ITEM 2 – MANAGEMENT’S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion
should be read in conjunction with the information contained in the condensed consolidated financial statements of the Company
and the notes thereto appearing elsewhere herein and in conjunction with the Management’s Discussion and Analysis set forth
in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012. Readers should carefully review the risk
factors disclosed in the Company’s Form 10-K for the year ended December 31, 2012 filed by the Company with the Securities
and Exchange Commission (“SEC”).
As used in this report,
the terms “Company,” “we,” “our,” “us,” and “AOB” refer to American
Oriental Bioengineering, Inc., a Nevada corporation.
PRELIMINARY NOTE REGARDING FORWARD-LOOKING
STATEMENTS
This quarterly report
contains forward-looking statements within the meaning of the federal securities laws. These include statements about our expectations,
beliefs, intentions or strategies for the future, which we indicate by words or phrases such as “anticipate,” “expect,”
“intend,” “plan,” “will,” “we believe,” “AOB believes,” “management
believes” and similar language. The forward-looking statements are based on the current expectations of AOB and are subject
to certain risks, uncertainties and assumptions, including those set forth in the discussion under “Management’s Discussion
and Analysis of Financial Condition and Results of Operations” in this report. Actual results may differ materially from
results anticipated in these forward-looking statements. We base the forward-looking statements on information currently available
to us, and we assume no obligation to update them.
Investors are also advised
to refer to the information in our previous filings with the SEC, especially on Forms 10-K, 10-Q, and 8-K, in which we discuss
in more detail various important factors that could cause actual results to differ from expected or historic results. It is not
possible to foresee or identify all such factors. As such, investors should not consider any list of such factors to be an exhaustive
statement of all risks and uncertainties or potentially inaccurate assumptions.
BUSINESS OVERVIEW
Global economic challenges
and uncertainties have impacted our business in 2011, 2012 and the first half of 2013. These challenges and uncertainties have
negatively affected consumers’ demands for both pharmaceutical and nutraceutical products, which contributed to the overall
decline in sales of our manufacturing segments.
In addition, the establishment
of price controls over prescription and over-the-counter medicines negatively impacted our business. There were two price adjustments
by the Price Control Office in 2011 and 2012, respectively that lowered certain prices of prescription and over-the-counter medicines.
As a result, we lost our ability to compete effectively due to the pricing adjustments, particularly when we entered the state-owned
hospitals’ purchase of medicine tendering process. As a result, sales in our manufacturing segments fell sharply.
The continuous increase
in cost of raw material also impacted our business as gross profit has declined since the end of 2010.
In addition to the
ongoing economic challenges and uncertainties, our business was negatively impacted by the toxic drug capsules incident in 2012.
Incidents like that shook the pharmaceutical industry and resulted in a decline in market demand. Although we were not directly
involved in the scandal and our facilities were inspected and passed the safety requirements, our subsequent sales have been impacted
significantly due to the loss of consumer confidence in pharmaceutical products and huge decline in market demand. All of these
challenges, uncertainties and incidents may continue to have an adverse impact on our future performance.
We are taking actions
to mitigate the impact of these economic conditions by: 1) focusing on our well-recognized brand names, including AOBO and our
Jinji products; 2) diversifying our products through products line extension; and 3) developing and introducing new products.
To mitigate the impact
of the increasing cost and supply of the raw material needed for our products, we entered into long-term supply contracts with
various third parties to grow Millettia and Xanthoceras Sorbifolia Bge (“XSB”), which are major raw materials. We bear
the cultivation cost for these raw materials, including leasing the land use rights. In return, we are entitled to purchase the
raw material at a pre-determined discounted price. Through these supply contracts, we believe that we can stabilize the supply
of our major raw materials in the long term and reduce the risk of increasing costs in future periods. In the fourth quarter of
2012, we recorded an impairment of approximately $8.5 million of our capitalized agricultural costs.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
This section should
be read together with the Summary of Significant Accounting Policies included as Note 3 to the consolidated financial statements
included in our amended Annual Report on Form 10-K for the year ended December 31, 2012 filed with the SEC on June 11, 2013.
Estimates affecting accounts receivable and inventories
The preparation of
our consolidated financial statements requires management to make estimates and assumptions that affect our reporting of assets
and liabilities (and contingent assets and liabilities). These estimates are particularly significant where they affect the reported
net realizable value of the Company’s accounts receivable and inventories.
At June 30, 2013 and
December 31, 2012, we have reserves of $17,599,876 and $18,134,912, respectively, against accounts receivable. Our estimate of
the appropriate reserve on accounts receivable at June 30, 2013 and December 31, 2012 was based on the aged nature of these accounts
receivable. In making our judgment, we assessed our customers’ ability to continue to pay their outstanding invoices on a
timely basis, and whether their financial position might deteriorate significantly in the future, which would result in their inability
to pay their debts to the Company.
At June 30, 2013 and
December 31, 2012, we have allowance against inventories amounting to $45,952 and $47,281, respectively. Our determination of this
allowance was based on potential impairments to the current carrying value of the inventories due to potential obsolescence of
aged inventories. In making our estimate, we considered the probable demand for our products in the future and historical trends
in the turnover of our inventories.
While we currently
believe that there is little likelihood that actual results will differ materially from these current estimates, if customer demand
for our products decreases significantly in the near future, or if the financial condition of our customers deteriorates in the
near future, we could realize significant write downs for slow-moving inventories or uncollectible accounts receivable and notes
receivable.
Policy affecting recognition of revenue
Among the most important
accounting policies affecting our consolidated financial statements is our policy of recognizing revenue in accordance with the
Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 605 “Revenue
Recognition”. Under this policy, all of the following criteria must be met in order for us to recognize revenue:
1. Persuasive evidence of an
arrangement exists;
2. Delivery has occurred or
services have been rendered;
3. The seller’s price
to the buyer is fixed or determinable; and
4. Collectability is reasonably
assured.
The majority of our
revenue results from sales contracts with distributors and revenue is recorded upon the shipment of goods. Management conducts
credit background checks for new customers as a means to reduce the subjectivity of assuring collectability. Based on these factors,
we believe that we can apply the provisions of FASB ASC 605 with minimal subjectivity.
Investment in equity method investment
We account for our
equity investment in accordance with FASB ASC 323, “Investments–Equity Method and Joint Ventures”. Under FASB
ASC 323, the equity method of accounting is used for investments in entities in which we have the ability to exercise significant
influence but do not own a majority equity interest or otherwise control. Under the equity method, we initially record our investment
at cost and adjust the carrying amount of the investment to recognize our proportionate share of each equity investee’s net
income or loss into consolidated statements of income after the date of acquisition.
We monitor our investments
for other-than-temporary impairment by considering factors including, but not limited to, current economic and market conditions,
the operating performance of the investee companies including current earnings trends and other company-specific information. We
perform an impairment assessment by comparing fair value of the investment to readily available market information, or if not available,
to discounted cash flow models.
Impairment
In evaluating long-lived
assets for recoverability, including finite-lived intangibles and property and equipment, we use our best estimate of future cash
flows expected to result from the use of the asset and eventual disposition. To the extent that estimated future, undiscounted
cash inflows attributable to the asset, less estimated future, undiscounted cash outflows, are less than the carrying amount, an
impairment loss is recognized in an amount equal to the difference between the carrying value of such asset and its fair value.
Assets to be disposed of and for which there is a committed plan of disposal, whether through sale or abandonment, are reported
at the lower of carrying value or fair value less costs to sell.
In evaluating capitalized
agriculture costs, we use our best estimate of the future cash flows expected to result from future market values, yields and costs
to harvest. To the extent that estimated future cash inflows attributable to the asset, less estimated future, cash outflows, are
less than the carrying amount, an impairment loss is recognized in an amount equal to the excess of the carrying value over the
estimated fair values of the capitalized agricultural costs.
The Company’s
annual impairment testing is performed in the fourth quarter of each year.
Share-based Compensation
We periodically issue
stock options and warrants to employees and non-employees in non-capital raising transactions for services and for financing costs.
We account for stock option and warrant grants issued and vesting to employees based on the authoritative guidance provided by
the FASB whereas the value of the award is measured on the date of grant and recognized over the vesting period. We account for
stock option and warrant grants issued and vesting to non-employees in accordance with the authoritative guidance of the FASB whereas
the value of the stock compensation is based upon the measurement date as determined at either a) the date at which a performance
commitment is reached, or b) at the date at which the necessary performance to earn the equity instruments is complete. Non-employee
stock-based compensation charges generally are amortized over the vesting period on a straight-line basis. In certain circumstances
where there are no future performance requirements by the non-employee, option grants are immediately vested and the total stock-based
compensation charge is recorded in the period of the measurement date.
The fair value of our
common stock option grant is estimated using the Black-Scholes-Merton option pricing model, which uses certain assumptions related
to risk-free interest rates, expected volatility, expected life of the common stock options, and future dividends. Compensation
expense is recorded based upon the value derived from the Black-Scholes-Merton option pricing model, and based on actual experience.
The assumptions used in the Black-Scholes-Merton option pricing model could materially affect compensation expense recorded in
future periods.
Accounting for Income Taxes and Uncertain
Income Tax Positions
We use an asset and
liability approach for financial accounting and reporting for income taxes that allows recognition and measurement of deferred
tax assets based upon the likelihood of realization of tax benefits in future years. Under the asset and liability approach, deferred
taxes are provided for the net tax effects of temporary differences between the carrying amounts of assets and liabilities for
financial reporting purposes and the amounts used for income tax purposes. A valuation allowance is provided for deferred tax assets
if it is more likely than not these items will either expire before we are able to realize their benefits, or that future deductibility
is uncertain. We account for uncertainty in income taxes in accordance with FASB ASC 740-10 which prescribes a recognition threshold
and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken
in a tax return. Our policy is to recognize interest and/or penalties related to income tax matters in income tax expense.
Newly Adopted Accounting Pronouncements
In July 2012, FASB
issued ASU No. 2012-02, “Intangibles – Goodwill and Other”. This update presents an entity with the option to
first to assess qualitative factors to determine whether it is more likely than not that an indefinite-lived intangible asset is
impaired as a basis for determining whether it is necessary to perform the quantitative impairment test in accordance with Subtopic
350-30, “Intangibles – Goodwill and Other – General Intangibles Other than Goodwill”. The more-likely-than-not
threshold is defined as having a likelihood of more than fifty percent. ASU No. 2012-02 will be effective for annual and impairment
tests performed for fiscal years beginning after 15 September 2012, with early adoption permitted. The Company does not expect
the adoption of this update will have a material effect on its consolidated financial statements.
In January 2013, the
FASB issued ASU 2013-01, Balance Sheet (Topic 210): Clarifying Scope of Disclosures Offsetting Assets and Liabilities. This ASU
clarifies which instruments and transactions are subject to the offsetting disclosure requirements by ASU 2011-11. This guidance
is effective for annual and interim reporting periods beginning January 1, 2013. We do not believe the adoption of this update
will have a material effect on our financial position and results of operations.
In February 2013, the
FASB issued ASU No. 2013-02, “Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other
Comprehensive Income.” The new guidance requires entities to report the effect of significant reclassifications out of accumulated
other comprehensive income on the respective line items in net income unless the amounts are not reclassified in their entirety
to net income. For amounts that are not required to be reclassified in their entirety to net income in the same reporting period,
entities are required to cross-reference other disclosures that provide additional detail about those amounts. The new guidance
is effective prospectively for all interim and annual periods beginning after December 15, 2012, with early adoption permitted.
The Company does not expect the adoption of this update will have a material effect on its consolidated financial statements.
Other recent accounting
pronouncements issued by the FASB (including its Emerging Issues Task Force), the AICPA, and the SEC did not or are not believed
by management to have a material impact on the Company's present or future consolidated financial statements.
RESULTS OF OPERATIONS – THREE
MONTHS ENDED JUNE 30, 2013 AS COMPARED TO THREE MONTHS ENDED JUNE 30, 2012
The following table
sets forth the amounts and the percentage relationship to revenues of certain items in our condensed consolidated statements of
income for the three months ended June 30, 2013 and 2012:
|
|
|
Three Months Ended June 30,
|
|
|
|
|
Results
|
|
|
% of Revenue
|
|
|
|
|
2013
|
|
|
2012
|
|
|
2013
|
|
|
2012
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Statement of Operations Data:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Revenues
|
|
$
|
20,224,137
|
|
|
$
|
27,446,926
|
|
|
|
100
|
%
|
|
|
100
|
%
|
|
Cost of sales
|
|
|
15,238,203
|
|
|
|
24,254,680
|
|
|
|
75
|
%
|
|
|
88
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
GROSS PROFIT
|
|
|
4,985,934
|
|
|
|
3,192,246
|
|
|
|
25
|
%
|
|
|
12
|
%
|
|
Selling, general and administrative expenses
|
|
|
11,018,304
|
|
|
|
12,060,135
|
|
|
|
54
|
%
|
|
|
44
|
%
|
|
Advertising costs
|
|
|
2,708,324
|
|
|
|
7,976,078
|
|
|
|
13
|
%
|
|
|
29
|
%
|
|
Research and development costs
|
|
|
1,722,671
|
|
|
|
1,729,301
|
|
|
|
9
|
%
|
|
|
6
|
%
|
|
Depreciation and amortization
|
|
|
1,855,076
|
|
|
|
1,578,733
|
|
|
|
9
|
%
|
|
|
6
|
%
|
|
Provision for reserves and doubtful accounts
|
|
|
(1,998,441
|
)
|
|
|
2,067,462
|
|
|
|
-10
|
%
|
|
|
8
|
%
|
|
LOSS FROM OPERATIONS
|
|
|
(10,320,000
|
)
|
|
|
(22,219,463
|
)
|
|
|
-51
|
%
|
|
|
-81
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Equity in losses from equity method investments
|
|
|
(1,004,141
|
)
|
|
|
(1,297,597
|
)
|
|
|
-5
|
%
|
|
|
-5
|
%
|
|
Interest expense, net
|
|
|
(1,003,307
|
)
|
|
|
(1,808,010
|
)
|
|
|
-5
|
%
|
|
|
-7
|
%
|
|
Other income (expenses), net
|
|
|
185,630
|
|
|
|
67,702
|
|
|
|
1
|
%
|
|
|
0
|
%
|
|
LOSS BEFORE INCOME TAX
|
|
|
(12,141,818
|
)
|
|
|
(25,257,368
|
)
|
|
|
-60
|
%
|
|
|
-92
|
%
|
|
Provision for income taxes
|
|
|
699,081
|
|
|
|
510,897
|
|
|
|
3
|
%
|
|
|
2
|
%
|
|
NET LOSS
|
|
|
(12,840,899
|
)
|
|
|
(25,768,265
|
)
|
|
|
-63
|
%
|
|
|
-94
|
%
|
|
Net income attributable to non-controlling interest
|
|
|
–
|
|
|
|
(18,932
|
)
|
|
|
–
|
|
|
|
0
|
%
|
|
NET LOSS ATTRIBUTABLE TO
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
AMERICAN ORIENTAL BIOENGINEERING, INC.
|
|
$
|
(12,840,899
|
)
|
|
$
|
(25,787,197
|
)
|
|
|
-63
|
%
|
|
|
-94
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
LOSS PER COMMON SHARE, BASIC AND DILUTED
|
|
$
|
(0.35
|
)
|
|
$
|
(0.66
|
)
|
|
|
|
|
|
|
|
|
Revenues
We classify
our revenues into two segments: manufacturing revenue and distribution revenue. The manufacturing revenue comprises revenue from
pharmaceutical and nutraceutical products. Revenues by segments and product categories were as follows:
|
|
|
Three Months Ended June 30,
|
|
|
Increase/
|
|
|
Increase/
|
|
|
|
|
2013
|
|
|
2012
|
|
|
(Decrease)
|
|
|
(Decrease)
|
|
|
Revenue from pharmaceutical products
|
|
$
|
12,268,177
|
|
|
$
|
15,887,829
|
|
|
$
|
(3,619,652
|
)
|
|
|
-23
|
%
|
|
Revenue from nutraceutical products
|
|
|
1,838,307
|
|
|
|
1,285,884
|
|
|
|
552,423
|
|
|
|
43
|
%
|
|
Total manufacturing revenue
|
|
|
14,106,484
|
|
|
|
17,173,713
|
|
|
|
(3,067,229
|
)
|
|
|
-18
|
%
|
|
Distribution revenue
|
|
|
6,117,653
|
|
|
|
10,273,213
|
|
|
|
(4,155,560
|
)
|
|
|
-40
|
%
|
|
Total revenues
|
|
$
|
20,224,137
|
|
|
$
|
27,446,926
|
|
|
$
|
(7,222,789
|
)
|
|
|
-26
|
%
|
Revenue
from our pharmaceutical products decreased from $15,887,829 for the
three months ended June 30,
2012
to $
12,268,177
for the same period of 2013, a 23% decrease. The decrease was primarily due to
the following factors:
|
|
·
|
Rapidly evolving Chinese government healthcare policies have a material impact on the entire pharmaceutical
industry in China. In April 2009, the State Council issued “Opinions of the State Council on Deepening the Reform of the
Medical and Health Care System,” a major public health initiative, the goal of which is to provide access to basic medical
care for every person in China by 2020. In the implementation of this plan, we witnessed increased dispensing of drugs that were
listed on the government-published essential drug list, and of products covered by the National Medical Insurance Catalog. This
nationwide trend has exerted a continuous and powerful downward pressure on the pricing of all generic drugs, whether branded or
not, resulting in a significant shrinkage of profit margins for manufacturers of these products.
|
|
|
·
|
Negative publicity surrounding the discovery of toxic substances in drug capsules in China in 2012
has resulted in an overall decline in demand in the pharmaceutical market. Although we were not directly involved in the scandal
and we have passed safety inspections, our sales have been impacted significantly due to the widespread loss of confidence by consumers
in pharmaceutical products.
|
|
|
·
|
Because of the actual and potential size of the Chinese pharmaceutical market, we face intense
competition from companies that manufacture products similar to ours, which has had a negative impact on our revenues. Many of
these manufacturers are more established than we are, have greater brand recognition of products that compete with ours, have more
financial, technical, marketing and other resources than we presently possess, and have a larger customer base. These competitors
are often able to respond more quickly to new or changing opportunities and customer requirements, and are able to undertake more
extensive promotional activities, offer more attractive terms to customers, or adopt more aggressive pricing policies.
|
|
|
·
|
Because traditional Chinese medicine injection products are not covered
under the new
essential drug list
, sales of SHL powder, one of our two flagship products, declined
from 2012 to 2013.
|
Revenue
in connection with our nutraceutical products increased from $1,285,884 in 2012 to $
1,838,307 in 2013
,
a 43% increase. We experienced material decreases in sales of our nutraceutical products in 2012 caused by the 2012 food safety
and drug problem in China, and have seen a rebound in sales in 2013.
Distribution
revenue decreased by $
4,155,560
or 40%, to $6,117,653 for the three months ended June 30, 2013
from $10,273,213 for the same period of 2012. Sales from our former Yushuntang subsidiary were $3,757,709 in 2012, but due to the
sale of our 6% interest in Yushuntang in December 2012, which resulted in the deconsolidation of this subsidiary, Yushuntang’s
sales are no longer consolidated in our statement of operations for 2013. Net of Yushuntang, sales from the balance of our distribution
business decreased from $6,515,504 in 2012 to $6,117,653 in 2013.
Cost of Sales and Gross Profit
Cost of sales was $15,238,203
for the three months ended June 30, 2013, compared to $24,254,680 for the three months ended June 30, 2012. Cost of sales by segments
and product categories were as follows:
|
|
|
Three Months Ended June 30,
|
|
|
Increase/
|
|
|
Increase/
|
|
|
|
|
2013
|
|
|
2012
|
|
|
(Decrease)
|
|
|
(Decrease)
|
|
|
Pharmaceutical products
|
|
$
|
8,180,724
|
|
|
$
|
12,973,803
|
|
|
$
|
(4,793,079
|
)
|
|
|
-37
|
%
|
|
Nutraceutical products
|
|
|
1,248,322
|
|
|
|
1,694,265
|
|
|
|
(445,943
|
)
|
|
|
-26
|
%
|
|
Total manufacturing cost
|
|
|
9,429,046
|
|
|
|
14,668,068
|
|
|
|
(5,239,022
|
)
|
|
|
-36
|
%
|
|
Distribution cost
|
|
|
5,809,157
|
|
|
|
9,586,612
|
|
|
|
(3,777,455
|
)
|
|
|
-39
|
%
|
|
Total cost
|
|
$
|
15,238,203
|
|
|
$
|
24,254,680
|
|
|
$
|
(9,016,477
|
)
|
|
|
-37
|
%
|
Cost of sales in the
manufacturing segment decreased with the corresponding drop in revenues for this segment. Gross profit as a percentage of revenues
for the manufacturing segment was 33% in 2012, up from 15% in 2012.
Cost of sales in the
distribution segment decreased along with sales from 2012 to 2013 as a result of the deconsolidation of Yushuntang at the end of
2012, with gross profit as a percentage of revenues also decreasing from 7% to 5%.
Selling, General and Administrative Expenses
Selling, general and
administrative expenses decreased from $12,060,135 in the three months ended June 30, 2012 to $11,018,304 in the three months ended
June 30, 2013, representing a 9% decrease. The details of our sales and marketing expenses were as follows:
|
|
|
Three Months Ended June 30,
|
|
|
Increase/
|
|
|
Increase/
|
|
|
|
|
2013
|
|
|
2012
|
|
|
(Decrease)
|
|
|
(Decrease)
|
|
|
Promotional materials and fees
|
|
$
|
1,477,323
|
|
|
$
|
1,194,219
|
|
|
$
|
283,104
|
|
|
|
24
|
%
|
|
Payroll
|
|
|
2,976,273
|
|
|
|
3,308,956
|
|
|
|
(332,683
|
)
|
|
|
-10
|
%
|
|
Shipping
|
|
|
383,264
|
|
|
|
445,855
|
|
|
|
(62,591
|
)
|
|
|
-14
|
%
|
|
Trips and traveling
|
|
|
759,568
|
|
|
|
1,425,902
|
|
|
|
(666,334
|
)
|
|
|
-47
|
%
|
|
Professional fees
|
|
|
1,737,381
|
|
|
|
1,331,863
|
|
|
|
405,518
|
|
|
|
30
|
%
|
|
Staff welfare and insurance
|
|
|
1,025,825
|
|
|
|
1,323,151
|
|
|
|
(297,326
|
)
|
|
|
-22
|
%
|
|
Stock based compensation
|
|
|
318,179
|
|
|
|
696,323
|
|
|
|
(378,144
|
)
|
|
|
-54
|
%
|
|
Miscellaneous
|
|
|
2,340,491
|
|
|
|
2,333,866
|
|
|
|
6,625
|
|
|
|
0
|
%
|
|
Total
|
|
$
|
11,018,304
|
|
|
$
|
12,060,135
|
|
|
$
|
(1,041,831
|
)
|
|
|
-9
|
%
|
The decreases in payroll,
trips and traveling, and staff welfare and insurance correspond to lower headcount in 2013 as compared with 2012.
Stock based compensation
decreased as a result of fewer directors receiving stock based compensation in 2013, as well as the completion of amortization
of previously-issued consultant shares and employee stock options.
Increased
professional fees resulted primarily from audit, legal and other professional fees incurred in 2013 in connection with bringing
our financial filings current.
Advertising Costs
Advertising
costs decreased by $5,267,754, or 66%, from $7,976,078 in the three months ended June 30, 2012 to $2,708,324 in the three months
ended June 30, 2013, primarily as a result of the initial implementation of our cost reduction measures started in 2012, as further
discussed in the “Liquidity” section. Advertising costs as a percentage of revenue decreased from 29% in 2012 to 13%
in 2013.
Research and Development Costs
Research and development
costs decreased by $6,630 from $1,729,301 in the three months ended June 30, 2012 to $1,722,671 in the three months ended June
30, 2013. Expressed as a percentage of revenue, research and development costs were 9% and 6% in 2013 and 2012, respectively.
Our research and development
activities consist of near term, middle term and long term stages which contribute to both our current and future business strategies.
Our key research and development programs include the improvement of our existing products and development of new products such
as SHL Lyophilized Injection Powder, Cease Enuresis Soft Gel and Jinji series products. The majority of our research and development
expenditures are on pharmaceutical products.
Depreciation and Amortization
Depreciation and amortization
expenses increased by $276,343, or 18%, in the three months ended June 30, 2013 as compared to the same period of 2012. This was
mainly due to increased amortization expense related to intangible assets acquired in 2012.
Provision for reserves and doubtful accounts
Provision
for doubtful accounts decreased from a charge of $2,067,462 in the three months ended June 30, 2012 to a reversal of bad debts
of $1,998,441 in the three months ended June 30, 2013. The reversal of bad debts is primarily due to the cash settlement of long
outstanding accounts receivable that had previously been 100% reserved. We evaluate the provision for doubtful accounts on an ongoing
basis, based upon our customers’ ability to continue to pay their outstanding invoices on a timely basis, and whether their
financial position might deteriorate significantly in the future, which would result in their inability to pay their debts to us.
Equity in Losses from Equity Method Investments
Equity in
losses from equity method investments decreased from $1,297,597 in the three months ended June 30, 2012 to $1,004,141 in the three
months ended June 30, 2013. The decreased loss was mainly due to lower estimated losses realized by AXN in the three months ended
June 30, 2013 as compared to the same period of 2012.
Interest Expense, Net
Net interest
expense was $1,808,010 in the three months ended June 30, 2012, compared to net interest expense of $1,003,307 for the three months
ended June 30, 2013. The decrease was mainly due to lower average balances of convertible notes resulting from early retirements
in the second half of 2012.
Income Tax
The Company’s
effective tax rate for the three months ended June 30, 2013 was 6%, compared to 2% in the three months ended June 30, 2012, due
primarily to higher losses in 2012. For additional information, see “Item 1. Financial Statements – Note 16. Income
Tax.”
RESULTS OF OPERATIONS – SIX MONTHS ENDED JUNE 30,
2013 AS COMPARED TO SIX MONTHS ENDED JUNE 30, 2012
The following table
sets forth the amounts and the percentage relationship to revenues of certain items in our condensed consolidated statements of
income for the six months ended June 30, 2013 and 2012:
|
|
|
Six Months Ended June 30,
|
|
|
|
|
Results
|
|
|
% of Revenue
|
|
|
|
|
2013
|
|
|
2012
|
|
|
2013
|
|
|
2012
|
|
|
Statement of Operations Data:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Revenues
|
|
$
|
41,230,900
|
|
|
$
|
53,192,202
|
|
|
|
100
|
%
|
|
|
100
|
%
|
|
Cost of sales
|
|
|
31,744,091
|
|
|
|
42,318,134
|
|
|
|
77
|
%
|
|
|
80
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
GROSS PROFIT
|
|
|
9,486,809
|
|
|
|
10,874,068
|
|
|
|
23
|
%
|
|
|
20
|
%
|
|
Selling, general and administrative expenses
|
|
|
23,495,026
|
|
|
|
24,042,204
|
|
|
|
57
|
%
|
|
|
45
|
%
|
|
Advertising costs
|
|
|
6,353,778
|
|
|
|
14,132,431
|
|
|
|
15
|
%
|
|
|
27
|
%
|
|
Research and development costs
|
|
|
3,129,716
|
|
|
|
3,296,234
|
|
|
|
8
|
%
|
|
|
6
|
%
|
|
Depreciation and amortization
|
|
|
3,719,283
|
|
|
|
3,659,432
|
|
|
|
9
|
%
|
|
|
7
|
%
|
|
Provision for reserves and doubtful accounts
|
|
|
(234,489
|
)
|
|
|
3,053,248
|
|
|
|
-1
|
%
|
|
|
6
|
%
|
|
Long term crop inventory costs
|
|
|
2,361,383
|
|
|
|
–
|
|
|
|
6
|
%
|
|
|
–
|
|
|
LOSS FROM OPERATIONS
|
|
|
(29,337,888
|
)
|
|
|
(37,309,481
|
)
|
|
|
-71
|
%
|
|
|
-70
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Equity in losses from equity method investments
|
|
|
(1,972,373
|
)
|
|
|
(1,489,047
|
)
|
|
|
-5
|
%
|
|
|
-3
|
%
|
|
Interest expense, net
|
|
|
(1,766,998
|
)
|
|
|
(3,551,280
|
)
|
|
|
-4
|
%
|
|
|
-7
|
%
|
|
Other income (expenses), net
|
|
|
171,829
|
|
|
|
348,749
|
|
|
|
0
|
%
|
|
|
1
|
%
|
|
LOSS BEFORE INCOME TAX
|
|
|
(32,905,430
|
)
|
|
|
(42,001,059
|
)
|
|
|
-80
|
%
|
|
|
-79
|
%
|
|
Provision for income taxes
|
|
|
1,050,326
|
|
|
|
953,965
|
|
|
|
3
|
%
|
|
|
2
|
%
|
|
NET LOSS
|
|
|
(33,955,756
|
)
|
|
|
(42,955,024
|
)
|
|
|
-82
|
%
|
|
|
-81
|
%
|
|
Net loss attributable to non-controlling interest
|
|
|
–
|
|
|
|
10,902
|
|
|
|
–
|
|
|
|
0
|
%
|
|
NET LOSS ATTRIBUTABLE TO
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
AMERICAN ORIENTAL BIOENGINEERING, INC.
|
|
$
|
(33,955,756
|
)
|
|
$
|
(42,944,122
|
)
|
|
|
-82
|
%
|
|
|
-81
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
LOSS PER COMMON SHARE, BASIC AND DILUTED
|
|
$
|
(0.93
|
)
|
|
$
|
(1.09
|
)
|
|
|
|
|
|
|
|
|
Revenues
We classify our revenues
into two segments: manufacturing revenue and distribution revenue. The manufacturing revenue comprises revenue from pharmaceutical
and nutraceutical products. Revenues by segments and product categories were as follows:
|
|
|
Six Months Ended June 30,
|
|
|
Increase/
|
|
|
Increase/
|
|
|
|
|
2013
|
|
|
2012
|
|
|
(Decrease)
|
|
|
(Decrease)
|
|
|
Revenue from pharmaceutical products
|
|
$
|
24,010,946
|
|
|
$
|
30,111,084
|
|
|
$
|
(6,100,138
|
)
|
|
|
-20
|
%
|
|
Revenue from nutraceutical products
|
|
|
3,531,529
|
|
|
|
3,211,136
|
|
|
|
320,393
|
|
|
|
10
|
%
|
|
Total manufacturing revenue
|
|
|
27,542,475
|
|
|
|
33,322,220
|
|
|
|
(5,779,745
|
)
|
|
|
-17
|
%
|
|
Distribution revenue
|
|
|
13,688,425
|
|
|
|
19,869,982
|
|
|
|
(6,181,557
|
)
|
|
|
-31
|
%
|
|
Total revenues
|
|
$
|
41,230,900
|
|
|
$
|
53,192,202
|
|
|
$
|
(11,961,302
|
)
|
|
|
-22
|
%
|
Revenue
from our pharmaceutical products decreased from $30,111,084 for the
six months ended June 30,
2012
to $24,010,946 for the same period of 2013, a 20% decrease. The decrease was primarily due to the following factors:
|
|
·
|
Rapidly evolving Chinese government healthcare policies have a material impact on the entire pharmaceutical
industry in China. In April 2009, the State Council issued “Opinions of the State Council on Deepening the Reform of the
Medical and Health Care System,” a major public health initiative, the goal of which is to provide access to basic medical
care for every person in China by 2020. In the implementation of this plan, we witnessed increased dispensing of drugs that were
listed on the government-published essential drug list, and of products covered by the National Medical Insurance Catalog. This
nationwide trend has exerted a continuous and powerful downward pressure on the pricing of all generic drugs, whether branded or
not, resulting in a significant shrinkage of profit margins for manufacturers of these products.
|
|
|
·
|
Negative publicity surrounding the discovery of toxic substances in drug capsules in China in 2012
has resulted in an overall decline in demand in the pharmaceutical market. Although we were not directly involved in the scandal
and we have passed safety inspections, our sales have been impacted significantly due to the widespread loss of confidence by consumers
in pharmaceutical products.
|
|
|
·
|
Because of the actual and potential size of the Chinese pharmaceutical market, we face intense
competition from companies that manufacture products similar to ours, which has had a negative impact on our revenues. Many of
these manufacturers are more established than we are, have greater brand recognition of products that compete with ours, have more
financial, technical, marketing and other resources than we presently possess, and have a larger customer base. These competitors
are often able to respond more quickly to new or changing opportunities and customer requirements, and are able to undertake more
extensive promotional activities, offer more attractive terms to customers, or adopt more aggressive pricing policies.
|
|
|
·
|
Because traditional Chinese medicine injection products are not covered
under the new
essential drug list
, sales of SHL powder, one of our two flagship products, declined
from 2012 to 2013.
|
Revenue
in connection with our nutraceutical products increased from $3,211,136 in the
six months ended June 30,
2012
to $3,531,529 in the
six months ended June 30,
2013, a 10% increase. We experienced material
decreases in sales of our nutraceutical products in 2012 caused by the 2012 food safety and drug problem in China, and have seen
a rebound in sales in 2013.
Distribution revenue
decreased by $6,181,557 or 31%, to $13,688,425 for the six months ended June 30, 2013 from $19,869,982 for the same period of 2012.
Sales from our former Yushuntang subsidiary were $7,997,571 in the six months ended June 30, 2012, but due to the sale of our 6%
interest in Yushuntang in December 2012, which resulted in the deconsolidation of this subsidiary, Yushuntang’s sales are
no longer consolidated in our statement of operations for 2013. Net of Yushuntang, sales from the balance of our distribution business
increased from $11,872,411 in 2012 to $13,688,425 in 2013.
Cost of Sales and Gross Profit
Cost of sales was $
31,744,091
in
the six months ended June 30,
2013, compared to $42,318,134 in
the
six months ended June 30,
2012. Cost of sales by segments and product categories were as follows:
|
|
|
Six Months Ended June 30,
|
|
|
Increase/
|
|
|
Increase/
|
|
|
|
|
2013
|
|
|
2012
|
|
|
(Decrease)
|
|
|
(Decrease)
|
|
|
Pharmaceutical products
|
|
$
|
16,466,784
|
|
|
$
|
21,053,648
|
|
|
$
|
(4,586,864
|
)
|
|
|
-22
|
%
|
|
Nutraceutical products
|
|
|
2,393,517
|
|
|
|
2,898,099
|
|
|
|
(504,582
|
)
|
|
|
-17
|
%
|
|
Total manufacturing cost
|
|
|
18,860,301
|
|
|
|
23,951,747
|
|
|
|
(5,091,446
|
)
|
|
|
-21
|
%
|
|
Distribution cost
|
|
|
12,883,790
|
|
|
|
18,366,387
|
|
|
|
(5,482,597
|
)
|
|
|
-30
|
%
|
|
Total cost
|
|
$
|
31,744,091
|
|
|
$
|
42,318,134
|
|
|
$
|
(10,574,043
|
)
|
|
|
-25
|
%
|
Cost of sales in the
manufacturing segment decreased with the corresponding drop in revenues for this segment. Gross profit as a percentage of revenues
for the manufacturing segment was 32% in 2013, up from 28% in 2012.
Cost of sales in the
distribution segment decreased along with sales from 2012 to 2013 as a result of the deconsolidation of Yushuntang at the end of
2012, with gross profit as a percentage of revenues also decreasing from 8% to 6%.
Selling, General and Administrative Expenses
Selling, general and
administrative expenses decreased from $24,042,204 in
the six months ended June 30,
2012 to $
23,495,026
in
the six months ended June 30,
2013, representing a 2% decrease. The details of our
sales and marketing expenses were as follows:
|
|
|
Six Months Ended June 30,
|
|
|
Increase/
|
|
|
Increase/
|
|
|
|
|
2013
|
|
|
2012
|
|
|
(Decrease)
|
|
|
(Decrease)
|
|
|
Promotional materials and fees
|
|
$
|
3,663,333
|
|
|
$
|
2,450,204
|
|
|
$
|
1,213,129
|
|
|
|
50
|
%
|
|
Payroll
|
|
|
6,421,119
|
|
|
|
6,456,740
|
|
|
|
(35,621
|
)
|
|
|
-1
|
%
|
|
Shipping
|
|
|
680,476
|
|
|
|
895,623
|
|
|
|
(215,147
|
)
|
|
|
-24
|
%
|
|
Trips and traveling
|
|
|
1,328,136
|
|
|
|
2,562,219
|
|
|
|
(1,234,083
|
)
|
|
|
-48
|
%
|
|
Professional fees
|
|
|
3,125,566
|
|
|
|
2,199,982
|
|
|
|
925,584
|
|
|
|
42
|
%
|
|
Staff welfare and insurance
|
|
|
2,229,915
|
|
|
|
2,842,941
|
|
|
|
(613,026
|
)
|
|
|
-22
|
%
|
|
Stock based compensation
|
|
|
879,169
|
|
|
|
1,360,458
|
|
|
|
(481,289
|
)
|
|
|
-35
|
%
|
|
Miscellaneous
|
|
|
5,167,312
|
|
|
|
5,274,037
|
|
|
|
(106,725
|
)
|
|
|
-2
|
%
|
|
Total
|
|
$
|
23,495,026
|
|
|
$
|
24,042,204
|
|
|
$
|
(547,178
|
)
|
|
|
-2
|
%
|
The increase in promotional
fees resulted from more promotional expense by us in an effort to generate additional sales in the highly competitive Chinese pharmaceutical
marketplace.
Increased
professional fees resulted primarily from audit, legal and other professional fees incurred in 2013 in connection with bringing
our financial filings current.
The decreases in payroll,
trips and traveling, and staff welfare and insurance correspond to lower headcount in 2013 as compared with 2012.
Stock based compensation
decreased as a result of fewer directors receiving stock based compensation in 2013, as well as the completion of amortization
of previously-issued consultant shares and employee stock options.
Advertising Costs
Advertising costs decreased
by $
7,778,653
, or 55%, from $14,132,431 in
the six months ended June
30,
2012 to $
6,353,778
in
the six months ended June 30,
2013,
primarily as a result of the initial implementation of our cost reduction measures started in 2012, as further discussed in the
“Liquidity” section. Advertising costs as a percentage of revenue decreased from 27% for 2012 to 15% for 2013.
Research and Development Costs
Research and development
costs decreased by $
166,518
from $3,296,234 in
the six months ended
June 30,
2012 to $
3,129,716
in
the six months ended June 30,
2013, primarily as a result of the initial implementation of our cost reduction measures started in 2012, as further discussed
in the “Liquidity” section. Expressed as a percentage of revenue, research and development costs were 8% and 6% for
2013 and 2012, respectively.
Our research and development
activities consist of near term, middle term and long term stages which contribute to both our current and future business strategies.
Our key research and development programs include the improvement of our existing products and development of new products such
as SHL Lyophilized Injection Powder, Cease Enuresis Soft Gel and Jinji series products. The majority of our research and development
expenditures are on pharmaceutical products.
Depreciation and Amortization
Depreciation and amortization
expenses increased by $59,851, or 2%, in
the six months ended June 30,
2013 as compared to
the
six months ended June 30,
2012. This was mainly due to increased amortization expense related to intangible assets acquired
in 2012.
Provision for reserves and doubtful accounts
Provision for doubtful
accounts decreased from a charge of $3,053,248 in
the six months ended June 30,
2012 to a reversal
of bad debts of $
234,489
in
the six months ended June 30,
2013.
The reversal of bad debts is primarily due to the cash settlement of long outstanding accounts receivable that had previously been
100% reserved. We evaluate the provision for doubtful accounts on an ongoing basis, based upon our customers’ ability to
continue to pay their outstanding invoices on a timely basis, and whether their financial position might deteriorate significantly
in the future, which would result in their inability to pay their debts to us.
Long term crop inventory
costs
Subsequent to
December 31, 2012, pre-harvest agriculture costs, including cultivation, labor, land leasing costs, and other crop and land
maintenance activities, will be capitalized if it is probable that future economic benefits from the use of the assets will
be increased. These pre-harvest agriculture costs usually require substantial investment in the early stages, gradually
decreasing to maintenance costs during the growing stage. During the six months ended June 30, 2013,
agricultural costs of $2,361,383 were expensed. During the six months ended June 30, 2012, agricultural costs of $3,395,407
were capitalized.
Equity in Losses from Equity Method Investments
Equity in losses from
equity method investments increased from $1,489,047 in
the six months ended June 30,
2012 to
$
1,972,373
in
the six months ended June 30,
2013. The increased
loss was mainly due to larger losses realized by AXN in the six months ended June 30, 2013 as compared to the same period of 2012.
Interest Expense, Net
Net interest expense
was $1,766,998 in
the six months ended June 30,
2013, compared to net interest expense of $3,551,280
for
the six months ended June 30,
2012. The decrease was mainly due to lower average balances
of convertible notes resulting from early retirements in the second half of 2012.
Income Tax
The Company’s
effective tax rate for
the six months ended June 30,
2013 was 3%, compared to 2% in
the
six months ended June 30,
2012, due primarily to higher losses in 2012. For additional information, see “Item 1. Financial
Statements – Note 16. Income Tax.”
FINANCIAL POSITION, LIQUIDITY AND CAPITAL RESOURCES
Cash
Our cash position at
June 30, 2013 was $7,004,814, representing a decrease of $92,284, or 1%, compared with our cash position of $7,097,098 at December
31, 2012. The change was mainly attributable to net cash used in operations of $5.3 million in the six months ended June 30, 2012,
offset by cash provided by investing activities of $3.1 million and provided by financing activities of $1.2 million.
We manage our cash
based on thorough consideration of our corporate strategy as well as macroeconomic considerations, and we take into account such
factors as interest income and foreign currency fluctuation.
Liquidity
Our financial statements
have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities
in the normal course of business. For the six months ended June 30, 2013, we recorded a loss from operations of $29,337,888 and
utilized cash in operations of $4,873,817.
As of June 30, 2013, we had a working capital deficit
of $36,114,345. In addition, we were in default of $49,161,000 of our convertible notes due July 15, 2015. On April 8, 2013, four
of the holders of the Notes filed this action claiming a default under the Notes, which allegedly resulted in an acceleration
of the maturity of the Notes. The Plaintiffs had previously commenced a similar action in federal court in New Jersey, but that
action was withdrawn and the present action was interposed. The action seeks payment of $20,378,608 plus prejudgment interest
and other fees and costs. The Company has been served with the complaint, and Plaintiffs agreed to extend the Company’s
time to answer. When that time passed on June 3, 2013, Plaintiffs refused to grant additional time and have now made a motion
seeking entry of a default. The Company filed its answer on June 5, 2013. We presently do not have the ability to pay these notes.
These factors, among others, raise substantial doubt about our ability to continue as a going concern. As a result, our independent
registered public accounting firm, in its report on our 2012 financial statements, has raised substantial doubt about our ability
to continue as a going concern. The financial statements do not include any adjustments that might be necessary should we be unable
to continue as a going concern. Our ability to continue as a going concern is dependent upon our ability to return to profitability
or to develop additional sources of financing or capital. No assurances can be given that we will be successful in obtaining additional
financing in the future and any future financing that we may obtain may cause significant dilution to existing stockholders.
Historically, our
main source of cash was through the sales of our products, common stock sales and debt financing. However, due to the
decrease in sales, our ability to meet contractual obligations and payables depends on our ability to implement cost
reductions effectively and obtain additional financing. We believe that the ongoing economic challenges and
uncertainties experienced in 2012 and the first half of 2013 will continue to negatively impact our business in the
remainder 2013. Thus, we expect that for 2013 we will continue to generate losses from operations, and our operating
cash flows will not be sufficient to cover operating expense; therefore, we expect to continue to
incur net losses
To meet our
capital needs, we are considering multiple alternatives, including, but not limited to, additional debt financing and
credit lines, delaying capital spending for future periods, and/or operating cost reductions. We believe we can
utilize our properties and land use rights located in Beijing, China to secure such financing. No assurance
can be given that the financing will be available or, if available, that it will be on terms that are satisfactory to us.
Even if we are able to obtain additional financing, it may contain undue restrictions on our operations, in the case of debt
financing or cause substantial dilution to shareholders, in case or equity financing.
We have
implemented a cost reduction plan that includes decreasing our overhead, research and development, and advertising costs,
which we estimate will save us 10% to 15% overall compared to 2012. We do not believe that this initiative will
jeopardize our current operations or future growth plans materially. We also plan to delay
our capital spending and additional expansion to future periods, including investments in construction in
progress.
Our plan to delay
our capital spending to future periods includes renegotiating the terms of our capital expenditure
commitments, and we do not believe such deferrals would cause us material contractual penalties as we believe
the contracts can be renegotiated. We have also examined the structural effect of a delay on the buildings and we
believe that they could sustain a delay of at least 2-3 years without comprising overall structural integrity. We have
also evaluated our current production lines and expect that they will continue to function through their estimated
useful lives.
Furthermore, as
of June 30, 2013, we had invested in capitalized agricultural cost for $17,804,002. These pre-harvest agriculture
costs usually require substantial investment in the early stages, gradually decreasing to maintenance costs during
the growing stage. We expect that the cost required for these crops will be around $2.5 million per year. We
anticipate that the crops will benefit our operations in terms of raw material supply for internal use, as well as
profit from selling to the market in 2018.
We have also
reviewed all of our current material obligations and expect that we could fulfill all of our material commitments, with
the exception of construction contracts which we believe can be renegotiated.
We do not plan to
further downsize our operations beyond the cost reductions discussed herein, including selling or closing any of our
subsidiaries or suspending any ongoing operations.
Total Debt
We had a total of $64,685,183
in debt as of June 30, 2013, as compared to $67,642,849 as of December 31, 2012. The decrease of $2,957,666 was mainly due to a
decrease in bank acceptance notes to vendors in the first half of 2013.
Cash Flow
Operating Activities
Cash flows used in
operations during the six months ended June 30, 2013 amounted to $4,873,817, representing a decrease in cash used of $29,563,772
compared with cash flows used in operations of $34,437,589 for six months ended June 30, 2012. The decrease in net cash used by
operating activities was primarily attributable to: (i) lower losses in 2013 as compared to 2012, and (ii) a large decrease in
accounts receivable of $16,838,907 in 2013, compared with a decrease of only $4,897,830 in 2012, and (iii) an increase of $3,326,358
in accrued expenses and other payables in 2013, as compared with a decrease of $4,135,928 in 2012.
Investing Activities
Our net cash provided
by investing activities amounted to $
2,594,473
in the six months ended June 30, 2013, as compared to net cash provided by investing
activities of $26,021,071 in the six months ended June 30, 2012. The changes mainly included: (i) cash inflow from the collection
of receivable for the sale of the NuoHua affiliate in the amount of $18,278,815 in 2012, and (ii) proceeds from the payment of
bank acceptance notes from customers in the first half of 2012 in the amount of $23,068,432 with a corresponding amount of only
$4,567,451 in 2013.
Financing Activities
Our net cash provided
by financing activities was $1,206,798 in the six months ended June 30, 2013, compared to cash provided by financing activities
of $1,924,118 in the six months ended June 30, 2012. The difference is primarily due to (i) net proceeds from bank loans and bank
acceptance notes to vendors, net of repayments, of $7,016,929 in 2012, as compared to net repayments of $3,252,251 in 2013, (ii)
decreases in restricted cash in 2013 resulting from decreases in bank acceptance notes which require restricted cash deposits,
and (iii) the purchase of treasury shares in the amount of $1,270,603 in 2012.
Issuance of Common Stock
See Part II, Item 2 for issuance
of unregistered shares of common stock.
Inflation
Inflation has not had a material
impact on our business.
Currency Exchange Fluctuations
The Company's operations
are exposed to a variety of global market risks, including the effect of changes in foreign currency exchange rates. These exposures
are managed, in part, with the use of a financial derivative. The Company does not use financial derivatives to hedge exposures
in the ordinary course of business or for speculative purposes.
We currently conduct
substantially all of our operations through our PRC subsidiaries. The functional currency of our PRC subsidiaries is the Chinese
RMB. The financial statements of our PRC subsidiaries are translated to U.S. dollars using year-end exchange rates as to assets
and liabilities and average exchange rates as to revenues, expenses, and cash flows. Capital accounts are translated at their historical
exchange rates when the capital transaction occurred. Translation adjustments resulting from this process are included in accumulated
other comprehensive income in the statement of shareholders’ equity. Transaction gains and losses that arise from exchange
rate fluctuations on transactions denominated in a currency other than the functional currency are included in the results of operations
as incurred.
As the majority of
our assets and substantially all of our revenue, costs and expenses are denominated in RMB, any significant revaluation of the
RMB may materially and adversely affect our cash flows, revenues and financial condition. For example, if the RMB depreciates against
the U.S. dollar, the value of our RMB revenues, earnings, and assets, as expressed in our U.S. dollar financial statements could
decline. In addition, if we decide to convert our RMB into U.S. dollars for the purpose of making payments for business purposes,
the U.S. dollar equivalent of the RMB we convert would be reduced. On the other hand, to the extent that we need to convert U.S.
dollars we receive from an offering of our securities into RMB for our operations, appreciation of the RMB against the U.S. dollar
could reduce the amount of the U.S. dollars available.
The local currencies
in the countries in which we sell our products may fluctuate in value in relation to other currencies. Such fluctuations may affect
the costs of our products sold and the value of our local currency profits. While we are not conducting any operations in countries
other than China at the present time, we may expand to other countries and may then have an increased risk of exposure of our business
to currency fluctuation.
The PRC government
imposes control over the conversion of RMB, into foreign currencies. Under the current unified floating exchange rate system, the
People’s Bank of China 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 FIEs, 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 to foreign exchange and remit such foreign exchange to their foreign exchange bank
accounts in China. 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 China,
including FIEs, which require foreign exchange for transactions relating to current account items, if within a certain limited
amount 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.
Between 1994 and 2004,
the exchange rate for RMB against the U.S. dollar remained relatively stable, most of the time in the region of approximately RMB8.28
to US$1.00. However, in 2005, the Chinese government announced that it would begin pegging the exchange rate of the RMB against
a number of currencies, rather than just the U.S. dollar.
Since a significant
amount of our future revenues are expected to be denominated in RMB, any existing and future restrictions on currency exchange
may limit our ability to utilize revenue generated in China to fund our business activities outside of China, if any, or expenditures
denominated in foreign currencies, or our ability to meet our foreign currency obligations, which could have a material adverse
effect on our business, financial condition and results of operations. We cannot be certain that the PRC regulatory authorities
will not impose more stringent restrictions on the convertibility of RMB with respect to foreign exchange transactions.
We recognized a foreign
currency translation adjustment of $7.4 million and $4.0 million for the six months ended June 30, 2013 and 2012, respectively.
The balance sheet amounts with the exception of equity at June 30, 2013 were translated at 6.2065 RMB to $1.00 USD as compared
to 6.3161 RMB at December 31, 2012. The equity accounts were stated at their historical rate.
The average translation
rates applied to the income and cash flow statement amounts for the three months ended June 30, 2013 and 2012 were 6.1882 RMB and
6.3309 RMB to $1.00 USD, respectively. We do not hedge our exposure to foreign exchange risk; as such, we may in the future experience
economic loss as a result of any foreign currency exchange rate fluctuations.