment process to strengthen the overall effectiveness of the team and to oversee the implementation of our enhanced internal controls over financial reporting.
In addition, we have allocated significant financial and human resources to strengthen the internal control structure. As part of our efforts to comply with Section 404 of the Sarbanes-Oxley Act for fiscal year 2008, we are actively working with external consultants to assess our data collection, financial reporting and control procedures and to strengthen our internal controls over financial reporting.
In this regard, during the third quarter of 2008, we have completed the draft of the updated policies and procedures for training and discussion at all involved levels. We plan to finalize these policies and procedures before the end of 2008.
In addition, as a result of the Audit Committee’s independent investigation of the circumstances that led to the restatement of the Company’s financial statements for the fiscal year ended December 31, 2007 and the fiscal quarter ended March 31, 2008, as described in Note 1 of Notes to the Condensed Consolidated Financial Statements contained herein, during the fourth quarter of 2008 the Company began to implement the following remedial actions to enhance its internal controls over financial reporting: we are providing additional training in SOX 404 compliance and financial document production and record retention to the Company’s finance personnel and other personnel who provide financial data that is incorporated into the Company’s financial statements; working with our external consultants to improve disclosure controls and procedures and internal controls over financial reporting, we have accelerated documentation of our policies and procedures and anticipate completing this effort by the end of 2008 and implementing the new procedures in January 2009. In addition, Qiong Hua Gao, the Company’s former Chief Financial Officer, has been appointed Supervisor of Internal Audit to work closely with the Company’s financial department and external consultants on implementing policies and procedures to strengthen the Company’s internal controls over financial reporting. As part of its implementation, the Company has hired finance personnel more experienced in the application of U.S. GAAP and Wendy Fu has been appointed as the Company’s new Chief Financial Officer.
We believe that the remedial steps that we have taken and intend to take will address the conditions identified by our CEO and CFO as significant deficiencies in our disclosure controls and procedures. Our CEO and CFO believe that there are no material inaccuracies, or omissions of material facts necessary to make the statements not misleading in light of the circumstances in which they were made, in this Form 10-Q.
Changes in internal control over financial reporting
Except as described above, there were no changes in our internal controls over financial reporting during the third fiscal quarter of 2008 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Class Action Lawsuits - Putative class action lawsuits have been asserted against the Company and certain of its officers and directors in the United States District Court for the Southern District of New York (the “Court”). Only one complaint, Beni Varghese v. China Shenghuo Pharmaceutical Holdings, Inc., Gui Hua Lan, Qiong Hua Gao, Gene Michael Bennett, And Yunhong Guan, Index No. 08 CIV. 7422 (the “Varghese Action”) has been served on the Company thus far.
The complaints allege, among other things, that certain of the Company’s SEC filings and other public statements contained false and misleading statements which resulted in damages to the plaintiffs and the members of the purported class when they purchased the Company’s securities. On the basis of those allegations, plaintiffs in each of the actions seek an unspecified amount of damages under Sections 10(b) and 20(a) of the Exchange Act.
On October 20, 2008, the Company and counsel to the plaintiff in the Varghese Action filed a stipulation with the Court in which the parties agreed that the plaintiff may file a consolidated, amended complaint within 60 days after the entry of an order appointing and approving lead counsel, and that the Company’s time to answer that complaint is extended until 60 days after the filing of the consolidated complaint.
The Company believes the allegations in the complaint are without merit, and intends to vigorously defend the lawsuits. The Company does not believe that the outcome of these suits will have a material, adverse effect on the Company.
ITEM 1A. RISK FACTORS
Except as reflected in this Form 10-Q, there have been no material changes from the risk factors previously disclosed in Item 1A of our Annual Report on Form 10-KSB, as amended, for the year ended December 31, 2007.
General economic conditions may affect our revenue and harm our business. We may become unable to repay or renegotiate our outstanding loans.
As widely reported, financial markets in the United States, Europe and Asia have been experiencing extreme disruption in recent months. Unfavorable changes in economic conditions, including declining consumer confidence, inflation, recession or other changes, may lead our customers to delay or reduce purchases of our products and our results of operations and financial condition could be adversely affected thereby. Challenging economic conditions also may impair the ability of our customers or distributors to pay for products they have purchased, and as a result, our reserves for doubtful accounts and write-offs of accounts receivable could increase. Our cash flows may be adversely affected by delayed payments or underpayments by our customers. As of September 30, 2008, we had cash and cash equivalents of $1.08 million. We have historically financed our business operations through bank loans. As of September 30, 2008, we had borrowed from banks and other institutions and had approximately $4.7 million in short-term notes payable outstanding. As of September 30, 2008, we had also borrowed $8.5 million which is reflected in our current portion of long-term debt. We have a relatively high debt ratio, and, in view of current credit market conditions, we may be unable to renegotiate the terms of our existing financing or secure additional financing on favorable terms, if at all. In the event that we are unable to repay or renegotiate our obligations as they become due, we may default on our obligations. The inability to secure additional financing could have a material adverse effect on our financial condition, and in the future we might cease to be able to operate as a going concern. Additional information regarding our debt obligations is contained in Note 7 of the Notes to the Condensed Consolidated Financial Statements contained herein. We are unable to predict the duration and severity of the current disruption in financial markets and adverse economic conditions.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS
Exhibit Number | | Description of Exhibit |
| 2.1 | | Share Exchange Agreement, dated as of June 30, 2006, by and among the Company, Kunming Shenghuo Pharmaceutical (Group) Co., Ltd., and Lan’s International Medicine Investment Co., Limited (incorporated by referenced from Exhibit 2.1 to the Quarterly Report on Form 10-QSB filed with the Securities and Exchange Commission on July 28, 2006). |
| 2.1(a) | | Amendment No. 1 to the Share Exchange Agreement, dated as of August 11, 2006, by and among the Company, Kunming Shenghuo Pharmaceutical (Group) Co., Ltd., and Lan’s International Medicine Investment Co., Limited (incorporated by reference from Exhibit 2.1(a) to the Registration Statement on Form SB-2 filed with the Securities and Exchange Commission on December 21, 2006). |
| | | |
| 2.1(b) | | Amendment No. 2 to the Share Exchange Agreement, dated as of August 28, 2006, by and among the Company, Kunming Shenghuo Pharmaceutical (Group) Co., Ltd., and Lan’s International Medicine Investment Co., Limited (incorporated by reference from Exhibit 2.1(b) to Current Report on Form 8-K filed with the Securities and Exchange Commission on September 1, 2006). |
| | | |
| 3.1 | | Certificate of Incorporation of the Company (incorporated by reference from Exhibit 3.1 to Registration Statement on Form 10-SB filed with the Securities and Exchange Commission on August 3, 2005). |
| | | |
| 3.2 | | Bylaws of the Company (incorporated by reference from Exhibit 3.2 to Registration Statement on Form 10-SB filed with the Securities and Exchange Commission on August 3, 2005, and incorporated herein by reference). |
| | | |
| 3.3 | | Articles of Merger Effecting Name Change (incorporated by reference from Exhibit 3.3 to Current Report on Form 8-K filed with the Securities and Exchange Commission on September 1, 2006). |
| | | |
| 31.1 | | Certification of the Chief Executive Officer pursuant to Exchange Act Rule 13a-14(a) or 15d-14(a). |
| | | |
| 31.2 | | Certification of the Chief Financial Officer pursuant to Exchange Act Rule 13a-14(a) or 15d-14(a). |
| | | |
| 32.1 | | Certification pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes Oxley Act of 2002.* |
* This exhibit shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934 or otherwise subject to the liabilities of that section, nor shall it be deemed incorporated by reference in any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, whether made before or after the date hereof and irrespective of any general incorporation language in any filings.SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| | CHINA SHENGHUO PHARMACEUTICAL HOLDINGS, INC. |
| | (Registrant) |
| | | |
| November 19, 2008 | By: | /s/ Gui Hua Lan |
| | | Gui Hua Lan |
| | | Chief Executive Officer and Chairman of the Board |
EXHIBIT INDEX
Exhibit Number | | Description of Exhibit |
| 2.1 | | Share Exchange Agreement, dated as of June 30, 2006, by and among the Company, Kunming Shenghuo Pharmaceutical (Group) Co., Ltd., and Lan’s International Medicine Investment Co., Limited (incorporated by referenced from Exhibit 2.1 to the Quarterly Report on Form 10-QSB filed with the Securities and Exchange Commission on July 28, 2006). |
| | | |
| 2.1(a) | | Amendment No. 1 to the Share Exchange Agreement, dated as of August 11, 2006, by and among the Company, Kunming Shenghuo Pharmaceutical (Group) Co., Ltd., and Lan’s International Medicine Investment Co., Limited (incorporated by reference from Exhibit 2.1(a) to the Registration Statement on Form SB-2 filed with the Securities and Exchange Commission on December 21, 2006). |
| | | |
| 2.1(b) | | Amendment No. 2 to the Share Exchange Agreement, dated as of August 28, 2006, by and among the Company, Kunming Shenghuo Pharmaceutical (Group) Co., Ltd., and Lan’s International Medicine Investment Co., Limited (incorporated by reference from Exhibit 2.1(b) to Current Report on Form 8-K filed with the Securities and Exchange Commission on September 1, 2006). |
| | | |
| 3.1 | | Certificate of Incorporation of the Company (incorporated by reference from Exhibit 3.1 to Registration Statement on Form 10-SB filed with the Securities and Exchange Commission on August 3, 2005). |
| | | |
| 3.2 | | Bylaws of the Company (incorporated by reference from Exhibit 3.2 to Registration Statement on Form 10-SB filed with the Securities and Exchange Commission on August 3, 2005, and incorporated herein by reference). |
| | | |
| 3.3 | | Articles of Merger Effecting Name Change (incorporated by reference from Exhibit 3.3 to Current Report on Form 8-K filed with the Securities and Exchange Commission on September 1, 2006). |
| | | |
| 31.1 | | Certification of the Chief Executive Officer pursuant to Exchange Act Rule 13a-14(a) or 15d-14(a). |
| | | |
| 31.2 | | Certification of the Chief Financial Officer pursuant to Exchange Act Rule 13a-14(a) or 15d-14(a). |
| | | |
| 32.1 | | Certification pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes Oxley Act of 2002.* |
* This exhibit shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934 or otherwise subject to the liabilities of that section, nor shall it be deemed incorporated by reference in any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, whether made before or after the date hereof and irrespective of any general incorporation language in any filings.
