ITEM 1. BUSINESS.
Unless the context otherwise requires, the terms “Shenghuo,” the “Company,” “we,” “us,” or “our” as used throughout this report refer to China Shenghuo Pharmaceutical Holdings, Inc., our 94.95%-owned subsidiary Kunming Shenghuo Pharmaceutical (Group) Co., Ltd. (“Shenghuo China”), and Shenghuo China’s subsidiaries organized under the laws of the People’s Republic of China (“PRC” or “China”): Kunming Shenghuo Medicine Co., Ltd. (wholly-owned), Kunming Pharmaceutical Importation and Exportation Co., Ltd. (wholly-owned), Kunming Shenghuo Cosmetics Co., Ltd. (wholly-owned), Shilin Shenghuo Pharmaceutical Co., Ltd. (wholly-owned) , and Kunming Shenghuo Hotel Management Co., Ltd. (80% interest).
Overview
We were incorporated in the State of Delaware on May 24, 2005. 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 a greyish-brown or greyish-yellow plant that only grows in a few geographic locations on earth, one of which is Yunnan Province in southwest China, where our operations are located. The main root of Panax notoginseng is cylindrically shaped and is most commonly one-to-six centimeters long and one-to-four centimeters in diameter. Panax notoginseng saponins (PNS), the active ingredient in Panax notoginseng, is 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 approximately 84.5% of our sales for the year ended December 31, 2011.
We have expanded our real estate owned and deployed in our pharmaceutical operations by 107,231 square feet. This is a result of the construction of our 29,212 square feet new 7-storey office building for our executives and administrative staff. We also built a 78,020 square feet 7-storey adjacent building to be used as a training facility for sales and marketing team, and our staff’s continuing education. These two new office buildings were built at a cost of approximately RMB26 million (approximately $4 million) by using cash flow from our operations and are debt free. We rented out the 3rd floor and part of the 4th floor of the training facility building totaling an area of 15,931 square feet for a term of four years. The lease began in April 2011 with an annual rental of RMB532,800 ($85,000) for the first year and 5% increment for each year in the next three years.
With the substantial completion of Shenghuo Plaza at the end of 2010, we entered into a new business - the hotel and hospitality business. Shenghuo Plaza consists of 17 storeys totaling approximately 252,984 square feet. Two floors of Shenghuo Plaza are utilized as 12 Ways Chinese Herbal Beauty Demonstration Center, which has begun trial operation since October of 2011. The balance of Shenghuo Plaza is used as a four-star business hotel - Zhonghuang Hotel, restaurant and banquet facilities and an entertainment venue. Shenghuo Plaza began trial operations since January 2011. The interior decoration and outfitting of all the floors were completed in November 2011. As of December 31, 2011, we incurred a cost of approximately RMB146.3 million (approximately $23 million) to build Shenghuo Plaza. While we have not conducted any appraisal, we believe that Shenghuo Plaza can be valued at approximately RMB250 million (approximately $39.7 million) based on the market price of comparable land and buildings. This assumes the issuance of the property ownership certificate and other permits discussed elsewhere herein.
We are also expanding into the businesses of wellness tourism. On April 30, 2009, we formed Shilin Shenghuo Pharmaceutical Co., Ltd. as a wholly owned subsidiary for the purpose of purchasing or leasing land to build our own medicinal herb planting base. On September 8, 2010, we signed an agreement with Management Commission of Kunming Shilin Taiwan Farmer Entrepreneur Centre (“Entrepreneur Centre”) to lease a piece of land located near the Stone Forest which has been recognized as world natural heritage. With an area of 437.9 acres (2,658 Mu), the land will be used to construct a Traditional Chinese Medicine (“TCM”)-based ecological wellness tourism destination that focuses on improving the health and extending the life expectancy of the elderly and introduce TCM culture - Xinglin International Health-Preserving Tourist Resort (the “Resort”). In the Resort, approximately 250.4 acres (1,520 Mu) are devoted to planting suitable-for-cultivating Sanchi and other medicinal herbs for use in the production of our medicinal products since 2011. The rest of the property will be used to build exhibition facilities which emphasize TCM culture, a temple, a TCM museum and apartments for elderly people.
Market Focus
Since our founding, we have focused primarily on the development of products to serve three major markets -cardiovascular and cerebrovascular disease, peptic ulcer disease and health products. Our goal has been to focus on the development of pharmaceutical products and over-the-counter products based on traditional Chinese medicines designed to address these areas.
·Cardiovascular and Cerebrovascular Disease. Hyperlipemia, which is high circulating blood levels of fats such as cholesterol and triglycerides, has ranked high on the list of modern health diseases. The primary effect of hyperlipemia is the development of cardiovascular and cerebrovascular diseases, including heart attacks and strokes.
·Peptic Ulcer Disease. A peptic ulcer is an erosion of the lining of the stomach or the upper part of the small intestine. The causative factors may include excess stomach acid, excess pepsin, Helicobacter Pylori infection, poor health and eating habits, and psychological stress. There is no radical cure for peptic ulcers, which may eventually lead to gastric hemorrhage, gastric perforation and even cancer. People of all ages can be affected by peptic ulcers, but they are most prevalent in persons between the ages of 45 and 55, with incidences in men being slightly higher than in women.
·Health and Food Products. The health products industry, which consists of non-prescription traditional Chinese medicines and supplements, has grown as a result of quality improvements in products and the introduction of new products to the market in China. Over the past two decades, health product sales in Chinese urban areas have increased. The Chinese Ministry of Health has approved several uses for health products and a substantial number of the products on the market are designed to aid in immunoregulation, blood fat regulation and fatigue resistance. In addition, China’s market for cosmetics products is one of the largest in Asia and within the top ten in the world.
Products
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 a greyish-brown or greyish-yellow plant that only grows in a few geographic locations on earth, one of which is Yunnan Province in southwest China, where our operations are located. The main root of Panax notoginseng is cylindrically shaped and is most commonly one-to-six centimeters long and one-to-four centimeters in diameter. Panax notoginseng saponins (PNS), the active ingredient in Panax notoginseng, is extracted from the plant using high-tech equipment and in accordance with the GMP standards. Our three major suppliers of Sanchi plant are Wenshan Qiyuan Trade Co., Ltd., Yunnan Baiyao Group Wenshan Qihua Co., Ltd., and Yunnan Changle Pharmaceutical Co., Ltd., accounting for 36%, 25% and 10% of our Sanqi supply for the year ended December 31, 2011, respectively.
Pharmaceutical Products
Our pharmaceutical product, the Xuesaitong Soft Capsules, is marketed under the Lixuwang brand name and other products are marketed under the Shenhuo brand name, which has been granted Famous Trademark status in Yunnan Province. Famous Trademark is granted by the Administration of Industry and Commerce of Yunnan Province after being approved by the Provincial Brand Attestation Council. This trademark indicates that the Company and its products under Shenhuo brand name have the support of the provincial government of Yunnan Province as a provincial leading enterprise and its product has a strong reputation in quality, after-sale services and market sales. "Lixuwang", the trademark of Xuesaitong Soft Capsules, was awarded the Chinese Well-Known Trademark Honor by the State Administration for Industry and Commerce of China in 2010. This prestigious award recognizes Xuesaitong’s market leading position; gives China Shenghuo access to additional government grants and the green path in anti-counterfeit campaign; and increases the value of this significant intangible asset. The following is a list of our approved pharmaceutical products and their intended uses:
Product Name
Intended Use
Xuesaitong Soft Capsules
Designed to invigorate the circulation of blood and improve microcirculation. Used for the treatment of symptoms of cardiovascular and cerebrovascular disease, such as angina pectoris, strangulation, squeezing and crushing of chest, acute and chronic peripheral vascular-metabolic disorders, brain occlusion, occlusion of retina central vein, acute and chronic cerebral vascular-metabolic disorders caused by arteriosclerosis. This product accounted for approximately 84.5% of our sales for the year ended December 31, 2011.
Qiye Shen’an Tablets
Designed to help relieve headache, insomnia, and palpitation. Designed to invigorate the circulation of blood, improve microcirculation and improve liver functionality.
Banlangen Tablets/Grains
Designed for the treatment of parotitis, pharyngitis, mastitis, swollen and sore throat due to cold and influenza.
Bergenini Tablets
Designed to help relieve cough and phlegm due to bronchial ailments.
Huangtengsu Tablets (film tablets)/Soft Capsules
Designed to treat the symptoms of dysentery, enteritis, respiratory tract infections, uncomplicated urethral, surgery infections and conjunctivitis.
Danshen Tablets
Designed to regulate blood circulation and treat the symptoms of blood stasis. Designed to treat the symptoms of coronary arteriosclerosis, angina pectoris and hyperlipemia.
Triperygium hypoglaucum Hutch Tablets
An immunosuppressant designed to treat the symptoms of rheumatoid arthritis.
Luotongding Tablets
Designed to reduce visceral pain, headache, and cramping.
Siji Sanhuang Tablets
Designed to relieve inflammation and alleviate fever, commonly in connection with pharyngitis.
Sulfadiazine Silver Ointment
Designed to the treatment or the prevention of infections related to burns.
Paracetamol Caffeine and Aspirin Powders
Designed to treat headaches, migraines and fevers caused by influenza and cold.
Tianqi Tongjing Capsules
Designed to treat dysmenorrhea and emmeniopathy caused by colds.
Yinhuang Capsules
Designed to relieve inflammation and sore of throat.
Rhizoma Aspidii and Chinese Wampi leaf Grains
Designed to treat effects of fever, aversion, headache, cough with excessive sputum.
Radix Polygoni Multiflori Capsules
Designed to treat effects of weakness of the kidney and liver, fatigue, and dizziness due to blood deficiencies.
Jinqiancao Tablet
Designed to eliminate dampness and heat, treating stranguria and reducing swelling.
Vitamin AD Soft Capsules
Designed to treat deficiencies of Vitamin A and D.
Vitamin C Tablets
Designed to treat deficiencies of Vitamin C.
Vitamin B6 Tablets
Designed to treat deficiencies of Vitamin B6.
Vitamin E Soft Capsules
Designed to treat deficiencies of Vitamin E.
New drug pipeline
·Wei Dingkang Soft Capsules - a type of traditional Chinese medicine designed to treat peptic ulcer disease by inhibiting bacterial growth, relieving stomach muscle spasms, and reducing inflammation of the intestinal lining. The product is designed to be effective for upset stomach, vomiting, pain and degradation of the stomach lining. The product has been approved by the State Food and Drug Administration (SFDA) for clinical testing. Phase II clinical trials were completed in December 2007, and the phase II exploratory and enhanced clinical trials were completed in 2010. In the third quarter of 2011, we held a seminar with related experts and drafted a preliminary clinical research protocol. We entered into an agreement with a clinical study company to run phase III clinical trials. We anticipate Phase III clinical trials will begin in May of 2012 and will be completed by the first half of 2014. Thereafter, we will submit the application for production approval. We expect to obtain production approval by the end of 2014. We expect to incur a cost of approximately RMB4.2 million (approximately $0.65 million) to run Phase III clinical trials from 2012 to 2014.
·Dencichine for Injection - is designed to treat hemorrhage diseases, such as stop or reduce bleeding during/after operations. The pharmacology and toxicology studies are almost finished and the results demonstrate that Dencichine for Injection shows high effectiveness and high safety both in our internal animal models tests and the test conducted by Nanjing Evaluation and Research Center. So far, we have completed the preparation of the materials and we plan to submit our application for clinical trials to State Food and Drug Administration (SFDA) in May 2012. Assuming required governmental approvals are obtained in a timely fashion, we anticipate that production and marketing of the product will begin in 2014. Dencichine for Injection is a drug requiring extensive testing by the national SFDA, including neurotoxicity testing, which may take a significant amount of time. In addition, clinical testing and audit processes are out of our control, so we must allow for additional time. We incurred approximately RMB658,404 (approximately $101,939) in 2011 and expect to incur approximately RMB4 to 6 million (approximately $0.6 million to $0.9 million) from 2012 to 2014 in connection with clinical trials.
·Sh1002 - is designed to treat one of complications of diabetes mellitus: retinal vascular lesions. We submitted Investigational New Drug Application (IND) for Sh1002 to FDA in October 2010 and have been approved to start IND study after December 24, 2010. The application for clinical trials for Sh1002 in America has also been approved by FDA and the Phase I clinical trial started in the second quarter of 2011 and a group consisted of 18 patient cases accepted the Phase I clinical trial and no one has any adverse drug reactions. With the completion of the Phase I clinical trial in January 2012, we are now preparing for the Phase II clinical trials. We plan to continue conducting the Phase II clinical trials in America and then license our technology to a foreign pharmaceutical company, while retaining the China domestic marketing and the global manufacturing right of Sh1002. We incurred approximately $303,335 for Phase I clinical trials and the preparation for Phase II clinical trials in 2011. Approximately $1.5 million is expected to be expended for Phase II clinical trials.
Health and Food Products
We offer a wide array of over-the-counter supplements as well as vitamin capsules and pills. The following are some of our non-prescription products and their intended uses. We have received government approval and currently market each of the supplements listed below.
Product Name
Intended Use
SHEN HUO Beauty Soft Capsules
Health food designed to help with balancing water in the body.
SHEN HUO Brighten Soft Capsules
Health food designed to help promote healthy skin affected by acne
SHEN HUO Immaculacy Soft Capsules
Health food designed to help promote healthy skin affected by spotting.
SHEN HUO Tian Xin Soft Capsules
Health food designed to reduce blood viscosity and improve blood circulation.
Lycopene Soft Capsules
Food product designed to treat side effects of and act as a general deterrent to certain carcinogens.
Oil of Purple Perilla Soft Capsules
Food product designed to treat effects of cough, asthma and astriction.
Soya Lecithin Soft Capsules
Food product designed to treat effects of high blood fat, hypertension and other diseases of cardiovascular and cerebrovascular systems.
Spirulina Soft Capsules
Food product designed to normalize stomach and intestinal functions.
Gingko Seed Soft Capsules
Food product designed to treat effects of asthma and cough and to normalize lung function.
Kudzu Root Soft Capsules
Food product designed to regulate female’s hormone secretion, improving the sleep quality.
Ass Hide Glue Soft Capsules
Food product designed to help promote healthy skin and complexion.
Hawthorn Soft Capsules
Food product designed to promote stomach function.
Yuhe Soft Capsules
Food product designed to help reduce triglyceride and cholesterol.
Panax Notoginseng Powder
Food product designed to treat effects of coronary heart disease, angina and haematemesis.
Panax Notoginseng Flower
Food product designed to treat effects of dizziness, tinnitus, high blood pressure and acute faucitis.
Panax Notoginseng Root
Food product designed to treat effects of coronary heart disease and angina.
ZAO ZAO KANG Natural Spirulina Extract Tablets
Food product designed to help promote immune system.
Jasmine Tea
Food product designed to help and promote healthy skin affected by acne.
Rose Tea
Food product designed to help promote healthy skin and complexion.
Skin-Nourishing Tea
Food product designed to help promote kidney and spleen functions.
Gegen Tablets
Food product designed to help promote the breast development.
Gastrodia Tuber Powder
Food product designed to treat effects of headache, dizziness and numbness.
Honeysuckle Grains
Food product designed to treat effects of common cold, swollen red eyes and skin sore and furuncle.
The SFDA issues certificates of medicine production approval that include the names, specifications, approval numbers and other information about the approved medicines. According to the law of the Drug Administration of the People’s Republic of China, a drug-manufacturing factory must acquire both the certificate of medicine production permit and medicine production approval before the drug-manufacturing factory has the necessary qualifications to manufacture, market and sell the medicine.
Our anticipated timelines for introduction and marketing of our new drugs depend, in large part, on government approval as well as our experience in the approval process and our communications with the SFDA. Therefore, there is no assurance that such approvals will be obtained at all, or that the anticipated timelines will be met. For instance, we intended to introduce and market certain generic non-prescription supplements such as Fructus Ligustri Lucidi, Radix Astragali Soft Capsules, Ginseng and Pilose Antler Soft Capsules, and Tranquilization Soft Capsules and had applied for approvals that were anticipated to be obtained during 2008. However, in July 2007, China’s former drug and food safety watchdog chief, Xiaoyu Zheng, was executed after being found guilty of corruption and dereliction of duty. Mr. Zheng’s failure to maintain proper standards and carry out correct pharmaceutical safety inspections led to approval of many medicines that should have been blocked or taken from the market. In order to cure Mr. Zhang’s dereliction, SFDA adapted a series of measures to tighten safety controls and strengthen its safety procedures for the pharmaceutical approval process. For these reasons, many drugs that had applications pending were forced to carry out re-examination and approvals have been delayed. In response to this changed regulatory process, the Company determined not to pursue its applications on proposed products further, and instead to shift research and development efforts from making generic drugs to high-tech ones like Wei Dingkang Soft Capsules as well as Dencichine for Injection.
Cosmetic Products
We also offer an expanding line of cosmetic products including lotions, creams and other cosmetic items. The revenue from cosmetics products was $623,000, accounting for approximately 1.4% of our total sales for the year ended December 31, 2011. We have conducted extensive research and have specifically formulated our cosmetic products to meet the cosmetic and skincare needs of our female consumers. Our “12 Ways™ Chinese Traditional Medicine Beauty Salon Series” (“12 Ways”) is a line of over 100 cosmetic products that includes facial masks and creams, skin and eye creams, and shampoos. Our line of products has acquired production approval to be sold only in China. Each of our cosmetic skincare products contains natural ingredients including herbal anti-irritants and anti-oxidants, as well as Sanchi. Our comprehensive line of skincare includes a mixture of basic products (e.g., creams and gels), treatment products (e.g., firming treatments), specialty helpers (e.g., masks), and beauty supplements. The use of supplements is an important element of skincare, nurturing the skin’s health using vital nutrients. Our cosmetic line combines the strength of several skincare methods to achieve healthy skin and beauty.
Strategic Adjustment in Cosmetic
Since the marketing of 12 Ways cosmetics, the Company tried to expand its sales and have expanded the geographic region in which our 12 Ways products were sold from our native Yunnan province to a number of cities and provinces outside our local region. But due to the insufficient funding for marketing development, the sales of 12 Ways cosmetics grew slowly and the subsidiary of cosmetics has suffered a continuing loss. The loss adversely effected the holistic operation of the Company. Currently, the Company has a tight budget, in order to focus on our principal business - pharmaceutical with our limited capital, the Company has decided to make adjustment in Cosmetic in the fourth quarter of 2011. We will not fund the market development for 12 Ways cosmetics until we have enough capital.
Our line of cosmetic products includes the following food products and health supplements.
Product Name
Intended Use
Jasmine Tea
Food product designed to help and promote healthy skin affected by acne.
Rose Tea
Food product designed to help promote healthy skin and complexion.
SHEN HUO Beauty Soft Capsules
Health supplement designed to help with balancing water in the body.
SHEN HUO Brighten Soft Capsules
Health supplement designed to help promote healthy skin affected by spotting.
SHEN HUO Immaculacy Soft Capsules
Health supplement designed to help promote healthy skin affected by acne.
12 Ways Yunnan Bamboo Anti-Acne Cream
Health supplement designed to help promote healthy skin affected by acne.
12 Ways DanShen Spot Fade Light Cream
Health supplement designed to lighten skin discoloration.
12 Ways Eye care series
Health supplement designed to improve the appearance of fine lines, dark circle, and puffiness.
12 Ways Sunscreen Series
Sunscreen product.
12 Ways Panax Notoginseng Moisturizer Series
Moisturizer.
12 Ways Snow Poria Whiten Series
Health supplement designed to lighten and whiten the skin.
Shenghuo Plaza and Zhonghuang Hotel
With the substantial completion of Shenghuo Plaza at the end of 2010, we entered into a new business - the hotel and hospitality business. Shenghuo Plaza consists of 17 storeys totaling approximately 252,984 square feet. Two floors of Shenghuo Plaza are designed to be utilized as 12 Ways Chinese Herbal Beauty Demonstration Center, which has begun trial operation since October of 2011. In the center, we use 12 Ways cosmetics to demonstrate how to keep beautiful and healthy, provide a variety of services, including acupuncture, body massage, foot massage and train our professional beauticians. The Company believes this center is helpful to promote 12 Ways’ brand recognition and the sales of 12 Ways cosmetics. In addition, 12 Ways beauty products are prominently displayed in the lobby of the Shenghuo Plaza in order to expose them to tourists and business clienteles. The balance of Shenghuo Plaza is used as a business hotel - Zhonghuang Hotel, restaurant and banquet facilities and an entertainment venue. The hotel is designed and decorated according to the four-star hotel standards. The market focus of the hotel is tour groups, business people, business conferences, wedding banquet, business banquet, and ancillary services. The Company believes that Shenghuo Plaza is a sound investment that will generate cash flow to support the R&D and the pharmaceutical business of the Company. On November 15, 2010, we formed Shenghuo Hotel Management of which we hold 80% equity interest, while Tianzhiheng Hotel Management Co., Ltd. ("Tianzhiheng") holds a 20% equity interest, to operate the hotel together. Tianzhiheng is a professional hotel management company with rich experiences in hotel operation. The Company believes the cooperation with Tianzhiheng can complement the Company's lack of experience in hotel management business and help the Company to operate the hotel better. As of December 31, 2011, we incurred a cost of approximately RMB146.3 million (approximately $23 million) to build Shenghuo Plaza. Since the construction has been substantially completed as of December 31, 2011, no significant further expenditure is expected. While we have not conducted any appraisal, we believe that Shenghuo Plaza can be valued at approximately RMB250 million (approximately $39.7 million) based on the market price of comparable land and buildings. This assumes the issuance of the property ownership certificate and other permits discussed elsewhere herein. Shenghuo Plaza began trial operations since January 2011. As the interior decoration and outfitting of all the floors were completed in November 2011, the entire Shenghuo Plaza is now open to the public on a trial basis and will be formally open to the public after we obtain our business license. In order to get the business license for Shenghuo Plaza, we must obtain the following certificates: (1) Certificate of Completion Acceptance and Environmental Protection, (2) Certificate of Inner Building Environment Examination, (3) Certificate of Fire Prevention Inspection, (4) Building Completion Examination Certificate and (5) Property Ownership Certificate. As of now, we have obtained the first three certificates mentioned above. We expect to receive the Building Completion Examination Certificate and Property Ownership Certificate in April of 2012. Once the Building Completion Examination Certificate and Property Ownership Certificate are issued, we intend to apply for a business license for Zhonghuang Hotel and use Shenghuo Plaza and the two new office buildings as mortgage collateral for a new loan amounting to RMB100 million (approximately $16 million) to finance the Xinglin International Health-Preserving Tourist Resort discussed below and to reduce current short term debt.
Xinglin International Health-Preserving Tourist Resort
We are also expanding into the businesses of wellness tourism. On April 30, 2009, we formed Shilin Shenghuo Pharmaceutical Co., Ltd. as a wholly owned subsidiary for the purpose of purchasing or leasing land to build our own medicinal herb planting base. On September 8, 2010, we signed an agreement with Management Commission of Kunming Shilin Taiwan Farmer Entrepreneur Centre (“Entrepreneur Centre”) to lease a piece of land located near the Stone Forest which has been recognized as a world natural heritage. With an area of 437.9 acres (2,658 Mu), the land will be used to construct a TCM-based ecological wellness tourism destination that focuses on improving the health and extending the life expectancy of the elderly and introduce TCM culture - Xinglin International Health-Preserving Tourist Resort (the “Resort”). In the Resort, approximately 250.4 acres (1,520 Mu) are devoted to planting suitable-for-cultivating Sanchi and other medicinal herbs for use in the production of our medicinal products since 2011. The rest of the property will be used to build exhibition facilities which emphasize TCM culture, a temple, a TCM museum and apartments for elderly people.
In an effort to reduce costs of raw materials used in our medicinal products, we have grown the medicinal herb Banlangen and Danshen, which are used in the production of our Banlangen Tablets/Grains and Danshen Tablets, on 197.6 acres (1,200 Mu) and 16.5 acres (100 Mu), respectively. We have harvested them at the beginning of 2012. We have also constructed greenhouses within the Resort in which the medicinal herb Sanqi has been grown on 3.3 acres (20 Mu) at the beginning of 2012, which we expect to harvest in 2014.
The total operating lease amounts to approximately RMB30.6 million (equals to approximately $ 4.9 million) with a lease term of 20 years. Our operating lease commitment is approximately $0.4 million for 2012, $0.2 million for each 2013 and 2014 and approximately $3.5 million for 2015.
In January of 2011, we submitted the plan of programming and design of the Resort. It was approved by the Urban and Rural Planning Committee of Shilin County, which consists, among others, of the Secretary of Shilin County Party Committee, the head of Shilin County, deputy head of Shilin County, Construction Bureau, Land and Resource Bureau, Finance Bureau, Environment Protection Bureau of Shilin County and Management Commission of Kunming Shilin Taiwan Farmer Entrepreneur Centre and so on, on March, 22, 2011. We anticipate that the whole Resort project will take 5 years to complete.
As of December 31 2011, we have paid RMB6,798,000($1,079,000) as installment payment, accounting for 18% of the total purchase price of RMB37,800,000 ($5,999,000) for the purchase of certain land use right for the Resort to the Entrepreneur Centre. The remaining balance will be paid in future installments as determined by the Entrepreneur Centre. The terms of the land use right purchase is set forth in the Supplemental Agreement on the Project of Construction of Shilin Shenghuo TCM Cultural Garden (the “Supplemental Agreement”), dated September 8, 2010 between Kunming Shenghuo and the Entrepreneur Center and was previously filed. Both the Lease Agreement and the Supplemental Agreement are subject to the fulfillment by Kunming Shenghuo of certain conditions including timely payment and construction and implementation of the Resort in accordance with the prescribed timeframe and standards.
Growth Strategies
We believe that our business has opportunities for growth through the following growth strategies:
·New Product Development. We have traditionally focused on research and development of products serving the cardiovascular and cerebrovascular disease, peptic ulcer disease and health products markets. We intend to devote additional resources to research and development and to continue to evaluate and develop high-tech and efficient TCM, where we perceive an unmet need and commercial potential, and to improve existing products to enhance their efficacy.
·Focus on Brand Development. 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 our main product "Xuesaitong" Soft Capsules is sold and “Shenhuo” - 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, which we can benefit from by developing and maintaining relationships with professionals within the industry, especially with physicians and hospitals.
·Domestic Growth (China). We intend to grow our internal marketing and sales function and increase our relationships with potential customers to expand the distribution and presence of our non-prescription brands and cosmetics. In expanding market share of our products, we intend to take advantage of our large manufacturing scale and reasonable cost control mechanisms, and our strong sales network. In addition, our goal is to establish our products as a preferred choice for prescription drugs in major hospitals. We believe that establishing a strong reputation with major hospitals may open the market for smaller, community and rural hospitals because patients from large hospitals also receive services from smaller hospitals. We hope to add other prescription drugs, some of which are now in late-stage clinical trial, into this channel over the next few years.
·International Growth. In addition to China, we have sold our products in Asian countries such as Indonesia, Singapore, Japan, Malaysia, Thailand and European countries such as the United Kingdom, Tajikistan, Russia and Kyrgyzstan. We hope to expand sales into other countries where our products could be affordable treatment options.
·Growth of Sales in OTC Market. As sales in the OTC market provides us with higher profit margins than sales to government run pharmacies in hospitals, we plan to increase our sales through the OTC market. In addition to Yunnan province where we generate the most OTC market sales revenue of Xuesaitong, we started to develop main OTC market since 2011 in provinces such as Jiangsu, Fujian, Guangdong, Hunan, Liaoning, Shandong, Heilongjiang, Chongqing, Guangxi and Zhejiang.
·Growth of Hotel and Hospitality Business. Zhonghuang hotel is designed and decorated according to the four-star hotel standards. The market focus of the hotel is tour groups, business people, business conferences, wedding banquet, business banquet, and ancillary services. We intend to focus on providing excellent and satisfying service to attract more and more customers.
In 2011, we insisted in the following four strategies to stabilize and further expand the market for our products: (1) attracting further investment, especially for provinces with low coverage, by implementing a policy of inviting investment, enhancing sales team construction as well as professional training and marketing promotion; (2) developing a plan and budget to expand distribution into the hospitals, which are not selling our products; (3) widening commercial channels by focusing on (i) strengthening the assessment of sales representative/agent’s commercial credits and accounts receivable management, (ii) integrating the resources of commercial channels on the basis of market conditions, and (iii) taking advantage of commercial channels to promote terminal distribution; and (4) expanding the over the counter market, based on the reputation of Lixuwang Soft Capsules, by launching over the counter products to the market, increasing market shares and sales scope and maximizing profit.
Research and Development
As of December 31, 2011, we employed 68 technicians, including 17 senior researchers, 23 mid-level researchers, and 28 junior analysts. The technicians’ specializations include medicine, pharmacology, chemistry, biology, and medicine production equipment. The amount spent for the years ended 2011 and 2010 on research and development is approximately $0.71 million and $0.66 million respectively.
In an attempt to capitalize on the natural resource of Sanchi in Yunnan Province and to develop a strong medical industry in the Yunnan Province, we established an enterprise technology center - Kunming Beisheng Science and Technology Development Company - in cooperation with the Shijia Research Center of Beijing University. However, the project has not generated revenues or conducted operations and on April 23, 2010, the Company got the approval from the government to dissolve Kunming Beisheng Science and Technology Development Company. Accordingly, the Company has established its own Technology Center, which has been equipped with advanced instruments and has recruited highly educated and experienced senior technicians to carry on the projects intended for the Shijia Research Center, such as developing new techniques of extraction, purification and quality control. Moreover the objectives of our Technology Center are the same as we set with Shijia: modernizing Chinese medicine development techniques; improving technological skill and processing techniques; industrialization of Chinese herbal medicine; creation of intellectual property rights; and deepening research into high-end Yunnan Province medicine. The business scope of the project includes development and technology transfer of bulk pharmaceuticals, prepared Chinese medicine, chemicals, biologicals, health food, and medical cosmetic products; importation of scientific instruments and medical technology, and communication with foreign and domestic research centers.
Establishing the Company owned Technology Center has greatly enhanced the Company’s research and development efforts by encouraging independent innovation, strengthening independent research and development capacity and boosting international competitiveness and reducing research and development expenses.
Marketing and Sales
As of December 31, 2011, our marketing team maintains sales offices in approximately 25 provinces throughout China. The sales network covers approximately 215 cities and is staffed by approximately 703 sales representatives.
Our main customers are regional wholesale companies, who resell our products to local hospitals, drug stores, and other channel distributors. In addition, we sell our products directly to retail drug stores. 89% of Xuesaitong’s sales came from sales in hospitals, while 11 % came from OTC markets. Our three largest customers in 2011 are Tianjin Zhongxing Medicine Co., Ltd., Guangzhou Medicine Co., Ltd., and Yunnan Medicine Co., Ltd.. The total sales of our three largest customers accounted for approximately 32.1%, and 25.0% of our sales for the years ended December 31, 2011 and 2010, respectively.
Prices for our products are fixed and determinable. Each time products are purchased, a specific price is agreed upon, a contract is signed and we and the customer are legally bound and neither can change the price. Prices for products are normally derived from our standard price lists; however, larger, more established customers are given quantity discounts. There are no instances in which payment for products sold is contingent on re-sell to or otherwise used by end-user patients.
We have established sales offices in 25 provinces in China that manage sales representatives according to our internal management rules and sales policy. Because the main product “Xuesaitong” Soft Capsules is sold to hospitals through regional wholesale companies located in the various cities of China and because China has thousands of wholesale companies, we employ a large number of sales representatives to expand into new markets and gain new customers.
Sales representatives will be provided with certain sales targets for a particular period according to set price. The sales representatives who complete the sales task within the prescribed period, will be given greater economic incentives and future cooperation opportunities. According to our sales policy, sales representatives earn commissions from us based on the sale amount and the amount collected. The Company reimburses the sales representatives their selling and marketing expenses when they submit the appropriate documentation to be reimbursed and their sales are collected. The Company reimburses the sales representatives their accrued selling expenses when the related accounts receivable are collected.
We believe it is in our-long-term best interest to grow our operations through the over-the-counter (“OTC”) market, which will produce higher profit margins. Besides Yunnan province where Xuesaitong has its presence many years ago, we started to expand Xuesaitong’s presence into the OTC market in selected areas outside Yunnan province around China since 2009. We developed several main OTC markets in 2011 in provinces such as Jiangsu, Fujian, Guangdong, Hunan, Liaoning, Shandong, Heilongjiang, Chongqing, Guangxi and Zhejiang. The performance of OTC market in Yunnan province is best among these provinces, with a gross sales of Xuesaitong Soft Capsules in the OTC market amounting to approximately $2.1 million. The Company reimburses the sales representatives their accrued selling expenses when related accounts receivable are collected.
Production
We manufacture and package our products at our factory located in Kunming, China. The factory, which was built in 2000, is approximately 161,460 square feet and includes a clean area that occupies approximately 86,110 square feet. Our clean area in the production facilities includes approximately 52,500 square feet of Class 10,000 certified area and 2,350 square feet of Class 100,000 certified area. The cleanliness classification is based on the number of dust particles and bacteria per cubic meter, so lower numbers indicate a higher cleanliness class. According to the Regulation for Quality Control of Drug Production issued by the SFDA, oral preparations of traditional Chinese medicines must be produced in a Class 300,000 certified or lower area. Our production facilities use equipment imported from the U.S. and are designed to meet American standards, so our Class 10,000 and Class 100,000 certified areas are cleaner than the Chinese national standard. The production facilities have more than 600 machines and supporting parts for pharmaceutical production from domestic and foreign suppliers. The factory has a total of 28 complete production lines for semi-finished and finished hard capsules, tablets, granules, powder, electuary, and emulsifier. The key facilities are two soft capsule production lines obtained from GIC Company, an American producer of industrial machinery, and an automatic packaging production line purchased from Klockner Haensel GmbH, a German company. In addition, all of our precision testing machines are supplied by Sharp Document Systems, U.S.A. Our production facilities are certified to be in compliance with Good Manufacturing Practice (GMP) standards. We have obtained pharmaceutical products and health food GMP certificates. We currently hold the following GMP certificates: (1) a GMP certificate for ointment products that expires on December 31, 2015; (2) a GMP certificate for powder products that expires on March 5, 2014; (3) a GMP certificate for products in the form of tablet, granule, capsule, and soft capsule that expires on July 18, 2012; and (4) a GMP certificate for health food products that expires on December 25, 2012.
We utilize a complex process in extracting active components from the Sanchi plant, purifying the components and manufacturing our products. A typical manufacturing process begins by obtaining the Sanchi plant from our supplier, washing, and dividing it into main root, branch root and rhizome. The branch root known as “Sanchi Jintiao” and rhizome is known as “Sanchi Jiankou.” The Sanchi Jiankou is the portion of the Sanchi that contains the active ingredient, Panax Notoginseng Saponins. The Sanchi Jiankou is then sent through a heavy pulverizing machinery to crush it into a specified powder size. The Sanchi Jiankou powder then undergoes a complex extracting process in which the powder is mixed with extracting solvents and the resulting solution is percolated and filter processed. The solution is concentrated by vacuum equipment while the extracting solvent is recollected and the active ingredient condensate is collected. The active ingredient condensate is then separated and purified through a chromatographic column, and the Sanchi polysaccharides and Sanchi saponins are collected separately. The solutions of Sanchi saponins and Sanchi polysaccharides are then separately purified by a second chromatographic column to remove pigments and other useless compounds and obtain the pure saponins and polysaccharides, respectively. The Sanchi saponins and Sanchi polysaccharides are then separately dried by a spray-dryer. The resulting powders are weighed and packaged into separate contamination resistant plastic bags, which undergo quality control inspections and are stored in a warehouse for use in our line of products. Production of each product varies depending on the ingredients and form of the product. Production usually includes mixing of the Sanchi powder and the delivery agent, such as oil for soft capsules. The ingredients are then processed using advanced pressing, drying, polishing and blister packaging equipment.
Quality Control
Our production facilities are designed and maintained with a view towards conforming with good practice standards. To comply with GMP operational requirements, we have implemented a quality assurance plan setting forth our quality assurance procedures. Our Quality Control department is responsible for maintaining quality standards throughout the production process. Quality Control executes the following functions:
·setting internal controls and regulations for semi-finished and finished products;
·implementing sampling systems and sample files;
·maintaining the quality of equipment, instruments, reagents, test solutions, volumetric solutions, culture media and laboratory animals;
·auditing production records to ensure delivery of quality products;
·monitoring the number of dust particles and microbes in the clean areas;
·evaluating stability of raw materials, semi-finished products and finished products in order to generate accurate statistics on storage duration and shelf life;
·articulating the responsibilities of Quality Control staff; and
·on-site evaluation of supplier quality control systems.
Competition
The pharmaceutical industry both within China and globally is increasingly competitive and is characterized by rapid and significant technological progress. Our competitors, both domestic and international, include large pharmaceutical companies, universities, and public and private research institutions that currently engage in or may engage in efforts related to the discovery and development of new pharmaceuticals. Many of these entities have substantially greater research and development capabilities and financial, scientific, manufacturing, marketing and sales resources than we do, as well as more experience in research and development, clinical trials, regulatory matters, manufacturing, marketing and sales. Our main domestic competitors are Kunming Pharmaceutical (Group) Co. Ltd. and Heilongjiang ZBD Pharmaceutical (Group) Co., Ltd., while main international competitors are Sanofi - Aventis and Bayer.
Competition in the manufacture and sale of medical products for cardiovascular and cerebrovascular disease in China is also intense. There are a large number of companies that are licensed to manufacture and sell these types of medical products in China. Western drugs such as lovastatins and nitroglycerine have more than half of the market share of medications used to treat cardiovascular and cerebrovascular disease in China. Chinese traditional medicines make up the next largest part of the market. On the whole, Chinese patent medicine still generally has many problems such as complex and unclear ingredients, inconsistent quality, slow action and ineffectiveness. As a result, new Chinese medicines tend not to stay on the market for very long.
There are also many Chinese traditional medicines available to treat peptic ulcers. While they are inexpensive and readily available, they are not as effective as western medicines. In China, peptic ulcers are usually treated with western medicines such as H2 blockers (e.g., Zantac), proton pump inhibitors (e.g., Nexium) and bismuth (e.g., Pepto-Bismol). In addition, amoxicillin and other antibiotics are now commonly used in conjunction to treat peptic ulcers.
The market for health and cosmetic products in China is also highly competitive. Both industries have a high number of competitors, some of which overlap, and many of which have a longer operating history and higher visibility, name recognition and financial resources than we do. Our competitors include manufacturers and marketers of personal care and nutritional products, pharmaceutical companies and other organizations.
Intellectual Property
We rely on a combination of trademark, copyright and trade secret protection laws in China, as well as confidentiality procedures and contractual provisions to protect our intellectual property. Our primary product, Xuesaitong Soft Capsules, first received patent protection and production and new medicine certification in 1999 which will continue until April 25, 2012. We have applied for renewal of the patent protection and are waiting for approval. We also have protections for our technology methods of using Sanchi to help stop bleeding and combination methods, production and function of the medicine to treat intestinal disease. Xuesaitong Soft Capsules receive protections from the SFDA, which will not issue additional drug permits other than those already issued during the protection period. "Lixuwang", the trademark of Xuesaitong Soft Capsules, was awarded the Chinese Well-Known Trademark Honor by the State Administration for Industry and Commerce of China in 2010. This prestigious award gives China Shenghuo green path in anti-counterfeit campaign and intellectual property protection. We have 24 registered trademarks in China. Other than the foregoing, we do not have any measures to prevent any infringement of our intellectual property rights.
Seasonality
Sales in the first quarter are usually lower due to people traveling and taking vacations during the traditional Chinese New Year and Chinese Spring Festival holidays. Sales in the fourth quarter are usually higher.
Government Regulations of Pharmaceuticals
Testing, approval, manufacturing, labeling, advertising, marketing, post-approval safety reporting, and export of our products or product candidates are extensively regulated by governmental authorities in the PRC and other countries. Our principal sales market is presently in China. We are subject to the Drug Administration Law of China, which governs the licensing, manufacturing, marketing and distribution of pharmaceutical products in China and sets penalties for violations. Additionally, we are subject to various regulations and permit systems by the Chinese government.
A pharmaceutical manufacturer must meet the GMP standards which were first enacted in 1988 for each of its production facilities in China in respect of each form of pharmaceutical product it produces. The GMP standards include staff qualifications, production premises and facilities, equipment, raw materials, environmental hygiene, production management, quality control and customer complaint administration. If a manufacturer meets the GMP standards, the SFDA will issue to the manufacturer a GMP certificate, with a five-year validity period. However, for a newly-established pharmaceutical manufacturer that meets the GMP standards, the SFDA will issue a GMP certificate with only a one-year validity period. The SFDA promulgated Good Manufacturing Practices for Pharmaceutical Products (2010 revised version) (the “new GMP”) on February 12, 2011, which became effective on March 1, 2011. The new GMP standards outline the basic principles and standards for the manufacturing of pharmaceutical products and the management of quality controls in the manufacturing process in the PRC. Pharmaceutical manufacturers (except manufacturers of injectables, blood products or vaccines, which have a three-year grace period) have a five-year grace period to upgrade existing facilities to comply with the new GMP standards.
The application and approval procedure in China for a newly developed drug product has numerous steps. New drug applicants prepare the documentation of pharmacological study, toxicity study and pharmacokinetics and drug metabolism (PKDM) study and new drug samples. Documentation and samples are then submitted to provincial food and drug administration (“provincial FDA”). The provincial FDA sends its officials to the applicant to check the applicant’s research and development facilities and to arrange a new drug examination committee meeting for approval deliberations. This process usually takes three months. After documentation and sample approval, the provincial FDA will submit the approved documentation and samples to SFDA. SFDA examines the documentation and tests the samples and arranges a new drug examination committee meeting for approval deliberations. If the application is approved by SFDA, SFDA will issue a clinical trial license to the applicant for clinical trials. The clinical trial license approval typically takes one year. The applicant completes the clinical trial process and prepares documentation and files for submission to SFDA for new drug approval. The clinical trial process usually takes one to two years, depending on the category and class of the new drug. SFDA examines the documentation, gives final approval for the new drug, and issues the new drug license to the applicant. This process usually takes eight months. The whole process for new drug approval usually takes three to four years.
Insurance Catalogues
Pursuant to the Decision of the State Council on the Establishment of the State Basic Medical Insurance System for Urban Employees and the Implementation Measures for the Administration of the Scope of Medical Insurance Coverage for Pharmaceuticals for Urban Employees, the Ministry of Labor and Social Security in China established the State Insurance Catalogue. The State Insurance Catalogue is divided into Parts A and B. The medicines included in Part A are designated by the Chinese governmental authorities for general application. Local governmental authorities may not adjust the content of medicines in Part A. Although the medicines included in Part B are designated by Chinese governmental authorities in the first instance, provincial level authorities may make limited changes to the medicines included in Part B, resulting in some regional variations in the medicines included in Part B from region to region. Patients purchasing medicines included in Part A are entitled to reimbursement of 100% of the costs of such medicines from the social medical fund in accordance with relevant regulations in China. Patients purchasing medicines included in Part B are required to pay a predetermined proportion of the costs of such medicines (approximately 10% of such costs).
The medicines included in the State Insurance Catalogues are selected by the Chinese government authorities based on various factors including treatment requirements, frequency of use, effectiveness and price. Medicines included in the State Insurance Catalogue are subject to price control by the Chinese government. The State Insurance Catalogues are supposed to be revised every two years. In connection with each revision, the relevant provincial drug authority collects proposals from relevant enterprises before organizing a comprehensive appraisal. The Ministry of Labor and Social Security then makes the final decision on any revisions based on the preliminary opinion suggested by the provincial drug administration. Other than completing a normal application process, we have no role in the selection of products for inclusion in the State Insurance Catalog.
In addition to the State Insurance Catalogue, each of the 31 Chinese provinces establishes its own provincial insurance catalogues (each, a “PIC”). A drug listed on the PIC will result in the patient purchasing such drug to receive the same 90% reimbursement as if such drug were listed on Part B of the State Insurance Catalogue. Since 2005, our primary product, Xuesaitong Soft Capsules had been listed in Part B of the State Insurance Catalogue. Xuesaitong Soft Capsules represented approximately 84.5% of our sales for the year ended December 31, 2011. On July 1, 2010, the updated State Insurance Catalogue became effective. Xuesaitong Soft Capsules, our primary product, was not included in Part B of the State Insurance Catalogue as it has been since 2005. Banlangen Tablets, Dansheng Tablets and Sulfadiazine Silver Ointment remain listed in the updated State Insurance Catalogue. Patients purchasing medicines included in Part B are entitled to reimbursement of about 90% of the costs of such medicines. There is an alternative route to achieve a similar result. That is, for Xuesaitong Soft Capsules to be included in the Provincial Insurance Catalog of each of the 31 Chinese provinces. This will allow the patient purchasing such drug to receive the same 90% reimbursement as if such drug were listed on Part B of the State Insurance Catalogue.
The Company in 2011 and 2010 applied for provincial listing in 31 provinces. Xuesaitong Soft Capsules has been listed in the 2010 Provincial Insurance Catalogs of the following sixteen provinces and cities: Tianjin, Jiangsu, Hebei, Henan, Shanghai, Heilongjiang, Fujian, Anhui, Guangdong, Yunnan, Beijing, Guangxi, Inner Mongolia, Shaanxi, Gansu and Hunan. The total percentage of sales derived from Xuesaitong Soft Capsules in these provinces account for approximately 77% in 2011 and 72% in 2010. Xuesaitong Soft Capsules has been delisted from the 2010 Provincial Insurance Catalogs of the following 15 provinces: Zhejiang, Jiangxi, Jilin, Liaoning, Shangdong, Shanxi, Chongqing, Hubei, Sichuan, Xinjiang, Guizhou, Qinghai, Ningxia, Tibet and Hainan provinces and city where it generated a sales of 20.19% in 2011 and 28% in 2010. Xuesaitong Soft Capsules accounted for about 84.5% of the Company's revenues in 2011. The Provincial Insurance Catalogs are normally updated every four years.
Further, the Department of Heath in China, which makes an independent assessment of the drugs available, publishes a “State Essential Drug List” as to what drugs are basic and prevalent and can satisfy the ordinary need for drugs to all the people. Patients purchasing medicines included in the “State Essential Drug List” are entitled to reimbursement of 90% of the costs of such medicines from the social medical fund in accordance with relevant regulations in China. In addition to the State Essential Drug List, each of the 31 Chinese provinces is entitled to add about 100 drugs to the State Essential Drug List. A drug listed on the provincial list will result in the patient purchasing such drug to receive the same 90% reimbursement. The Company’s Xuesaitong Soft Capsules was listed on the “State Essential Drug List” in 2000 and 2004 and the list is supposed to be updated every four years. Xuesaitong Soft Capsules is not included in the State Essential Drug List now but has been listed in four provinces and cities’ 2010 provincial essential drug list - Yunnan, Henan, Hunan and Tianjin.
Price Controls
The wholesale and retail prices of medicines that are included in the national and provincial insurance catalogs are subject to price controls administered by the Price Control Office under the National Development and Reform Commission, or the NDRC, or their provincial price control authorities. Since Xuesaitong Soft Capsules is no longer listed in the 2010 State Insurance Catalog and the 2010 Provincial Insurance Catalogs of Zhejiang, Jiangxi, Jilin, Liaoning, Shangdong, Shanxi, Chongqing, Hubei, Sichuan, Xinjiang, Guizhou, Qinghai, Ningxia, Tibet and Hainan, it is no longer subject to the state price control and provincial price controls in these twelve provinces and the Company has the right to determine the retail price of .Xuesaitong Soft Capsules in these provinces. However, since Xuesaitong Soft Capsules is still listed in the insurance catalogs of the rest of the sixteen provinces, its price is still subject to price control administered by the price control authorities in those provinces.
The original price, as approved by the government, was RMB45 (approximately $7.1) per box of 24 capsules. As of December 31, 2011, its maximum price has been adjusted to RMB58.6 (approximately $9.3) per box of 24 capsules. Since March 2007, Xuesaitong Soft Capsules has been placed into the category of “Higher Price for Better Quality” by the National Development and Reform Commission (The “NDRC”). Therefore, the drug benefits from price protection and is exempted from price reduction. Moreover, the category has become a standard of choosing medicines for cardiovascular and cerebrovascular disease.
Environmental Matters
We comply with the Environmental Protection Law of China as well as the applicable local regulations. In addition to statutory and regulatory compliance, we actively ensure the environmental sustainability of our operations. Penalties would be levied upon us if we fail to adhere to and maintain certain standards. Such failure has not occurred in the past, and we generally do not anticipate that it will occur in the future, but no assurance can be given in this regard.
Employees
As of December 31, 2011, we had 656 employees and 416 of these are full-time employees and receive labor insurance. These employees are organized into a union under the labor laws of China and can bargain collectively with us. In addition, we employ over 703 sales representatives who are paid on a commission basis. These representatives are not part of the union. We maintain good relations with our employees.
We are required to contribute a portion of our employees’ total salaries to the Chinese government’s social insurance funds, including medical insurance, unemployment insurance and job injuries insurance, and a housing assistance fund, in accordance with relevant regulations. We expect the amount of our contribution to the government’s social insurance funds to increase in the future as we expand our workforce and operations.
Additional Information
We are subject to the information and periodic reporting requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and in accordance with the Exchange Act, we file annual, quarterly and special reports, and other information with the Securities and Exchange Commission. These periodic reports and other information are available for inspection and copying at the regional offices, public reference facilities and website of the Securities and Exchange Commission referred to below.
Statements contained in this report about the contents of any contract or any other document that is filed as an exhibit are not necessarily complete, and we refer you to the full text of the contract or other document filed as an exhibit. A copy of annual, quarterly and special reports and related exhibits and schedules may be inspected without charge at the Public Reference Room maintained by the Securities and Exchange Commission at 100 F Street, N.E., Washington, D.C. 20549. Copies of such reports may be obtained from the Securities and Exchange Commission upon payment of the prescribed fee. Information regarding the operation of the Public Reference Room may be obtained by calling the Securities and Exchange Commission at 1-800-SEC-0330 or visiting their website at www.sec.gov. The Securities and Exchange Commission maintains a web site that contains reports, proxy and information statements, and other information regarding registrants that file electronically with the SEC.
ITEM 1A.
ITEM 1A. RISK FACTORS.
Any investment in our common stock involves a high degree of risk. Investors should carefully consider the risks described below and all of the information contained in this report before deciding whether to purchase our common stock. Our business, financial condition or results of operations could be materially adversely affected by these risks if any of them actually occur. The trading price of our common stock could decline due to any of these risks, and an investor may lose all or part of his investment. Some of these factors have affected our financial condition and operating results in the past or are currently affecting our company. This report also contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including the risks we face as described below and elsewhere in this report. With respect to this discussion, the terms “Shenghuo,” the “Company,” “we,” “us,” or “our” refer to China Shenghuo Pharmaceutical Holdings, Inc., our 94.95%-owned subsidiary Kunming Shenghuo Pharmaceutical (Group) Co., Ltd. (“Shenghuo China”) and the five foreign owned subsidiaries of Shenghuo China that are organized under the laws of the People’s Republic of China (“PRC” or “China”).
RISKS RELATED TO OUR OPERATIONS
We May Not Be Able To Refinance or Repay Loans We Have Received.
As of December 31, 2011, we had approximately $22.1 million of loans maturing in 2012 (including an aggregate of $3.3 million maturing in January 2012, which has been repaid as of the date of the report, $7.5 million maturing in April 2012, $4.5 million maturing in May 2012, $0.4 million maturing in June 2012, $5.6 maturing in August 2012, $0.8 million maturing in September 2012 and $0.04 million to be repaid on demand). Although we plan to use Shenghuo Plaza and the two new office buildings as mortgage collateral for new loans to reduce current short term debt once we obtain the Property Ownership Certificate, there can be no assurance that we will be able to refinance the loans on acceptable terms or at all, and we do not have at this time the cash necessary to repay the loans as they mature. If we do not refinance or cannot repay our outstanding loans and we default on our obligations, the lenders can demand accelerated payment and foreclose on collateral, our financial condition would be materially adversely affected, and we could be forced to cease operations. Furthermore, even if we are able to obtain extensions on our existing loans, such extensions may include operational and financial covenants significantly more restrictive than our current loan covenants, which would adversely affect our plans and business goals.
Although We Achieved Positive Income For The Years Ended December 31, 2011 and 2010 Respectively, We Recorded Working Capital Deficiency for the Years Ended December 31, 2011, and 2010, And Our Business Condition Is Uncertain.
Although we have had a history prior to 2008 of positive income, working capital and retained earnings and we realized a net income of approximately $0.1 million and $1.2 million for the year ended December 31, 2011 and December 31, 2010, respectively, we incurred a net loss of approximately $6.6 million and $4.6 million for the years ended December 31, 2009 and December 31, 2008, respectively. We also recorded a working capital deficiency amounting to approximately $23.2 million and $15.3 million for the years ended December 31, 2011 and 2010, respectively. These factors raise substantial doubt about the Company’s ability to continue as a going concern. Many of those losses occurred in 2009 and were associated with our effort to develop better channels for selling our products with a view to also growing our sales through the OTC market, in order to realize higher product margins. Although our OTC market increased during these two years, it is uncertain whether our efforts in that regard will ultimately succeed to the level we envision.
Our Current Business Is Primarily Based On A Single Product, Which Currently Accounts For Approximately 84.5% Of Our Revenues, And We May Not Be Able To Generate Significant Revenue If This Product Fails.
Approximately 84.5% of our sales for the year ended December 31, 2011 comes from a single product, Xuesaitong Soft Capsules, and our business may fail if this product fails or generates materially less sales revenues. If we experience delays, increased expenses, or other difficulties in the manufacture and sale of the Xuesaitong Soft Capsules, or if our renewal application of the patent protection is rejected, then we may not be able to generate significant revenues or profitability, and our business and financial condition would be materially adversely affected and we could be forced to cease operations, in which case investors may lose all or part of their investment in our company.
We Rely On A Few Suppliers For Sanchi, The Primary Ingredient in Most of Our Products, And Any Disruption With Our Suppliers Could Delay Product Shipments And Have a Material Adverse Impact on Our Business Operations And Profitability.
Due to the limited availability of Sanchi, we currently rely on a small number of suppliers as our source for Sanchi, the primary raw material that is needed for us to produce our products. We believe that there are few alternative suppliers available to supply the Sanchi plant, and should any of our current suppliers terminate their business arrangements with us or increase their prices of materials supplied, it would delay product shipments and adversely affect our business operations and profitability. In addition, if the suppliers refused to sell Sanchi, or increased the sales prices of Sanchi, this would also have a material adverse impact on the results of operations. In an effort to reduce costs of Sanchi, in 2011, we constructed green houses in which Sanqi has been grown on the 3.3 acres (20 Mu) within the Resort. We hope this will reduce our reliance on third party suppliers of Sanqi in the future. However, since it normally takes three years from the time Sanchi is grown until the first yield is realized, we will continue to be dependent on third party suppliers in the immediately future.
If Our Primary Product Is Replaced By Other Medicines, Is Removed From Key Independent Insurance Catalogues of the Various Provinces, Our Revenue Will Suffer Substantially.
Under Chinese regulations, patients purchasing medicines listed by China’s state and/or provincial governments in the insurance catalogues, which include the State Insurance Catalogue and the insurance catalogues of various provinces (“PIC”), may be reimbursed, in part or in whole, by a social medicine fund. Accordingly, pharmaceutical distributors prefer to engage in the distribution of medicines listed in the State Insurance Catalogue or the PICs. Since 2005, our main, Xuesaitong Soft Capsules, had been listed in the State Insurance Catalogue. The content of the State Insurance Catalogue is subject to change by the Ministry of Labor and Social Security of China, and new medicines may be added to the State Insurance Catalogue by provincial level authorities as part of their limited ability to change certain medicines listed in the State Insurance Catalogue. Xuesaitong Soft Capsules accounted for approximately 84.5% of our sales for the year ended December 31, 2011. On July 1, 2010, the updated State Insurance Catalogue became effective. Xuesaitong Soft Capsules, our primary product, was not included in Part B of the State Insurance Catalogue as it has been since 2005. However, if Xuesaitong Soft Capsules is included in the Provincial Insurance Catalog of each of the 31 Chinese provinces, this will allow the patient purchasing such drug to receive the same 90% reimbursement as if such drug were listed on Part B of the State Insurance Catalogue. The update of all Provincial Insurance Catalogs of the 31 Chinese provinces has been completed in 2011 and Xuesaitong Soft Capsules has been listed in the 2010 Provincial Insurance Catalogs of the following sixteen provinces and cities: Tianjin, Jiangsu, Hebei, Henan, Shanghai, Heilongjiang, Fujian, Anhui, Guangdong, Yunnan, Beijing, Guangxi, Inner Mongolia, Shaanxi, Gansu and Hunan. The total percentage of sales derived from Xuesaitong Soft Capsules in these provinces account for approximately 72% in 2010 and 77% in 2011. Xuesaitong Soft Capsules has been delisted from the 2010 Provincial Insurance Catalogs of the following 15 provinces: Zhejiang, Jiangxi, Jilin, Liaoning, Shangdong, Shanxi, Chongqing, Hubei, Sichuan, Xinjiang, Guizhou, Qinghai, Ningxia, Tibet and Hainan provinces and city where it generated a sales of 28% in 2010 and 20.19% in 2011. Should the Company fail to receive provincial approval in the major provinces in which it is sold, such failure could have a material adverse impact on the Company.
We May Need To Raise Additional Capital To Fund Our Operations And Failure To Raise Additional Capital May Force Us To Delay, Reduce, Or Eliminate Our Product Development Programs.
Due to the large amount of funds required for research and development and the subsequent marketing of products, the pharmaceutical industry is very capital intensive. The industry is characterized by small receivable turnovers, which could mean that we will need more working capital if our revenues increase. We have traditionally been committed to research and development and it is possible that we will need to raise additional capital within the foreseeable future. Additional capital may be needed for the development of new products or product lines, advances to sales representatives, financing of general and administrative expenses, licensing or acquisition of additional technologies, and marketing of new or existing products. There are no assurances that we will be able to raise the appropriate amount of capital needed for our future operations. Failure to obtain funding when needed may force us to delay, reduce, or eliminate our product development programs.
Currently, all of the Company’s land, buildings and machinery are collateral securing certain bank loans. If we default on the repayment obligations when due, the properties may be foreclosed upon by the lenders, and our operations would be materially adversely affected and we might cease to be able to operate as a going concern.
We May Have Difficulty Establishing Adequate Management, Legal And Financial Controls In The PRC.
PRC companies have historically not adopted a western style of management and financial reporting concepts and practices, which includes strong corporate governance, internal controls, and computer, financial and other control systems. In addition, we have had difficulty in hiring and retaining a sufficient number of qualified employees to work in the PRC, including employees trained in US GAAP. As a result of these factors, we have had and continue to have difficulty in establishing management, legal and financial controls, collecting financial data and preparing financial statements, books of account and corporate records and instituting business practices that meet western standards. We have experienced difficulties in implementing and maintaining adequate internal controls as required under Section 404 of the Sarbanes-Oxley Act of 2002, resulting in significant deficiencies and material weaknesses in our internal controls which could impact the reliability of our financial statements and prevent us from complying with SEC rules and regulations and the requirements of the Sarbanes-Oxley Act of 2002. This occurred in 2008, and caused the restatement of our financial statements for fiscal 2007 and the first quarter of 2008, and the temporary suspension of trading in our stock on the NYSE Amex. Any such deficiencies, weaknesses or lack of compliance could have a materially adverse effect on our business.
Our Three Largest Customers Account For A Significant Percentage of Our Sales. We Cannot Be Certain That These Sales Will Continue; If They Do Not, Our Revenues Will Likely Decline.
Our three largest customers accounted for approximately 32.1% and 25.0% of our sales for the years ended December 31, 2011 and 2010, respectively. We do not have any long-term contracts with these customers, each of whom orders only on a “purchase order” basis. There can be no assurances that any of these customers will continue to purchase products from us. The loss of any or all of these customers or a significant reduction in their orders would have a materially adverse effect on our revenues.
The Failure To Manage Growth Effectively Could Have An Adverse Effect On Our Business, Financial Condition, And Results Of Operations.
The rapid market growth, if any, of our pharmaceutical products may require us to expand our employee base for managerial, operational, financial, and other purposes. As of December 31, 2011, we had 416 full-time, salaried employees, in addition to our employment of over 703 sales representatives who are paid on a commission basis. The continued future growth will impose significant added responsibilities upon the members of our management to identify, recruit, maintain, integrate, and motivate new employees. Aside from increased difficulties in the management of human resources, we may also encounter working capital issues, as we need increased liquidity to finance the purchases of raw materials and supplies, research and development of new products, acquisition of new businesses and technologies, and the hiring of additional employees. For effective growth management, we will be required to continue improving our operations, management, and financial systems and control. Our failure to manage growth effectively may lead to operational and financial inefficiencies that will have a negative effect on our profitability.
Our Planned Expansion Of Sales Into Overseas Markets Could Fail, Reduce Operating Results And/Or Expose Us To Increased Risks Associated With Different Market Dynamics And Competition In Any Of The Foreign Countries Where We Attempt To Sell Our Products.
We would face many new obstacles in our planned expansion of product sales in overseas markets. These markets are untested for our products and we face risks in expanding our business overseas, which include differences in regulatory product testing requirements, patent protection, taxation policy, legal systems and rules, marketing costs, fluctuations in currency exchange rates and changes in political and economic conditions. We may not be as successful as our competitors in generating revenues in international markets due to the lack of recognition of our products or other factors. Developing product recognition overseas is expensive and time-consuming and our international expansion efforts may be more costly and less profitable than we expect. If we are not successful in our target markets, our sales could decline, our margins could be negatively impacted and we could lose market share, any of which could materially harm our business, results of operations and profitability.
We Are Dependent On Certain Key Personnel And Loss Of These Key Personnel Could Have A Material Adverse Effect On Our Business, Financial Condition And Results Of Operations.
Our success is, to a certain extent, attributable to the management, sales and marketing, and pharmaceutical factory operational expertise of key personnel. Gui Hua Lan, our non-executive Chairman of the Board, Feng Lan, our Chief Executive Officer and President, Lei Lan, our Vice President, and Raymond Wang, our Chief Financial Officer, perform key functions in the operation of our business. There can be no assurance that we will be able to retain these officers after the term of their employment contracts expire. The loss of these officers could have a material adverse effect upon our business, financial condition, and results of operations. We must attract, recruit and retain a sizeable workforce of technically competent employees. Our ability to effectively implement our business strategy will depend upon, among other factors, the successful recruitment and retention of additional highly skilled and experienced management and other key personnel. We cannot assure that we will be able to hire or retain such employees.
Our Business And The Success Of Our Products Could Be Harmed If We Are Unable To Maintain Our Brand Image.
We believe that establishing and strengthening our Lixuwang brand is critical to achieving widespread acceptance of our products and to establishing key strategic relationships. The importance of brand recognition will increase as current and potential competitors enter the Chinese pharmaceutical market with competing products. Our ability to promote and position our Lixuwang brand depends largely on the success of our marketing efforts and our ability to provide high quality products and customer service. These activities are expensive and we may not generate a corresponding increase in sales to justify these costs. If we fail to establish and maintain our brand, or if our brand value is damaged or diluted, we may be unable to maintain or increase our sales or revenue.
We Face Intense Competition In The Pharmaceutical Industry And Such Competition Could Cause Our Sales Revenue And Profits To Decline.
The pharmaceutical industry both within China and globally is intensely competitive and is characterized by rapid and significant technological progress, and our operating environment is increasingly competitive. We face intense competitors that will attempt to create or are marketing products in the PRC that are similar to our products. Our competitors, both domestic and international, include large pharmaceutical companies, universities, and public and private research institutions that currently engage in or may engage in efforts related to the discovery and development of new pharmaceuticals. Many of these entities have substantially greater research and development capabilities and financial, scientific, manufacturing, marketing and sales resources than we do, as well as more experience in research and development, clinical trials, regulatory matters, manufacturing, marketing and sales. There can be no assurance that our products will be either more effective in their therapeutic abilities and/or be able to compete in price with that of our competitors. Failure to do either of these may result in decreased profits.
If Our Pharmaceutical Products Fail To Receive Regulatory Approval Or Are Severely Limited In These Products’ Scope Of Use, We May Be Unable To Recoup Considerable Research And Development Expenditures.
The production of our pharmaceutical products is subject to the regulatory approval of the State Food and Drug Administration (SFDA) in China. The regulatory approval procedure for pharmaceuticals can be quite lengthy, costly, and uncertain. Depending upon the discretion of the SFDA, the approval process may be significantly delayed by additional clinical testing and require the expenditure of resources not currently available; in such an event, it may be necessary for us to abandon our application. Even where approval of the product is granted, it may contain significant limitations in the form of narrow indications, warnings, precautions, or contra-indications with respect to conditions of use. If approval of our product is denied, abandoned, or severely limited in terms of the scope of products use, it may result in the inability to recoup considerable research and development expenditures. In this regard, in 2009, two non-prescription supplemental pharmaceutical products, Levofloxacin Hydrochloride Soft Capsules and Brufen Soft Capsules, for which we had applied for production approval, were rejected by SFDA under its new, stricter regulatory procedures, and we are now unable to recoup those R&D investments.
Currently, two of our products, Wei Dingkang Soft Capsules and Dencichine for Injection, have pending applications with the SFDA. Phase II exploratory and enhanced clinical trials for Wei DingKang have been completed in 2010 and Phase III clinical trials are expected start in May 2012 and completed by June 2014. The pharmacology and toxicology studies of Dencichine for Injection are almost finished and we are planning to apply for clinical trails for it with the State Food and Drug Administration (SFDA) in May of 2012. Clinical trails may take a significant amount of time. In addition, clinical testing and audit processes are out of our control, so we must allow for additional time. The Chinese Military Medical Institute performs these tests. The risk is that if we do not receive timely approval for either of these drugs, then production will be delayed and sales of the products cannot be planned for.
If All Or A Significant Portion Of Our Customers With Trade Receivables Fail To Pay All Or Part Of The Trade Receivables Or Delay The Repayment, Our Net Income Will Decrease And Our Profitability Will Be Adversely Affected.
As of December 31, 2011, our net accounts and notes receivable (less allowance for doubtful accounts of approximately $2.6 million) were approximately $18.1 million. The standard credit period for most of our new clients is two months. For certain clients, such as long-standing clients or large clients, we will extend the credit period. Currently, most of our clients have established a long-term corporate relationship with us, so their credit periods are generally six months. Within the medical industry in China, the collection period is generally longer than that for other industries. Our estimated average collection period for the year ended December 31, 2011 was 71 days. There is no assurance that our trade receivables will be fully repaid on a timely basis. If all or a significant portion of our customers with trade receivables fail to pay all or part of the trade receivables or delay the payment due to us for whatever reason, our net profit will decrease and our profitability will be adversely affected, and our liquidity will be adversely affected.
Our Success Is Highly Dependent On Continually Developing New And Advanced Products, Technologies, And Processes And Failure To Do So May Cause Us To Lose Our Competitiveness In The Pharmaceutical Industry And May Cause Our Profits To Decline.
To remain competitive in the pharmaceutical industry, it is important to continually develop new and advanced products, technologies, and processes. There is no assurance that our competitors’ new products, technologies, and processes will not render our existing products obsolete or non-competitive. Our competitiveness in the pharmaceutical market therefore relies upon our ability to enhance our current products, introduce new products, and develop and implement new technologies and processes. The research and development of new products and technologies is costly and time consuming, and there are no assurances that our research and development of new products will either be successful or completed within the anticipated timeframe, if at all. Our failure to technologically evolve and/or develop new or enhanced products may cause us to lose our competitiveness in the pharmaceutical industry and may cause our profits to decline.
If We Fail To Develop New Products With High Profit Margins And Our High Profit Margin Products Are Substituted By Competitor’s Products, Our Gross And Net Profit Margins Will Be Adversely Affected.
The pharmaceutical industry is very competitive, and there may be pressure to reduce sale prices of products without a corresponding decrease in the price of raw materials. In addition, the medical industry in China is highly competitive and new products are constantly being introduced to the market. In order to increase the sales of our products and expand our market, we may be forced to reduce prices in the future, leading to a decrease in gross profit margin. To the extent that we fail to develop new products with high profit margins and our high profit margin products are substituted by competitors’ products, our gross profit margins will be adversely affected.
The Commercial Success Of Our Products Depends Upon The Degree Of Market Acceptance Among The Medical Community And Failure To Attain Market Acceptance Among The Medical Community May Have An Adverse Impact On Our Operations And Profitability.
The commercial success of our products depends upon the degree of market acceptance among the medical community, such as hospitals and physicians. Even if our products are approved by the SFDA, there is no assurance that physicians will prescribe or recommend our products to patients. Furthermore, a product’s prevalence and use at hospitals may be contingent upon our relationship with the medical community. The acceptance of our products among the medical community may depend upon several factors, including but not limited to, the product’s acceptance by physicians and patients as a safe and effective treatment, cost effectiveness, potential advantages over alternative treatments, and the prevalence and severity of side effects. Failure to attain market acceptance among the medical community may have an adverse impact on our operations and profitability.
Our Primary Product Is Subject To Price Controls By The China Government, Which May Affect Both Our Revenues And Net Income.
The laws of the PRC provide for the government to fix and adjust prices. Our primary product Xuesaitong Soft Capsules was subject to price controls which affected our gross profit, gross margin and net income. Since Xuesaitong Soft Capsules is no longer listed in the 2010 State Insurance Catalog and the 2010 Provincial Insurance Catalogs of Zhejiang, Jiangxi, Jilin, Liaoning, Shangdong, Shanxi, Chongqing, Hubei, Sichuan, Xinjiang, Guizhou, Qinghai, Ningxia, Tibet and Hainan, it is no longer subject to the state price control and provincial price controls in these fifteen provinces and the Company has the right to determine the retail price of Xuesaitong Soft Capsules in these provinces. However, since Xuesaitong Soft Capsules is still listed in the insurance catalogs of the rest of the sixteen provinces, its price is still subject to price control administered by the price control authorities in those provinces.
It is possible that additional products may be subject to price control, or that price controls may be increased in the future. To the extent that we are subject to price control, our revenue, gross profit, gross margin and net income will be affected since the revenue we derive from our sales will be limited and we may face no limitation on our costs. Further, if price controls affect both our revenue and costs, our profitability will be effectively subject to regulatory authorities in the PRC.
Our Certificates, Permits, And Licenses Related To Our Pharmaceutical Operations Are Subject To Governmental Control And Renewal And Failure To Obtain Renewal Will Cause All Or Part Of Our Operations To Be Terminated.
We are subject to various PRC laws and regulations pertaining to the pharmaceutical industry. We have attained certificates, permits, and licenses required for the operation of a pharmaceutical enterprise and the manufacturing of pharmaceutical products in the PRC. The pharmaceutical production permit and GMP certificates are valid for a term of five years and the health food certifications are valid for four year terms, and each must be renewed before their expiration. We originally obtained our Medicine Production Permit on November 4, 1996, which is valid until December 31, 2015. The Medicine Production Permit applies to products described as tablet, granule, capsule, soft capsule, powder, ointment and medicinal. If the permit expires without renewal, we will not be able to operate medicine production which will cause our operations to be terminated.
We intend to apply for renewal of these certificates, permits, and licenses prior to expiration. During the renewal process, we will be re-evaluated by the appropriate governmental authorities and must comply with the then-prevailing standards and regulations which may change from time to time. In the event that we are not able to renew the certificates, permits and licenses, all or part of our operations may be terminated. Furthermore, if escalating compliance costs associated with governmental standards and regulations restrict or prohibit any part of our operations, our operations and profitability may be materially adversely affected.
Failure To Comply With Applicable GMP Standards Could Have A Material Adverse Effect On Our Business, Financial Condition And Results Of Operations.
We are required to comply with applicable GMP regulations, which include requirements relating to personnel, premises and equipment, raw materials and products, qualification and validation, documents management, production management, quality control and quality assurance, and products distribution and recall. Manufacturing facilities must be approved by governmental authorities before we can use them to commercially manufacture our products and are subject to inspection by regulatory agencies. The SFDA have implemented the more stringent new GMP standards which are aimed at improving drug production management and controlling risks in the production process and introduce internationally-recognized quality control mechanisms. The latest update to the GMP standards have greatly raised the bar for quality control, documentation, and overall manufacturing processes, thus causing an increase of cost in manufacturing and decrease of profit margins.
A pharmaceutical manufacturer must meet the new GMP standards, which became effective on March 1, 2011for each of its production facilities in China with respect to each form of pharmaceutical products it produces within a five-years grace period. Manufacturers of injectables, blood products, or vaccines have a three-years grace period to bring existing facilities in line with the revisions.
We have obtained pharmaceutical products and health food GMP certificates. We currently hold the following GMP certificates: (1) a GMP certificate for ointment products that expires on December 31, 2015; (2) a GMP certificate for powder products that expires on March 5, 2014; (3) a GMP certificate for products in the form of tablet, granule, capsule, and soft capsule that expires on July 18, 2012; and (4) a GMP certificate for health food products that expires on December 25, 2012.
Although our products meet the GMP guidelines and we are in the process to renew some GMP certificates and, we may not obtain clearance from the SFDA in the event that we are inspected. Although we intend to upgrade our production facilities to bring them in line with the new GMP standards, any failure to comply with the new GMP standards may subject us to fines or other penalties, which may have a material and adverse impact on our business, financial condition and results of operations.
We Cannot Guarantee The Protection Of Our Intellectual Property Rights And If Infringement Or Counterfeiting Of Our Intellectual Property Rights Occurs, Our Reputation And Business May Be Adversely Affected.
To protect the reputation of our products, we have registered and applied for registration of our trademarks in the PRC where we have a major business presence. Our products are sold under these trademarks. There is no assurance that there will not be any infringement of our brand name or other registered trademarks or counterfeiting of our products in the future. Should any such infringement or counterfeiting occur, our reputation and business may be adversely affected. We may also incur significant expenses and substantial amounts of time and effort to enforce our intellectual property rights in the future. Such diversion of our resources may adversely affect our existing business and future expansion plans.
We Expect to Lose Certain Preferential Tax Concessions, Which May Cause Our Tax Liabilities To Increase And Our Profitability To Decline.
We enjoy preferential tax concessions in the PRC as a high-tech enterprise. We had a tax preference for 2008, as determined by the PRC government and the regional tax authorities. On March 16, 2007, the National People’s Congress of China enacted a new PRC Enterprise Income Tax Law (the “EIT Law”), under which domestic-invested enterprises and foreign-invested entities will be subject to enterprise income tax at a uniform rate of 25% unless they qualify under certain limited exceptions. The new law became effective on January 1, 2008. During the transition period for enterprises established before March 16, the tax rate will gradually increase starting in 2008 and will be equal to the new tax rate in 2012. The Company is qualified to enjoy preferential tax rate under relevant PRC tax laws and regulations, with effective income tax rate of 10% in 2009, 11% in 2010 and 12% in 2011. All subsidiaries which are non-manufacturers will be subject to the EIT Law at a rate of 25%.
Because of the EIT Law, our tax liabilities will increase and our profits may accordingly decline as our reduced income tax rate is no longer applicable and/or the tax relief on investment in PRC is no longer available. Any future increase in the enterprise income tax rate applicable to us or other adverse tax treatments will increase our tax liabilities and reduce our net income. Further, any future increase in the enterprise income tax rate applicable to us or other adverse tax treatments, such as the discontinuation of preferential tax treatments for high and new technology enterprises altogether, would have a material adverse effect on our results of operations and financial condition.
We Do Not Carry Insurance To Cover Any Losses Due To Fire, Casualty Or Theft At Our Production Facility Located In Kunming, China.
We have not obtained fire, casualty and theft insurance, and there is no insurance coverage for our raw materials, goods and merchandise, furniture and buildings in China. Any losses incurred by us will have to be borne by us without any assistance, and we may not have sufficient capital to cover material damage to, or the loss of, our production facility due to fire, severe weather, flood or other cause, and such damage or loss would have a material adverse effect on our financial condition, business and prospects
We Are Responsible For The Indemnification Of Our Officers And Directors. Our Indemnification Obligations Could Adversely Affect Our Business, Financial Condition And Results Of Operations.
Our bylaws require us to indemnify our current and former directors, officers, employees and agents against most actions of a civil, criminal, administrative or investigative nature. Consequently, we may be required to expend substantial funds to satisfy these indemnity obligations. We currently hold directors’ and officers’ liability insurance policies for the benefit of our directors and officers, although our insurance coverage may not be sufficient in some cases. Furthermore, our insurance carriers may seek to deny coverage in some cases, in which case we may have to fund the indemnification amounts owed to such directors and officers ourselves. Therefore, our indemnification obligations could result in the diversion of our financial resources and may adversely affect our business, financial condition and results of operations.
We May Suffer As A Result Of Product Liability Or Defective Products.
We may produce products which inadvertently have an adverse pharmaceutical effect on the health of consumers despite proper testing. Existing PRC laws and regulations do not require us to maintain third party liability insurance to cover product liability claims. However, if a product liability claim is brought against us, it may, regardless of merit or eventual outcome, result in damage to our reputation, breach of contract with our customers, decreased demand for our products, costly litigation, product recalls, loss of revenue, and the inability to commercialize some products.
We Rely On The Cooperation With Research Laboratories And Universities, And If These Institutions Cease To Cooperate With Us And We Cannot Find Other Suitable Substitute Research And Development Partners, Our Ability To Develop New Products May Be Hindered And Our Business May Be Adversely Affected.
We cooperate with several research institutions. We rely to a certain extent on these institutions for our development of new products. There is no assurance that these institutions will continue cooperating with us to develop new products. In the event that these institutions cease to cooperate with us and it cannot find other suitable substitute research and development partners, our ability to develop new products may be hindered and our business may be adversely affected.
We Are Expanding Into The Hotel Management And Wellness Tourism Business Of Which We Don’t Have Prior Experience.
In December 2010, we substantially finished the construction of the 17-storey Shenghuo Plaza. Two floors of Shenghuo Plaza are designed to be utilized as 12 Ways Chinese Herbal Beauty Demonstration Center, which has begun trial operation since October of 2011. The balance of Shenghuo Plaza is used as a four-star business hotel - Zhonghuang Hotel, restaurant and banquet facilities and an entertainment venue. The Company also plans to develop a TCM-based ecological wellness tourism destination that focuses on improving the health and extending the life expectancy of the elderly and introduce TCM culture - Xinglin International Health-Preserving Tourist Resort (the “Resort”). We do not have any track record in the hotel, hospitality and wellness tourism business and there can be no assurance that we will be successful in attracting the business clientele or tourists we are seeking, meeting hotel room occupancy projections and at projected rates and achieving ancillary revenues from the restaurant and entertainment facilities within Shenghuo Plaza. The successful opening and operation of Shenghuo Plaza and the Resort is subject to various contingencies, many of which are beyond our control. These contingencies include, among others, the ability to: purchase and negotiate acceptable lease terms, secure required governmental permits and approvals, generate sufficient operating cash flows or secure adequate capital on commercially reasonable terms to fund our plans, hire, train and retain qualified personnel and the successful integration of this new line of business into our existing operations. Any failure to successfully operate Shenghuo Plaza could have a material adverse effect on our results of operations. In addition, our plan to develop the Resort will place increased demands on our operational, managerial and administrative resources. The planned expansion may not produce the revenues, earnings, or business synergies that we anticipate which could cause our business and financial condition to be materially and adversely affected.
To mitigate the risk, on November 15, 2010, we formed Shenghuo Hotel Management of which we hold 80% equity interest, and Tianzhiheng holds 20% equity interest, to operate Zhonghuang Hotel together. Tianzhiheng is a professional hotel management company with extensive experience in hotel management. We believe the cooperation with Tianzhiheng can complement our lack of experience in hotel management business.
Shenghuo Plaza Is In Trial Operation Now. We May Not Be Able To Get the Property Ownership Certificate And Business License As Promptly As We Expected. Any Delay Or Failure To Get Them Will Have An Adverse Impact On Our Operation Of The Shenghuo Plaza And Our Ability To Use The Shenghuo Plaza And The Two New Office Buildings As Mortgage Collateral For Any Of The Bank Loans We Borrow.
We substantially completed the construction of Shenghuo Plaza at the end of 2010. Shenghuo Plaza consists of 17 storeys, two of which are utilized as 12 Ways Chinese Herbal Beauty Demonstration Center and the balance is used as a four-star business hotel-Zhonghuang Hotel, restaurant and banquet facilities and an entertainment venue. As of December 31, 2011, we incurred a cost of approximately RMB146.3 million (approximately $23 million) to build Shenghuo Plaza. While we have not conducted any appraisal, we believe that Shenghuo Plaza can be valued at approximately RMB250 million (approximately $39.7 million) based on the market price of comparable land and buildings.
Shenghuo Plaza began trial operations since January 2011. As the interior decoration and outfitting of all the floors were completed in November 2011, the entire Shenghuo Plaza is now open to the public on a trial basis and will be formally open to the public after we obtain our business license. In order to get the business license for Shenghuo Plaza, we must obtain the following certificates: (1) Certificate of Completion Acceptance and Environmental Protection, (2) Certificate of Inner Building Environment Examination, (3) Certificate of Fire Prevention Inspection, (4) Building Completion Examination Certificate and (5) Property Ownership Certificate. As of now, we have obtained the first three certificates mentioned above. We expect to receive the Building Completion Examination Certificate and Property Ownership Certificate in April of 2012. Once the Building Completion Examination Certificate and Property Ownership Certificate are issued, we intend to apply for a business license for Zhonghuang Hotel and use Shenghuo Plaza and the two new office buildings as mortgage collateral for a new loan amounting to RMB100 million (approximately $16 million) to finance the Xinglin International Health-Preserving Tourist Resort and to reduce current short term debt. However, in order to get a Property Ownership Certificate of Shenghuo Plaza, we must obtain all of the certificates mentioned above first. There is no assurance that we will get the Building Completion Examination Certificate, the Property Ownership Certificate, or the business license within the time frame mentioned above. Any delay or failure to get them will have an adverse impact on our operation of the Shenghuo Plaza and our ability to use the Shenghuo Plaza and the two new office buildings as mortgage collateral for any of the bank loans we borrow.
RISKS RELATED TO CONDUCTING BUSINESS IN CHINA
All Of Our Assets Are Located In China And Substantially All Of Our Revenues Are Derived From Our Operations In China, And Changes In The Political And Economic Policies Of The PRC Government Could Have A Significant Impact Upon The Business We May Be Able To Conduct In The PRC And Our Results Of Operations And Financial Condition.
Our business operations may be adversely affected by the current and future political environment in the PRC. The PRC has operated as a socialist state since the mid-1900s and is controlled by the Communist Party of China. The Chinese government exerts substantial influence and control over the manner in which we must conduct our business activities. The PRC has only permitted provincial and local economic autonomy and private economic activities since the 1970s. The government of the PRC has exercised and continues to exercise substantial control over virtually every sector of the Chinese economy, particularly the pharmaceutical industry, through regulation and state ownership. Our ability to operate in China may be adversely affected by changes in Chinese laws and regulations, including those relating to taxation, import and export tariffs, raw materials, environmental regulations, land use rights, property and other matters. Under our current leadership, the government of the PRC has been pursuing economic reform policies that encourage private economic activity and greater economic decentralization. There is no assurance, however, that the government of the PRC will continue to pursue these policies, or that it will not significantly alter these policies from time to time without notice.
The PRC Laws And Regulations Governing Our Current Business Operations Are Sometimes Vague And Uncertain. Any Changes In Such PRC Laws And Regulations May Have A Material And Adverse Effect On Our Business.
The PRC’s legal system is a civil law system based on written statutes, in which system decided legal cases have little value as precedents unlike the common law system prevalent in the United States. There are substantial uncertainties regarding the interpretation and application of PRC laws and regulations, including but not limited to the laws and regulations governing our business, obtaining government approvals, and the enforcement and performance of our arrangements with customers in the event of the imposition of statutory liens, death, bankruptcy and criminal proceedings. The Chinese government has been developing a comprehensive system of commercial laws, and considerable progress has been made in introducing laws and regulations dealing with economic matters such as foreign investment, corporate organization and governance, commerce, taxation and trade. However, because these laws and regulations are relatively new, and because of the limited volume of published cases and judicial interpretation and their lack of force as precedents, interpretation and enforcement of these laws and regulations involve significant uncertainties. There is no assurance that the PRC government will continue to pursue these policies or that its position on these issues will not change without notice. New laws and regulations that affect existing and proposed future businesses may also be applied retroactively. We are considered a foreign persons or foreign funded enterprises under PRC laws, and as a result, we are required to comply with PRC laws and regulations. We cannot predict what effect the interpretation of existing or new PRC laws or regulations may have on our businesses. If the relevant authorities find that we are in violation of PRC laws or regulations, they would have broad discretion in dealing with such a violation, including, without limitation:
·levying fines;
·revoking our business and other licenses;
·requiring that we restructure our ownership or operations; and
·requiring that we discontinue any portion or all of our business.
The Ability Of Our Chinese Operating Subsidiaries To Pay Dividends May Be Restricted Due To Foreign Exchange Control Regulations Of China.
The ability of our Chinese operating subsidiaries to pay dividends may be restricted due to the foreign exchange control policies and availability of cash balance of the Chinese operating subsidiaries. Because substantially all of our operations are conducted in China and substantially all of our revenues are generated in China, our revenue being earned and currency received are denominated in Renminbi (RMB). RMBis subject to the exchange control regulation in China. Under the current unified floating exchange rate system, the People’s Bank of China (“PBOC”) publishes an exchange rate, which we refer to as the PBOC exchange rate, based on the previous day’s dealings in the inter-bank foreign exchange market. Financial institutions authorized to deal in foreign currency may enter into foreign exchange transactions at exchange rates within an authorized range above or below the PBOC exchange rate according to market conditions.
Pursuant to the Foreign Exchange Control Regulations of the PRC issued by the State Council which came into effect on April 1, 1996, and the Regulations on the Administration of Foreign Exchange Settlement, Sale and Payment of the PRC which came into effect on July 1, 1996, regarding foreign exchange control, conversion of RMB into foreign exchange by Foreign Investment Enterprises, or FIE’s, for use on current account items, including the distribution of dividends and profits to foreign investors, is permissible. FIEs are permitted to convert their after-tax dividends and profits into foreign exchange and remit such foreign exchange to their foreign exchange bank accounts in the PRC. Conversion of RMB into foreign currencies for capital account items, including direct investment, loans, and security investment, is still under certain restrictions. On January 14, 1997, the State Council amended the Foreign Exchange Control Regulations and added, among other things, an important provision, which provides that the PRC government shall not impose restrictions on recurring international payments and transfers under current account items.
Enterprises in the PRC (including FIEs) which require foreign exchange for transactions relating to current account items, may, without approval of the State Administration of Foreign Exchange, or SAFE, effect payment from their foreign exchange account or convert and pay at the designated foreign exchange banks by providing valid receipts and proofs.
Convertibility of foreign exchange in respect of capital account items, such as direct investment and capital contribution, is still subject to certain restrictions, and prior approval from the SAFE or its relevant branches must be sought.
Furthermore, the RMB is not freely convertible into foreign currencies nor can it be freely remitted abroad. Under the PRC’s Foreign Exchange Control Regulations and the Administration of Settlement, Sales and Payment of Foreign Exchange Regulations, Foreign Invested Enterprises are permitted either to repatriate or distribute its profits or dividends in foreign currencies out of its foreign exchange accounts, or exchange RMB for foreign currencies through banks authorized to conduct foreign exchange business. The conversion of RMB into foreign exchange by Foreign Invested Enterprises for recurring items, including the distribution of dividends to foreign investors, is permissible. The conversion of Reminbi into foreign currencies for capital items, such as direct investment, loans and security investment, is subject, however, to more stringent controls.
Our operating subsidiaries are FIEs to which the Foreign Exchange Control Regulations are applicable. Accordingly, we will have to maintain sufficient foreign exchange to pay dividends and/or satisfy other foreign exchange requirements.
The Foreign Currency Exchange Rate Between U.S. Dollars And RMB Could Adversely Affect Our Financial Condition.
To the extent that we need to convert dollars into RMB for our operational needs, our financial position and the price of our common stock may be adversely affected should the RMB appreciate against the U.S. dollar at that time. Conversely, if we decide to convert our RMB into dollars for the operational needs or paying dividends on our common stock, the dollar equivalent of our earnings from our subsidiary in China would be reduced should the dollar appreciate against the RMB. We currently do not hedge our exposure to fluctuations in currency exchange rates.
Until 1994, the RMB experienced a gradual but significant devaluation against most major currencies, including dollars, and there was a significant devaluation of the RMB on January 1, 1994 in connection with the replacement of the dual exchange rate system with a unified managed floating rate foreign exchange system. As a result, from 1994 to July 2005, the value of the RMB relative to the U.S. dollar remained stable. Countries, including the United States, argued that the RMB was artificially undervalued due to China’s monetary policies and pressured China to allow the RMB to float freely in world markets. In July 2005, the PRC government changed its policy of pegging the value of the RMB to the dollar, and the value of the RMB relative to the U.S. dollar has appreciated since then. Under the new policy the RMB is permitted to fluctuate within a narrow and managed band against a basket of designated foreign currencies. While the international reaction to the RMB revaluation has generally been positive, there remains significant international pressure on the PRC government to adopt an even more flexible currency policy, which could result in further and more significant appreciation of the RMB against the dollar.
Inflation In The PRC Could Negatively Affect Our Profitability And Growth.
While the PRC economy has experienced rapid growth, such growth has been uneven among various sectors of the economy and in different geographical areas of the country. Rapid economic growth can lead to growth in the money supply and rising inflation. During the past two decades, the rate of inflation in China has been as high as approximately 20%. In 2011, the inflation rate was 5.4% and in January 2012, the inflation rate was 4.5%. If prices for our products rise at a rate that is insufficient to compensate for the rise in the costs of supplies such as raw materials, it may have an adverse effect on our profitability. In order to control inflation in the past, the PRC government has imposed controls on bank credits, limits on loans for fixed assets and restrictions on state bank lending. The implementation of such policies may impede economic growth. Repeated rises in interest rates by the central bank would likely slow economic activity in China which could, in turn, materially increase our costs and also reduce demand for our products.
Recent PRC Regulations Relating To Acquisitions Of PRC Companies By Foreign Entities May Create Regulatory Uncertainties That Could Restrict Or Limit Our Ability To Operate. Our Failure To Obtain The Prior Approval Of The China Securities Regulatory Commission, Or The CSRC, For The Listing And Trading Of Our Common Stock On NYSE Amex Could Have A Material Adverse Effect On Our Business, Operating Results, Reputation And Trading Price Of Our Common Stock.
The PRC State Administration of Foreign Exchange, or SAFE, issued a public notice in January 2005 concerning foreign exchange regulations on mergers and acquisitions in China. The public notice states that if an offshore company controlled by PRC residents intends to acquire a PRC company, such acquisition will be subject to strict examination by the relevant foreign exchange authorities. The public notice also states that the approval of the relevant foreign exchange authorities is required for any sale or transfer by the PRC residents of a PRC company’s assets or equity interests to foreign entities for equity interests or assets of the foreign entities.
In April 2005, SAFE issued another public notice further explaining the January notice. In accordance with the April notice, if an acquisition of a PRC company by an offshore company controlled by PRC residents has been confirmed by a Foreign Investment Enterprise Certificate prior to the promulgation of the January notice, the PRC residents must each submit a registration form to the local SAFE branch with respect to their respective ownership interests in the offshore company, and must also file an amendment to such registration if the offshore company experiences material events, such as changes in the share capital, share transfer, mergers and acquisitions, spin-off transaction or use of assets in China to guarantee offshore obligations. The April notice also provides that failure to comply with the registration procedures set forth therein may result in restrictions on our PRC resident shareholders and our subsidiaries. Pending the promulgation of detailed implementation rules, the relevant government authorities are reluctant to commence processing any registration or application for approval required under the SAFE notices.
In addition, on August 8, 2006, the Ministry of Commerce (“MOFCOM”), joined by the State-Owned Assets Supervision and Administration Commission of the State Council, State Administration of Taxation, State Administration for Industry and Commerce, CSRC and SAFE, amended and released the Provisions for Foreign Investors to Merge and Acquire Domestic Enterprises, new foreign-investment rules which took effect September 8, 2006, superseding much, but not all, of the guidance in the prior SAFE circulars. These new rules significantly revise China’s regulatory framework governing onshore-offshore restructurings and how foreign investors can acquire domestic enterprises. These new rules signify greater PRC government attention to cross-border merger, acquisition and other investment activities, by confirming MOFCOM as a key regulator for issues related to mergers and acquisitions in China and requiring MOFCOM approval of a broad range of merger, acquisition and investment transactions. Furthermore, the new rules establish reporting requirements for acquisition of control by foreigners of companies in key industries, and reinforce the ability of the Chinese government to monitor and prohibit foreign control transactions in key industries.
Specifically, this regulation, among other things, has some provisions that purport to require that an offshore special purpose vehicle, or SPV, formed for listing purposes and controlled directly or indirectly by PRC companies or individuals shall obtain the approval of the CSRC prior to the listing and trading of such SPV’s securities on an overseas stock exchange. On September 21, 2006, the CSRC published on its official website procedures specifying documents and materials required to be submitted to it by SPVs seeking CSRC approval of their overseas listings. However, the application of this PRC regulation remains unclear with no consensus currently existing among the leading PRC law firms regarding the scope and applicability of the CSRC approval requirement.
Because we completed our restructuring before September 8, 2006, the effective date of the new regulation, we believe it is not necessary for us to submit the application to the CSRC for its approval, and the listing and trading of our Common Stock on NYSE Amex does not require CSRC approval.
If the CSRC or another PRC regulatory agency subsequently determines that CSRC approval was required for our initial public offering that was completed in June 2007, we may face regulatory actions or other sanctions from the CSRC or other PRC regulatory agencies. These regulatory agencies may impose fines and penalties on our operations in the PRC, limit our operating privileges in the PRC, delay or restrict the repatriation of the proceeds of subsequent offerings into the PRC, or take other actions that could have a material adverse effect on our business, financial condition, results of operations, reputation and prospects, as well as the trading price of our Common Stock. The CSRC or other PRC regulatory agencies also may take actions requiring us, or making it advisable for us, to halt future offerings before settlement and delivery of the Common Stock offered in such future offerings. Consequently, if you engage in market trading or other activities in anticipation of and prior to settlement and delivery, you do so at the risk that settlement and delivery may not occur.
Also, if the CSRC later requires that we obtain its approval, we may be unable to obtain a waiver of the CSRC approval requirements, if and when procedures are established to obtain such a waiver. Any uncertainties and/or negative publicity regarding this CSRC approval requirement could have a material adverse effect on the trading price of our Common Stock. Furthermore, published news reports in China recently indicated that the CSRC may have curtailed or suspended overseas listings for Chinese private companies. These news reports have created further uncertainty regarding the approach that the CSRC and other PRC regulators may take with respect to us.
These new rules may significantly affect the means by which offshore-onshore restructurings are undertaken in China in connection with offshore private equity and venture capital financings, mergers and acquisitions. It is expected that such transactional activity in China in the near future will require significant case-by-case guidance from MOFCOM and other government authorities as appropriate. It is anticipated that application of the new rules will be subject to significant administrative interpretation, and we will need to closely monitor how MOFCOM and other ministries apply the rules to ensure its domestic and offshore activities continue to comply with PRC law. Given the uncertainties regarding interpretation and application of the new rules, we may need to expend significant time and resources to maintain compliance.
It is uncertain how our business operations or future strategy will be affected by the interpretations and implementation of the SAFE notices and new rules. Our business operations or future strategy could be adversely affected by the SAFE notices and the new rules. For example, we may be subject to more stringent review and approval process with respect to our foreign exchange activities.
Failure To Comply With The United States Foreign Corrupt Practices Act Could Subject Us To Penalties And Other Adverse Consequences.
We are subject to the United States Foreign Corrupt Practices Act, which generally prohibits United States companies from engaging in bribery or other prohibited payments to foreign officials for the purpose of obtaining or retaining business. Foreign companies, including some that may compete with us, are not subject to these prohibitions. Corruption, extortion, bribery, pay-offs, theft and other fraudulent practices occur from time-to-time in the PRC. We can make no assurance, however, that our employees or other agents will not engage in such conduct for which we might be held responsible. If our employees or other agents are found to have engaged in such practices, we could suffer severe penalties and other consequences that may have a material adverse effect on our business, financial condition and results of operations.
Any Recurrence Of Severe Acute Respiratory Syndrome, Avian Flu, Or Another Widespread Public Health Problem, In The PRC Could Adversely Affect Our Operations.
A renewed outbreak of severe acute respiratory syndrome, avian flu or another widespread public health problem in China, where all of our manufacturing facilities are located and where all of our sales occur, could have a negative effect on our operations. Such an outbreak could have an impact on our operations as a result of:
·quarantines or closures of some of our manufacturing facilities, which would severely disrupt our operations;
·the sickness or death of our key officers and employees; and
·a general slowdown in the Chinese economy.
Any of the foregoing events or other unforeseen consequences of public health problems could adversely affect our operations.
A Downturn In The Economy Of The PRC May Slow Our Growth And Profitability.
The growth of the Chinese economy has been uneven across geographic regions and economic sectors. There can be no assurance that growth of the Chinese economy will be steady or that any downturn will not have a negative effect on our business, especially if it results in either a decreased use of our products or in pressure on us to lower our prices. The downturn in the Chinese economy and worldwide in 2008, 2009 and 2010 has had an adverse impact on the financial condition of patients and hospitals, which in turn affects our pharmaceutical sales and collection of trade receivables.
If We Make Equity Compensation Grants To Persons Who Are PRC Citizens, They May Be Required To Register With The State Administration Of Foreign Exchange Of The PRC, Or SAFE. We May Also Face Regulatory Uncertainties That Could Restrict Our Ability To Adopt An Equity Compensation Plan For Our Directors And Employees And Other Parties Under PRC Law.
On April 6, 2007, SAFE issued the “Operating Procedures for Administration of Domestic Individuals Participating in the Employee Stock Ownership Plan or Stock Option Plan of An Overseas Listed Company,” also know as “Circular 78.” It is not clear whether Circular 78 covers all forms of equity compensation plans or only those which provide for the granting of stock options. For any plans which are so covered and are adopted by a non-PRC listed company after April 6, 2007, Circular 78 requires all participants who are PRC citizens to register with and obtain approvals from SAFE prior to their participation in the plan. In addition, Circular 78 also requires PRC citizens to register with SAFE and make the necessary applications and filings if they participated in an overseas listed company’s covered equity compensation plan prior to April 6, 2007. In 2009 we adopted, and our stockholders approved, our 2009 Stock Incentive Plan pursuant to which we may make option grants to our officers and directors, most of whom are PRC citizens. Circular 78 may require our officers and directors who receive option grants and are PRC citizens to register with SAFE. We believe that the registration and approval requirements contemplated in Circular 78 will be burdensome and time consuming. If it is determined that any of our equity compensation plans are subject to Circular 78, failure to comply with such provisions may subject us and participants of our equity incentive plan who are PRC citizens to fines and legal sanctions and prevent us from being able to grant equity compensation to our PRC employees. In that case, our ability to compensate our employees and directors through equity compensation would be hindered and our business operations may be adversely affected.
You May Experience Difficulties In Effecting Service Of Legal Process, Enforcing Foreign Judgments Or Bringing Original Actions In China Based Upon U.S. Laws, Including The Federal Securities Laws Or Other Foreign Laws Against Us Or Our Management.
All of our current operations are conducted in China. Moreover, all of our directors and officers are nationals and residents of China. All or substantially all of the assets of these persons are located outside the United States and in the PRC. As a result, it may not be possible to effect service of process within the United States or elsewhere outside China upon these persons. In addition, uncertainty exists as to whether the courts of China would recognize or enforce judgments of U.S. courts obtained against us or such officers and/or directors predicated upon the civil liability provisions of the securities law of the United States or any state thereof, or be competent to hear original actions brought in China against us or such persons predicated upon the securities laws of the United States or any state thereof.
RISKS RELATED TO OUR CAPITAL STRUCTURE
If We Default Under Our Loan Contract With Yunnan Shuang Long Branch Of Agricultural Bank Of China, We Could Forfeit Part Or All Of Our Equity Interests In Shenghuo China And Our Stock Price May Be Substantially Depressed.
One of the Company’s loan with Shuang Long Branch of Agricultural Bank of China (or ABC), executed on August 24, 2009, is secured by, among other things, a pledge of the Company’s 94.95% shares in Shenghuo China, our main operating subsidiary. Default by the Company under this loan facility, if not waived or modified, would permit the ABC to accelerate the loan and enforce on the pledged shares, and we may be forced to forfeit part or all of our equity ownership interests in Shenghuo China. In addition, our stock price may be substantially depressed as a result of the foreclosure or the sales of the pledged shares.
The Price Of Our Common Stock May Be Volatile, And If An Active Trading Market For Our Common Stock Does Not Develop, The Price Of Our Common Stock May Suffer And Decline.
We cannot assure you that an active trading market will develop or be sustained or that the market price of our common stock will not decline. The price of our common stock is highly volatile and may fluctuate substantially due to many factors, some of which are outside of our control.
Our Common Stock Could Be At Risk Of Being Delisted By The NYSE Amex, Making It More Difficult For Stockholders To Dispose Of Or To Obtain Accurate Quotations As To The Value Of Their Stock.
Our common stock currently trades on NYSE Amex (the “Exchange”). The Exchange, as a matter of policy, will consider the suspension of trading in, or removal from listing of any stock if, among other things, (i) the company fails to maintain stockholder’s equity of at least $2 million if the company has sustained losses from continuing operations or net losses in two of its three most recent fiscal years, (ii) the company fails to maintain stockholder’s equity of $4 million if the company has sustained losses from continuing operations or net losses in three of its four most recent fiscal years; (iii) the company fails to maintain stockholder’s equity of $6 million if the company has sustained losses from continuing operations or net losses in its five most recent fiscal years; or (iv) the company has sustained losses which are so substantial in relation to its overall operations or its existing financial resources, or its financial condition has become so impaired that it appears questionable, in the opinion of the NYSE Amex, as to whether such issuer will be able to continue operations and/or meet its obligations as they mature; or (v) it has been selling for a substantial period of time at a low price per share and the issuer fails to effect a reverse split of such shares within a reasonable time after being notified that the Exchange deems such action to be appropriate. In its review, the Exchange will consider all pertinent factors including, market conditions in general, the number of shares outstanding, plans which may have been formulated by management, applicable regulations of the state or country of incorporation or of any governmental agency having jurisdiction over the issuer, the relationship to other Exchange policies regarding continued listing, and, in respect of securities of foreign issuers, the general practice in the country of origin of trading in low-selling price issues. The delisting of our common stock by the Exchange would adversely affect the price and liquidity of our common stock.
On September 22, 2010 the Company received notice from the Exchange Staff indicating that the Company is below certain of the Exchange’s continued listing standards due to the fact that its stockholder’s equity is less than $2,000,000, it has sustained losses from continuing operations, and it has net losses in two out its three most recent fiscal years, as set forth in Section 1003(a)(i) of the NYSE Amex Company Guide. The Company was afforded the opportunity to submit a plan of compliance to the Exchange to demonstrate its ability to regain compliance with the continued listing standards by March 22, 2012. On October 29, 2010 and November 29, 2010, the Company presented its plan and responses to supplemental questions to the Exchange.
On December 6, 2010 the Exchange notified the Company that it accepted the Company’s plan of compliance and granted the Company an extension until March 22, 2012 to regain compliance with the continued listing standards. On March 21, 2012, the Exchange notified the Company its decision to defer making a determination on whether the Company has regained compliance until the company files the Annual Report on the Form 10-K on March 30, 2012. The Company has been subject to periodic review by Exchange Staff during the extension period. Failure to make progress consistent with the plan or to regain compliance with the continued listing standards by March 30, 2012 could result in the Company being delisted from the Exchange.
Shares Eligible For Future Sale May Adversely Affect The Market Price Of Our Common Stock, As The Future Sale Of A Substantial Amount Of Outstanding Stock In The Public Marketplace Could Reduce The Price Of Our Common Stock.
In June 2007, we completed a public offering and sale of 460,000 shares of common stock. In addition, we registered 2,000,000 shares of common stock issued in a Private Placement, and all lock up restrictions regarding these shares have expired. We also registered 4,006,400 additional shares of common stock, effective September 19, 2007 (Registration No. 333-144959).
Additionally, the former stockholders of Shenghuo China may be eligible to sell all or some of our shares of common stock by means of ordinary brokerage transactions in the open market pursuant to Rule 144, promulgated under the Securities Act (“Rule 144”), subject to certain limitations. In general, pursuant to Rule 144, a non-affiliate stockholder who has satisfied a six month holding period may, under certain circumstances, sell shares under Rule 144 without any volume limitation. Any substantial sale of common stock pursuant to any resale prospectus or Rule 144 may have an adverse effect on the market price of our common stock by creating an excessive supply.
After March 31, 2009, no open market sales of securities covered by these registrations will be permitted (other than sales pursuant to Rule 144) until a new registration statement is filed and becomes effective.
Our Principal Stockholder Has Significant Influence Over Us.
Our largest shareholder, Lan’s Int’l Medicine Investment Co., Limited, or LIMI, beneficially owns or controls approximately 77.3% of our outstanding shares. Gui Hua Lan, our non-executive Chairman of the Board, Feng Lan, our Chief Executive Officer and President, and Zheng Yi Wang are directors of LIMI and have voting and investment control over the shares owned by LIMI. In addition, Gui Hua Lan, Feng Lan and Zheng Yi Wang own 62.42%, 5.15% and 1.45%, respectively, of LIMI’s issued and outstanding shares, and Lei Lan, our Vice President, owns 9.37% of LIMI. We have other officers and directors who also hold equity interests in LIMI. LIMI has controlling influence in determining the outcome of any corporate transaction or other matters submitted to our shareholders for approval, including mergers, consolidations and the sale of all or substantially all of our assets, election of directors, and other significant corporate actions. LIMI also has the power to prevent or cause a change in control. In addition, without the consent of LIMI, we could be prevented from entering into transactions that could be beneficial to it. The interests of LIMI may differ from the interests of our other shareholders.
The Interests Of The Existing Minority Shareholders In Shenghuo China And Shenghuo Hotel Management May Diverge From Our Own Interests And This May Adversely Affect Our Ability To Manage Shenghuo China And Shenghuo Hotel Management.
Shenghuo China, our principal operating subsidiary, is an equity joint venture in which we directly own a 94.95% interest and Kunming Dian Jiao Investment Consulting Co., Ltd., or Dian Jiao, owns the remaining 5.05% interest. Shenghuo Hotel Management is an equity joint venture in which we directly own a 80% interest and Kunming Tianzhiheng Hotel Management Co., Ltd., or Tianzhiheng, owns the remaining 20% interest. Dian Jiao or Tianzhiheng’s interests may not be aligned with our interest at all times. If our interests diverge, Dian Jiao or Tianzhiheng may exercise its right under PRC laws and its consent rights to protect its own interest, which may be adverse to us and our investors. Further, should we wish to transfer our equity interest in Shenghuo China or Shenghuo Hotel Management, in whole or in part, to a third-party, Dian Jiao or Tianzhiheng has a right of first refusal under China’s joint venture regulations.
In addition to its statutory rights as a minority shareholder, Dian Jiao has additional rights under the joint venture contract and under the articles of association of Shenghuo China. The joint venture contract and articles of association require the consent of each of Shenghuo China’s shareholders and/or unanimous board approval on matters such as a major change in the business line of the company and expansion or amendment of the business scope of the company.
Under our joint venture contract with Tianzhiheng, the consent of the other shareholder is required when either of the shareholders transfers all or part of its investment to a third party.
Dian Jiao or Tianzhiheng has thus far been cooperative with us in handling matters with respect to the business of Shenghuo China and Shenghuo Hotel Management respectively. There is no assurance, however, that Dian Jiao or Tianzhiheng will continue to act in a cooperative manner in the future.
The Ability Of Our Chinese Operating Subsidiaries To Pay Dividends May Be Restricted Due To Our Corporate Structure.
Substantially all of our operations are conducted in China and substantially all of our revenues are generated in China. As an equity joint venture, Shenghuo China is required to establish reserve funds and staff and workers’ bonus and welfare funds, each of which is appropriated from net profit after taxation but before dividend distributions in accordance with Chinese law. Shenghuo China is required to allocate at least 10% of our net profits to the reserve fund until the balance of this fund has reached 50% of Shenghuo China’s registered capital.
In addition, the profit available for distribution from our Chinese subsidiaries is determined in accordance with generally accepted accounting principles in China. This calculation may differ from the one performed under generally accepted accounting principles in the United States, or GAAP. As a result, we may not receive sufficient distributions from our Chinese subsidiaries to enable us to make dividend distributions to our stockholders in the future and limitations on distributions of the profits of Shenghuo China could negatively affect our financial condition and assets, even if our GAAP financial statements indicate that our operations have been profitable.
Weaknesses In Our Internal Controls Over Financial Reporting or Disclosure Controls and Procedures Have Had and May Continue to Have A Material Adverse Effect On Our Business, The Price Of Our Common Stock, Operating Results And Financial Condition.
We are required to establish and maintain appropriate internal controls over financial reporting and disclosure controls and procedures. In connection with the restatement of our previously issued financial statements for the fiscal year ended December 31, 2007 and the fiscal quarter ended March 31, 2008 and our assessments of our disclosure controls and procedures under Item 307 of Regulation S-K, management concluded that as of December 31, 2010 and December 31, 2011, our disclosure controls and procedures were not effective and that we had material weaknesses in our internal control over financial reporting. Please refer to the discussion under Item 9A, “Controls and Procedures” for further discussion of our material weaknesses as of December 31, 2011. Should we be unable to remediate those or any other material weaknesses promptly and effectively, such weaknesses could harm our operating results, result in a material misstatement of our financial statements, cause us to fail to meet our financial reporting obligations or prevent us from providing reliable and accurate financial reports or avoiding or detecting fraud. This, in turn, could result in a loss of investor confidence in the accuracy and completeness of our financial reports, which could have an adverse effect on our stock price. Any litigation or other proceeding or adverse publicity relating to the material weaknesses could have a material adverse effect on our business and operating results.
These deficiencies include our accounting personnel do not have sufficient knowledge, experience and training in maintaining our books and records and preparing financial statements in accordance with US generally accepted accounting principles (“US GAAP”) standards and SEC rules and regulations. The accounting skills and understanding necessary to fulfill the requirements of US GAAP-based reporting, including the skills of US GAAP-based period end closing, consolidation of financial statements, and US GAAP conversion, are inadequate and were inadequately supervised. The lack of adequate US GAAP review resulted in some material audit adjustments for the year ended December 31, 2010, which were made to adjust taxes payable for tax provision, adjust deferred tax, and record prior year audit adjustments to adjust the allowance for doubtful accounts. We expect to expend a significant amount of funds to address these deficiencies and there is no guarantee that we will be able to resolve these deficiencies, which may result in an adverse impact on our business and operating results and the price of our common stock.
Standards For Compliance With Section 404 Of The Sarbanes-Oxley Act Of 2002 Are Uncertain, And If We Fail To Comply In A Timely Manner, Our Business Could Be Harmed And Our Stock Price Could Decline.
Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 and Item 308 of Regulation S-K, we are required to annually furnish a report by our management on our internal control over financial reporting. Such report must contain, among other matters, an assessment by our principal executive officer and our principal financial officer on the effectiveness of our internal control over financial reporting, including a statement as to whether or not our internal control over financial reporting is effective as of the end of our fiscal year. This assessment must include disclosure of any material weakness in our internal control over financial reporting identified by management.
Performing the system and process documentation and evaluation needed to comply with Section 404, Item 307 and Item 308 is both costly and challenging. During the course of our testing we may identify deficiencies which we may not be able to remediate in time to meet the deadline imposed by the Sarbanes-Oxley Act of 2002 for compliance with the requirements of Section 404. In addition, if we fail to maintain the adequacy of our internal controls, as such standards are modified, supplemented or amended from time to time, we may not be able to ensure that we can conclude on an ongoing basis that we have effective internal controls over financial reporting under Item 308 of Regulation S-K or effective disclosure controls and procedures under Item 307 of Regulation S-K, which may cause investors to lose confidence in our business and reported financial information and have a material adverse effect on the price of our common stock.
Our Common Stock May Be Considered A “Penny Stock,” And Thereby Be Subject To Additional Sale And Trading Regulations That May Make It More Difficult To Sell.
Our common stock may be considered to be a “penny stock” if it does not qualify for one of the exemptions from the definition of “penny stock” under Section 3a51-1 of the Securities Exchange Act for 1934, as amended (the “Exchange Act”). Our common stock may be a “penny stock” if it meets one or more of the following conditions (i) the stock trades at a price less than $5.00 per share; (ii) it is not traded on a “recognized” national exchange; (iii) it is not quoted on the Nasdaq Capital Market, or even if so, has a price less than $5.00 per share; or (iv) is issued by a company that has been in business less than three years with net tangible assets less than $5 million.
The principal result or effect of being designated a “penny stock” is that securities broker-dealers participating in sales of our common stock will be subject to the “penny stock” regulations set forth in Rules 15-2 through 15g-9 promulgated under the Exchange Act. For example, Rule 15g-2 requires broker-dealers dealing in penny stocks to provide potential investors with a document disclosing the risks of penny stocks and to obtain a manually signed and dated written receipt of the document at least two business days before effecting any transaction in a penny stock for the investor’s account. Moreover, Rule 15g-9 requires broker-dealers in penny stocks to approve the account of any investor for transactions in such stocks before selling any penny stock to that investor. This procedure requires the broker-dealer to (i) obtain from the investor information concerning his or her financial situation, investment experience and investment objectives; (ii) reasonably determine, based on that information, that transactions in penny stocks are suitable for the investor and that the investor has sufficient knowledge and experience as to be reasonably capable of evaluating the risks of penny stock transactions; (iii) provide the investor with a written statement setting forth the basis on which the broker-dealer made the determination in (ii) above; and (iv) receive a signed and dated copy of such statement from the investor, confirming that it accurately reflects the investor’s financial situation, investment experience and investment objectives. Compliance with these requirements may make it more difficult and time consuming for holders of our common stock to resell their shares to third parties or to otherwise dispose of them in the market or otherwise.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS.
Smaller reporting companies are not required to provide the information required by this item.
ITEM 2.
ITEM 2. PROPERTIES.
We have land use rights to two parcels of land with a total area of approximately 66.7 acres and own a 161,460 square foot factory. The land use rights for both parcels have terms of 50 years and end in 2048 and 2050. Our principal executive offices are located at No. 2, Jing You Road, Kunming National Economy & Technology Developing District, People’s Republic of China 650217.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
From time to time, we may become involved in various lawsuits and legal proceedings which arise in the ordinary course of business. Litigation is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm our business. However, we are currently not aware of any such legal proceedings or claims that we believe will have, individually or in the aggregate, a material adverse affect on our business, financial condition or operating results.
ITEM 4.
ITEM 4. MINE SAFETY DISCLOSURES.
Not applicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
Commencing on July 25, 2007, our shares of common stock began trading on the Exchange under the ticker symbol “KUN.”
The high and low sales prices for our common stock for each full quarterly period from January 1, 2010 to December 31, 2011 are set forth below:
Holders
As of March 23, 2012, there were 8 shareholders of record of our common stock and an indeterminate number of beneficial holders who held our common stock in street name.
Dividend Policy
We have not declared or paid any cash dividends on our common stock and we currently intend to retain future earnings, if any, to finance the expansion of our business. We do not expect to pay any cash dividends in the foreseeable future. The decision whether to pay cash dividends on our common stock will be made by our board of directors, at their discretion, and will depend on our financial condition, operating results, capital requirements and other factors that the board of directors considers significant. The PRC government imposes controls on the conversion of RMB into foreign currencies and the remittance of currencies out of the PRC, which also may affect our ability to pay cash dividends in the future.
Equity Compensation Plan
On June 15, 2009, our Board of Directors and stockholders adopted and approved our 2009 Stock Incentive Plan (the “2009 Plan”). The 2009 Plan allows for awards of stock options for up to 2,000,000 shares of common stock. As of December 31, 2010, no options to purchase common stock had been granted under the 2009 Plan.
As of December 31, 2011, the following warrants are outstanding:
Recent sales of unregistered securities
None.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
Smaller reporting companies are not required to provide the information required by this item.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
Forward-Looking Statements
The following Management’s Discussion and Analysis (“MD&A”) is intended to help the reader understand the results of operations and financial condition of China Shenghuo Pharmaceutical Holdings, Inc. Throughout this document, references to “we,” “our,” the “Company” refer to China Shenghuo Pharmaceutical Holdings, Inc. and its subsidiaries. MD&A should be read in conjunction with our financial statements and the related notes, and the other financial information included in this 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, our ability to repay certain bank loans due in 2011, general economic and business conditions; changes in foreign, political, social, and economic conditions; our expansion into the retail distribution of our cosmetic products; regulatory initiatives and compliance with governmental regulations; the ability to achieve further market penetration and additional customers; and various other matters, many of which are beyond our control. Should one or more of these risks or uncertainties occur, or should underlying assumptions prove to be incorrect, actual results may vary materially and adversely from those anticipated, believed, estimated or otherwise indicated. Consequently, all of the forward-looking statements made in this report are qualified by these cautionary statements and there can be no assurance of the actual results or developments. Refer to the sections entitled “Risk Factors” and “Special Note Regarding Forward-Looking Statements” contained in this report.
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 the greyish-brown or greyish-yellow plant that only grows in a few geographic locations, 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 root 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 the GMP standards. Our main product, Xuesaitong Soft Capsules, accounted for approximately 84.5% of our sales for the year ended December 31, 2011 as compared to more than 90.9% of our sales for the year ended December 31, 2010.
We have expanded our real estate owned and deployed in our pharmaceutical operations by 107,231 square feet. This is a result of the construction of our 29,212 square feet new 7-storey office building for our executives and administrative staff. We also built a 78,020 square feet 7-storey adjacent building to be used as a training facility for sales and marketing team, and our staff’s continuing education. These two new office buildings were built at a cost of approximately RMB26 million (approximately $4million) by using cash flow from our operations and are debt free. We rented out the 3rd floor and part of the 4th floor of the training facility building totaling an area of 15,931 square feet for a term of four years. The lease began in April 2011 with an annual rental of RMB532,800 ($85,000) for the first year and 5% increment for each year in the next three years.
Shenghuo Plaza and Zhonghuang Hotel
With the substantial completion of Shenghuo Plaza at the end of 2010, we entered into a new business - the hotel and hospitality business. Shenghuo Plaza consists of 17-storey totaling approximately 252,984 square feet. Two floors of Shenghuo Plaza are utilized as 12 Ways Chinese Herbal Beauty Demonstration Center, which has begun trial operation since October of 2011. In the center, we use 12 Ways cosmetics to demonstrate how to keep beautiful and healthy, provide a variety of services, including acupuncture, body massage, foot massage and train our professional beauticians. The Company believes this center is helpful to promote 12 Ways’ brand recognition and the sales of 12 Ways cosmetics. In addition, 12 Ways beauty products are prominently displayed in the lobby of the Shenghuo Plaza in order to expose them to tourists and business clienteles. The balance of Shenghuo Plaza is used as a business hotel - Zhonghuang Hotel, restaurant and banquet facilities and an entertainment venue. The hotel is designed and decorated according to the four-star hotel standards. The market focus of the hotel is tour groups, business people, business conferences, wedding banquet, business banquet, and ancillary services. The Company believes that Shenghuo Plaza is a sound investment that will generate cash flow to support the R&D and the pharmaceutical business of the Company. On November 15, 2010, we formed Shenghuo Hotel Management of which we hold 80% equity interest, while Tianzhiheng Hotel Management Co., Ltd. ("Tianzhiheng") holds 20% equity interest, to operate the hotel together. Tianzhiheng is a professional hotel management company with rich experiences in hotel operation. The Company believes the cooperation with Tianzhiheng can complement the Company's lack of experience in the hotel management business and help the Company to operate the hotel better. As of December 31, 2011, we incurred a cost of approximately RMB146.3 million (approximately $23 million) to build Shenghuo Plaza. While we have not conducted any appraisal, we believe that Shenghuo Plaza can be valued at approximately RMB250 million (approximately $39.7 million) based on the market price of comparable land and buildings. This assumes the issuance of the property ownership certificate and other permits discussed elsewhere herein. Shenghuo Plaza has begun trial operations since January 2011 with certain interior decorating and outfitting being carried out on those floors not yet ready for guest occupancy. The interior decorating of the rest of the floors has been completed in November 2011. The entire Shenghuo Plaza is now open to the public on a trial basis and will be formally open to the public after we obtain our business license. In order to get the business license for Shenghuo Plaza, we must obtain the following certificates: (1) Certificate of Completion Acceptance and Environmental Protection, (2) Certificate of Inner Building Environment Examination, (3) Certificate of Fire Prevention Inspection, (4) Building Completion Examination Certificate and (5) Property Ownership Certificate. As of now, we have obtained the first three certificates mentioned above. We expect to receive the Building Completion Examination Certificate and Property Ownership Certificate in April of 2012. Once the Building Completion Examination Certificate and Property Ownership Certificate are issued, we intend to apply for a business license for Zhonghuang Hotel and use Shenghuo Plaza and the two new office buildings as mortgage collateral for a new loan amounting to RMB100 million (approximately $16 million) to finance the Xinglin International Health-Preserving Tourist Resort discussed below and to reduce current short term debt.
Xinglin International Health-Preserving Tourist Resort
We are also expanding into the businesses of wellness tourism. On April 30, 2009, we formed Shilin Shenghuo Pharmaceutical Co., Ltd. as a wholly owned subsidiary for the purpose of purchasing or leasing land to build our own medicinal herb planting base. On September 8, 2010, we signed an agreement with Management Commission of Kunming Shilin Taiwan Farmer Entrepreneur Centre (“Entrepreneur Centre”) to lease a piece of land located near the Stone Forest which has been recognized as a world natural heritage. With an area of 437.9 acres (2,658 Mu), the land will be used to construct a TCM-based ecological wellness tourism destination that focuses on improving the health and extending the life expectancy of the elderly and introduce TCM culture - Xinglin International Health-Preserving Tourist Resort (the “Resort”). In the Resort, approximately 250.4 acres (1,520 Mu) are devoted to planting suitable-for-cultivating Sanchi and other medicinal herbs for use in the production of our medicinal products in 2011. The rest of the property will be used to build exhibition facilities which emphasize TCM culture, a temple, a TCM museum and apartments for elderly people.
In an effort to reduce costs of raw materials used in our medicinal products, we have grown the medicinal herb Banlangen and Danshen, which are used in the production of our Banlangen Tablets/Grains and Danshen Tablets, on 197.6 acres (1,200 Mu) and 16.5 acres (100 Mu), respectively. We have harvested them at the beginning of 2012. We have also constructed greenhouses within the Resort in which the medicinal herb Sanqi are grown on 3.3 acres (20 Mu) at the beginning of 2012, which we expect to harvest in 2014.
The total operating lease amounts to approximately RMB30.6 million (equals to approximately $ 4.9 million) with a lease term of 20 years. Our operating lease commitment is approximately $0.4 million for 2012, $0.2 million for each 2013 and 2014 and approximately $3.5 million for 2015.
In January of 2011, we submitted the plan of programming and design of the Resort. It was approved by the Urban and Rural Planning Committee of Shilin County, which consists of, among others, the Secretary of Shilin County Party Committee, the head of Shilin County, deputy head of Shilin County, Construction Bureau, Land and Resource Bureau, Finance Bureau, Environment Protection Bureau of Shilin County and Management Commission of Kunming Shilin Taiwan Farmer Entrepreneur Centre and so on, on March, 22, 2011. We anticipate that the whole Resort project will take 5 years to complete.
As of December 31 2011, we have paid RMB6,798,000($1,079,000) to the Entrepreneur Centre as a installment payment for the purchase of certain land use right for the Resort. The Company has paid 18% of the total purchase price of RMB37,800,000 ($5,999,000) for the land use right. The remaining balance will be paid in future installments as determined by the Entrepreneur Centre. The terms of the land use right purchase is set forth in the Supplemental Agreement on the Project of Construction of Shilin Shenghuo TCM Cultural Garden (the “Supplemental Agreement”), dated September 8, 2010 between Kunming Shenghuo and the Entrepreneur Center and previously filed. Both the Lease Agreement and the Supplemental Agreement are subject to the fulfillment by Kunming Shenghuo of certain conditions including timely payment and construction and implementation of the Resort in accordance with the prescribed timeframe and standards.
New drug pipeline
·Wei Dingkang Soft Capsules - a type of traditional Chinese medicine designed to treat peptic ulcer disease by inhibiting bacterial growth, relieving stomach muscle spasms, and reducing inflammation of the intestinal lining. The product is designed to be effective for upset stomach, vomiting, pain and degradation of the stomach lining. The product has been approved by the State Food and Drug Administration (SFDA) for clinical testing. Phase II clinical trials were completed in December 2007, after which the phase II exploratory and enhanced clinical trials have commenced and completed in 2010. In the third quarter of 2011, we have held a seminar with related experts and drafted a preliminary clinical research protocol. We have entered into an agreement with a clinical study company to run phase III clinical trials. We anticipate Phase III clinical trials will begin in May of 2012 and will be completed by the first half of 2014. Thereafter, we will submit the application for production approval. We expect to obtain production approval by the end of 2014. We expect to incur a cost of approximately RMB4.2 million (approximately $0.65 million) to run Phase III clinical trials from 2012 to 2014.
·Dencichine for Injection - is designed to treat hemorrhage diseases, such as stop or reduce bleeding during/after operations. The pharmacology and toxicology studies are almost finished and the results demonstrate that Dencichine for Injection shows high effectiveness and high safety both in our internal animal models tests and the test conducted by Nanjing Evaluation and Research Center. So far, we have completed the preparation of the materials and we plan to submit our application for clinical trials to State Food and Drug Administration (SFDA) in May 2012. Assuming required governmental approvals are obtained in a timely fashion, we anticipate that production and marketing of the product will begin in 2014. Dencichine for Injection is a drug requiring extensive testing by the national SFDA, including neurotoxicity testing, which may take a significant amount of time. In addition, clinical testing and audit processes are out of our control, so we must allow for additional time. We incurred approximately RMB658,404 (approximately $101,939) in 2011 and expect to incur approximately RMB4 to 6 million (approximately $0.6 million to $0.9 million) from 2012 to 2014 in connection with clinical trials.
·Sh1002 - is designed to treat one of complications of diabetes mellitus: retinal vascular lesions. We submitted Investigational New Drug Application (IND) for Sh1002 to FDA in October 2010 and have been approved to start IND study after December 24, 2010. The application for clinical trials for Sh1002 in America has also been approved by FDA and the Phase I clinical trial has been started in the second quarter of 2011 and a group consisted of 18 patient cases accepted the Phase I clinical trial and no one has any adverse drug reactions. With the completion of the Phase I clinical trial in January 2012, we are now preparing for the Phase II clinical trials. We plan to continue conducting the Phase II clinical trials in America and then license our technology to a foreign pharmaceutical company, while retaining the China domestic marketing and the global manufacturing right of Sh1002. We incurred approximately $303,335 for Phase I clinical trials and the preparation for Phase II clinical trials in 2011. Approximately $1.5 million is expected to be expended for Phase II clinical trials.
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. However, we intend to devote additional resources to research and development and to continue to evaluate and develop additional high-tech 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 our main product “Xuesaitong” Soft Capsules is sold and “Shenhuo” - the brand under which most of our products are sold. "Lixuwang", the trademark of Xuesaitong Soft Capsules, was awarded the Chinese Well-Known Trademark Honor by the State Administration for Industry and Commerce of China in 2010. This prestigious award gives China Shenghuo green path in anti-counterfeit campaign and intellectual property protection. 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 represented approximately 84.5% of our sales for the year ended December 31, 2011. In addition to the State Insurance Catalogue, each of the 31 Chinese provinces establishes its own provincial insurance catalogue (each, a “PIC”). A drug listed on the PIC will result in the patient purchasing such drug to receive the same 90% reimbursement as if such drug were listed on Part B of the State Insurance Catalogue. In November 2009, the Ministry of Labor and Social Security in China announced the updated State Insurance Catalogue, which takes effect on July 1, 2010, and the Xuesaitong Soft Capsules was no longer listed. At present, it has been announced that Banlangen Tables, Dansheng Tables and Sulfadiazine Silver Ointment have already been approved to be listed in the newly announced State Insurance Catalogue. The Ministry of Labor and Social Security in China plans to update the State Insurance Catalogue every two years, but since 2000, the catalog has been updated only twice.
In order to mitigate the negative impact the removal from the State Insurance Catalogue may have on the Company, we have been coordinating with various provinces to list the Xuesaitong Soft Capsules on the various PICs and so far, Xuesaitong Soft Capsules is listed on sixteen provinces or cities’ PIC, the sales from these provinces or cities accounted for approximately 77% of our total sales of Xuesaitong in 2011.
Further, the Department of Heath in China, which makes an independent assessment of the drugs available, publishes a “State Essential Drug List” as to what drugs are basic and prevalent and can satisfy the ordinary need for drugs to all the people. Patients purchasing medicines included in the “State Essential Drug List” are entitled to reimbursement of 90% of the costs of such medicines from the social medical fund in accordance with relevant regulations in China. In addition to the State Essential Drug List, each of the 31 Chinese provinces is entitled to add about 100 drugs to the State Essential Drug List. A drug listed on the provincial list will result in the patient purchasing such drug to receive the same 90% reimbursement. The Company’s Xuesaitong Soft Capsules was listed on the “State Essential Drug List” in 2000 and 2004 and the list is supposed to be updated every four years. Xuesaitong Soft Capsules is not included in the State Essential Drug List now but has been listed in four provinces and cities’ 2010 provincial essential drug list - Yunnan, Henan, Hunan and Tianjin.
Xuesaitong Soft Capsules is subject to wholesale and retail price controls by the Chinese government, and is primarily sold in China, and 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 (“SFDA”) 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. Our three largest customers are Tianjin Zhongxing Medicine Co., Ltd., Yunnan Medicine, Co.,Ltd. and Guangzhou Medicine Co., Ltd., all of which accounted for 13.7%, 11.5% and 6.9% of our sales for the year ended December 31, 2011.
As of December 31, 2011, our medicine marketing team maintains sales offices in approximately 25 provinces throughout China. The sales network covers approximately 215 cities and is staffed by approximately 703 sales representatives. We intend to grow our internal marketing and sales function and increase our relationships with other potential customers 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.
Our business is capital intensive, and these research and development, marketing, sales network expansion and cosmetic product expansion initiatives will require us to expend significant cash resources, which could adversely affect our profitability and liquidity. We do face certain challenges and risks, including our relatively high debt ratio, which is one of our main risks. We have encountered a shortage of working capital and are exploring possible ways to address our short and long term cash needs.
We believe that among the most important economic or industry-wide factors relevant to our growth in the short term is the 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 have applied for the designation of Xuesaitong Soft Capsules as a medicine with “good quality worthy of high price,” which we received in February 2007. Currently, the Chinese government supports the medical system in urban and rural communities.
According to data from the China State Statistical Bureau, the total retail sales of TCM and western medicines in China grew 17.9% on a year-over-year basis in 2011. This growth was driven by a number of favorable factors including the reform of the medical system in China, improving standards of living from an increase in disposable income, an aging population, the improving access and higher participation in the State Basic Medical Insurance System, and the increase in government spending on public health care.
In January 21, 2009, the Chinese government announced a healthcare reform plan proposing the government spend upward of RMB850 billion over the next three years to make medical services and products more affordable and accessible to the entire population. We believe the successful implementation of the policies outlined in the plan will have a significant impact on the domestic pharmaceutical sector. There are five key tasks the healthcare reforms are aiming to address: 1) to expand medical insurance coverage and increase participation rate, 2) set up a national basic drug system, 3) establishment of an extensive public health system, 4) increasing the efficiency and improve the quality of basic medical services, especially in the rural areas, and 5) reform state-owned hospitals.
TCM, including prescription and over-the-counter pharmaceuticals, have been widely used in China for many years and are an important part of the overall Chinese culture. The recently announced healthcare reform plan contains measures and policies that we believe will help support and promote the growth and development of the domestic TCM market. TCM drug manufacturers are likely to benefit from this reform as we believe the government will add more TCM-related drugs to the national medicine catalog. In addition, we expect the government will focus on disease prevention as it rolls out the nationwide medical insurance coverage. The TCM market is a vibrant and growing industry despite the challenging economic environment and it will remain a part of mainstream medicine in China.
We hope to stabilize the sales channel into hospitals and widen the reach of sales in urban and rural communities at the same time. Large increases in medicine sales at an average lower price will ensure the growth of general medicinal sales over the next few years. Also, we are focusing our efforts on developing better channels for selling our products to expand our revenue and to counter fierce market competition. To that extend, we began to build relationships with new high-quality sales agents and terminate our relationships with sales agent with poor historical performances during 2009. We believe that this shift will provide a sound foundation for our operations going forward.
Strategic Adjustment in Cosmetic
Since the marketing of 12 Ways cosmetics, the Company tried to expand its sales and have expanded the geographic region in which our 12 Ways products were sold from our native Yunnan province to a number of cities and provinces outside our local region. But due to the insufficient funding for marketing development, the sales of 12 Ways cosmetics grew slowly and the subsidiary of cosmetics has suffered a continuing loss. The loss adversely effected the holistic operation of the Company. Currently, the Company has a tight budget, in order to focus on our principal business - pharmaceutical with our limited capital, the Company has decided to make adjustment in Cosmetic in the fourth quarter of 2011. We will not fund the market development for 12 Ways cosmetics until we have enough 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. Over the last three years, the price of the main raw material we use - sanchi - has been fluctuating, which will likely increase our cost of product sold. In addition, our expected increased expenses for research and development, marketing and sales may have an adverse affect on future profit levels and available cash resources.
Company History
We were incorporated in the State of Delaware on May 24, 2005. We were originally organized as a “blank check” shell company to investigate and acquire a target company or business seeking the perceived advantages of being a publicly held corporation. Our principal business operations from inception to August 31, 2006, to closing of the Share Exchange, was to achieve long-term growth potential through a combination with a business rather than immediate, short-term earnings. On June 30, 2006, we entered into a Share Exchange Agreement (the “Exchange Agreement”) with Kunming Shenghuo Pharmaceutical (Group) Co., Ltd. (“Shenghuo China”) and Lan’s Int’l Medicine Investment Co., Limited, a Hong Kong corporation and shareholder holding 93.75% of the equity interest of Shenghuo China (“LIMI”). On August 11, and 28, 2006, the parties entered into Amendment No. 1 and 2 to the Exchange Agreement, respectively. Pursuant to the Exchange Agreement, as amended, we agreed to issue an aggregate of 16,255,400 shares of our common stock to LIMI and its designees in exchange for 93.75% of the equity interest of Shenghuo China (the “Share Exchange”). The Share Exchange closed on August 31, 2006. Upon the closing of the Share Exchange, we (i) became the 93.75% parent of Shenghuo China, (ii) assumed the operations of Shenghuo China and its subsidiaries and (iii) changed our name from SRKP 8, Inc. to China Shenghuo Pharmaceutical Holdings, Inc.
On June 18, 2007, the Board of Shenghuo China resolved to increase the registered capital of Shenghuo China by $734,348 from $9,665,017 to $10,399,365. As a result, we own approximately 94.95% of the equity interests of Shenghuo China, and Kunming Dian Jiao Investment Consulting Co., Ltd. ("Dian Jiao") owns approximately 5.05% of the equity interests of Shenghuo China.
Shenghuo China owns a 100% equity interest in Kunming Shenghuo Medicine Co., Ltd. (“Medicine”), Kunming Pharmaceutical Importation and Exportation Co., Ltd.(“Import/Export”), and Kunming Shenghuo Cosmetics Co.(“Cosmetic”), Ltd.
On April 30, 2009, Shenghuo China formed Shi Lin Shenghuo Pharmaceutical Co., Ltd. (“Shi Lin”) as a wholly owned subsidiary. Shi Lin was formed for the purpose of purchasing or leasing land suitable for cultivating the medicinal herb Panax notoginseng for use in the production of the Company’s medicinal products. As of December 31, 2011, Shi Lin had not started its operation.
On September 22, 2010 the Company received notice from NYSE Amex LLC (the “NYSE Amex” or “Exchange”) Staff indicating that the Company is below certain of the Exchange’s continued listing standards due to the fact that its stockholder’s equity is less than $2,000,000, it has sustained losses from continuing operations, and it has net losses in two out its three most recent fiscal years, as set forth in Section 1003(a)(i) of the NYSE Amex Company Guide. The Company was afforded the opportunity to submit a plan of compliance to the Exchange to demonstrate its ability to regain compliance with the continued listing standards by March 22, 2012. On October 29, 2010 and November 29, 2010, the Company presented its plan and responses to supplemental questions to the Exchange.
On November 15, 2010, Shenghuo formed Kunming Shenghuo Hotel Management Co., Ltd. (“Hotel”). According to the investment agreement with an independent third party, Shenghuo holds 80% equity interest in Hotel by investing the land use right and construction of the hotel while the third party holds a 20% equity interest by decorating the hotel, to operate the hotel together.
On December 6, 2010 the Exchange notified the Company that it accepted the Company’s plan of compliance and granted the Company an extension until March 22, 2012 to regain compliance with the continued listing standards. On March 21, 2012, the Exchange notified the Company its decision to defer making a determination on whether the Company has regained compliance until the company files the Annual Report on the Form 10-K on March 30, 2012. The Company has been subject to periodic review by Exchange Staff during the extension period. The stockholder’s equity was approximately $2.1 million and $2.0 million as of December 31, 2011 and 2010, respectively.
Critical Accounting Policies and Estimates
Application of Critical Accounting Policies
We consider the policies discussed below as critical to understanding our Consolidated Financial Statements, as their application places the most significant demands on management’s judgment, since financial reporting results rely on estimates of the effects of matters that are inherently uncertain. In instances where different estimates could have reasonably been used, we disclosed the impact of these different estimates on our operations. In certain instances, like revenue recognition, the accounting rules are prescriptive; therefore, it would not have been possible to reasonably use different estimates. Changes in assumptions and estimates are reflected in the period in which they occur. The impact of such changes could be material to our results of operations and financial condition in any quarterly or annual period.
Specific risks associated with these critical accounting policies are discussed throughout the MD&A, where such policies affect our reported and expected financial results. For a detailed discussion of the application of these and other accounting policies, refer to Note 2 - Summary of significant accounting policies, in the Consolidated Financial Statements.
Allowance for Doubtful Accounts and Credit Losses
Accounts receivable are reviewed periodically as to whether they are past due based on contractual terms and their carrying values have become impaired. An allowance for doubtful accounts is recorded in the period in which loss is determined to be probable based on an assessment of specific evidence indicating doubtful collection, historical experience, account balance aging and prevailing economic conditions. Measurement of such losses requires consideration of historical loss experience, including the need to adjust for current conditions, and judgments about the probable effects of relevant observable data, including present economic conditions such as delinquency rates and financial health of specific customers. We have considered all available information in our assessments of the adequacy of the provision for doubtful accounts and we do not expect there would be significant changes on conditions that would result in material effect on the allowance estimation. We will continue to assess our receivable portfolio in light of the current economic environment and its impact on our estimation of the adequacy of the allowance for doubtful accounts.
Income Taxes and Tax Valuation Allowances
We follow Statement of Accounting Standard Codification (“ASC”) Topic 740 “Accounting for Income Taxes”, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred income taxes are recognized for the tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at each period end based on enacted tax laws and statutory tax rates, applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized.
We regularly review our deferred tax assets for recoverability considering historical profitability, projected future taxable income, the expected timing of the reversals of existing temporary differences and tax planning strategies. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income and tax planning strategies in making this assessment. If we are unable to generate sufficient future taxable income, or if there is a material change in the actual effective tax rates or time period within which the underlying temporary differences become taxable or deductible, we could be required to increase the valuation allowance against all or a significant portion of our deferred tax assets resulting in a substantial adverse impact on our operating results.
Results of Operations
The following table sets forth our results of operations for the years ended December 31, 2011 and 2010.
Fiscal Years Ended December 31, 2011 and 2010
Sales: Sales for the year ended December 31, 2011 were approximately $44.2 million, an increase of approximately $11.5 million, or 35%, from approximately $32.7 million for the year ended December 31, 2010. The increase in sales was primarily due to the Company’s main product Xuesaitong’s sales increasing in Tianjin City, Jiangsu, Guangdong and Yunnan Province as Xuesaitong was listed on the PIC list of Tianjin City since the second half year in 2010 and the Company strengthened sales promotion in the provinces and cities where Xuesaitong was listed on their PIC lists, especially Yunnan Province and Tianjin City. The OTC market also contributed part of increase of revenue as the Company also strengthened the OTC market development in 2011.
Cost of sales: Our cost of sales for the year ended December 31, 2011 was approximately $17.0 million, an increase of approximately $5.8 million, or 52%, from approximately $11.2 million for the year ended December 31, 2010. The increase in cost of sales was due to the increase of the sales volume and the purchase price of Sanqi which is the main raw material of our main product Xuesaitong. Although we have started to grow Sanqi within the Resort, we will not be able to harvest until 2014 because it has a three year growth cycle. In addition, the Zhonghuang Hotel began trial operation since January 2011 which has contributed $2.3 million to the increase of cost of sales.
Gross profit: Our gross profit for the year ended December 31, 2011 was approximately $27.2 million as compared with approximately $21.5 million for the year ended December 31, 2010. Gross profit as a percentage of revenues was approximately 61.5% for the year ended December 31, 2011, a decrease of 4.3% from 65.8 % for the year ended December 31, 2010. The decrease in gross profit percentage was primarily due to the increase of cost of sales set forth above.
Selling expenses: Selling expenses were approximately $19.8 million for the year ended December 31, 2011, an increase of approximately $4.1 million, or 26%, from approximately $15.7 million for the year ended December 31, 2010. The primary reason for the increase in selling expenses was due to increase of sales commission to sales representative in line with the sales increment.
We reimburse the sales representatives their selling and marketing expenses when they submit the appropriate documentation to be reimbursed. We reimburse the sales representatives their accrued selling expenses when related accounts receivable are collected.
General and administrative expenses: General and administrative expenses were approximately $5.0 million for the year ended December 31, 2011, an increase of approximately $1.4 million, or 38%, from approximately $3.6 million for the year ended December 31, 2010. The increase was primarily due to the increase of the management’s traveling expenses and conference expenses for expanding our sales channel. In addition, Zhonghuang Hotel began trial operation since January 2011 which has contributed approximately $0.5 million to the increase of general and administrative expense.
Research and development expenses: Research and development expense for the year ended December 31, 2011 was approximately $0.71 million as compared to approximately $0.66 million for the year ended December 31, 2010. The increase was primarily due to the expenditures in 2011 for the Phase I clinical test of Sh1002 in America which amounted to $303,335.
Net other expense: Net other expense, which includes interest income, subsidy income, interest expense, other income and other expense, was approximately $1.5 million for the year ended December 31, 2011 as compared to approximately $0.1 million for the year ended December 31, 2010, an increase of approximately $1.4 million, or 1323%. The increase was mainly due to less subsidy income from provincial government as compared the same period in 2010 and more interest expenses in the 2011.
Income tax benefit (expense): Income tax benefit was $11,765 for the year ended December 31, 2011 as compared to income tax expense $105,764 for the year ended December 31, 2010. The tax benefit was mainly from medicine segment of the Company and the deferred tax assets benefit from accrued expenses and provisions for inventory.
Net income attributable to stockholders: We achieved a net income attributable to stockholders of approximately $0.1 million for the year ended December 31, 2011 as compared to approximately $1.2 million for the year ended December 31, 2010. The decrease in net income attributable to stockholders was primarily due to the decrease of subsidy income and increase of interest expense.
Liquidity and Capital Resources
General - As of December 31, 2011, we had cash and cash equivalents of approximately $1.2 million. We have historically financed our business operations through bank loans, in addition to equity offerings. In 2011, the Company achieved a net income of approximately $0.1 million although we suffered sharp increase of interest expense. Our consolidated current liabilities exceeded its consolidated current assets by approximately $23.2 million as of December 31, 2011, and approximately $15.3 million as of December 31, 2010.
For the year ended December 31, 2011, we had net cash used in operating activities of approximately $1.0 million, a decrease of over approximately $6.8 million from net cash provided by operating activities of approximately $5.8 million for the year ended December 31, 2010. We believe that we would be able to obtain more cash flows from operating activities by strengthen control on working capital management.
Cash flow
Operating Activities: Net cash used in operating activities for the year ended December 31, 2011 was approximately $1.0 million, as compared to net cash provided by operating activities of approximately $5.8 million for the year ended December 31, 2010. These results reflect the impacts of a decrease of approximately $6.8 million in working capital.
Investing Activities: Net cash used in investing activities was approximately $2.3 million for the year ended December 31, 2011, as compared to net cash used in the amount of approximately $8.0 million for the year ended December 31, 2010. The decrease in net cash used in investing activities was primarily due to less capital expenditure for Shenghuo Plaza in 2011.
Financing Activities: Net cash provided by financing activities was approximately $2.8 million for the year ended December 31, 2011 compared to net cash provided in the amount of approximately $1.8 million for the year ended December 31, 2010. The increase in cash provided was primarily due to the increase of loans borrowed from banks.
Restricted net assets
Our consolidated net income can be distributable only after sufficient appropriation of reserves. Amounts restricted to transfer funds to the stockholder through loans, advance, or dividends, include paid-in capital, additional paid-in capital and reserve funds of the Company as determined pursuant to the PRC accounting standards and regulations. However, since the Company recorded an accumulated deficit, the restricted net assets were determined up to the net assets of the Company, which was approximately $2.1 million and $2.0 million as of December 31, 2011 and 2010, respectively.
Working Capital Deficiency
Our consolidated current liabilities exceeded our consolidated current assets by approximately $23.2 million as of December 31, 2011, and approximately $15.3 million as of December 31, 2010. These factors raise substantial doubt about the Company’s ability to continue as a going concern. In order to continue as a going concern, the Company will need, among other things, additional capital resources. Management’s plan is to obtain such resources for the Company by obtaining capital from management and significant shareholders sufficient to meet its minimal operating expenses and seeking equity and/or debt financing by using Shenghuo Plaza and the two new office buildings as mortgage collateral after the Company obtains the Property Ownership Certificate in April of 2012. However, management cannot provide any assurances that the Company will be successful in accomplishing any of its plans. In the event we are not able to obtain funding, we will not be able to implement or may be required to delay all or part of our business plan, and our ability to attain profitable operations, generate positive cash flows from operating and investing activities and materially expand the business will be materially adversely affected. The accompanying consolidated financial statements do not include any adjustments relating to the classification of recorded asset amounts or amounts and classification of liabilities that might be necessary should the company be unable to continue in existence.
As of December 31, 2011, our net accounts and notes receivable (less allowance for doubtful accounts of approximately $2.6 million) were approximately $18.1 million, an increase of approximately $6.6 million, from approximately $11.5 million (net of allowance for doubtful accounts of approximately $2.3 million) as of December 31, 2010. In order to maintain our existing market and customers and further to expand our sales in the increasingly competitive business environment, the Company decided to allow some of our customers historically with good credit to extend their credit terms, which led to the increase of the accounts receivable. Before 2009, we made 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 to develop new customers. We believed that the sales representatives would be better able to expand into new markets and to secure new customers if they were advanced funds for their travel, meals and other incidental expenses that arose in connection with their sales activities. 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 2006, we began to more vigorously pursue collection of all sales representative advances. Nonetheless, there are some sales representative 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. Pursuant to the policies adopted at the beginning of 2009, instead of advancing sales representatives money to sustain or develop markets, we reimburse sales representatives their selling and marketing expenses when they present expense vouchers. Management considers this a better way to manage the potential for bad debts on the advances to sales representatives. We pay the accrued selling expenses only when we collect an account receivable for which a sales representative has presented his expense receipts. Because we offer a grace period of one to three months to our clients for remitting payments due, the accrued sales expenses may remain outstanding as long as it takes to collect the corresponding accounts receivable.
Other receivables (net of allowances for doubtful accounts), consisted mainly of receivables due from sales representatives and employee advances, these were approximately $4.1 million as of December 31, 2011 and 2010.
As of December 31, 2011, our accounts payable were approximately $9.4 million, an increase of approximately $0.4 million, from approximately $9.0 million as of December 31, 2010. The increase of accounts payable is mainly attributed to the extension in payment terms with certain major suppliers.
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 sales representatives to pay a certain percentage of the sales price as deposit before we deliver the products to the customers. The deposits were approximately $6.1 million as of December 31, 2011, increased approximately $1.2 million, from approximately $4.9 million as of December 31, 2010.
Other payables and accrued expense, mainly consisted of accrued commission payable to the sales representatives, increased by approximately $2.1 million, from approximately $9.7 million as of December 31, 2010 to approximately $11.8 million as of December 31, 2011 due to the net effect of payment and accrual for commission.
To the extent that we cannot satisfy our cash needs, whether from operations or from a financing source, our business may 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 wholesale companies or distributors. We will continue to accelerate the collection of trade receivables and shorten the turnover days.
In April 2011, we signed a loan agreement with Fudian Bank and obtained a short-term borrowing amounting to RMB8 million (approximately $1.3 million) between April 22, 2011 and April 21, 2012. This short-term borrowing was collateralized by the Shenghuo’s patent - a Method of Synthetic Preparation of Dencichine for Treatment of Bleeding (No. ZL00109992.2).
In July, 2011, we entered into a factoring agreement with Bank of China (the “BOC”) to transfer our accounts receivable with full recourse and the proceeds received from BOC being recognized as collateralized borrowings. Under this renewed factoring agreement, BOC agrees to provide the Company a maximum of approximately RMB30 million (approximately $4.8 million) factoring advance until July 28, 2012.
In August, 2011, we signed a loan agreement with Agricultural Bank of China (the “ABC”) and obtained a short-term borrowing amounting to RMB35 million (approximately $5.6 million) between August 26, 2011 and August 25, 2012. This short-term borrowing was collateralized by Shenghuo’s shares.
In September, 2011, Medicine borrowed a short-term loan in the amount of RMB5 million (approximately $0.8 million) from China Minsheng Bank Corporation. This loan was guaranteed by a maximum loan allowance contract of RMB10 million, or approximately $1.6 million. The unused line of credit as of December 31, 2011 was approximately $0.8 million.
Further, in December 2011, we signed a loan agreement with China Merchants Bank and obtained a short-term borrowing amounting to RMB2.66 million (approximately $0.42 million) between December 30, 2011 and June 29, 2012. This short-term borrowing was collateralized by bank acceptance bills.
The completion of Shenghuo Plaza is expected to generate more cash flows and increase our ability to obtain additional financing from banks. Considering the financial resources presently available, we believe that we have sufficient working capital for our present requirements and for at least the next 12 months assuming that we are able to obtain mortgage financing on the Shenghuo Plaza and the two new office buildings. We will continue to make efforts to expand our sales to get more cash flow.
However, we may require additional capital for acquisitions, for expanding business to related fields, or for the operation of the subsidiaries and there is no assurance that such funding will be available. Please see Note 10 -Borrowings in the Consolidated Financial Statements.
Off-Balance Sheet Commitment and Arrangements
On September 8, 2010, the Company signed an agreement with Management Commission of Kunming Shilin Taiwan Farmer Entrepreneur Centre to lease land for planting suitable-for-cultivating medicinal herb for use in the production of the Company’s medicinal products and to construct a health preserving zone and travel service center. The total operating lease amounted to approximately $4.9 million with a lease term of 20 years. Up to approximately $4.4 million under this lease agreement would be paid in the coming 4 years.
The Company plans to pay the lease expense by using the cash flow from our operation.
As of December 31 2011, we have paid RMB6,798,000($1,079,000) as installment payment, accounting for 18% of the total purchase price of RMB37,800,000 ($5,999,000) for the purchase of certain land use right for the Resort to the Entrepreneur Centre. The remaining balance will be paid in future installments as determined by the Entrepreneur Centre. The terms of the land use right purchase is set forth in the Supplemental Agreement on the Project of Construction of Shilin Shenghuo TCM Cultural Garden (the “Supplemental Agreement”), dated September 8, 2010 between Kunming Shenghuo and the Entrepreneur Center and was previously filed. Both the Lease Agreement and the Supplemental Agreement are subject to the fulfillment by Kunming Shenghuo of certain conditions including timely payment and construction and implementation of the Resort in accordance with the prescribed timeframe and standards.
Except as aforementioned, the Company does not have any outstanding off-balance sheet guarantees, interest rate swap transactions or foreign currency forward contracts. In addition, the Company does not engage in trading activities involving non-exchange traded contracts. In our ongoing business, we do not enter into transactions involving, or otherwise form relationships with, unconsolidated entities or financials partnerships that are established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.
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 our operations in the PRC. In addition, all of our revenue is denominated in the Chinese Yuan RMB (“RMB”), which must be converted into other currencies before remittance out of the PRC. Both the conversion of RMBinto 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.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Smaller reporting companies are not required to provide the information required by this item.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The information required by this Item 8 is incorporated by reference to the Consolidated Financial Statements beginning at page at the end of this Form 10-K.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES.
Evaluation of disclosure controls and procedures
Our management, with the participation of our chief executive officer and chief financial officer, Mr. Gui Hua Lan and Mr. Raymond Wang respectively, evaluated the effectiveness of our disclosure controls and procedures. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports, such as this report, that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the Company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on that evaluation, Mr. Lan and Mr. Wang concluded that despite our hiring of a CFO who is familiar with U.S. GAAP in this April, more training offered to our staff in the accounting department and improvements in areas of previously identified weakness in internal control over financial reporting identified (described below), our disclosure controls and procedures were not effective as of December 31, 2011.
Management’s Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Internal control over financial reporting refers to the process designed by, or under the supervision of, our principal executive officer and principal financial officer, and effected by our Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles, and includes those policies and procedures that:
(1) Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of our assets;
(2) Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorization of our management and directors; and
(3) Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisitions, use or disposition of our assets that could have a material effect on the financial statements.
Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, this risk. Management is responsible for establishing and maintaining adequate internal control over financial reporting for the company.
As of December 31, 2011, our management conducted an assessment of the effectiveness of our internal control over financial reporting, based on the framework established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, or COSO. Based on this assessment, our management has concluded that despite our hiring of a CFO who is familiar with U.S. GAAP in April 2011, more training offered to our staff in the accounting department and improvements in areas identified below, our internal controls were not effective as of December 31, 2011.
Lack of US GAAP expertise - Despite substantial efforts to improve the Company’s controls and procedures, as previously reported by the Company, our accounting personnel do not have sufficient knowledge, experience and training in maintaining our books and records and preparing financial statements in accordance with US GAAP standards and SEC rules and regulations. The accounting skills and understanding necessary to fulfill the requirements of US GAAP-based reporting, including the skills of US GAAP-based period end closing, consolidation of financial statements, and US GAAP conversion, are inadequate and were inadequately supervised.
Our management has identified the following steps to address the above material weakness:
(1) We will hire, as needed, key accounting personnel with technical accounting expertise and reorganize the finance department to ensure that accounting personnel with adequate experience, skills and knowledge relating to complex, non-routine transactions are directly involved in the review and accounting evaluation of our complex, non-routine transactions.
(2) We will employ, as needed, outside professionals to provide key accounting personnel ongoing technical trainings to ensure their proper understanding of newly announced accounting standards.
In this fiscal year ended December 31, 2011, we have recruited certain accounting personnel with knowledge of US GAAP and organized trainings in US GAAP. However, these steps could not adequately enable our financial staff to fulfill the requirements of US GAAP as it needs more time in training. Accordingly, we continue to believe there is a material weakness relating to the insufficient integration of our personnel with US GAAP expertise into the financial reporting process, resulting in inadequate processes and documentation to address accounting and reporting requirements under US GAAP.
Our management is not aware that the material weakness in our internal control over financial reporting causes them to believe that any material inaccuracies or errors existed in our financial statement as of December 31, 2011.
Changes in Internal Control over Financial Reporting
The Company did not have the internal financial resources to devote further effort to this given its other business priorities and intention to return to profitability.
ITEM 9B.
ITEM 9B. OTHER INFORMATION.
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE.
The information required by this Item is incorporated by reference to the applicable information in our Proxy
Statement related to the 2012 Annual Meeting of Stockholders (the “2012 Proxy Statement”).
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
The information required by this Item is incorporated by reference to the applicable information in the 2012 Proxy Statement.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.
The information required by this Item is incorporated by reference to the applicable information in the 2012 Proxy Statement.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE.
The information required by this Item is incorporated by reference to the applicable information in the 2012 Proxy Statement.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES.
The information required by this Item is incorporated by reference to the applicable information in the 2012 Proxy Statement.
PART IV
ITEM15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES.
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).
10.1
Joint Establishment Agreement of Kunming Beisheng Science & Technology Development Co., Ltd. dated January 1, 2006 entered into by and between the Company and Beijing University Shijia Research Center (translated to English) (incorporated by reference from Exhibit 10.8 to the Registration Statement on Form SB-2 filed with the Securities and Exchange Commission on December 21, 2006).
Exhibit
Number
Description of Exhibit
10.2
Joint Venture Agreement for Kunming Shenghuo Pharmaceutical Group Co., Ltd. dated May 22, 2006 entered into by and between Lan’s International Medicine Investment Co., Limited and SDIC Venture Capital Investment, Co., Ltd. (translated to English) (incorporated by reference from Exhibit 10.9 to the Registration Statement on Form SB-2 filed with the Securities and Exchange Commission on December 21, 2006).
10.3
Form of Independent Director’s Agreement, entered into by the Company with each of Mingyang Liao, Yunhong Guan, Jason Zhang and Xiaobo Sun (incorporated by reference from Exhibit 10.1 to the Current Report on Form 8-K filed with the Securities and Exchange Commission on September 26, 2007).
10.4
Form of Warrant Agreement, entered into by the Company with each of Gene Michael Bennett and Yunhong Guan (incorporated by reference from Exhibit 10.2 to the Current Report on Form 8-K filed with the Securities and Exchange Commission on September 26, 2007).
10.5
Form of Warrant to be issued to be issued to the Underwriter, entered into by the Company and Westpark Capital Inc. (incorporated by reference from Exhibit 4.1 to the Registration Statement on Form SB-2 filed with the Securities and Exchange Commission on June 11, 2007).
10.6
Line of Credit Agreement dated August 6, 2009 by and between Kunming Shenghuo Pharmaceutical (Group) Co., Ltd. and the Agricultural Bank of China Limited Inc. (incorporated by reference from Exhibit 10.1 to the Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on November 16, 2009.)
10.7
Pledge Agreement dated August 21, 2009 by and between the Company and Agricultural Bank of China Shuanglong Branch. (incorporated by reference from Exhibit 10.2 to the Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on November 16, 2009.)
10.8
Insurance Policy dated May 4, 2009 issued by Ping An Property & Casualty Insurance Company of China, Ltd. in favor of the Company. (incorporated by reference from Exhibit 10.3 to the Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on November 16, 2009.)
10.9
Indemnity Agreement dated June 9, 2009 by and among the Company, Ping An Property & Casualty Insurance Company of China, Ltd. and China Construction Bank Kunming Heping Branch. (incorporated by reference from Exhibit 10.4 to the Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on November 16, 2009.)
10.10
Loan Contract dated August 24, 2009 by and between Kunming Shenghuo Pharmaceutical (Group) Co., Ltd. and the Agricultural Bank of China Limited Inc. (incorporated by reference from Exhibit 10.17 to the Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 14, 2010.)
10.11
Loan Contract dated March 26, 2008 by and between Kunming Shenghuo Pharmaceutical (Group) Co., Ltd. and the Agricultural Bank of China Limited Inc. (incorporated by reference from Exhibit 10.18 to the Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 14, 2010.)
10.12
Rights Pledge Contract dated August 19, 2009 by and between the Company and the Agricultural Bank of China Limited Inc. (incorporated by reference from Exhibit 10.19 to the Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 14, 2010.)
10.13
Mortgage Contract dated March, 2008 by and between Kunming Shenghuo Pharmaceutical (Group) Co., Ltd. and the Agricultural Bank of China Limited Inc. (incorporated by reference from Exhibit 10.20 to the Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 14, 2010.)
Exhibit
Number
Description of Exhibit
10.14
Loan Contract dated March 30, 2007 by and between Kunming Shenghuo Pharmaceutical (Group) Co., Ltd. and China Construction Bank, Kunming Heping Branch. (incorporated by reference from Exhibit 10.21 to the Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 14, 2010.)
10.15
Mortgage Contract dated March 30 , 2007 by and between Kunming Shenghuo Pharmaceutical (group) Co., Ltd. and China Construction Bank, Kunming Heping Branch. (incorporated by reference from Exhibit 10.22 to the Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 14, 2010.)
10.16
Borrowing Contract dated March 29, 2010 by and between Kunming Shenghuo Pharmaceutical (Group) Co., Ltd. and Kunming Municipal Bureau of Finance, Branch Bureau of Kunming National Economy and Technology Developing District. (incorporated by reference from Exhibit 10.23 to the Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 14, 2010.)
10.17
Loan Contract dated January, 2010 by and between Kunming Shenghuo Pharmaceutical (Group) Co., Ltd. and the Agricultural Bank of China Limited Inc. (incorporated by reference from Exhibit 10.24 to the Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 14, 2010.)
10.18
Mortgage Contract dated January, 2010 by and between Kunming Shenghuo Pharmaceutical (Group) Co., Ltd. and the Agricultural Bank of China Limited Inc. (incorporated by reference from Exhibit 10.25 to the Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 14, 2010.)
10.19
Loan Contract dated April 7, 2010 by and between Kunming Shenghuo Pharmaceutical (Group) Co., Ltd. and the Agricultural Bank of China Limited Inc. (incorporated by reference from Exhibit 10.27 to the Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 14, 2010.)
10.20
Mortgage Contract dated March 31, 2010 by and between Kunming Shenghuo Pharmaceutical (Group) Co., Ltd. and the Agricultural Bank of China Limited Inc., Kunming Shuanglong Sub-Branch. (incorporated by reference from Exhibit 10.28 to the Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 14, 2010.)
10.21
Mortgage Contract dated March 31, 2010 by and between Kunming Shenghuo Pharmaceutical (Group) Co., Ltd. and the Agricultural Bank of China Limited Inc., Kunming Shuanglong Sub-Branch. (incorporated by reference from Exhibit 10.29 to the Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 14, 2010.)
10.22
Factoring Agreement dated May 13, 2011 by and between Kunming Shenghuo Pharmaceutical (Group) Co., Ltd. and Heping Branch, China Construction Bank. (incorporated by reference from Exhibit 10.1 to the Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on May 16, 2011.)
10.23
Loan contract dated April 22, 2011 by and between Kunming Shenghuo Pharmaceuticals (Group) Co., Ltd. and Fudian Bank. (incorporated by reference from Exhibit 10.2 to the Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on May 16, 2011.)
10.24
Guaranty Agreement on Pledge of Right dated April 22, 2011 by and between Kunming Shenghuo Pharmaceutical (Group) Co., Ltd. and Fudian Bank. (incorporated by reference from Exhibit 10.3 to the Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on May 16, 2011.)
Exhibit
Number
Description of Exhibit
10.25
Loan Contract, dated May 20, 2011 by and between Kunming Shenghuo Pharmaceutical (Group) Co., Ltd. and Agricultural Bank of China. (incorporated by reference from Exhibit 10.1 to the Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on August 15, 2011.)
10.26
Mortgage Contract, dated May 20, 2011 by and between Kunming Shenghuo Pharmaceutical (Group) Co., Ltd. and Agricultural Bank of China. (incorporated by reference from Exhibit 10.2 to the Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on August 15, 2011.)
10.27
Pledge Contract, dated May 20, 2011 by and between Kunming Shenghuo Pharmaceutical (Group) Co., Ltd. and Agricultural Bank of China. (incorporated by reference from Exhibit 10.3 to the Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on August 15, 2011.)
10.28
Factoring Agreement, dated July 29, 2011 by and between Kunming Shenghuo Pharmaceutical (Group) Co., Ltd. and Bank of China, Yunnan Branch. (incorporated by reference from Exhibit 10.4 to the Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on August 15, 2011.)
10.29
Short Term Domestic Credit Insurance, dated May 4, 2011, between Kunming Shenghuo Pharmaceutical (Group) Co., Ltd. and China Ping An Insurance Company. (incorporated by reference from Exhibit 10.5 to the Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on August 15, 2011.)
10.30
Agreement on Indemnities Transfer, dated May 5, 2011, between Kunming Shenghuo Pharmaceutical (Group) Co., Ltd. and China Ping An Insurance Company. (incorporated by reference from Exhibit 10.6 to the Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on August 15, 2011.)
10.31
Loan Contract, dated August 26, 2011 by and between Kunming Shenghuo Pharmaceutical (Group) Co., Ltd. and Agricultural Bank of China. (incorporated by reference from Exhibit 10.1 to the Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on November 14, 2011.)
10.32
Lease Agreement on the Project of Construction of Shilin Shenghuo TCM Cultural Garden between Kunming Shenghuo Pharmaceutical (Group) Co.,Ltd and Management Commission of Kunming Shilin Taiwan Farmer Entrepreneur Centre, dated September 8, 2010 (Revised) (incorporated by reference from Exhibit 10.2 to the Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on November 14, 2011.)
10.33
Supplemental Agreement on the Project of Construction of Shilin Shenghuo TCM Cultural Garden between Kunming Shenghuo Pharmaceutical (Group) Co.,Ltd and Management Commission of Kunming Shilin Taiwan Farmer Entrepreneur Centre, dated September 8, 2010 (Revised) (incorporated by reference from Exhibit 10.3 to the Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on November 14, 2011.)
10.34*
Loan Contract, dated December 26, 2011 by and between Kunming Shenghuo Pharmaceutical (Group) Co., Ltd. and China Merchants Bank.
10.35*
Financial Service Contract, dated September 29, 2011 by and between Kunming Shenghuo Medicine Co., Ltd. and China Minsheng Bank Corporation.
14.1
China Shenghuo Pharmaceutical Holdings, Inc. Code of Business Conduct and Ethics (incorporated by reference from Exhibit 99.1 to the Current Report on Form 8-K filed with the Securities and Exchange Commission on June 12, 2007).
Exhibit
Number
Description of Exhibit
16.1
Letter from Hansen, Barnett & Maxwell, P.C. dated August 26, 2009 (incorporated by reference from Exhibit 16.1 to the Current Report on Form 8-K filed with the Securities and Exchange Commission on August 26, 2009.)
21.1
List of Subsidiaries (incorporated by reference from Exhibit 21.1 to the Registration Statement on Form SB-2 on Form S-3 filed with the Securities and Exchange Commission on September 18, 2007).
31.1*
Rule 13a-14(a) Certification of the Chief Executive Officer of China Shenghuo Pharmaceutical Holdings, Inc. in accordance with Section 302 of the Sarbanes-Oxley Act of 2002.
31.2*
Rule 13a-14(a) Certification of the Chief Financial Officer of China Shenghuo Pharmaceutical Holdings, Inc. in accordance with Section 302 of the Sarbanes-Oxley Act of 2002.
32.1*
Section 1350 Certification of the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101**
Interactive data files pursuant to Rule 405 of Regulation S-T (furnished herewith).
*
Filed herewith.
**
The interactive data files in Exhibit No. 101 hereto are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, and not filed for purposes of Section 18 of the Securities and Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.
SIGNATURES
In accordance with Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
CHINA SHENGHUO PHARMACEUTICAL HOLDINGS, INC.
(Company)
March 30, 2012 By: /s/ Feng Lan
Feng Lan
Chief Executive Officer and President (Principal Executive Officer)
In accordance with the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
By: /s/ Feng Lan
Date: March 30, 2012
Feng Lan
Chief Executive Officer, President and Director
(Principal Executive Officer)
By: /s/ Raymond Wang
Date: March 30, 2012
Raymond Wang
Chief Financial Officer
(Principal Financial and Accounting Officer)
By: /s/ Gui Hua Lan
Date: March 30, 2012
Gui Hua Lan
Non-executive Chairman of the Board
By: /s/ Lei Lan
Date: March 30, 2012
Lei Lan
Vice President and Director
By: /s/ Yunhong Guan
Date: March 30, 2012
Yunhong Guan
Director
By: /s/ Jason Yuanxin Zhang
Date: March 30, 2012
Jason Yuanxin Zhang
Director
By: /s/ Xiaobo Sun
Date: March 30, 2012
Xiaobo Sun
Director
CHINA SHENGHUO PHARMACEUTICAL HOLDINGS, INC.
AND SUBSIDIARIES
CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2011 AND 2010
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders
of China Shenghuo Pharmaceutical Holdings, Inc.
We have audited the accompanying consolidated balance sheet of China Shenghuo Pharmaceutical Holdings, Inc. and Subsidiaries (the “Company”) as of December 31, 2011, and the related consolidated statements of income and comprehensive income, changes in equity and cash flows for the year then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company, as of December 31, 2011, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.
The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the consolidated financial statements, the Company has a significant working capital deficiency, which raises substantial doubt about its ability to continue as a going concern. Management’s plans regarding those matters are also described in Note 2. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
/s/ Marcum Bernstein & Pinchuk llp
New York, NY
March 30, 2012
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders of
China Shenghuo Pharmaceutical Holdings, Inc.
We have audited the accompanying consolidated balance sheet of China Shenghuo Pharmaceutical Holdings, Inc. and Subsidiaries (“the Company”) as of December 31, 2010, and the related consolidated statements of operations and comprehensive income, changes in equity, and cash flows for the year ended December 31, 2010. The Company’s management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2010, and the results of its operations and its cash flows for the year ended December 31, 2010 in conformity with accounting principles generally accepted in the United States of America.
/s/ Bernstein & Pinchuk LLP
New York, NY
March 30, 2011
CHINA SHENGHUO PHARMACEUTICAL HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Amounts in USD, except shares)
See notes to consolidated financial statements
CHINA SHENGHUO PHARMACEUTICAL HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS (CONT’D)
(Amounts in USD, except shares)
See notes to consolidated financial statements
CHINA SHENGHUO PHARMACEUTICAL HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE INCOME (LOSS)
(Amounts in USD, except shares)
See notes to consolidated financial statements
CHINA SHENGHUO PHARMACEUTICAL HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY
(Amounts in USD, except shares)
See notes to consolidated financial statements
CHINA SHENGHUO PHARMACEUTICAL HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in USD)
See notes to consolidated financial statements
CHINA SHENGHUO PHARMACEUTICAL HOLDINGS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
NOTE 1 - ORGANIZATION AND NATURE OF OPERATIONS
(a)Nature of Business
China Shenghuo Pharmaceutical Holdings, Inc, (“CSPH”), incorporated in Delaware, United States of America, through its subsidiaries (collectively the “Company”), designs, develops, markets, sells and exports pharmaceutical, nutritional supplements, cosmetic products, and also engages in the hotel operating business mainly in the People’s Republic of China (“PRC”). The Company also conducts research and development using the medicinal herb Panax notoginseng, also known as Sanqi, Sanchi, or Tienchi, which is grown in two provinces in the PRC. Sales from the cosmetic products represent less than 10% of total sales of the Company.
(b)Organization
The CSPH owns a 94.95% equity interest in Kunming Shenghuo Pharmaceuticals (Group) Co., Ltd. (“Shenghuo”). Shenghuo owns a 100% equity interest in Kunming Shenghuo Medicine Co., Ltd. (“Medicine”), Kunming Pharmaceutical Importation and Exportation Co., Ltd. (“Import/Export”) and Kunming Shenghuo Cosmetics Co., Ltd. (“Cosmetic”), respectively.
On April 30, 2009, Shenghuo formed Shi Lin Shenghuo Co., Ltd. (“Shi Lin”) as a wholly owned subsidiary. Shi Lin was formed for the purpose of purchasing or leasing land suitable for cultivating the medicinal herb Panax notoginseng for use in the production of the Company’s medicinal products. As of December 31, 2011, Shi Lin does not generate any revenue.
On November 15, 2010, Shenghuo formed Kunming Shenghuo Hotel Management Co., Ltd. (“Hotel”). According to the investment agreement with an independent third party, Shenghuo holds 80% equity interest in Hotel by investing the land use right and construction of the hotel while the third party holds a 20% equity interest by decorating the hotel, to operate the hotel together.
Except for CSPH, all other entities are formed in and operate within the PRC.
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(a)Basis of presentation and consolidation
The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“US GAAP”).
The consolidated financial statements have been prepared on the basis that the Company will continue to operate throughout the next twelve months as a going concern. The Company’s consolidated current liabilities exceeded its consolidated current assets by approximately USD23,189,000 as of December 31, 2011 and USD15,326,000 as of December 31, 2010. These factors raise substantial doubt about the Company’s ability to continue as a going concern. In order to continue as a going concern, the Company will need, among other things, additional capital resources. Management’s plan is to obtain such resources for the Company by obtaining capital from management and significant shareholders sufficient to meet its minimal operating expenses and seeking equity and/or debt financing by using Shenghuo Plaza and the two new office buildings as mortgage collateral after the Company obtains the Property Ownership Certificate in April of 2012. However, management cannot provide any assurances that the Company will be successful in accomplishing any of its plans. In the event that the Company is not able to obtain funding, it will not be able to implement or may be required to delay all or part of the business plan, and the ability to attain profitable operations, generate positive cash flows from operating and investing activities and materially expand the business will be materially adversely affected. The accompanying consolidated financial statements do not include any adjustments relating to the classification of recorded asset amounts or amounts and classification of liabilities that might be necessary should the company be unable to continue in existence.
(b)Principle of consolidation
The consolidated financial statements include the financial statements of the CSPH and its subsidiaries. All significant inter-company transactions and balances have been eliminated in consolidation.
Non-controlling interests represent the ownership interests in the subsidiaries that are held by owners other than the parent and are part of the equity of the consolidated group. The non-controlling interests are reported in the consolidated balance sheets within equity, separately from the parent’s equity. Net income or loss and comprehensive income or loss is attributed to the parent and the non-controlling interests. If losses attributable to the parent and the non-controlling interests in a subsidiary exceed their interests in the subsidiary’s equity, the excess, and any further losses attributable to the parent and the non-controlling interests, is attributed to those interests.
(c)Use of estimates
The preparation of financial statements in conformity with US GAAP requires Management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Judgments and estimates of uncertainties are required in applying the Company’s accounting policies in certain areas. The following are some of the areas requiring significant judgments and estimates: a) Going concern; b) valuation allowance for deferred tax assets based on estimated future taxable income as described in note 15; c) allowance for doubtful receivables as described in note 5 and note 6; d) Depreciable life for property, plant and equipment. The relevant amounts could be adjusted in the near term if experience differs from current estimates.
(d)Foreign currency translation
CSPH’s functional currency is the United States dollar (“USD”). The functional currency of the CSPH’s subsidiaries in the PRC is RMB (“RMB”).
At the date a foreign currency transaction is recognized, each asset, liability, revenue, expense, gain, or loss arising from the transaction is measured initially in the functional currency of the recording entity by use of the exchange rate in effect at that date. The increase or decrease in expected functional currency cash flows upon settlement of a transaction resulting from a change in exchange rates between the functional currency and the currency in which the transaction is denominated is recognized as foreign currency transaction gain or loss that is included in determining net income for the period in which the exchange rate changes. At each balance sheet date, recorded balances that are denominated in a foreign currency are adjusted to reflect the current exchange rate.
The Company’s reporting currency is USD. Assets and liabilities of the PRC subsidiaries are translated at the current exchange rate at the balance sheet dates, and revenues and expenses are translated at the average exchange rates during the reporting periods. Translation adjustments are reported in other comprehensive income.
(e)Cash and cash equivalents
Cash includes not only currency on hand but demand deposits with banks or other financial institutions. Cash equivalents are short-term, highly liquid investments with original maturities of three months or less that are readily convertible to cash.
(f)Accounts and notes receivable
Accounts receivable are recognized and carried at original sale amounts less an allowance for uncollectible accounts, as needed.
Accounts receivable are reviewed periodically as to whether they are past due based on contractual terms and their carrying values have become impaired. An allowance for doubtful accounts is recorded in the period in which loss is determined to be probable based on an assessment of specific evidence indicating doubtful collection, historical experience, account balance aging and prevailing economic conditions. Accounts receivable balances are written off after all collection efforts have been exhausted.
Notes receivable represent bankers’ acceptances that have been arranged with third-party financial institutions by certain customers to settle their purchases from us. These bankers’ acceptances are non-interest bearing and are collectible within six months. Such sales and purchasing arrangements are consistent with industry practices in the PRC.
There are no outstanding amounts from customers that individually represent greater than 10% of the total balance of accounts receivable for the years presented.
The Company entered into a factoring agreement with Bank of China (“BOC”), to transfer accounts receivable with full recourse. The Company is required to repurchase the transferred accounts receivable, if any controversy arises on the accounts receivable, at a price of proceeds received from BOC less settled accounts receivable plus interest and other necessary penalty or expense. The Company accounts for its transferred accounts receivable in accordance with Accounting Standard Codification (“ASC”) Topic 810, with the proceeds received from BOC being recognized as collateralized borrowings.
(g)Other receivables
Other receivables are presented at cost less allowance for doubtful accounts. Other receivables include sales representative advances for market development, employee advances and sales office advances for facilities of sales activities. As time passes from when advances are made to sales representatives for travel and related expenses, the Company provides allowance for these older receivables based on review of collectability risk from each particular sales representative and aging of the ending balance. Other receivables balances are written off after all collection efforts have been exhausted.
(h)Inventories
Inventories are stated at lower of cost or market. Cost is determined using weighted average method. Inventories include raw material, work in process and finished goods. The variable production overheads are allocated to each unit of production on the basis of the actual use of the production facilities. The allocation of fixed production overheads to the costs of conversion is based on the normal capacity of the production facilities.
Where there is evidence that the utility of inventories, in their disposal in the ordinary course of business, will be less than cost, whether due to physical deterioration, obsolescence, changes in price levels, or other causes, a provision is accrued for the difference with charges to cost of goods sold.
Costs incurred to physically transfer product to customer locations are recorded as a component of cost of goods sold.
(i)Property, plant and equipment
Property, plant and equipment are stated at historical cost less accumulated depreciation and impairment. The historical cost of acquiring an item of property, plant and equipment includes the costs necessarily incurred to bring it to the condition and location necessary for its intended use. If an item of property, plant and equipment requires a period of time in which to carry out the activities necessary to bring it to that condition and location, the interest cost incurred during that period as a result of expenditures for the item is a part of the historical cost. This item is categorized as construction in progress and is not depreciated until substantially all the activities necessary to bring it to the condition and location necessary for its intended use are completed.
Depreciation of property, plant and equipment is calculated using the straight-line method (after taking into account their respective estimated residual values) over the estimated useful lives of the assets as follows:
Depreciation of property, plant and equipment attributable to manufacturing activities is capitalized as part of inventories, and expensed to cost of goods sold when inventories are sold.
Expenditures for maintenance and repairs are expensed as incurred.
The gain or loss on the disposal of property, plant and equipment is the difference between the net sales proceeds and the carrying amount of the relevant assets and is recognized in the consolidated statements of operations.
(j)Intangible assets
The Company’s intangible assets mainly consist of land use rights and office software. According to the laws of the PRC, the government owns all the land in the PRC. Companies or individuals are authorized to possess and use the land only through land use rights granted by the government. Land use rights and software are carried at cost and charged to expense on a straight-line basis over the period as follows:
(k)Impairment or disposal of long-lived assets
A long-lived asset (asset group) is tested for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. An impairment loss is recognized only if the carrying amount of a long-lived asset (asset group) is not recoverable and exceeds its fair value. The carrying amount of a long-lived asset (asset group) is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset (asset group). The assessment is based on the carrying amount of the asset (asset group) at the date it is tested for recoverability, whether in use or under development. An impairment loss is measured as the amount by which the carrying amount of a long-lived asset (asset group) exceeds its fair value. There were no events or changes in circumstances that necessitated a review of impairment of long-lived assets as of December 31, 2011 and 2010, respectively.
(l)Accrued expenses and other payables
Accrued expenses and other payables primarily consist of accrued commission expense, accrued legal expense and accrued payroll expense, etc.
(m)Sales representative deposits
Sales representative deposits consist of funds paid in advance by the sales representatives to obtain the Company’s products to sell. The Company retains these deposits during the time the sales representatives provide services to the Company. When the Company receives full payment from the customer or sales representatives terminate sales services, the deposits are returned to the sales representatives. The Company records deposits from sales representatives when payments are received.
(n)Fair value of financial instruments
The carrying amounts reported in the consolidated balance sheets for accounts and notes receivable, other receivables, advances to suppliers, accounts payable, advances from customers, other payables and accrued expenses, deposits payable approximate fair value because of the immediate or short-term maturity of these financial instruments. Management believes the interest rates on short-term notes payable and long-term debt reflect rates currently available in the PRC. Thus, the carrying value of these loans approximates fair value.
(o)Income and other taxes
CSPH and its consolidated entities each files tax returns separately.
Value added tax (“VAT”)
Pursuant to the Provisional Regulation of China on VAT and their implementing rules, all entities and individuals (“taxpayers”) that are engaged in the sale of products in the PRC are generally required to pay VAT at a rate of 17% of the gross sales proceeds received, less any deductible VAT already paid or borne by the taxpayers. Further, when exporting goods, the exporter is entitled to a portion of or all the refund of VAT that it has already paid or incurred.
CSPH’s PRC subsidiaries are subject to VAT at 17% on their revenues.
Income tax
The Company follows ASC Topic 740, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred income taxes are recognized for the tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at each period end based on enacted tax laws and statutory tax rates, applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized.
The Company follows ASC Topic 740, which prescribes a more-likely-than-not threshold for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, accounting for income tax in interim periods, and income tax disclosures. The Company did not have any interest and penalties associated with tax positions and did not have any significant unrecognized uncertain tax positions as of December 31, 2011 and 2010.
The Company is not subject to any income tax in the United States. Shenghuo is qualified to enjoy preferential tax rate under relevant PRC tax laws and regulations, with effective income tax rate of 10% in 2009, 11% in 2010 and 12% in 2011. All other subsidiaries in the PRC were subject to income tax at a rate of 25% for the years presented.
(p)Revenue recognition
The Company recognizes revenue in accordance with ASC Topic 605. All of the following criteria must exist in order for the Company to recognize revenue: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services have been rendered; (3) price to the buyer is fixed or determinable; and (4) collectability is reasonably assured.
Delivery does not occur until products have been shipped to the wholesale companies, risk of loss has been transferred to the wholesale companies and wholesale companies’ acceptance has been obtained, or the Company has objective evidence that the criteria specified in wholesale companies’ acceptance provisions have been satisfied. The sales price is not considered to be fixed or determinable until all contingencies related to the sale have been resolved.
In general, the Company does not allow wholesale companies to return products unless there are defects in manufacturing or workmanship. Sales returns are subject to a strict process and have to be authorized by Management. Sales returns are netted against sales when occurred. Historically, the amounts of sales returns have been immaterial.
Revenue for the Hotel business is recognized when the services have been rendered.
(q)Subsidy income
Subsidy income received in cash from government is subject to the revenue recognition standards and hence will not be recognized as income until any conditions attached to the subsidy are satisfied.
(r)Advertising expenses
Advertising expenses, which generally represent the cost of promotions to create or stimulate a positive image of the Company or a desire to buy the Company’s products and services, are expensed as incurred. Advertising costs amounting to approximately USD21,000 and USD70,000 for the years ended December 31, 2011 and 2010, respectively, were recorded in the selling expenses.
(s)Research and development
Research and development costs are expensed as incurred. These expenses consist of the costs of the Company’s internal research and development activities and the costs of developing new products and enhancing existing products. Research and development costs amounting to approximately USD710,000 and USD656,000 for the years ended December 31, 2011 and 2010, respectively, were recorded in the statements of operations.
(t)Retirement and other postretirement benefits
Full-time employees of the Group in the PRC participate in a government mandated defined contribution plan, pursuant to which certain pension benefits, medical care, employee housing fund and other welfare benefits are provided to employees. Chinese labor regulations require that the PRC subsidiaries of the Group make contributions to the government for these benefits based on certain percentages of the employees’ salaries. The Group has no legal obligation for the benefits beyond the contributions made. The total amounts for such employee benefits, which were expensed as incurred, were approximately USD514,000 and USD262,000 for the years ended December 31, 2011 and 2010, respectively.
(u)Appropriated retained earnings
The income of CSPH’s PRC subsidiaries is distributable to its shareholder after transfer to reserves as required by relevant PRC laws and regulations and the subsidiaries’ articles of association. Appropriations to the reserves are approved by the respective boards of directors.
Reserves include statutory reserves and other reserves. Statutory reserves can be used to make good previous years’ losses, if any, and may be converted into capital in proportion to the existing equity interests of stockholders, provided that the balance after such conversion is not less than 25% of the registered capital. The appropriation of statutory reserve may cease to apply if the balance of the fund is equal to 50% of the entity’s registered capital. Pursuant to relevant PRC laws and articles of association of CSPH’s PRC subsidiaries, the appropriation to the statutory reserves is 15% of net profit after taxation of respective entity, as determined in accordance with PRC accounting standards and regulations. The results of operations reflected in the financial statements prepared in accordance with U.S. GAAP might differ from those reflected in the statutory financial statements of CSPH’s PRC subsidiaries.
(v)Basic and diluted earnings per share
The computation of basic and diluted earnings per share is based on the weighted-average number of shares outstanding during the periods presented. Potentially dilutive securities for the years ended December 31, 2011 and 2010 include 46,000 and 246,000 warrants respectively (note 14). However, since the average market price of the related common stock for these two years exceeds the exercise price, the warrants are considered having no dilutive effect in computation of earnings per share.
(w)Credit risk
All of cash has been deposited in the banks with great reputation in China and there is little possibility of credit risk.
The carrying amounts of accounts receivable and sales representative advances included in the balance sheets represent the Company’s major exposure to credit risk in relation to its financial assets. No other financial assets carry a significant exposure to credit risk. The Company performs ongoing credit evaluations of each customer’s financial condition. It maintains an allowance for doubtful accounts. Management believes the Company’s current allowance is adequate.
(x)Concentration
Due to the limited availability of Sanqi the Company currently relies on a small number of suppliers as its source for Sanqi, the primary raw material that is needed to produce its products. Management believes that there are few alternative suppliers available to supply the Sanqi, and should any of the current suppliers terminate their business arrangements with the Company or increase their prices of materials supplied, it would delay product shipments and materially adversely affect the Company’s business operations and profitability. The Company had concentrations of purchase raw materials from three vendors each of which was over 10% of total purchase accounting for 70.6% for the years ended December 31, 2011 and from two vendors accounting for 55.6% of total purchases for the years ended December 31, 2010.
During the year ended December 31, 2011, the Company had concentration of sales to two customers accounting for 25.2%. Each of them accounted for more than 10% of the total sales of the Company. No concentration risk on sales existed for the Company in 2010.
As of December 31, 2011 and 2010, there was no significant concentration on accounts receivables from single customer.
Approximately 84.5% and 90.9% of our sales for the year ended December 31, 2011 and 2010 respectively came from a single product, Xuesaitong Soft Capsules, and the Company’s business may fail if this product fails or generates materially less sales revenues. If the Company experiences delays, increased expenses, or other difficulties in the manufacture and sale of the Xuesaitong Soft Capsules, or if the licenses and government approvals are revoked to sell the product, or this product is no longer carried in the Provincial Insurance Catalogs of the sixteen provinces and cities, the Company may not be able to generate significant revenues or profitability, and its business and financial condition would be materially adversely affected and it could be forced to cease operations.
The Company conducts its business widely in China, and management does not consider any concentration on geographic risk.
(y)Recent accounting pronouncements
From time to time, new accounting standards issued by the Financial Accounting Standards Board (“FASB”) are adopted by the Company as of the specified effective date. Unless otherwise discussed, the Company believes that the impact of recently issued standards that are not yet effective will not have a material impact on its financial position or results of operations upon adoption.
NOTE 3 - SEGMENT REPORTING
The Company has four major operating segments, Medicine, Cosmetic, Hotel and Shi Lin. The Company’s operating segments are based primarily on different type of business and represent the primary mode used to assess allocation of resources and performance. The Company evaluates its business segments primarily on the basis of segment earnings, with segment earnings defined as earnings before corporate expense, depreciation and amortization expense, interest, income taxes and certain other items.
(a) Segment reporting of 2011:
During the year ended December 31, 2011 and 2010, the revenue from external customers in other segment was generated from the Cosmetic business.
Reconciliations of segment revenue, profit and loss and assets with consolidated amount are listed as follows,
(b) Segment reporting of 2010:
Reconciliations of segment revenue, profit and loss and assets with consolidated amount are listed as follows:
NOTE 4 - RESTRICTED CASH
As of December 31, 2011, restricted cash represents the security deposits that serve as collateral for the notes payable and current bank loans amounting to US$317,993 and US$476,122, respectively, from Medicine. (2010: Nil)
NOTE 5 - ACCOUNTS AND NOTES RECEIVABLE, NET
Accounts and notes receivable consisted of the following:
During the year ended December 31, 2011, an allowance for the doubtful accounts were provided for, with corresponding expense amounting to approximately USD170,000 charged in the consolidated statement of operations, compared with approximately USD111,000 in 2010.
NOTE 6 - OTHER RECEIVABLES, NET
Other receivables consisted mainly of receivables due from sales representatives and employee advances as following:
During the year ended December 31, 2011, an allowance for the doubtful accounts was provided for, with expense amounting to approximately USD2,000 charged in the consolidated statement of operations, compared with approximately USD1,423,000 in 2010.
NOTE 7 - INVENTORIES
Inventories consisted of the following:
During the year ended December 31, 2011, due to the expiration of certain inventory, a write-off of approximately USD58,000 has been provided for, and recognized in cost of goods sold, compared with approximately USD227,000 in 2010
NOTE 8 - PROPERTY, PLANT AND EQUIPMENT, NET
Property and equipment consisted of the following:
As of December 31, 2011 and 2010, the construction in progress consisted of the Shilin project and the Shenghuo Plaza and the training centre, respectively.
By the end of December 31, 2011, the Hotel decoration and furnishing contributed by the third party was approximately USD3,199,000.
Depreciation expenses were approximately USD1,437,000 and USD702,000 for the years ended December 31, 2011 and 2010, respectively.
Certain property, plant and equipment with the carrying amounts of approximately USD5,092,000 were pledged as collateral for bank borrowings as of December 31, 2011, compared with USD5,433,000 in 2010.
Interest expenses that had been capitalized for construction in progress amounted to approximately USD148,000 and USD271,000 for the years ended December 31, 2011 and 2010 respectively.
NOTE 9 - INTANGIBLE ASSETS, NET
Intangible assets consisted of the following:
All the land use rights were pledged as collateral for bank borrowings as of December 31, 2011 and 2010.
Amortization expenses for intangible assets were approximately USD79,000 and USD61,000 for the years ended December 31, 2011 and 2010, respectively.
Estimated aggregate future amortization expense for the succeeding five years and thereafter as of December 31, 2011 is as follows:
NOTE 10 - BORROWINGS
The Company’s borrowings are payable to banks and the governmental financial bureau. The following summarizes the Company’s debt obligations and respective balances as of December 31, 2011 and 2010:
(a) The current portion of the long-term bank borrowings mature in April 2012.
(b) As of December 31, 2011 and 2010, the balance of borrowings from Agricultural Bank of China (the “ABC”) was approximately USD16,252,000 and USD14,858,000, respectively, among which, borrowings amounting to approximately USD10,697,000 and USD8,818,000, respectively was collateralized by land use rights and buildings, while the others in an aggregate amount of approximately USD5,555,000 and USD6,040,000, respectively were guaranteed by the CSPH’s 94.95% shares in Shenghuo.
(c) As of December 31, 2011, short-term borrowings of approximately USD1,270,000 from Fudian Bank was collateralized by the Shenghuo’s patent. (2010: Nil)
(d) As of July 29, 2011,the Company was granted of a one-year line of credit by Bank of China with a maximum of RMB30,000,000 (approximately USD4,761,000) factoring advance between July 29, 2011 and July 28, 2012.
As of December 31, 2011 and 2010, short-term borrowings of approximately USD3,333,000 and USD2,569,000, respectively, were secured by accounts receivable, with an amount of approximately USD4,166,000 and USD3,211,000, respectively. The unused line of credit as of December 31, 2011 was approximately USD1,428,000 which required additional collaterals upon withdrawal.
(e) As of December 31, 2011, short-term borrowings of RMB5,000,000 (approximately USD794,000) from China Minsheng Bank Corporation was guaranteed by a maximum loan guarantee contract of RMB10,000,000, or approximately USD1,587,000. (2010: Nil) The unused line of credit as of December 31, 2011 was approximately USD793,000. (2010: Nil)
(f) As of December 31, 2011, short-term borrowings of RMB2,660,000 (approximately USD422,000) from China Merchant Bank was collateralized by the bank acceptance notes approximately USD450,000. (2010: Nil)
(g) The weighted average interest rate for the borrowings at December 31, 2011 and 2010 are as follows:
(h) Interest expense for the short-term bank borrowings is approximately USD1,075,000 and USD277,000 for the years ended December 31, 2011 and 2010, respectively.
(i) The borrowings from governmental financial bureau are interest free, and repaid on demand.
NOTE 11 - OTHER PAYABLES AND ACCRUED EXPENSES
Accrued expenses and other payables consist of the following:
NOTE 12 - RELATED PARTY TRANSACTIONS AND BALANCES
The Group entered into shares transfer agreements with Mr. Feng Lan, the officer of the Company, in August 2011 for the 1% and 1% shares of Import/Export and Medicine he held respectively with considerations of RMB10,000 (approximately USD1,600) and RMB100,000 (approximately USD16,000) respectively for the 1% and 1% shares of Import/Export and Medicine respectively.
The Group also entered into shares transfer agreements with Mr. Lei Lan, the officer of the Company, in June 2011 for the 1.82% shares of Cosmetics with a consideration of RMB100,000 (approximately USD16,000) for the 1.82% shares of Cosmetics.
Both transactions mentioned above were finished in the third quarter of 2011. After then the Group holds 100% shares of Import/Export, Medicine and Cosmetics.
As of December 31, 2011 and 2010, the Company has following related party balances:
(a)Amounts due from related parties as of December 31, 2011 mainly consists of prepayment made to Dianjiao, which is under common control with the Company.
NOTE 13 - RESTRICTED NET ASSETS
As described in note 2(u), the net income of the Company is distributable only after sufficient appropriation of reserves. Amounts restricted to transfer funds to the stockholder through loans, advance, or dividends, include paid-in capital, additional paid-in capital and reserve funds of the Company as determined pursuant to the PRC accounting standards and regulations. However, since the Company recorded an accumulated deficit, the restricted net assets were determined up to the net assets of the Company, which was approximately USD2,116,000 and USD2,041,000 as of December 31 2011 and 2010, respectively.
NOTE 14 - WARRANTS
Details of warrants activity during the years ended December 31, 2010 and 2011 was as follows:
The following summarizes the outstanding warrants as of December 31, 2011:
As of December 31, 2011, exercise prices are significantly higher than CSPH’s stock price which was approximately USD0.35 per share. Management believes it is unlikely that these warrants will be exercised.
NOTE 15 - INCOME TAXES AND OTHER TAXES
(a)Taxes and related payables
Taxes and related payables are composed of the following:
(b)Deferred tax assets, net
The temporary differences and carryforwards which give rise to the deferred income tax assets are as follows:
Certain subsidiaries of CSPH have an aggregate tax loss carryforwards available amounting to approximately USD2,781,000, which begins to expire in 2012, if unused by the offset of future taxable income of the individual subsidiaries. The following table below summarizes the expiration dates of tax loss carryforwards.
Management believes that the remaining tax loss carryforwards of Cosmetic and Import/Export amounting to approximately USD2,340,000 is unlikely to be deductable in the future years, therefore the corresponding deferred tax assets were recognized with full allowance provided.
(c)Income tax (benefit) expense
Following is a reconciliation of income taxes calculated at the statutory rates to actual income tax (benefit) expense:
The income tax (benefit) expense consisted of the following:
According to the PRC Tax Administration and Collection Law, the statute of limitations is three years if the underpayment of taxes is due to computational errors made by the taxpayer or the withholding agent. The statute of limitations is extended to five years under special circumstances, where the underpayment of taxes is more than USD15,871 (RMB100,000). In the case of transfer pricing issues, the statute of limitation is ten years. There is no statute of limitation in the case of tax evasion.
NOTE 16 - COMMITMENTS AND CONTINGENCIES
(a)Operating lease commitment
On September 8, 2010, the Company signed an agreement with Management Commission of Kunming Shilin Taiwan Farmer Entrepreneur Centre (“Entrepreneur Centre”) to rent the land for planting suitable-for-cultivating medicinal herb for use in the production of the Company’s medicinal products and to construct a health preserving zone and travel service center.
During 2011 and 2010, rental expense of USD384,746 and USD94,221 respectively under this agreement has been recognized in operating expenses.
As December 31, 2011, the operating lease commitment under this agreement is summarized as below:
(b)Capital Commitment
As of December 31, 2011, the Company had a capital commitment of USD5,682,093 for Xinglin International Health-Preserving Tourist Resort (the “Resort”), among which, $4,920,297 will be used for purchasing land use right and is expected to be paid upon the requirement of the Management Committee of Kunming Shilin Taiwan Farmer Entrepreneur Centre, and the remaining $761,796 is design fee for the Resort and will be paid to a design company according to their progress of the design. (2010: Nil)
NOTE 17 - SUBSEQUENT EVENTS
Management has considered all events occurring through the date of consolidated financial statements have been issued, and has determined that there are no such events that are material to the consolidated financial statements, or all such material events have been fully disclosed.