Item 1. Business.
The following summary is qualified in its entirety by the more detailed information appearing elsewhere in this Form 10-K. In this Form 10-K, unless the context requires otherwise, the terms “we”, “our”, “us” and the “Company” refer to Tanke Biosciences Corporation, a Nevada corporation formerly known as Greyhound Commissary, Inc. (“Greyhound”), as well as our direct and indirect subsidiaries, and our principal operating business, Guangzhou Tanke Industry Co., Ltd. (“Guangzhou Tanke”), a company organized under the laws of the People’s Republic of China (“China” or the “PRC”), which we control via a series of variable interest entity contractual agreements (the “VIE Agreements”) more fully described below.
We conduct our business through our subsidiaries, principally our wholly-owned subsidiary China Flying Development Limited (“China Flying”), a Hong Kong incorporated company, and its wholly-owned subsidiary Guangzhou Kanghui Agricultural Technology Co., Ltd. (“Kanghui Agricultural” or the “WFOE”), a wholly foreign owned enterprise incorporated as a limited liability company under the laws of the PRC. We operate and control Guangzhou Tanke through Kanghui Agricultural and China Flying and in connection with the VIE Agreements.
“RMB” and “Renminbi” refer to the legal currency of China and “$”, “US dollar” and “US$” refer to the legal currency of the United States.
Overview of Our Business
Through Guangzhou Tanke, our principal operating business, we are one of the leading animal nutrition and innovative feed additive providers in China. Our products are distinguished from traditional artificial feed additives in that they are environmental-friendly and are designed to optimize the growth and health of livestock such as pigs, poultry and cattle, as well as farmed fish. One of our most popular products is an organic trace mineral additive that we believe is one of the few Chinese-developed organic products in the trace mineral market.
In 2001, we were designated a certified hi-tech company by the Guangzhou City Commission of Science and Technology as recognition for new technology that we developed in the agricultural industry, and in addition to our headquarters, we operate in a modern 34,000 square-meter manufacturing facility in the Huadu Economic District, Guangzhou City, Guangdong province. As the Chinese economy continues to evolve and prosper, the opportunity for technology companies like the Company should increase dramatically.
Our feed additive products are distinguished from traditional artificial feed additives in that they are non-hazardous, environmental friendly and safe for livestock and their human consumers, making them compatible with China's efforts to develop a safer food supply. Such feed additive products are environmental friendly because animals that consume them produce fewer waste products than other animals and a decrease in the amount of waste produced is beneficial to the environment.
As a growing player in providing advanced, environmental-friendly and innovative feed additives, we believe that sales will rapidly increase as more large scale farms and feed producers in China seek “Pollution-Free” certifications from the Chinese government. These certifications indicate that the farm or food production facility has taken material steps to make its manufacturing process as environmental friendly as possible and the food provided as safe as possible. Large scale farms and feed producers in China that seek "Pollution-Free" certifications may be more likely to receive such certifications if they use our Organic Trace Mineral Additives. Pursuant to a May 3, 2005 paper, published by the MU Extension of the University of Missouri-Columbia, the main advantage of feeding organic trace minerals to animals is to increase the bioavailability to the animal, thereby decreasing the amount of waste and, correspondingly, the amount of pollution. In addition, feed additives are utilized in China at less than half the rate of the United States and Europe, and we have a significant growth opportunity as Chinese farmers and ranchers include a greater amount of increasingly sophisticated additives in their feed.
Our major products address most key market categories within China’s animal feed additive industry, including:
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Organic Trace Mineral Additives
, which accounted for approximately 79% of our revenue in 2011 and 86% of our revenue in 2012;
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Feed Acidifiers, Seasonings and Flavor Enhancers
, which accounted for approximately 17% of our revenue in 2011 and 11% of our revenue in 2012; and
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Herbal Medicinal Additives
, which accounted for approximately 1% of our revenue in both 2011 and 2012.
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Our extensive distribution network reaches China’s top 10 feed producers and the 500 largest animal farming operations. As a result of our diversified products and extensive distribution network, we believe that we are ideally positioned to help meet China’s growing demand for safe and reasonably priced food.
From Guangzhou Tanke’s incorporation in April 1997, when it manufactured one product utilizing a small rented facility in Gaotang in the Guangdong province, Guangzhou Tanke has grown into one of China’s largest feed additive producers. As of December 31, 2012, we marketed 26 different brands of feed additives and had an aggregate production capacity, on average of approximately 560 metric tons per week of feed additives, of which 350 metric tons are organic trace minerals. We estimate that we are currently operating at a blended average across our product lines of approximately 63% of our manufacturing capacity at our current facility. To satisfy increasing demand of our products and to provide better services, we have acquired land use right and started construction of our second manufacturing facility in Qingyuan, Guangdong. The new facility will utilize the most advanced technology and automated systems which greatly reduce per unit cost and improve product quality. It is expected to be fully operational in the first half of 2014.
We launched a new product in the second half of 2012 called “Water Soluble Organic Multi-Vitamin Electrolyte”. Unlike traditional feed additives that are mixed with solid animal feed, this product is fed to animals by dissolving it in drinking water for the animals to consume. Research data indicates that this form of application will create better absorption of minerals and nutritional substances, thus improving efficiency and reducing cost. Throughout 2012, we continued to modify our products to improve ease of application. We started focusing on marketing our products directly to the end users, the largest animal farming companies in China, and to the smaller animal farms through regional and local distributors. In 2013, we have several new product introductions in the pipeline, for use mainly on improving health and enhancing growth in pigs, chicken, cattle, and seafood.
Background and Key Events
Greyhound, our predecessor corporation, was organized on May 24, 1989 under the laws of the State of Idaho and was re-incorporated under the laws of the State of Nevada on November 1, 2007. Greyhound was initially created to provide a variety of services related to the operation of a nearby greyhound dog-racing track. Following inception, Greyhound raised funds to assist it in providing food, shelter, healthcare and other services to animals used in the greyhound racing. Subsequently the track was closed and the business was curtailed. Beginning in 1995, Greyhound engaged in an ongoing search for suitable business opportunities, including a potential merger.
On February 9, 2011, Greyhound closed (i) a share exchange transaction (the “Share Exchange”), pursuant to which (among other things) we became the sole stockholder of China Flying and changed our name to “Tanke Biosciences Corporation”, and (ii) a private placement (the “Private Placement”) of $7,670,071 for 6,669,627 units (the “Units”), with each Unit consisting of a $1.15 principal amount 8% Senior Convertible Note (each, a “Note”) and a Common Stock Purchase Warrant (each, a “Warrant”) to purchase one share of our common stock, with an exercise price of $1.40 per share. The Share Exchange and the Private Placement are more fully described below.
Our principal offices are located at East Tower of Hui Hao Building, No. 519 Machang Road, Pearl River New City, Guangzhou, China. Our telephone number is +86-20-3885-9025.
VIE Agreements
On January 3, 2011, Kanghui Agricultural, a wholly-owned subsidiary of China Flying, entered into the VIE Agreements with Guangzhou Tanke and the Tanke Shareholders (Guixiong Qiu, Bi Gao, Xiuzhen Liang, and Bing Teng). Pursuant to the VIE Agreements, Kanghui Agricultural effectively assumed management of the business activities of Guangzhou Tanke and has the right to appoint all executives and senior management and the members of the board of directors of Guangzhou Tanke. The VIE Agreements are comprised of a series of agreements, including a Consulting Services Agreement, Operating Agreement, Voting Rights Proxy Agreement, Equity Pledge Agreement and Option Agreement, through which Kanghui Agricultural has the right to advise, consult, manage and operate Guangzhou Tanke for an annual fee in the amount of Guangzhou Tanke’s yearly net profits after tax. The Tanke Shareholders have pledged their rights, titles and equity interest in Tanke as security for Kanghui Agricultural to collect consulting and services fees provided to Guangzhou Tanke through an Equity Pledge Agreement. In order to further reinforce Kanghui Agricultural’s rights to control and operate Guangzhou Tanke, the Tanke Shareholders have granted Kanghui Agricultural an exclusive right and option to acquire all of their equity interests in Tanke through an Option Agreement.
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Equity Interest Pledge Agreement. The WFOE and the Tanke Shareholders have entered into Equity Interest Pledge Agreements, pursuant to which each shareholder pledges all of his shares of Guangzhou Tanke to the WFOE in order to guarantee cash-flow payments under the applicable Consulting Services Agreement. The Equity Pledge Agreement further entitles the WFOE to collect dividends from Guangzhou Tanke during the term of the pledge.
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Consulting Services Agreement. Guangzhou Tanke and the WFOE has entered into a Consulting Services Agreement, which provides that the WFOE will be the exclusive provider of consulting and management services to Guangzhou Tanke and Guangzhou Tanke will pay all of its net income based on the quarterly financial statements to the WFOE for such services. Any such payment from the WFOE to the Company would need to comply with applicable Chinese laws affecting payments from Chinese companies to non-Chinese companies. See “Risk Factors – Risks Associated With Doing Business in China – ‘
Due to various restrictions under Chinese laws on the distribution of dividends by our Chinese operating companies, we may not be able to pay dividends to our stockholders
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The State Administration of Foreign Exchange restrictions or changes in foreign exchange regulations in China may affect our ability to pay dividends in foreign currency or conduct other foreign exchange business
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Operating Agreement. Pursuant to the operating agreement among the WFOE, Guangzhou Tanke and each of Tanke Shareholders, the WFOE provides guidance and instructions on Guangzhou Tanke’s daily operations and financial affairs. The Tanke Shareholders must designate the candidates recommended by the WFOE as their representatives on their respective boards of directors. The WFOE has the right to appoint senior executives of Guangzhou Tanke. In addition, the WFOE agrees to guarantee Guangzhou Tanke’s performance under any agreements or arrangements relating to Guangzhou Tanke’s business arrangements with any third party. Guangzhou Tanke, in return, agrees to pledge its accounts receivable and all of its assets to the WFOE. Moreover, Guangzhou Tanke agrees that without the prior consent of the WFOE, Guangzhou Tanke will not engage in any transactions that could materially affect its assets, liabilities, rights or operations, including, without limitation, incurrence or assumption of any indebtedness, sale or purchase of any assets or rights, incurrence of any encumbrance on any of its assets or intellectual property rights in favor of a third party or transfer of any agreements relating to its business operation to any third party.
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Option Agreement. Pursuant to the option agreement among the WFOE, Guangzhou Tanke and each of Tanke Shareholders, the Tanke Shareholders have granted Kanghui Agricultural an exclusive right and option to acquire all of their equity interests in Guangzhou Tanke upon an event of default.
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Voting Right Proxy Agreement. Pursuant to the voting right proxy agreement among the WFOE, Guangzhou Tanke and its shareholders, the Tanke Shareholders have granted the WFOE a voting and proxy right to vote their equity interest on Guangzhou Tanke.
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We have been advised by our PRC legal counsel, Martin Hu & Partners, in an opinion dated January 4, 2011, that: (1) our inner-PRC shareholding structure complies with PRC laws and regulations; (2) the contractual arrangements between the WFOE, China Flying, Guangzhou Tanke and its shareholders are valid and binding on all parties to these arrangements and do not violate relevant PRC laws or regulations; (3) each of the WFOE and Guangzhou Tanke has the requisite corporate power to own, lease and operate its properties, to enter into contracts and to conduct its business and (4) each of the WFOE and Guangzhou Tanke is qualified to do business in the respective jurisdiction of its establishment.
Call Option Agreement
In addition, on January 3, 2011, the Tanke Shareholders each entered into a call option agreement (the “Call Option Agreement”) with Golden Genesis Limited (“Golden Genesis”), a British Virgin Islands company, and Wong Kwai Ho, a Hong Kong resident owning 100% of the issued and outstanding shares of Golden Genesis. Pursuant to the Call Option Agreement, the Tanke Shareholders each received three year options exercisable for shares of common stock in the Company and options for 34% of the shares shall vest and become exercisable on December 31, 2011, options for 33% of the shares shall vest and become exercisable on December 31, 2012 and options for 33% of the shares shall vest and become exercisable on December 31, 2013. Upon exercise of the options, the Tanke Shareholders may purchase each share for $0.01 and if the Tanke Shareholders exercise all of their options they will own a majority of our outstanding shares of Common Stock and Golden Genesis will no longer be a stockholder of the Company. The Call Option Agreement provides that Golden Genesis shall not dispose of the respective portion of the shares of common stock without the Tanke Shareholders’ prior written consent.
Pursuant to the Call Option Agreement, Golden Genesis shall transfer up to 100% of the shares of the Company’s common stock to the Tanke Shareholders over the next three years. Upon the completion of such transfers the Tanke Shareholders will be stockholders of the Company and Golden Genesis will no longer be a stockholder of the Company.
We entered into the VIE Agreements and Call Option Agreement in order to comply with applicable Chinese law and because such structure was a tax-efficient alternative for the Tanke Shareholders. First, under an alternative structure, we would be required to obtain the approval of the PRC government because the WOFE did not exist for two years prior to the transaction. Second, under an alternative structure, we would be required to pay the Tanke Shareholders cash for the capital stock of Guangzhou Tanke because stock-for-stock acquisitions are not permitted. Lastly, the structure provided by the VIE Agreements is tax-free to the Tanke Shareholders under applicable PRC law.
Share Exchange
On February 9, 2011, pursuant to a Share Exchange Agreement, dated January 3, 2011 (the “Share Exchange Agreement”), between Greyhound, Golden Genesis and China Flying, the Company closed the Share Exchange and acquired all of the outstanding equity securities of China Flying from Golden Genesis, which was the sole shareholder of China Flying immediately prior to the closing of the Share Exchange. In exchange, we issued to Golden Genesis 10,758,000 newly issued shares of our common stock. In addition, pursuant to the terms of the Share Exchange Agreement, the Company effected a 1 for 8.512 reverse stock split to modify the Company’s capital structure to accommodate the transactions contemplated by the Share Exchange and the Private Placement and to put in place an appropriate capital structure for the Company following the closing of the Share Exchange and the Private Placement. Such securities were not registered under the Securities Act of 1933, as amended (the “Securities Act”). These securities qualified for exemption under Section 4(2) of the Securities Act since the issuance of securities by us did not involve a public offering. All references to number of shares and per share amounts included in this report give effect to the 1 for 8.512 reverse stock split.
We consummated the Share Exchange in order to acquire China Flying and Kanghui Agricultural. Pursuant to the terms of the VIE Agreements, the Share Exchange also resulted in us acquiring control of the business and operations of Guangzhou Tanke. We acquired Guangzhou Tanke through the VIE Agreements, rather than an acquisition of Guangzhou Tanke’s assets or equity, because: (i) the tax and other consequences of a share exchange with a foreign entity that result in the acquisition of a Chinese company are uncertain due to PRC laws that were effective on September 8, 2006 and (ii) if Guangzhou Tanke is not acquired via a share exchange transactions, PRC authorities may require it to be acquired for cash, however the Company was not able to raise a sufficient amount of cash to purchase Guangzhou Tanke.
Private Placement
On February 9, 2011, in connection with the closing of the Share Exchange, we closed the Private Placement of 6,669,627 Units, at a purchase price of $1.15 per Unit, pursuant to the Securities Purchase Agreement. Each Unit consisted of a $1.15 principal amount 8% Senior Convertible Note and a Common Stock Purchase Warrant to purchase one share of the Company’s common stock, with an exercise price of $1.40 per share. We sold 6,669,627 Units in the Private Placement, for gross proceeds of $7,670,071.50. In addition, in connection with the Private Placement, the Company also issued to certain affiliates of Euro Pacific Capital, Inc. (“Euro Pacific”), the lead placement agent in the Private Placement, three-year Agent Warrants to purchase an aggregate of 666,963 shares of our common stock at an exercise price of $1.15 per share. The issuances of the Notes, the Warrants and the Agent Warrants were exempt from registration under Section 4(2) of the Securities Act of 1933, and the Private Placement met the requirements to qualify for exemption under Regulation D promulgated under the Securities Act. The first $1,474,006 of proceeds from the Private Placement were used primarily to pay expenses of the Share Exchange and the Private Placement, including $400,000 reserved for financial marketing of the Company for the U.S. capital markets. Proceeds above these amounts will be used primarily to develop new products, acquire patents, add manufacturing capacity, advertising, promotion, increasing and training sales personnel and for general working capital needs of the Company. The net proceeds from the Private Placement shall be not be used for the satisfaction of any portion of the Company’s bank debt or debt due to related parties (other than payment of accounts payable in the ordinary course of the Company’s business and consistent with prior practices), or to redeem any common stock or common stock equivalents of the Company. In connection with the closing of the Private Placement, we also entered into the following additional agreements:
Notes
. We offered and sold $7,670,071.50 worth of Notes convertible into up to 6,669,627 shares of our common stock, in conjunction with a purchase of the Units. The Notes are payable 24 months from February 9, 2011 with an interest rate of 8% per annum payable semiannually in arrears. At the option of the holder, the Notes may be converted into common stock at a price of $1.15 per share, which is subject to customary weighted average and stock based anti-dilution protection.
Warrants
. We offered and sold Warrants to purchase up to 6,669,627 shares of common stock in conjunction with a purchase of the Units. Each Warrant entitles the holder to purchase one share of our common stock. The Warrants will be exercisable in whole or in part, at an initial exercise price per share of $1.40, which is subject to customary weighted average and stock based anti-dilution protection. The Warrants may be exercised at any time upon the election of the holder, beginning on the date of issuance and ending of the third anniversary of the closing of the Private Placement.
Agent Warrants
. We issued to certain affiliates of Euro Pacific, our lead placement agent in the Private Placement, three-year Agent Warrants to purchase an aggregate of 666,963 shares of common stock at an exercise price of $1.15 per share. The Agent Warrants also contain a cashless exercise option.
Registration Rights Agreement
. Under the terms of the Registration Rights Agreement, we agreed to file a Registration Statement on Form S-1 with the SEC within 60 days of the closing of the Private Placement registering the number of shares of common stock underlying the Units sold in the Private Placement, and to use our best efforts to have the registration statement declared effective prior to September 15, 2011. As of December 31, 2012 and 2011, we accrued the maximum amount of $460,206 for registration delay penalty.
Interest Escrow Agreement
. Pursuant to the Interest Escrow Agreement, the Company deposited into escrow an amount of proceeds of the Private Placement equal to one semi-annual interest payment on the Notes to secure prompt interest payments under the Notes. Until such time as 75% of the Notes are converted into shares of common stock, if such escrow is depleted in order to make interest payments, the Company has agreed to promptly replenish such escrow amount.
Securities Escrow Agreement
. Pursuant to the Securities Escrow Agreement, Golden Genesis placed in escrow 2,000,000 shares of common stock (the “Escrow Shares”), to be disbursed to either the Investors on a pro rata basis or to Golden Genesis based on the financial performance of Guangzhou Tanke, our principal operating business. If our “Adjusted Income” (as defined below) for the year ending December 31, 2011 is (i) at least $4,652,410, then Golden Genesis shall receive an aggregate of one million (1,000,000) Escrow Shares or (ii) less than $4,652,410, then the Investors shall receive an aggregate of one million (1,000,000) Escrow Shares. If our Adjusted Income for the year ending December 31, 2012 is (i) at least $7,571,111, then Golden Genesis shall receive an aggregate of one million (1,000,000) Escrow Shares or (ii) less than $7,571,111, then the Investors shall receive an aggregate of one million (1,000,000) Escrow Shares. For the purposes of the Securities Escrow Agreement, “Adjusted Income” means the sum of: (A) the Company’s net income; plus (B) any expense incurred in connection with the transactions contemplated by the Securities Purchase Agreement in connection with the Private Placement, including, without limitation, expenses related to the filing of a registration statement; plus (C) any depreciation and amortization expenses related to the expenses described in (B) above for the fiscal year ending December 31, 2011 or December 31, 2012 (as applicable), in each case as determined in accordance with GAAP, as reported in the Company’s Annual Report on Form 10-K as filed with the SEC.
We did not achieve the Adjusted Income of $4,652,410 for the year ended December 31, 2011, therefore 1,000,000 shares of common stock placed in escrow have been distributed to the Investors on a pro rata basis, pursuant to the terms of the Securities Escrow Agreement. We did not achieve the Adjusted Income of $7,571,111 for the year ended December 31, 2012 either, and we are in discussion with the investors for a waiver of the make good share distribution or a reduced quantity.
As of February 10, 2013, we are in default under the terms of the Notes. The default is the result of the Company’s failure to pay to the investors approximately $7.67 million in principal plus accrued interest due and payable on February 9, 2013 under the terms of the Notes. We have subsequently released $229,000 held in escrow to the investors, of which $68,178 was used to pay investors all remaining accrued interest, and the balance applied towards the principal. As of February 25, 2013, the principal balance was paid down to $7,509,232.
As a result of our failure to pay all amounts due and payable under the Notes as of February 9, 2013, all obligations of the Company under the Notes are immediately due and payable and the investors may exercise any other remedies the investors may have under the transaction documents, at law or in equity.
We are currently in discussion with Euro Pacific, investors representative, and investors regarding proposals relating to the Notes and the Company’s default thereunder, including a repayment schedule for the remaining principal. Euro Pacific’s visit to Kanghui and Guangzhou Tanke in China in March 2013 facilitated a continuous dialogue between the Company and investors in developing a feasible plan to resolve this issue in the near future.
Corporate Name Change
On February 8, 2011, in connection with the closing of the Share Exchange and Private Placement, we filed a Certificate of Amendment to our Articles of Incorporation with the Secretary of State of the State of Nevada to change our corporate name from “Greyhound Commissary, Inc.” to “Tanke Biosciences Corporation”, a name that more accurately reflects the business operations of the Company following the closing of the Share Exchange. The name change was effective as of February 10, 2011.
Our Organizational Structure
Our organization structure is illustrated below:
Mr. Guixiong Qiu is the sole director of the Company and Golden Genesis, the Company’s largest stockholder. Other than Mr. Qiu, Golden Genesis does not have other stockholders or officers. Ms. Wong Kwai Ho is the sole director of China Flying. Ms. Wu Chun Rui is the sole director of Kanghui Agricultural and the legal representative who is authorized to sign corporate documents on behalf of Kanghui Agricultural. Mr. Guixiong Qiu, Mr. Bi Gao, Mr. Xugang Shu, and Ms. Xiuzhen Liang are the directors and officers of Guangzhou Tanke and its subsidiaries, Guangzhou Tanke Bio-Tech Co., Ltd., Guangzhou Jenyi Bio-Tech Co., Ltd., Guangzhou Tanke Animal Health Co., and Qingyuan Tanke Bio-Tech Co., Ltd.
Development of Business
We believe our rapid growth in recent years has been supported by the continuing expansion of the market for feed additive products in China as well as our introduction of new products to meet increased demand by our customers for more diversified and efficient products.
In 2000, we introduced our first organic trace mineral additive and this segment of our business has become our fastest growing. In 2008, sales of organic trace minerals accounted for the majority of our revenue, generating approximately $4.8 million, or 56% of our total sales. The growth continued in 2009 as sales increased to approximately $8.5 million, or 70% of our total sales for that year. As of December 31, 2010, sales of organic trace minerals rose to $15.2 million, or 76% of our total sales. In 2011, organic trace mineral products continued to rise 24% to $18.9 million, or 79% of total sales. In 2012, organic trace mineral products continued to grow 30% to $24.6 million, or 86% of total sales.
In 2003, we became a member of the National Feed Industry Standardization Technical Committee, a prestigious appointment that added significantly to our credibility. Over the years, we have helped the government established three national standards and one industry standard for animal feed additives. These are: (1) GB/T 21694-2008 product standard for feed additive of zinc methionine; (2) GB/T 20802-2006 product standard for feed additive of copper methionine; (3) NY/T 1498-2008 product standard for feed additive of methionine iron and (4) GB/T 22489-2008 product standard for feed additive of methionine manganese.
In 2006, we were recognized as an “Excellent Enterprise” by the provincial government for our technology innovation in the feed additive industry. During the same year, we formed two fully owned subsidiaries, Guangzhou Jenyi Bio-Tech and Guangzhou Tanke Animal Health Product to further expand and diversify our business into herbal feed additives and veterinary drugs.
In 2007, our production of organic trace minerals was granted “National Torch Project” by the Chinese Ministry of Science and Technology. Launched in 1988 by the Chinese government, the Torch Program is China’s most important program to encourage and recognize high technology projects and achievements based on certain technological standards and national economic benefits.
During the period of 2006 to 2011, we received three patents granted by the State Intellectual Property Office and had five patents pending in the areas of (1) the methodology of feed additive production; (2) the procedure associated with testing products, among others. In 2012, we did not receive patent approvals but two of the applications are very close to be approved. In addition, we filed another seven patent applications in 2012. We acquired a new production technology from an agricultural research institute in the second quarter of 2012 for RMB 3 million which included two pending patent applications. This new technology enables us to use a new natural raw material to product high quality antioxidant feed additives.
Much effort and resources were put into building our technology innovation center at the existing manufacturing facility in Huadu. Once the new facility in Qingyuan is complete, high volume production will be moved there and the existing Huadu facility will focus on research and innovation, and developing and testing new products. Some low volume, high impact, specialty products will be manufactured at the Huadu facility.
We launched one new product in the second half of 2012 called “Water Soluble Organic Multi-Vitamin Electrolyte”. Unlike traditional feed additives that are mixed with solid animal feeds, this product is fed to animals by dissolving it in drinking water. Research data indicates that this form of application will facilitate better absorption of minerals and nutritional substances, thus improving efficiency and reducing cost. Throughout 2012, we continued to modify our products to improve ease of application.
In 2012, we formed a new sales and marketing division focusing on marketing directly to the end user channel, particularly the largest animal farming companies in China, and to smaller animal farms through regional and local distributors. In 2013, we have several new product introductions in the pipeline, mainly focus on improving health and enhancing growth in pigs, chicken, cattle, and seafood. We are in the process of setting up a production line at Huadu plant to start producing a new category of product called “premix” feed additive. This product is widely used in the “end user” channel and we have always possessed the technology and know-how but now we have lined up the sourcing of raw materials, which are primarily protein and our own organic trace minerals. When the new facility in Qingyuan starts up, it will have a production line with substantially higher capacity for premixes.
Overview of the Chinese Feed Additive Market
Over the past decade, as a result of a series of market-based reforms, China’s economy has experienced unprecedented growth, with an average annual GDP growth rate of over 10%. As China has become more prosperous, the rapid growth in per capita income and consumer choices has led to a dramatic improvement in living standards and dietary patterns. Chinese consumers have significantly increased their consumption of high-protein food such as meat and other livestock and in the place of traditional staple grain-based foods. This growing demand for high-protein foods has had a material impact on the growth of the feed additive market.
Source: World Bank
Beginning in the mid-1970s, in response to China’s increasing and diversifying food consumption, its domestic feed industry began to experience rapid development and transitioned into the world’s second largest feed producer behind the United States. According to a recent research report issued by IBISWorld in March 2011, (originated in 1971, IBISWorld is the market research organization that specializes in the long range forecasting of industries and business environments in Australia, the US and China), revenue of the animal feed manufacturing industry (including pet food) increased from $39.8 billion in 2007 to a forecast $97.62 billion in 2011. This represents an annualized growth rate of 27.8%. This growth momentum is expected to continue in future years with projected total revenue of $158.63 billion in 2017, or an average growth rate of 14.8% per year.
In the past decade, feed producers have become more efficient, with new, high production mills replacing older, smaller mills. As part of their effort to improve the quality of agricultural output and the efficiency of animal production, commercial feed producers have increased their use of feed additives. Animal farms are facing the challenges of ever rising cost of natural feed such as corn and soybean meal, the increasing need to control livestock disease outbreaks, as well as the growing concern on meat quality and overall food safety, which all led to the increasing use of natural and organic feed additives that are free of GMO (genetically modified organism) and antibiotics. According to a new market report published by Transparency Market Research "Animal Feed and Feed Additives Market - Global Industry Size, Market Share, Trends, Analysis, and Forecast, 2011 - 2018", global animal feed additives market was worth USD 13.5 billion in 2011 and is expected to reach USD 17.5 billion in 2018.
According to Chinese Feed Industry Information, there has been rapid growth in the animal feed industry in China, however, development and research of feed additives in China has not had similar growth. Many of the highly efficient, low toxic and less residual feed additive products are heavily dependent on importation thereby creating a significant opportunity for domestic manufacturers, like the Company, to increase its market share in China. Additionally, while, according to the European Union Register of Feed Additives published June 1, 2011, the European Union has hundreds of feed additive formulas approved for use, to date China has only approved approximately 220 feed additive formulas, of which most are imported. As China permits more feed additive formula approvals in an attempt to close the gap with the western developed countries, the Company will benefit since it has the technology and manufacturing capability to produce these new and more effective products.
One of the primary components of the Company’s business is Feed Acidifiers and it has gained significant momentum in recent years as a substitute for growth promoters that rely on antibiotics as the primary ingredient. The desirability of Feed Acidifiers is a result of growing concerns about drug-resistant “superbugs” in humans and animals resulting from the indiscriminate use of antibiotics. The global feed industry has been under scrutiny for years for its use of antibiotics as growth promoters in the rearing process of livestock, prompting the European Union to ban the use of Antibiotic Growth Promoters (AGPs) in January 2006. The Chinese government is currently tightening the industry standard and may follow the EU’s lead to restrict or ban the use of AGPs. Our Feed Acidifiers differ from other growth promoters because they contain alkaloids to stimulate acid production in an animal’s stomach, lowering the pH levels to improve overall animal health. Such Feed Acidifiers do not rely on antibiotics as a primary ingredient. Rather, the ingredients in our Feed Acidifiers comply with the more restrictive requirements of the EU and the increased regulation that we anticipate in the future from China’s regulatory authorities.
In response to quality control breakdowns from isolated Chinese manufacturers in 2007, in June, 2009, the Chinese Ministry of Agriculture announced Bulletin No. 1224 (the Safe Use of Feed Additive Specification), which tightened feed additive quality control standards by specifying “norms” of trace elements and other feed additives usage. The maximum normative amounts set by the Chinese government are required to be strictly followed and implemented. As a result of these regulations, the Company expects this new regulation to drive the market to shift from high dosage, low absorption rate inorganic products to low dosage, high absorption rate organic products. Our products meet the requirements described in the new regulations in that they require a smaller amount of additive (a lower dosage) for the same nutritional effect as inorganic products. In addition, our products increase the bioavailability of the animal resulting in less excretion to the environment. As one of the pioneers in the organic trace minerals additive segment, Guangzhou Tanke, as a member of the Chinese Feed Association, participated in setting the national standards on the usage of organic trace minerals additives. As a result, we are well positioned to further expand our market position.
In the fourth quarter of 2012, the Company began the certification process of FAMI-QS. It is the only certifiable code specifically aimed at specialty feed ingredients and their mixtures (feed additives, functional feed ingredients, premixtures, specialty complementary feed, specialty complementary dietetic feed) for animal nutrition. The code addresses safety, quality and regulatory compliance in order to minimize the risk that unsafe specialty feed ingredients enter the food and feed chain. It was also the first Community Guide to Good Practice to obtain official recognition from the European Commission as foreseen in the Feed Hygiene Regulation. It offers independent certification for all operators placing these products on the market. The FAMI-QS code is designed for international validity; thus, participants in FAMI-QS can be found all over the world. Today, certified companies are spread across more than 49 countries. In February 2013, the Company, through its subsidiary Guangzhou Tanke Bio-Tech, became a FAMI-QS certified company. Earning the FAMI-QS certification is a significant achievement for the Company. Because of the worldwide recognition of this seal of approval, especially in the EU countries, it will greatly elevate our export sales.
Competition in the Chinese Market
The Chinese feed additive market is highly fragmented, with approximately 2,500 feed additive companies nationwide and no participant having a greater than 1.2% market share. While many of the Company’s domestic competitors are smaller businesses that operate in relatively specialized niche product areas, the industry is in the process of transforming itself from small, family-based operations into large, enterprise based businesses.
Foreign firms are also attempting to gain a foothold in the Chinese feed additive market, but generally charge higher prices than those of domestic manufacturers.
Our largest Chinese competitors include:
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Changsha Xingjia Bio Tech Co., Ltd., which is engaged in developing, marketing and producing safe, environmental friendly trace mineral feed additives. Changsha offers compound acidifier, amino acid chelated trace elements, copper chloride and other products. Changsha has sales office nationwide and subsidiaries in Thailand and Singapore.
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Debon Bio Tech Co., Ltd., which was established in 2004 and is a Sino-German joint venture engaged in feed additive development and raw material trading. Debon has a long term partnership with its German partner and imports piglet nutrition and feed additives from overseas.
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We also compete with the following large international manufacturers:
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Zinpro Corporation, a manufacturer of trace minerals. Zinpro offers iron, copper, manganese, zinc and cobalt products used in the dairy, beef, poultry, swine, and equine industries. Headquartered in Eden Prairie, Minnesota, Zinpro has sales offices in the United States, Canada, Mexico, the Netherlands, China, Japan, Thailand, Brazil, Australia and New Zealand.
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Alltech Inc., an animal health and nutrition company. Alltech manufactures nutritional products and solutions for the feed industry. It provides natural feed ingredients and Sel-Plex organic selenium for use in animal species with selenium deficiencies for feed and food manufactures in North America, Latin America, the Asia-Pacific, Europe, the Middle East, and Africa. Alltech is headquartered in Nicholasville, Kentucky and has bioscience centers in the United States, Ireland, and Thailand.
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Growth Strategy
Our goal is to become the leading provider of feed additives in China. Our primary growth strategy is as follows:
Strengthen our leadership position in the organic trace mineral market and substantially increase our Chinese market share within the next three years.
In recent years, Chinese inorganic minerals have been linked to contamination by heavy metals and dioxins. As a result, farmers and feed producers are increasingly switching to organic trace minerals based on research that indicates that quality organic minerals are superior to inorganic minerals in bioavailability, health and performance.
As the largest organic trace minerals producer in China, accounting for approximately 6.6% of total production on an annual basis, the Company is ideally positioned to benefit from the substantial growth it anticipates in the organic trace mineral market. To meet the expected demand, we are building a second manufacturing facility that would double our organic trace mineral production capacity.
Expand sales of the Company’s products to other market segments within China.
In 2012, we established a new sales and marketing division targeting a different marketing channel – the “end user” market. Instead of increasing overall sales staffs, we dedicated a few experienced sales and marketing representatives, to provide services and technical support to animal farmers, especially the largest ones in China. Smaller farmers will buy our products through authorized distributors we set up in various cities and provinces. Our sales representatives’ primary function is to visit the end users and provide training and support. Many smaller farmers in China are still buying premixed feed products from feed producers who purchase our feed additives and mix them with feed and sell to the farmers. While we anticipate significant growth will come from this new marketing initiative, we do not expect our growth in the “end user” market will cannibalize our existing business with the feed producers.
Increase the Company’s production capacity.
In 2011, we installed a new production line at our current manufacturing facility in Huadu, increasing the total production capacity by 40% to 560 metric tons on average per week. In addition, we have begun remodeling and upgrading the old production line in 2012, investing over $760,000 to further improve efficiency and capacity of the current facility. Due to a longer process of getting all the various government approvals and permits, the Qingyuan new facility project was delayed but it has no impact to our ability to produce and service our customers because of the improvements at the existing facility in Huadu. We anticipate the new facility construction to be completed and testing of production lines to begin in the fourth quarter of 2013. The Qingyuan plant will be fully operational in the first half of 2014. All the production of our high volume products such as Organic Trace Mineral Additives and Premix Additives will be moved to Qingyuan to take advantage of the most advanced technology and highly automated processes. Our existing Huadu facility will become our R&D center focusing on new product development and producing small quantity, high margin products. We are in active search of new sites that are appropriate for future capacity expansion in the next two to three years, especially in the northeast and northwest regions of China.
Increase the Company’s investment in research and development.
To maintain a competitive advantage in the marketplace, we will continue to devote greater resources to our in-house research and development team and to enhance and expand our collaborations with institutions and universities. Our goal is to be validated and designated as one of the State-Level Enterprise Technical Centers. As of February 2013, there are only 887 of such centers in China.
Additionally, we plan to strengthen our collaboration with institutions and universities as part of our effort to stay on the cutting edge of the feed additive business. We work closely with major agricultural research institutions in developing new products and technologies. We believe that as the Chinese market continues to grow and mature, companies will face increasing competitive pressure both in the area of technology and talented personnel. Our partnership with institutions and universities will not only provide us with skilled human resources, but also will assist us in staying on the cutting edge of the industry. Currently, the majority of our research partners are located in the Guangdong Province, but we intend to establish similar cooperative relationships with schools in other regions as well as internationally.
Strengthen international sales.
We plan to increase our attendance at industry exhibitions worldwide to market our products to a broader market of potential customers. In our experience, participating in these exhibitions is an effective way to introduce our products overseas and develop new customers. We launched a new English only website to introduce our company and products to potential customers outside of China and we plan to establish key distributorships in Central and South America, Eastern Europe, and Southeast Asia. Obtaining FAMI-QS certification opened up more opportunities to market our products in the international arena.
Competitive Strengths
We believe that the following competitive strengths have contributed to our current market position and will enable us to capitalize on the growth opportunities in the feed additive market in China:
We have a leading market position in the organic trace mineral market.
We are the largest provider and producer of organic trace minerals in China with production capacity of 350 metric tons per week. We acquired land use rights in Qingyuan, Guangdong province, to build a second manufacturing facility, a project we expect to be finished and testing begun by end of 2013. As this facility become fully operational in the first half of 2014, we expect to more than double our production capacity of organic trace minerals.
We offer a diversified product portfolio.
Following the introduction of Guangzhou Tanke’s first flavor enhancer into the market in 1997, we have introduced a broad product portfolio, including organic trace mineral, functional regulation additives, herbal medicinal additives, and water soluble electrolyte additives. Within each of these segments, we produce a diverse array of products.
We have strong research and development capabilities.
We have made significant investments in research and development. We focus our research and development efforts on creating new products with large potential markets and on improving existing technologies, both with a view towards increasing market share and growing the business.
We are in compliance with standard manufacturing guidelines for our industry.
We have an ISO 9001/2000 International Quality Management System Certificate for our operations management system and Good Manufacturing Practice (GMP) for our manufacturer compliance for animal drugs, certifying our commitment to the integrity of our products. The World Health Organization (WHO) initiated the GMP system in the 1960s, and China adopted it in the early 1980s. GMP guidelines define standards for the pharmaceutical manufacturing process to reduce the possibility of contamination errors. Companies that fail to meet GMP specifications will be restricted or banned from production. Most recently at the beginning of 2013, we obtained the certification of FAMI-QS, an international certifiable code specifically aimed at specialty feed ingredients and their mixtures (feed additives, functional feed ingredients, premixtures, specialty complementary feed, specialty complementary dietetic feed) for animal nutrition.
Our management team has extensive knowledge of, and experience in, the feed additive industry.
Our management team, led by Guixiong Qiu, Guangzhou Tanke’s founder and the Company’s Chief Executive Officer, match their academic backgrounds in agriculture and chemistry with extensive knowledge of the feed additive industry in China and a proven track record of developing and marketing quality feed additive products.
Products and Services
We currently market 26 different brands of feed additives at various price points to meet the demands of existing and prospective customers. Within each brand there are seven different mixes that correspond to the different growth stages of an animal’s life cycle. Our business focuses on four key business areas: organic trace minerals additives, functional regulation additives, herbal medicinal additives and other.
Organic Trace Mineral Additives
We are China’s largest domestic provider of organic trace mineral additives, specializing in the development and production of chelated organic trace minerals additives. Our current trace mineral manufacturing facility is the largest chelating facility in China and has the capacity to produce approximately 350 metric tons of organic trace mineral per week.
Our total revenue for organic trace minerals in 2012 was approximately $24.6 million. Such revenue accounted for approximately 86% of our 2012 revenues and carried a gross profit margin of approximately 36%.
Minerals play an important role in the growth and development of fish, livestock, pigs and cattle and are routinely used by breeders to supplement their animals’ diets. Animals require two classes of minerals: major minerals, which include sodium, potassium, chloride, calcium, magnesium, phosphorus, and sulfur, and trace minerals, which include copper, iron, manganese, molybdenum, zinc, chromium, fluorine, selenium and silicon. Major and trace minerals are differentiated primarily by the amount of a particular mineral that an animal requires. Animals require a minimum of 100 milligrams per day of the major minerals to carry out normal bodily functions and less than 100 milligrams per day of trace minerals.
While major minerals are typically present in most feed products provided to animals, Chinese farmers and ranchers are placing an increasing emphasis on the consumption of trace minerals, which help the animal’s body perform its daily routines more efficiently.
Trace minerals are widely available as feed additives in two main forms: organic and inorganic. Although both forms are commonly used, important differences exist in their bioavailability and environmental impact. Bioavailability means the degree or rate at which a nutrient of medication is absorbed and becomes available to the body. Organic trace minerals increase bioavailability, reducing feed costs and minimizing nutrient buildup in the soil. Environmentally, new restrictions are likely to be imposed on producers to reduce nutrient excretion, making the Company’s organic feed additives more appealing to breeders. The Company’s products are more appealing because they achieve similar production results to inorganic feed additives while requiring smaller amounts of trace materials.
Our organic trace minerals are marketed primarily in, but also outside of China, to large scale feed producers and farmers under the brand name “Qili”. Our principle organic trace minerals products are:
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Iron glycine chelate (G/Fe-140);
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Iron glycine chelate (G/Fe-185);
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Zinc glycine chelate (G/Zn-220);
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Manganese glycine chelate (G/Mn-220);
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Copper glycine chelate (G/Cu-210);
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Chromium glycine chelate (G/Cr-001);
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Iron methionine chelate (M/Fe-155);
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Zinc methionline chelate (M/Zn-190);
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Manganese methionine chelate (M/Mn-155);
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Copper methionine chelate (M/Cr-001);
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Zinc lysine chelate (L/Zn-105);
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Zinc lysine chelate (L/Zn-145); and
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Copper lysine chelates (L/Cu-100).
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According to a certificate report issued by Guangdong Feed Industry Association dated April 28, 2011, Qili products provide the essential minerals (zinc, copper, manganese and chromium) and lysine, which is an amino acid essential to a nutritious livestock feed program. Such products provide nutritional balance for the animals in order for them to have a healthier life. Qili products also help animals absorb these essential minerals and lysine in order to slow the process by which nutrients pass through the animal.
We also produce and market multiple trace mineral premix products for livestock and poultry under the trademark “Qilimix,” which has been particularly successful in foreign markets. These products contain highly bioavailable minerals and result in the lowest excretion of minerals into the environment, especially for high content copper and zinc. Qilimix products are used to improve the reproductive performance of sows and breeder poultry, the growth and reproductive performance of pigs and the quality and color of animal carcasses.
Functional Regulation Additives
We are one of the leading developers and providers of functional regulation additives in China. According to the Chinese Ministry of Agriculture, the Chinese market for functional feed additives in 2009, including feed acidifiers and flavor enhancers, was $328 million. Our total revenues and net sales of functional feed additives in 2011 and 2012 were approximately $4.2 million and approximately $3.1 million, respectively, accounting for approximately 1% of China’s total production.
Sales from functional regulation additives represent approximately 11% of our 2012 revenues and carry a gross profit margin of approximately 33%.
Functional feed additives are widely used to enhance the properties of other feed products, improve feed efficiency and stimulate the rapid maturation of the immune system. We currently produce two types of functional regulation additives: feed acidifiers and flavor enhancers.
Feed Acidifiers
Feed acidifiers are used to prevent microbial degradation of raw materials or finished feeds and to maintain the quality of feed. We produce and market feed acidifiers under the trademark “Qilicid.” Qilicid products consist of alkaloids that stimulate acid production and lower pH levels, inhibiting the development of pathogenic bacteria in the stomach and stimulating endogenous pepsin activities in the stomach and enzyme production in the intestine.
According to a certificate report issued by Guangdong Feed Industry Association dated April 28, 2011, Qilicid products slow the passage of the feed through the animal’s intestine, allowing ample time for digestion, increasing feed intake and nutritional efficiency, reducing undesired gut microorganisms, supporting endogenous digestive enzymes and improving animal growth performance.
Flavor Enhancers
Flavor enhancers are widely used throughout the world as an important agent in the production of blended and high-grade feed to ensure animals obtain the required nutrients and to improve feed efficiency. There are two types of flavor agents: aroma agents, which impart a pleasant scent to feed and come from the roots, stems, leaves, and fruits of natural plants and from artificial compounds, and taste agents, which include sweeteners, which improve the feed’s taste and promotes continuous eating and come from flavor agents, salty agents and other flavoring materials.
All flavor enhancers are used to improve feed palatability, enhance animal appetite and stimulate saliva, gastric and pancreatic juices and other digestive juice secretion and gastrointestinal motility and ultimately feed consumption and yield from production animals.
As animals grow, their nutritional needs change, requiring corresponding changes to feed. Such feed changes often result in reduced intake by animals accustomed to the flavor of prior feed. Flavor agents can be mixed with different feeds to result in the same or similar flavor as previous feed, which help animals maintain their food intake and successfully switch to a new formula. Additionally, during periods of weaning and transportation, animals and fish normally reduce feed intake. Adding a flavor agent to blended feed can help alleviate stress and unease, increasing feed consumption and ensuring that an animal obtains the nutrients it requires.
We produce and sell the following (non-sugar) natural sweeteners, feed flavor enhancers, and attractants for use with feed for pigs, piglets, fish and other aquatic animals under the trademark “Tankeball™” Functional Flavoring Series:
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Tanksweet ST (a mixed sweetener designed to improve the palatability and acceptability of all pig feed);
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Tankarom ST (a feed flavor enhancer and functional physiological regulator that assists animals in overcoming the negative effects of weaning, stress, disease, medications or mal-flavored feedstuffs);
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Tankmix SA (a co-mixed product with sweetener and flavoring that makes feed more attractive);
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Tankebaal sweet (a mixed sweetener to improve the palatability and acceptability of all pig feed);
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Tankarom (a functional physiological regulator);
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Fishy Spicy (an aroma agent added to fishmeal to enhance fishy taste, cover-up mal-flavors in feeds and improve the palatability of feed products);
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Aquatic Lives’ Attractants (consisting of concentrated extracts from natural seafood and high efficient attractants rich in amino acids that improve the feed intake of fish); and
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Kimyso™ (a micro-granulated solid dispersion Kitasamycin premix).
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Herbal Medicinal Additives
We have placed an emphasis on developing and promoting herbal medicinal additives blended with feed products in China. Herbal feed additives utilize traditional Chinese medicine theory to improve an animal’s digestion and appetite and to regulate the yin and yang balance of an animal’s health.
Herbal medicines come from plants, plant extracts, fungal and bee products, minerals, shells and certain animal parts. Compared to synthetic antibiotics or inorganic chemicals, these naturally-derived products are less toxic, residue free and thought to be ideal feed additives for animal consumption. Herbal Medicinal Additives represent approximately 1% of our 2012 revenues and net sales and carry a gross profit margin of approximately 8%.
We produce and sell the following trademarked products in the Herbal Medicinal Additives sector, all of which are derived from Chinese natural plants, herbs and minerals:
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Extra-Health™ (improves animal immune system and functions);
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Qilimix™ (a natural feed additive for livestock and poultry designed to improve the reproductive and growth performance of farm animals); and
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Recoccider™ (a highly efficient anticoccidial premix containing Ethopabate and Diclazuril designed to inhibit DHSS and DHRS).
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Our total revenue for Herbal Medicinal Additives in 2012 was approximately $293,454.
Other Revenues
The Company and its subsidiaries have received numerous awards from industry associations, including the National Innovative and Outstanding Enterprises of Feed Additive Industry award and a Certificate of Honor, from the China Feed Industry Association, and various local and national government agencies, including the National Award Certificate of Advanced Science and Technology, from the Chinese State Department and a Certificate of National Torch Program from the Torch High Technology Industry Development Center of Ministry of Sciences and Technology, in recognition for the products and processes it has developed over the years and, as a result, is considered a well-respected company in its field.
We also engage in various businesses including the domestic distribution of raw materials and providing technical support and know-how to our customers. As one of the leading producers and distributors of feed additives in China, we are able to engage in certain distribution activities to other Chinese companies. In connection with this, we purchase raw materials from certain manufacturers and sell such materials domestically to other feed additive manufacturers. We are able to purchase raw material at a relatively lower price. Subsequently, we sell those raw materials to other customers at a premium.
Our total revenue for Other Revenue in 2012 was approximately $623,327. Such revenue accounted for approximately 2% of our total 2012 revenue, and carried a gross profit margin of approximately 6.8%.
Marketing
The majority of our marketing in China is conducted through sales visits to feed producers, farmers and other potential customers. During these sales meetings, the Company’s sales team distributes marketing materials and shares its extensive knowledge on husbandry and cultivation of farm animals.
As part of our marketing effort, every two years, we co-sponsor the Chinese Academy’s international seminar on Animal Health Products and Feed Additives, inviting speakers and participants who are academic professionals, industry experts or key managers in the agriculture business. The seminar is designed to introduce recent developments and trends in the feed additive business and to provide a platform for increasing awareness of our products. Since beginning the seminar in 2002, it has become one of the important events in the industry and typically attracts more than five hundred professionals.
Outside of China, we market our products mainly through participation in industry exhibitions.
Sales and Distribution
Our target customers are mid-to-large sized feed product factories and large scale producers. These customers have substantial bargaining power and require the feed additive products that they use to meet the highest standards of quality, productivity and efficiency, which we believe gives us a competitive advantage over our smaller competitors. In 2012, we established a separate sales and marketing division to target the “end-user” market segment, selling our products to the largest animal farms and through distributers to mid and smaller size animal farms. In total, we employ 43 sales and marketing employees, including 21 in regional sales, 5 in distribution, 4 in the aquatic group, 4 in international sales, 3 in marketing and 6 in technical support.
As of December 31, 2012, we had no customer that accounted for more than ten percent of our consolidated revenues. For the year 2012, sales to our top 10 customers accounted for approximately 46% of our revenue and for the year 2011, sales to our top 10 customers accounted for approximately 59% of our revenue. The following table identifies customers that purchased more than 5% of our products during the years ended December 31, 2012 and 2011:
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% of Consolidated
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% of Consolidated
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Customers
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Revenue in 2012
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Customers
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Revenue in 2011
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Guangzhou Tienhe Lianhua
Agriculture Technology Co., Ltd.
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8.8%
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Guangzhou Tienhe Lianhua
Agriculture Technology Co., Ltd.
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14.0%
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Jin Yin Ke Bio-Tech Co., Ltd.
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8.6%
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Jin Yin Ke Bio-Tech Co., Ltd.
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12.0%
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Nanning Baihe Bio-Tech Co., Ltd.
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6.3%
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Guangzhou Hai Hong Chuang
Aquaculture Co., Ltd.
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6.1%
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Weifeng Zhong Ji Feed Co., Ltd.
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6.0%
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Henan Guangan Bio-Tech Co., Ltd.
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5.5%
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We sell our products throughout China with a combination of our internal sales teams and a network of distributors in 28 regions, including Guangdong, Sichuan, Shandong and Liaoning provinces, which have significant animal breeding industries.
Presently, about 80% of our sales are generated through our internal sales force, with the remaining 20% via our agents. The Company currently has sales offices in the cities of Shengyang, Chengdu, Xiameng, Xi’an, Nanning and Zhengjiang.
Our products are sold in Xinjiang, Gansu, Neimeriggu, Sichuan, Yunnan, Guanxi, Haihan, Guizhou, Chongqing, Shanxi, Henan, Hubei, Hunan, Guangdong, Fujian, Jiangxi, Anhui, Jiangsu, Shanghai, Shandong, Tianjin, Beijing, Liaoning, Jilin and Heilongjiang provinces.
While the vast majority of our sales are domestic, an aggregate of approximately 1.6% of our sales are to customers in Thailand, Vietnam, Cambodia, South Korea, The Philippines, Uruguay, Taiwan, Pakistan, Malaysia, Turkey, and Hungary.
Customer Service
Our service and support infrastructure quickly and efficiently provides clients with customized products, technical support and advice. We assign our technicians to prospective customers to conduct a thorough analysis of the customer’s needs, followed by a detailed customized product manual. While the manuals vary according to the specific product, they typically include a product introduction that includes nutrition facts, a user guide, expiration dates and storage and packaging information, among other things. For the large-scale farmer or feed producer, our team also provides training courses to help our customers understand our products and how to use them most effectively.
Upon the delivery of our products to new customers, we provide after-sales support, which not only serves to resolve any technical issues, but also helps identify other opportunities for increasing business with current customers. We utilize a multi-tiered product strategy pursuant to which we tailor our products to the needs and preferences of the feed market.
Raw Materials and Suppliers
The raw materials for our products include agricultural commodities and fine powders like amino acid, organic trace minerals and organic acid. Although most of our principal raw materials are widely available in China, the price for certain raw materials can fluctuate. We have adopted measures to reduce our risks in both raw material supply costs and availability, including establishing long-term relationships with suppliers and diversifying supply sources. We also enter into supply agreements with key vendors and prepay a year’s worth of purchases to lock in prices.
To assure the consistency of our raw material supplies, we source most of our materials from mid-to large size companies. Before making any purchase with a new vendor, we evaluate the vendor’s products and attempt to select the most reliable and reputable vendor. We regularly conduct similar evaluations throughout our purchasing process to ensure that we are purchasing high quality raw materials at competitive prices. Because we source our raw materials from several vendors, we are not dependent on any particular vendor or merchant as a sole provider for our raw materials.
Our top ten suppliers provide approximately 70% of our total raw material purchases in 2012 and 73% in 2011. The following table identifies suppliers that provide more than 5% of our raw materials during the years ended December 31, 2012 and 2011:
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Suppliers
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% Supplied in 2012
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Suppliers
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% Supplied in 2011
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Zhengzhou Tuoyang Industrial Co.,
Ltd.
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16.1%
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Guangzhou Tienhe Lianhua Agriculture Technology Co., Ltd.
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23.0%
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Shijiazhuang Gu Qiao Chemical
Engineering Co., Ltd.
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15.2%
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Shijiazhuang Gu Qiao Chemical
Engineering Co., Ltd.
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10.0%
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Guangzhou Tienhe Lianhua
Agriculture Technology Co., Ltd.
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14.5%
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Guangzhou Zhongxin Specialty Feed
Co., Ltd.
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10.2%
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Shijiazhuang Donghua Jinlong
Chemical Engineering Co., Ltd.
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5.8%
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Research and Development
We are strongly committed to the development of new products and processes and the enhancement of our existing products and technology. We conduct research and development and acquire new technologies through our in-house research team in collaboration with various universities and research institutions and through technology acquisitions from third parties. We plan to achieve the status of State-Level Enterprise Technical Center. This is a highly prestigious status recognized by the National Development and Reform Commission, Ministry of Science and Technology, Ministry of Finance, General Administration of Customs, and State Administration of Taxation of only a few Chinese enterprises after they possess certain minimum requirements of assets, sales, credit rating, R&D structure and spending, scientific and technical resources, plus having developed a number of industry standards, published research papers, obtained a number of famous trademarks and patents, and commercialized a number of valuable new products. Achieving this honor will entitle the Company to many preferential policies plus allow us to attract more technical talents, be more competitive in the industry, and receive more projects and grants from the government.
Our in-house development team consists of seven PhD’s and forty-eight researchers of which 80% have college degrees and nineteen hold graduate degrees. This team is responsible for developing new products and responding to customer needs. Spending on research and development was $290,833 and $246,038 in 2012 and 2011, respectively. Such figures were net of government grants we received from working on government sponsor R&D projects. Gross spending on R&D in 2012 was over $1.2 million before subtracting the credit from government grants. Our in-house team has contributed to the establishment of four national standards for feed additives, has applications pending for twelve Chinese patents covering synthetic methods for manufacturing additives and holds three Chinese patents covering new products, methodologies and machines used to mix and dry feed additives. We believe that our participation in the development of national standards provides us with an insight into Chinese regulators’ focus and a competitive advantage versus our competitors. We do not receive any compensation or sponsorship from customers for our research and development activities.
To further expand our development platform, we have entered into development agreements with several universities and research institutions, including the Institute of Subtropical Agro-ecology of the Chinese Academy of Sciences, Guangdong University of Technology, Zhongkai Institute of Agriculture Engineering, Northeast Agriculture University and Southeast Agriculture University. These cooperative ventures are conducted under agreements that grant us the exclusive right to commercially exploit these new processes and procedures in exchange for licensing fees to the research partner. Besides partnering with Chinese universities and research institutes on developing new technology, we are actively seeking to develop relationship with top agricultural researchers in the U.S. and other countries. Our goal is to find the best and most advanced technology and apply it into developing new products.
Manufacturing
We operate from a modern 34,000 square-meter manufacturing facility in the Huadu Economic District, in Guangdong province. As of December 31, 2012, we had an aggregate production capacity of approximately 560 metric tons on average per week of feed additive, of which 350 metric tons are organic trace minerals. We estimate that we are currently operating at a blended average across our product lines of approximately 63% of our manufacturing capacity at our current facility. We expect our manufacturing output to increase in 2013 and beyond, and are constructing a second facility, which is currently scheduled to be completed in the fourth quarter of 2013 and fully operational in the first half of 2014. This second facility is being built at the economic and industrial development zone in Qingyuan where the Company has acquired a Land Use Agreement from the local government. This particular area is designated specifically for the purpose of building manufacturing factories of this kind and we are one of the new occupants among many other similar manufacturers. There is no land use right issue at this facility.
In 2003, Guangzhou Tanke entered into a Land Lease Agreement valid from May 20, 2006 until May 20, 2021 with the government of Huaqiao Town, Huadu District, Guangzhou under which the Government of Huaqiao town granted Guangzhou Tanke a land use right covering the land where Guangzhou Tanke’s manufacturing facility currently stands. This agreement will be superseded by a Land Use Right Certificate and will be automatically terminated once the Company obtains such certificate. We are currently negotiating with the local government to obtain such certificate, which would permit us to operate our business as it is currently conducted. If the Company is not able to obtain a Land Use Right Certificate, the PRC government may declare the Land Lease Agreement invalid, evict the Company’s personnel from the premises and remove the Company’s manufacturing facilities. However we have the full support of the Huadu government officials in obtaining this certificate and we anticipate that it will be granted within 2013.
Intellectual Property
As a result of our extensive research and development, we own valuable patents, trademarks and licenses and regard our intellectual property as a major component of our competitive strategy. Our granted patents include:
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A Chinese utility model patent (ZL200620154038.5) the Company owns for a mixed drier of feed additives. The patent was issued in November 2007 and will expire on March 2017.
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A Chinese patent (ZL200710030121.0), that the Company jointly owns with the Guangdong University of Technology for the methodology of preparation of copper and zinc glycine complexes by ball milling and solid-static doping. The patent was issued in July 2010 and will expire in July 2030.
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A Chinese patent (ZL200810198628.1), that the Company owns for a method of detecting and determining the rate of chelation in amino acid trace mineral chelation. The patent was issued in 2011.
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We have twelve pending Chinese patent applications that were developed either through our in-house research team or in collaboration with various Chinese research institutions or universities. Two of our patent applications were submitted in 2008, three were submitted in 2010, and seven were submitted in 2012. Based on our experience and the advice we received from Chinese counsel, there is a two to three year period prior to the receipt of a patent approval. We expect that these twelve applications, without any delay due to any dispute and/or other causes, will be granted within 2013 and 2014.
In 2012, we acquired from an agricultural research institute the fully commercial-ready technology, the validated manufacturing process, and the right to two pending patent of a new antioxidant production technology for animal feed additives. We began utilizing this new process in the third quarter of 2012 and sales of antioxidant increased substantially during the second half of 2012.
On June 17, 2008, Tanke Bio-Tech entered into an exclusive Licensing Agreement with the Institute of Subtropical Agro-ecology of the Chinese Academy of Sciences (the “Institute”), whereby the Institute granted Tanke Bio-Tech an exclusive license for the use of (a) Chinese Patent ZL200410013212.X which governs the methodology to extract metal sulfur protein from pork liver and (b) Chinese Patent ZL200510120505.2 which is a formula and methodology to enhance the immune system of piglets. Tanke Bio-Tech agreed to pay the Institute an aggregate amount of RMB 6.6 million for the exclusive use of the two patents. The term of the exclusive license for the patents is from January 1, 2008 to December 30, 2012 unless earlier terminated by Tanke Bio-Tech pursuant to the terms of the agreement. This licensing agreement was extended for another year through the end of 2013. The related cost has been expensed as incurred.
In 2011, the company trademark “Tanke” was recognized by the City of Guangzhou as “Famous Trademark”. We have also registered seven trademarks with the Trademark Office of the State Administration for Industry and Commerce of China, including “Tanke”, “Qilimix,” “Qili” and “CTanke”.
Seasonality
Although our business is not significantly affected by seasonality, demand for our products tends to be lower from January to April because large amount of animals raised by husbandry farms are sold during the Chinese New Year in February. The demand for our products will peak from May to September, due to the high growth summer season of animal farming. Then in the fall season, many feed manufactures will complete stocking by December before the Chinese New Year.
Quality Control
Following quality control breakdowns from isolated Chinese manufacturers in the past several years and the resultant negative publicity, we have placed a strong emphasis on maintaining the quality and integrity of our products. To that end, the Company’s internal quality controls are implemented in accordance with the requirements of ISO 9001/2000. The Company has also received the ISO 9001/2000 International Quality Management System and HACCP management system certificates and the GMP certification for an animal drug production line. In February 2013, we completed the certification process of FAMI-QS, the international quality standard for specialty feed ingredients and their mixtures (feed additives, functional feed ingredients, premixtures, specialty complementary feed, specialty complementary dietetic feed) for animal nutrition. The FAMI-QS certificate was officially issued on March 1, 2013.
Our quality control center reviews the quality of the factors involved in production of our products, including the examination of raw material, product testing and sampling. Our laboratory maintains samples of each of our delivered products in the event of customer issues or a regulatory review.
Government Regulation
Our domestic business activities are regulated by various governmental agencies in China and Guangdong province and our foreign sales are subject to similar requirements in the countries in which the Company does business. These laws govern current operations and product safety and may require remediation of environmental incidents.
Regulations of PRC Feed Additive Industry
The animal feed additive market in China is managed under a legal system that includes registration, permits, supervision and inspection. The major regulations applying to feed additive industry in China include (i) the Regulation on Administration of Feed and Feed Additive; (ii) the Administrative Measure on Approval Reference Number of Feed Additive and Additive Premixed Feed; (iii) the Administrative Measure on Production License of Feed Additive and Additive Premixed Feed; and (iv) the Administrative Measure on New Feed and New Feed Additive. The Ministry of Agriculture of China also promulgates various notices and rules regulating the feed and feed additive industry from time to time.
Tanke Bio-Tech, a subsidiary of Guangzhou Tanke that we control via the VIE agreements, currently holds the Inspection and Quarantine Registration Certificate for Enterprise of Production, Processing and Storage of Feed for Export, Feed Additive Production License, Premixed Additive Feed Production Certificate and Food Safety Management System Certification. Jenyi Bio-Tech, a subsidiary of Guangzhou Tanke that we control via the VIE agreements, currently holds Certificate for Compliance for Company of Feed Production, the Feed Additive Production License and Additive Premixed Feed Production License. Tanke Animal Health, a subsidiary of Guangzhou Tanke that we control via the VIE agreements, currently holds Veterinary Medicine Production Certificate and Veterinary Medicine GMP Certificate. We believe that we are in compliance with PRC environmental and agricultural laws and regulations.
Feed Additive Industry
The feed additive industry in China falls within the encouraged category for foreign investment in accordance with the Catalogue of Industries for Guiding Foreign Investment. As a result of this designation companies in the feed additive industry, including Guangzhou Tanke and its subsidiaries, qualify for certain tax incentives and VAT exemptions.
Environmental Laws and Regulations
As required under the PRC Environmental Laws and Regulations, we have obtained an Opinion on the Environmental Impact Statement issued by the Environmental Protection Bureau of Huadu District on February 16, 2004, approving the construction of our manufacturing site. Since we have neither obtained the Land Use Right Certificate of the manufacturing site nor the Property Ownership Certificate, we are unable to apply for the examination and acceptance of environmental appraisal. Since this delay to obtain environmental approval was caused by the change of zoning regulations, the environmental bureau of Guangdong Province issued us the waste disposal permit on March 2, 2011 valid from March 2011 to March 30, 2014. The relevant procedures for environmental protection will be completed along with the settlement of the land issue. As long as we obtain the environmental permit, our business will continue. However, if we lose such permit, the applicable PRC government may require us to discontinue our operating business. The actual cost for environmental law compliance will vary depending upon the nature and quantity of the waste generated along with the daily production of the products. The Company estimates its expenditures for waste disposal is approximately $7,692/year.
Foreign Exchange Regulations
We receive substantially all of our revenues in Chinese Renminbi, which is currently not a freely convertible currency. In China, SAFE regulates the conversion of Chinese Renminbi into foreign currencies. Pursuant to applicable Chinese laws and regulations, foreign invested enterprises incorporated in China are required to apply for “Foreign Exchange Registration Certificates.” Currently, conversion within the scope of the “current account” (e.g. remittance of foreign currencies for payment of dividends, trade and service-related foreign exchange transactions, etc.) can be effected without requiring the approval of SAFE, instead, need to be registered with the SAFE. However, conversion of currency in the “capital account” (e.g. for capital items such as direct investments, loans, securities, etc.) still requires the approval of SAFE. On July 21, 2005, the Chinese government changed its policy of pegging the value of Chinese Renminbi to the U.S. dollar. Under the new policy, Chinese Renminbi may fluctuate within a narrow and managed band against a basket of certain foreign currencies. It is possible that the Chinese government could adopt a more flexible currency policy, which could result in more significant fluctuation of Chinese Renminbi against the U.S. dollar.
PRC M&A Rule, Circular 75 and Circular 638
On August 8, 2006, six Chinese government agencies, namely, the Ministry of Commerce, or MOFCOM, the State Administration for Industry and Commerce, or SAIC, the China Securities Regulatory Commission, or CSRC, the State Administration of Foreign Exchange, or SAFE, the State Assets Supervision and Administration Commission, or SASAC, and the State Administration for Taxation, or SAT, jointly issued the Regulations on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors, referred to as the “New M&A Rules”, which became effective on September 8, 2006. The New M&A Rules purport, among other things, to require offshore “special purpose vehicles,” that are (1) formed for the purpose of overseas listing of the equity interests of Chinese companies via acquisition and (2) are controlled directly or indirectly by Chinese companies and/or Chinese individuals, to obtain the approval of the CSRC prior to the listing and trading of their securities on overseas stock exchanges. Based on our understanding of current Chinese Laws and pursuant to a legal opinion, dated January 4, 2011, that we received from Martin Hu and Partners, (i) Kanghui Agricultural was incorporated by a foreign investor and was not deemed to be an acquisition of the equity or assets of a “Chinese domestic company” as such term is defined under the New M&A Rules and (ii) no provision in the New M&A Rules clearly classifies the contractual arrangements between Kanghui Agricultural and Guangzhou Tanke as a type of transaction falling within the New M&A Rules.
The SAFE issued a public notice in October 2005, or the Circular 75, requiring Chinese residents to register with the local SAFE branch before establishing or controlling any company outside of China for the purpose of capital financing with assets or equities of Chinese companies, referred to in the Circular 75 as special purpose vehicles, or SPVs. Chinese residents who are shareholders of SPVs established before November 1, 2005 were required to register with the local SAFE branch before June 30, 2006. Further, Chinese residents are required to file amendments to their registrations with the local SAFE branch if their SPVs undergo a material event involving changes in capital, such as changes in share capital, mergers and acquisitions, share transfers or exchanges, spin-off transactions or long-term equity or debt investments. To date, the Chinese residents who are shareholders of Guangzhou Tanke do not own any equity in the Company, currently such Chinese residents do not need to file registrations with SAFE pursuant to Circular 75. When the Chinese residents exercise their options in the future to receive any share of the Company pursuant to the Call Option Agreement, they will need to file registrations with SAFE.
If within two years of formation the applicable PRC authorities determine that Kanghui Agricultural lacks a business in the ordinary course, Kanghui Agricultural may be deemed to be a wholly foreign owned holding company and therefore the relevant PRC authority may determine that Kanghui Agricultural’s purchase of shares of Guangzhou Tanke pursuant to the Option Agreement may be subject to approvals required under the new M&A Rule. The relevant PRC authorities may further determine Tanke Shareholders’ exercise of their options to acquire shares of Common Stock of the Company pursuant to the Call Option Agreement may be subject to approvals required under the new M&A Rule. Tanke Shareholders who are Chinese residents and acquire shares of common stock may be subject to registration requirements with SAFE pursuant to Circular 75.
Pursuant to the Circular 698, where a foreign investor transfers the equity interests of a Chinese resident enterprise indirectly via disposing of the equity interests of an overseas holding company, which we refer to as an Indirect Transfer, and such overseas holding company is located in a tax jurisdiction that: (i) has an effective tax rate less than 12.5% or (ii) does not tax foreign income of its residents, the foreign investor shall report such Indirect Transfer to the competent tax authority of the Chinese resident enterprise. The Chinese tax authority will examine the true nature of the Indirect Transfer, and if the tax authority considers that the foreign investor has adopted an abusive arrangement in order to avoid Chinese tax, they will disregard the existence of the overseas holding company and re-characterize the Indirect Transfer and as a result, gains derived from such Indirect Transfer may be subject to Chinese withholding tax at the rate of up to 10%. Circular 698 also provides that, where a non-Chinese resident enterprise transfers its equity interests in a Chinese resident enterprise to its related parties at a price lower than the fair market value, the competent tax authority has the power to make a reasonable adjustment to the taxable income of the transaction.
Employees
As of March 2013, we employed 130 full-time personnel. We believe that we maintain a satisfactory and safe working environment that it has a history of low turnover. We believe that we comply in all material respects with applicable Chinese labor laws.
Item 1A. Risk Factors.
Our business, as well as our common stock, are highly speculative in nature and involve a high degree of risk. Our securities should be purchased only by persons who can afford to lose their entire investment. Accordingly, prospective investors should carefully consider, along with other matters referred to herein, the following risk factors in evaluating our business before purchasing any of our common stock.
Risks Related to Our Business
We may not possess all the licenses required to operate our business, or may fail to maintain the licenses we currently hold. This could subject us to fines and other penalties, which could have a material adverse effect on our results of operations.
We are required to hold a variety of permits, licenses and certificates to conduct our business in China and we may not possess all of the permits, licenses and certificates required for our business. We entered into a Land Lease Agreement valid from May 20, 2006 to May 20, 2021 with the government of Huaqiao Town, Huadu District, Guangzhou under which the Government of Huaqiao Town granted us a land use right covering the land where our manufacturing facility currently stands. This lease will be superseded by a Land Use Right Certificate and will be automatically terminated once we obtain such certificate. Due to changes in the relevant PRC regulations, we have not been granted such certificate for this land. Therefore, pursuant to applicable PRC law, we are not permitted to operate our manufacturing facility without such certificate and as a result, there is a risk that the PRC government may declare our Land Lease Agreement invalid.
We are currently working with the local government to obtain a Land Use Right Certificate, which would permit us to operate our business as it is currently conducted. Without the Land Use Right Certificate, we are unable to apply for a Property Ownership Certificate for our manufacturing facilities. Until we obtain the Land Use Right Certificate, the PRC government may evict our personnel from the premises and remove our manufacturing facilities that we built on the premises. Such action would have a very significant and negative impact on our operations and business.
In addition, there may be other circumstances under which the approvals, permits, licenses or certificates granted by the governmental agencies are subject to change without substantial advance notice, and it is possible that we could fail to obtain the approvals, permits, licenses or certificates that are required to expand our business as we intend. If we fail to obtain or to maintain such permits, licenses or certificates, or renewals are granted with onerous conditions, we could be subject to fines and other penalties and be limited in the number or the quality of the products that we would be able to offer. As a result, our business, result of operations and financial condition could be materially and adversely affected.
Concerns with the safety and quality of agricultural feed additive products could cause customers to avoid our products.
We could be adversely affected if our customers and the ultimate consumers of our feed additive products lose confidence in the safety and quality of various feed additive products. Adverse publicity about these types of concerns may discourage our customers from buying our products or cause production and delivery disruptions. Any negative change in customer perceptions about the safety and quality of our feed additive products could adversely affect our business and financial condition.
If our feed additive products become adulterated or misbranded, we would need to recall those items and may experience product liability claims if consumers are injured as a result.
Animal feed products occasionally contain contaminants due to inherent defects in those products or improper storage or handling. Under adverse circumstances, animal feed manufacturers may need to recall some of their products if they become adulterated or misbranded, and may also be liable if the consumption of any of their products causes injury. A widespread product recall could result in changes to one or more of our business processes, product shortages, loss of customer confidence in our products or other adverse effects on our business. If we are required to defend against a product liability claim, whether or not we are found liable under the claim, we could incur substantial costs, our reputation could suffer and our customers might substantially reduce their existing or future orders from us.
We face significant competition in the sales of our animal feed additive products.
Competition in the feed additive industry, especially with companies with greater resources, may make us unable to compete successfully, which could adversely affect our business.
In general, the competitive factors in the feed additive industry in China include:
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price;
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product quality;
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brand identification;
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breadth of product line; and
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customer service.
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To the extent that our products and services do not exhibit these qualities, our ability to compete will be hindered.
The markets in which we operate are highly competitive and fragmented and we may not be able to maintain market share.
We operate in highly competitive markets and compete with numerous local Chinese feed additive manufacturers. We expect competition to persist and intensify in the future. Our domestic competitors are mainly leaders in the feed additive markets in China. Our small local competitors may have better access in certain local markets to customers and prospects, an enhanced ability to customize products to a particular region or locality and more established local distribution channels within a small region. We also compete with large Chinese national and multi-national competitors who may have competitive advantages over us in certain areas such as access to capital, technology, product quality, economies of scale and brand recognition and may also be better positioned than us to develop superior product features and technological innovations and to exploit and adapt to market trends. Due to the lack of publicly available information about our competitors and industry, we may not be able to conduct in-depth research and analysis on our current or new markets. Therefore, we may not be able to determine our direct competitors, such competitors' revenues or market share.
In addition, China’s entry into the World Trade Organization may lead to increased foreign competition for us. International producers and traders import products into China that generally are of higher quality than those produced in the local Chinese market. We may face additional competition if these products are considered to be better than the type of feed additives we produce. If we are not successful in our marketing and advertising efforts to increase awareness of our brands, our revenues could decline, which could have a material adverse effect on our business, financial condition, results of operations and share price. We may not be able to compete successfully against existing or new competition in our markets.
We may not be able to fully implement our current business strategy if we are unable to acquire and develop a second manufacturing facility.
As part of our current business strategy, we intend to continue to increase our production volume in order to gain additional market share. In connection with that strategy, we plan to build a second manufacturing facility that would double our organic trace mineral production capacity. Though remote, there is a risk that we may be unable to acquire the land use rights for this facility or to commence or finish construction of the new facility, or operate it at a profit. If we are unable to achieve any or all of the foregoing it could have a material adverse effect on our business and results of operations.
We cannot be certain that our feed additive product innovations and marketing achievements to date will continue.
We believe that our past performance has been based on, and our future prospects will depend upon, in large part, our ability to continue to improve our existing feed additive products or develop new feed products. We may not be successful in introducing, marketing and producing any new feed products or feed additive product innovations, or that we will develop and introduce, in a timely manner, innovations to our existing products which satisfy customer needs or achieve market acceptance. Our failure to develop new feed additive products and introduce them successfully and in a timely manner could harm our ability to grow our business and could have a material adverse effect on our business, results of operations and financial condition.
We purchase many commodities that we use for raw materials and packaging; price changes for such commodities may adversely affect our profitability.
The raw materials used in our feed additive business are largely commodities that experience price fluctuations caused by external conditions and changes in governmental agricultural programs that we cannot control. As a result, we try to recover our commodity cost increases by increasing prices, promoting a higher-margin product mix and creating additional operating efficiencies. Substantial increases in the prices of packaging materials, such as corrugated cardboard, aluminum products, films and plastics, or higher prices of our raw materials could adversely affect our operating performance and financial results. Any substantial fluctuation in the prices of raw materials, if not offset by increases in our sales prices, could adversely affect our profitability.
Outbreaks of livestock disease can adversely affect sales of our products.
Outbreaks of livestock diseases can significantly affect demand for our feed additive products and could result in governmental restrictions on the sale of livestock products to or from customers, or require our customers to destroy their feeds. This could result in the cancellation of orders of feed additive products by our customers and create adverse publicity that may have a material adverse effect on the agricultural products industry and our ability to market our products successfully.
We do not typically have long-term sales contracts with our customers and our customers could at any time reduce purchases of, or entirely cease purchasing, our products, harming our operating results and business.
We typically do not have long-term volume sales contracts with our customers. Accordingly, our customers could reduce their purchases from us or cease purchasing our products altogether when a particular contract expires. A variety of factors, including economic, health, regulatory, political and social instability, could contribute to a slowdown in the demand or a reduction in the market price for our products because poultry demand and pricing is highly correlated with general economic activities. If any of our customers experience serious financial difficulties, it may lead to a decline in sales and write-offs of accounts receivable, which could harm our results of operations.
The cessation of tax exemptions and deductions by the Chinese government may affect our profitability.
On March 16, 2007, the National People’s Congress of China enacted a new tax law, or the New Tax Law, whereby both foreign investment enterprises, or FIEs, and domestic companies will be subject to a uniform income tax rate of 25%. On November 28 2007
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the State Council of China promulgated the Implementation Rules of the New Tax Law, the “Implementation Rules”. Both the New Tax Law and the Implementation Rules have become effective on January 1, 2008. Both the New Tax Law and the Implementation Rules provide tax exemption treatment for enterprises engaged in agricultural industries, such as farming, foresting, fishing and animal husbandry. We have been informed that certain of our Chinese subsidiaries are eligible for relevant preferential tax treatment, including tax reduction and exemption, and certain of our products are exempt from value added tax. In the future, if the relevant tax authorities determine that Guangzhou Tanke, our principal operating business, is not eligible for tax exemption treatment it may materially and adversely affect our profits, business and financial performance.
Potential environmental liability could have a material adverse effect on our operations and financial condition.
As a manufacturer, we are subject to various Chinese environmental laws and regulations on air emission, waste water discharge, solid wastes and noise. The Environmental Protection Bureau of Huadu District, Guangzhou issued the Opinion on the Environmental Impact Statement regarding the Construction Project of Tanke Group on February 16, 2004. To date, we have not obtained any documentation of environment appraisal and acceptance inspection with respect to the completion of projects of the factory buildings and the production lines, because we have not obtained a Land Use Right Certificate for such site nor have we been granted Property Ownership Certificate. We are in the process of applying for a Land Use Right Certificate, which will enable us to obtain an environmental appraisal and acceptance inspection with respect to our facilities. Following our receipt of a Land Use Right Certificate, we anticipate that we will be able to obtain the necessary environmental approvals, but there can be no assurance in this regard. We may not be able to comply with environmental regulations at all times as the Chinese environmental legal regime is evolving and becoming more stringent. Therefore, if the Chinese government imposes more stringent regulations in future, we may have to incur additional and potentially substantial costs and expenses in order to comply with new regulations, which may negatively affect our results of operations. Furthermore, no assurance can be given that all potential environmental liabilities have been identified or properly quantified or that any prior owner, operator, or tenant has not created an environmental condition unknown to us. If we fail to obtain our Land Use Right Certificate or to comply with any of the present or future environmental regulations in any material aspects, we may suffer from negative publicity and be subject to claims for damages that may require us to pay substantial fines or have our operations suspended or even be forced to cease operations.
We do not presently maintain business disruption insurance and any disruption of the operations in our production facility would damage our business.
All of our feed additive products are currently manufactured in our production facility in the Huadu Economic Development Zone near the capital city of Guangzhou in the province of Guangdong, China. Our operations could be interrupted by fire, flood, earthquake and other events beyond our control. Any disruption of the operations in our production facility would have a significant negative impact on our ability to manufacture and deliver products as we would likely be unable to outsource our production on terms favorable to us, if at all. Failure to replace any lost production capability would cause a potential reduction in sales, the cancellation of orders, loss of valuable employees, damage to our reputation and potential lawsuits.
Our products and processes can expose us to product liability claims.
Product liability claims or product recalls can adversely affect our business reputation and expose us to increased scrutiny by local, provincial, and central governmental regulators. The packaging, marketing and distribution of agricultural feed additive products entail an inherent risk of product liability and product recall and the resultant adverse publicity. We may be subject to significant liability if the consumption of any of our products causes injury, illness or death of livestock, other animals or humans. We could be required to recall certain of our feed additive products in the event of contamination or damage to the products. In addition to the risks of product liability or product recall due to deficiencies caused by our production or processing operations, we may encounter the same risks if any third party tampers with our feed additive products. We may be required to perform product recalls, or that product liability claims will be asserted against us in the future. Any claims that may be made may create adverse publicity that would have a material adverse effect on our ability to market our feed additive products successfully or on our business, reputation, prospects, financial condition and results of operations. A successful product liability claim in excess of our insurance coverage could have a material adverse effect on us and could prevent us from obtaining adequate product liability insurance in the future on commercially reasonable terms.
Our current and future operations substantially depend on our management team and other key personnel, the loss of any of whom could disrupt our business operations.
Our business does and will depend in substantial part on the continued service of our senior management and founder, including but not limited to Guixiong Qiu, Xugang Shu and Bo Jun. The loss of the services of one or more of our key personnel could impede implementation and execution of our business strategy and result in the failure to reach our goals. We do not carry key person life insurance for any of our officers or employees. Our future success will also depend on the continued ability to attract, retain and motivate highly qualified personnel in the diverse areas required for continuing our operations. The rapid growth of the economy in China has caused intense competition for qualified personnel. We may not be able to retain our key personnel or that we will be able to attract, train or retain qualified personnel in the future.
Volatile energy prices could adversely affect our operating results.
In the last few years, energy prices have risen dramatically and are now volatile, which has resulted in increased and unpredictable increases for our raw materials costs. Continued or volatile increases in energy prices could adversely affect demand for our feed products and increase our operating costs, both of which would reduce our operating income.
If we need additional financing, we may not be able to find such financing on satisfactory terms or at all. The cost of obtaining additional financing may adversely affect our stockholders or the financial interests of the Company.
Our capital requirements may be accelerated as a result of many factors, including the growth and timing of our business development activities, budget shortfalls, unanticipated expenses or capital expenditures, future product opportunities, future licensing opportunities and future business combinations. Consequently, we may need to seek additional debt or equity financing, which may not be available on favorable terms, if at all, and which may be dilutive to our stockholders.
We may seek to raise additional capital through public or private equity offerings, debt financings or additional corporate collaboration and licensing arrangements. To the extent we raise additional capital by issuing equity securities, our stockholders may experience dilution. To the extent that we raise additional capital by issuing debt securities, we may incur substantial interest obligations, may be required to pledge assets as security for the debt and may be constrained by restrictive financial and/or operational covenants. Any provider of debt financing would also be superior position to our stockholders’ interest in the event of a bankruptcy or liquidation. To the extent we raise additional funds through collaboration and licensing arrangements, it may be necessary to relinquish some rights to our technologies or product candidates, or grant licenses on unfavorable terms.
We face risks associated with currency exchange rate fluctuations; any adverse fluctuation may adversely affect our operating margins
Almost all
of our revenues are denominated in Renminbi. Conducting business in currencies other than US dollars subjects us to fluctuations in currency exchange rates that could have a negative impact on our reported operating results. Fluctuations in the value of the US dollar relative to other currencies impact our revenues, cost of revenues and operating margins and result in foreign currency translation gains and losses. If the exchange rate of the Renminbi is affected by lowering its value as against the US dollar, our reported profitability when stated in US dollars will decrease. Historically, we have not engaged in exchange rate hedging activities and have no current intention of doing so.
We may not be able to adequately protect and maintain our intellectual property, trademark, and brand names.
Our business has and will depend on our ability to continue to develop and market feed additive products. We currently own three patents and have entered into an exclusive licensing agreement with respect to two other patents covering aspects of the manufacturing and production of feed additives. We have filed applications for twelve additional patents. Our inability to protect our rights to this intellectual property may adversely affect our ability to prevent competitors from using our products and developments.
Intellectual property rights in China are still developing, and there are uncertainties involved in the protection and the enforcement of such rights. We will need to pay special attention to protecting our intellectual property and trade secrets. Failure to do so could lead to the loss of a competitive advantage that could not be compensated by our damages award.
Risks Related to Our Corporate Structure
The Chinese government may determine that the VIE Agreements which we utilize to operate Guangzhou Tanke are not in compliance with applicable Chinese laws, rules and regulations and that they are therefore unenforceable.
In China it is widely understood that foreign investment enterprises, or FIEs, are forbidden or restricted from engaging in certain businesses or industries which are sensitive to the economy. As we intend to centralize our management and operation in China without being restricted to conduct certain business activities which are important for our current or future business but are restricted or might be restricted in the future, we believe our VIE Agreements will be essential for our business operation.
A WFOE that operates for certain period of time is allowed to further acquire or invest in a Chinese domestic company, which is not in a limited or prohibited industry under the Catalogue, without approval from the Chinese foreign investment authority. Assuming that the WFOE, Kanghui Agricultural, has been operating for a certain period of time, the acquisition of the operating company (as being in the encouraged industry) by the WFOE will need no approval from foreign investment authority. However, after acquisition by WFOE, if the operating company intends to expand or invest in another Chinese domestic company (which is a limited or prohibited industry under the Catalogue) in the future, such acquisition or investment may need further approval from the foreign investment authority or may be rejected in case of prohibited industry because of its direct foreign investment background, such further acquisition or investment by the operating company may raise the concern of the foreign investment authority for its possible intention of bypassing the restrictions imposed under the Catalogue regarding the limited and prohibited industry for foreign investment.
Under the VIE structure, the operating company has no foreign investment background. Its future business expansion or investment will not be subject to the restrictions imposed under the Catalogue for foreign investment.
Pursuant to the terms of the VIE Agreement, almost all of our business activities in China are managed and operated by China Flying though Kanghui Agricultural, and almost all economic benefits and risks arising from the business of Guangzhou Tanke are transferred to China Flying and Kanghui Agricultural.
There are risks involved with the operation of Guangzhou Tanke under the VIE Agreements. We received an opinion, dated January 4, 2011, from Martin Hu & Partners, our PRC legal counsel, that if the Chinese government determines the VIE Agreement used to control the operating company to be unenforceable as they circumvent the Chinese restrictions relating to foreign investment restrictions, the relevant regulatory authorities would have broad discretion in dealing with such breach, including:
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imposing economic penalties;
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discontinuing or restricting the operations of China Flying, Kanghui Agricultural or Guangzhou Tanke;
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imposing conditions or requirements in respect of the VIE Agreements with which Kanghui Agricultural or Guangzhou Tanke may not be able to comply;
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requiring us to restructure the relevant ownership structure or operations;
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taking other regulatory or enforcement actions that could adversely affect our business; and
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revoking the business license and/or the licenses or certificates of China Flying or Kanghui Agricultural, Guangzhou Tanke, and/or voiding the VIE Agreements.
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Any of these actions could have a material adverse impact on our business, financial condition and results of operations. Under PRC law the feed additive industry is not currently prohibited from receiving direct foreign investments. We implemented the VIE Agreements in order to ensure that if PRC law changes in the future that it will not adversely affect us.
We depend upon the VIE Agreements in conducting our operations in China, which may not be as effective as direct ownership.
We conduct our business through our Chinese operating subsidiaries and generate the revenues through the VIE Agreements. The VIE Agreements may not be as effective as direct ownership in providing us with control over Guangzhou Tanke. Under the VIE structure, if the parties breach or terminate any one of the VIE agreements, the WFOE (namely, Kanghui Agricultural) may not be able to receive the agreed benefits or profits from the operating company, which will in turn have an impact on distributing funds to the registrant.
The VIE Agreements are governed by Chinese laws and provide for the resolution of disputes through arbitration proceedings pursuant to Chinese laws. Accordingly, the VIE Agreements will be interpreted in accordance with Chinese laws. If Guangzhou Tanke or its shareholders fail to perform the obligations under the VIE Agreements, we may have to rely on legal remedies under Chinese laws, including seeking specific performance or injunctive relief, and claiming damages, and there is a risk that we may be unable to obtain these remedies. The legal environment in China is not as developed as in other jurisdictions. As a result, uncertainties in the Chinese legal system could limit our ability to enforce the VIE Agreements.
The pricing arrangement under the VIE Agreements may be challenged by Chinese tax authorities.
We could face adverse tax consequences if Chinese tax authorities determine that the VIE Agreements were not entered into based on arm’s length negotiations. If the Chinese tax authorities determine that the VIE Agreements were not entered into on an arm’s length basis, they may adjust the income and expenses of our company for Chinese tax purposes which could result in higher tax liability.
Any deterioration of the relationship between Kanghui Agricultural and Guangzhou Tanke could materially and adversely affect the overall business operation of our company.
Our relationship with Guangzhou Tanke is governed by the VIE Agreements, which are intended to provide us, through our ownership of China Flying and indirect ownership of Kanghui Agricultural, with effective control over the business operations of Guangzhou Tanke. Guangzhou Tanke could violate the VIE Agreements, go bankrupt, suffer from difficulties in its business, fail to renew necessary permits and certifications or otherwise become unable to perform its obligations under the VIE Agreements and, as a result, our operations, reputation, business and stock price could be severely harmed.
If Kanghui Agricultural exercises the purchase options over Guangzhou Tanke’s equity pursuant to the VIE Agreements, the payment of purchase prices could materially and adversely affect our financial position.
Under the VIE Agreements, China Flying, through its ownership of Kanghui Agricultural, holds an option to purchase all or a portion of the equity of Guangzhou Tanke at a price, pro rata in case of not all, based on the capital paid in by the Tanke Shareholders ($1,147,704 or 9.5 million RMB). If applicable Chinese laws and regulations require an appraisal of the equity interest or provide other restrictions on the purchase price, the purchase price shall be the lowest price permitted under the applicable Chinese laws and regulations. As Guangzhou Tanke is already a contractually controlled affiliate to our company, Kanghui Agricultural’s purchase of Guangzhou Tanke’s equity would not bring immediate benefits to us. Due to the existence of the VIE Agreements, we currently receive all of the revenue of Guangzhou Tanke, after the payment of taxes. Therefore, even if we own Guangzhou Tanke, we will not have a stronger claim to its revenue. In addition, payment of the option price would significantly decrease our cash and this reduction of cash would have a material adverse impact on our financial position.
If the consulting service agreement between Kanghui Agricultural and Guangzhou Tanke is terminated, it could materially and adversely affect the business operation of our company.
Either Guangzhou Tanke or Kanghui Agricultural may terminate the consulting service agreement entered into by and between them as part of the VIE agreements if circumstances arise that could materially and adversely affect the performance of the objectives of this agreement. We may close our control over the operations of Guangzhou Tanke if the consulting service agreement is terminated.
Risks Associated With Doing Business in China
If Guangzhou Tanke’s land use rights are revoked, we would have no operational capabilities.
Under Chinese law, land is owned by the state or rural collective economic organizations. The rural collective economic organizations issue to tenants the rights to use rural land. Use rights can be revoked and the tenants forced to vacate at any time when redevelopment of the land is in the public interest. The public interest rationale is interpreted quite broadly and the process of land appropriation may be less than transparent. We rely heavily on Guangzhou Tanke’s land use rights for our operations, and the loss of such rights would have a material adverse effect on our business.
We entered into a Land Use Right Grant Agreement with the government of Huaqiao Town, Huadu District, Guangzhou under which the Government of Huaqiao Town granted us certain land use rights for an area of approximately 60 mu where our manufacturing facility is built. The land use right of such parcel of land is owned collectively by local farmers. However, we currently do not maintain a Land Use Right Certificate for such parcel of land. Having no use right certificate of our land would have a material adverse effect on us as we would be required to relocate our facilities and obtain new land use rights, and there is a risk that we would not be able to accomplish such a relocation with reasonable cost or at all.
In addition, we currently do not maintain a building ownership certificate for our manufacturing facility. Because Guangzhou Tanke does not have land use right certificate on this parcel of land, it neither applied for nor will be granted a building ownership certificate for the manufacturing facility it built on this parcel of land. We may not be able to eventually obtain the building ownership certificate for the foresaid land with reasonable cost.
Economic, political and social conditions in China are subject to significant uncertainty and could affect our business.
All of our operations are located in China and our business is subject to political and economic uncertainties in China. The economy of China differs from the economies of most developed countries in many respects, including the level of government involvement, the level of development, control of foreign exchange, and methods for allocating resources. A substantial portion of productive assets in China are owned by the Chinese government. Changes in Chinese policies, laws and regulations, or in their interpretation or the imposition of confiscatory taxation, restrictions on currency conversion, restrictions or prohibitions on imports, restrictions or prohibitions on dividend payments to stockholders, devaluations of currency or the nationalization or other expropriation of private enterprises may occur from time to time without notice and could have a material adverse effect on our business. Nationalization or expropriation could result in the total loss of our investment in China. We have no control over most of these risks and may be unable to anticipate changes in Chinese economic and political conditions.
The Chinese government exerts substantial influence over the manner in which we must conduct our business activities.
We are dependent on our relationship with the local government in the province in which we operate our business. Chinese government has exercised and continues to exercise substantial control over virtually every sector of the Chinese economy through regulation and state ownership. Our ability to operate in China may be harmed by changes in its laws and regulations, including those relating to taxation, environmental regulations, land use rights, property and other matters. The Chinese central or local governments may impose new, stricter regulations or interpretations of existing regulations that would require additional expenditures and efforts on our part to ensure our compliance with such regulations or interpretations. Accordingly, government actions in the future, including any decision not to continue to support recent economic reforms and to return to a more centrally planned economy or regional or local variations in the implementation of economic policies, could have a significant effect on economic conditions in China or particular regions thereof, and could require us to divest ourselves of any interest we then hold in Chinese properties.
Future inflation in China may inhibit our ability to conduct business in China. In recent years, the Chinese economy has experienced periods of rapid expansion and high rates of inflation. Rapid economic growth can lead to growth in the money supply and rising inflation. If prices for our products rise at a rate that is insufficient to compensate for the rise in the costs of supplies, it may have an adverse effect on profitability. These factors have led to the adoption by Chinese government, from time to time, of various corrective measures designed to restrict the availability of credit or regulate growth and contain inflation. High inflation may in the future cause Chinese government to impose controls on credit and/or prices, or to take other action, which could inhibit economic activity in China, and thereby harm the market for our products.
If relations between the United States and China worsen, our share price may decrease and we may have difficulty accessing U.S. capital markets.
At various times during recent years, the United States and China have had disagreements over political and economic issues. Any political or trade controversies between the United States and China in the future could adversely affect the market price of our common stock and our ability to access U.S. capital markets.
During the year ended December 31, 2012, we derived approximately 98% of our sales in China. A slowdown or other adverse developments in China’s economy may materially and adversely affect our customers, demand for our products and our business.
During the year ended December 31, 2012, we generated 98% of our sales in China. We continue to focus our growth of business primarily in China in the next few years simply due to the market growth potential and the cost of doing business is still relatively low comparing with selling overseas. However, the significant growth of China’s economy in recent years may not continue. The industry which we are involved in China is relatively new and growing, but we do not know how sensitive we are to a slowdown in economic growth or other adverse changes in the Chinese economy which may affect demand for our products. In addition, the Chinese government also exercises significant control over Chinese economic growth through the allocation of resources, controlling payment of foreign currency-denominated obligations, setting monetary policy and providing preferential treatment to particular industries or companies. Although we are in one of the industries the Chinese government highly supports – agriculture, and receive certain preferential treatment, we are uncertain how significant an overall economic slowdown or recession in China will reduce the demand of our products and adversely affect our business.
We may have limited legal recourse under Chinese laws if disputes arise under our contracts with third parties.
The Chinese government has enacted some laws and regulations dealing with matters such as corporate organization and governance, foreign investment, commerce, taxation and trade. However, their experience in implementing, interpreting and enforcing these laws and regulations is limited, and our ability to enforce commercial claims or to resolve commercial disputes is unpredictable. If our new business ventures are unsuccessful, or other adverse circumstances arise from these transactions, we face the risk that the parties to these ventures may seek ways to terminate the transactions, or, may hinder or prevent us from accessing important information regarding the financial and business operations of these acquired companies. The resolution of these matters may be subject to the exercise of considerable discretion by agencies of the Chinese government, and forces unrelated to the legal merits of a particular matter or dispute may influence their determination. Any rights we may have to specific performance, or to seek an injunction under Chinese laws, in either of these cases, are severely limited, and without a means of recourse by virtue of the Chinese legal system, we may be unable to prevent these situations from occurring. In addition, the inability to enforce or obtain a remedy under any of our future agreements could result in a significant loss of business, business opportunities or capital and could have a material adverse impact on our operations business and financial condition.
Because our principal assets are located outside of the United States and our sole director and officer and all of our key employees reside in China, outside of the United States, it may be difficult for you to enforce your rights based on the United States federal securities laws against us and our officers and directors in the United States or to enforce judgments of United States courts against us or them in China.
Our sole director and officer and all of our key employees
reside in China, outside of the United States. In addition, our principal operating business is located in China and all of our assets are located outside of the United States. China does not have a treaty with United States providing for the reciprocal recognition and enforcement of judgments of courts. It may therefore be difficult for investors in the United States to enforce their legal rights based on the civil liability provisions of the United States federal securities laws against us in the courts of either the United States or China and, even if civil judgments are obtained in courts of the United States, to enforce such judgments in Chinese courts. Further, it is unclear if extradition treaties now in effect between the United States and Chinese would permit effective enforcement against us or our officers and directors of criminal penalties, under the United States federal securities laws or otherwise.
We may have difficulty establishing adequate management, legal and financial controls in China, which could impair our planning processes and make it difficult to provide accurate reports of our operating results.
China historically has been deficient in Western style management and financial reporting concepts and practices, as well as in modern banking, and other control systems. We may have difficulty in hiring and retaining a sufficient number of qualified employees familiar with these concepts, practices and systems to work in China. As a result of these factors, and especially given that we expect to be a publicly listed company in the U.S. and subject to regulation as such, we may experience 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 may have difficulty establishing adequate management, legal and financial controls in China.
Currency fluctuations and restrictions on currency exchange may adversely affect our business, including limiting our ability to convert Chinese Renminbi into foreign currencies and, if Chinese Renminbi were to decline in value, reducing our revenue in U.S. dollar terms.
Our reporting currency is the U.S. dollar and our operations in China use their local currency as their functional currency. Substantially all of our revenue and expenses are in Chinese Renminbi. We are subject to the effects of exchange rate fluctuations with respect to any of these currencies. For example, the value of the Renminbi depends to a large extent on Chinese government policies and China’s domestic and international economic and political developments, as well as supply and demand in the local market. Since 1994, the official exchange rate for the conversion of Renminbi to the U.S. dollar had generally been stable and the Renminbi had appreciated slightly against the U.S. dollar. However, on July 21, 2005, the Chinese government changed its policy of pegging the value of Chinese Renminbi to the U.S. dollar. Under the new policy, Chinese Renminbi may fluctuate within a narrow and managed band against a basket of certain foreign currencies. It is possible that the Chinese government could adopt a more flexible currency policy, which could result in more significant fluctuation of Chinese Renminbi against the U.S. dollar. We can offer no assurance that Chinese Renminbi will be stable against the U.S. dollar or any other foreign currency.
Our financial statements are translated into U.S. dollars at the applicable exchange rates in each applicable period. To the extent the U.S. dollar strengthens against foreign currencies, the translation of these foreign currencies denominated transactions results in reduced revenue, operating expenses and net income for our international operations. Similarly, to the extent the U.S. dollar weakens against foreign currencies, the translation of these foreign currency denominated transactions results in increased revenue, operating expenses and net income for our international operations. We are also exposed to foreign exchange rate fluctuations as we convert the financial statements of our foreign consolidated subsidiaries into U.S. dollars in consolidation. If there is a change in foreign currency exchange rates, the conversion of the foreign consolidated subsidiaries’ financial statements into U.S. dollars will lead to a translation gain or loss which is recorded as a component of other comprehensive income. In addition, we have certain assets and liabilities that are denominated in currencies other than the relevant entity’s functional currency. Changes in the functional currency value of these assets and liabilities create fluctuations that will lead to a transaction gain or loss. We have not entered into agreements or purchased instruments to hedge our exchange rate risks. The availability and effectiveness of any hedging transaction may be limited and we may not be able to hedge our exchange rate risks.
The application of Chinese regulations relating to the overseas listing of Chinese domestic companies is uncertain, we may be subject to penalties for failing to request approval of the Chinese authorities prior to listing our shares in the U.S. and we may be subject to additional approval requirements for Kanghui Agricultural’s acquisition of Guangzhou Tanke.
On August 8, 2006, six Chinese government agencies, namely, the Ministry of Commerce, or MOFCOM, the State Administration for Industry and Commerce, or SAIC, the China Securities Regulatory Commission, or CSRC, the State Administration of Foreign Exchange, or SAFE, the State Assets Supervision and Administration Commission, or SASAC, and the State Administration for Taxation, or SAT, jointly issued the Regulations on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors, which we refer to as the “New M&A Rules”, which became effective on September 8, 2006. The New M&A Rules purport, among other things, to require offshore “special purpose vehicles,” that are (1) formed for the purpose of overseas listing of the equity interests of Chinese companies via acquisition and (2) are controlled directly or indirectly by Chinese companies and/or Chinese individuals, to obtain the approval of the CSRC prior to the listing and trading of their securities on overseas stock exchanges.
There are substantial uncertainties regarding the interpretation, application and enforcement of the New M&A Rules and CSRC has yet to promulgate any written provisions or formally declare or state whether the overseas listing of a China-related company structured similar to ours is subject to the approval of CSRC. Any violation of these rules could result in fines and other penalties on our operations in China, restrictions or limitations on remitting dividends outside of China, and other forms of sanctions that may cause a material and adverse effect to our business, operations and financial conditions.
The new mergers and acquisitions regulations also established additional procedures and requirements that are expected to make merger and acquisition activities by foreign investors more time-consuming and complex, including requirements in some instances that the Ministry of Commerce be notified in advance of any change-of-control transaction in which a foreign investor takes control of a Chinese domestic enterprise that owns well-known trademarks or China’s traditional brands. If within two years, the relevant PRC authority determines that Kanghui Agricultural lacks a business in the ordinary course, Kanghui Agricultural may be considered as a wholly foreign owned holding company and therefore Kanghui Agricultural’s acquisition of Guangzhou Tanke may be subject to additional approvals that are required under the new M&A Rule. Complying with the requirements of the new mergers and acquisitions regulations in completing this type of transactions could be time-consuming, and any required approval processes, including CSRC approval, may delay or inhibit our ability to complete such transactions, which could affect our ability to expand our business or maintain our market share.
Recent Chinese regulations relating to the establishment of offshore special purpose companies by Chinese residents may subject our Chinese resident shareholders to penalties in certain circumstance. After exercising their rights under the Call Option Agreement, the Tanke Shareholders will need to register with SAFE according to Circular 75. Circular 75 affects the Tanke Shareholders and does not apply to us, our subsidiaries including Guangzhou Tanke, or any shareholders who are not PRC residents.
The SAFE issued a public notice in October 2005, or the SAFE Circular No. 75 (“Circular 75”), requiring Chinese residents to register with the local SAFE branch before establishing or controlling any company outside of China for the purpose of capital financing with assets or equities of Chinese companies, referred to in the Circular 75 as special purpose vehicles, or SPVs. Chinese residents who are shareholders of SPVs established before November 1, 2005 were required to register with the local SAFE branch before June 30, 2006. Further, Chinese residents are required to file amendments to their registrations with the local SAFE branch if their SPVs undergo a material event involving changes in capital, such as changes in share capital, mergers and acquisitions, share transfers or exchanges, spin-off transactions or long-term equity or debt investments.
To date, the Chinese residents who are shareholders of Guangzhou Tanke do not own any equity in the Company, and for such reason they do not need to file registrations with the foreign exchange authority pursuant to Circular 75. The ground for this statement is Article 2 of Circular 75, according to which a Chinese resident is required to file the registration under Circular 75 only when it is to directly establish or indirectly control an offshore special purpose vehicle. Strictly speaking, by executing the Call Option Agreement alone, Tanke Shareholders shall not be deemed to own any shares in the Company and therefore will not trigger the registration of Circular 75. Unless and until Tanke Shareholders intend to exercise the call option to own the shares of the Company, they will not be required to complete the registration under Circular 75.
Pursuant to the vesting schedule set forth in the Call Option Agreement, the Tanke Shareholders are permitted to exercise their options for shares of common stock in the Company. When exercising their right to acquire Option Shares, the Tanke Shareholders will need to file registrations with SAFE. Any failure by the Tanke Shareholders to file their registration with SAFE will restrict and prohibit such individuals from transferring the proceeds from a sale of common stock to China. If such sales proceeds are transferred to China without SAFE registration, any individual in violation thereof could be subject to a fine imposed by the PRC foreign exchange control agency in an amount of approximately 30% of the sales price as well as criminal liabilities. See “Business—Government Regulation – Foreign Exchange Regulation”.
Under applicable PRC laws, a Chinese domestic resident legal person or natural person (collectively, the “Resident Person”) shall register with SAFE if such Resident Person “directly establishes or indirectly controls” a Special Purpose Vehicle in another country. The aforementioned “directly establish or indirectly controls” could be by an individual Resident Person or by several Resident Persons collectively.
The Special Purpose Vehicle means a foreign enterprise established for the purpose of an equity financing (including convertible bond financing) outside of China by using the assets or interests held by such individual or several Resident Persons in the Chinese enterprise. In this regard, if the Tanke Shareholders exercise their right under the Call Option Agreement and, therefore, individually or collectively control us, under applicable PRC law, we will be deemed to be a Special Purpose Vehicle because we are controlled by a Resident Person and our interests in Guangzhou Tanke, through the VIE Agreements, was used in connection with our equity financing in the US.
Before exercising their rights under the Call Option Agreement, none of the Tanke Shareholders may obtain shares in us and, therefore, shall not be deemed to be controlling us. In this regard, Circular 75 will not apply. After exercising their rights under the Call Option Agreement, the Tanke Shareholders (all of them are Chinese residents and, therefore, fall into the definition of Resident Person) will be deemed as individually or collectively controlling us. Therefore, the Tanke Shareholders will need to register with SAFE according to Circular 75. Circular 75 affects the Tanke Shareholders and does not apply to any shareholders who are not PRC residents.
It is expressly stated in the Article 1 of Circular 75 that Circular 75 only applies to Chinese residents (including the natural person holding Chinese identity card or passport; the natural person habitually residing in China for economic or other benefit ties without holding Chinese identity card or passport; and the company, institution or other economic entity incorporated in China) who directly establish or indirectly control the special purpose vehicle. Therefore, under Circular 75, only a Chinese resident who directly establishes or indirectly controls the special purpose vehicle is liable for registration with local foreign exchange authority. Circular 75 does not extend its application to any non-Chinese resident, such as the Company, or any non-Chinese shareholders of the Company. As to Kanghui Agricultural, although it is a Chinese resident, it does not engage in any activity within the scope of “directly establishing or indirectly controlling the special purpose vehicle”, and therefore is not within the application of Circular 75
For such reason, the Company, the non-Chinese shareholders of the Company, and the subsidiaries of the Company (including Kanghui Agricultural) will not be subject to any administrative or criminal liabilities due to Tanke Shareholders failure of complying with Circular 75.
The uncertainty regarding the interpretation and implementation of Circular 75 that may have impact on the Company is the definition of "Control" stipulated in Article 1 of Circular 75. Circular 75 applies only to Chinese residents who intend to directly establish or INDIRECTLY CONTROL an offshore purpose vehicle for the purpose of raising capital overseas. It is stipulated in Circular 75 that "Control" shall refer to "the behavior that a Chinese resident obtains the rights to carry out business operation of, to gain proceeds from or to make decisions for a special purpose vehicle by means of acquisition, trusteeship, holding shares on behalf of others, voting rights, repurchase, convertible bonds, etc."
Mr. Qiu Guixiong, one of the Tanke shareholders, is the sole director of the Company and therefore has the decisive power to the operation of the Company. However, he obtains the control over the Company by means of directorship in the Company rather than any of the means expressly set out in Circular 75 (i.e., acquisition, trusteeship, holding shares on behalf of others, voting rights, repurchase, convertible bonds).
Strictly speaking, the Call Option Agreement placed a condition on exercising of the voting power by Golden Genesis (the “Grantor”). It is expressly stated in Article 2.8 of the Call Option Agreement that the Grantor “agrees not to exercise any of its voting rights with respect to the Option Shares……on behalf of the Grantees without the prior written consent of the Grantees,……before all of the Grantor’s shares are transferred to the Grantee,…”. This arrangement does not directly grant the voting power to the Grantees (which includes Mr. Qiu), rather limiting the voting power of the Grantor. Such condition placed cannot be strictly equivalent to the “voting power” mentioned in Circular 75 because that, under the Chinese law perspective, the voting power is attached to the equity and Tanke Shareholders do not have the title of the Option Shares before exercising the option right. To date, there is no further interpretation regarding the “voting power” under the Circular 75.
Circular 75 remains unclear on whether the control gained through the directorship should be deemed “Control” within its application. To date, there is no further amendment or detailed interpretation regarding the definition of "Control" of Circular 75. Our informal consultation with some officials of foreign exchange authorities confirmed that the control over a special purpose vehicle through the position of directorship does not belong to the scope of the “Control” under Circular 75. We are therefore of the opinion that, in absence of further amendments or detailed regulations regarding the definition of "Control" in Circular 75, the chance that Mr. Qiu Guixiong's position will be definitely determined as "control" over the Company is rare.
However, if the Chinese local foreign exchange authority determines under its own discretion that Mr. Qiu Guixiong is a de facto controller of the Company and his control over the Company should be deemed to be within the scope of Notice 75, Mr. Qiu Guixiong may be required to finish the registration under Circular 75, even before he exercises the call option right on the shares of the Company. Under such circumstance, Mr. Qiu’s non-compliance under Circular 75 will not affect Kanghui Agricultural to distribute funds to us because that, as being mentioned before, Tanke Shareholders’ failure of complying with the Circular 75 will not trigger Kanghui Agricultural or us to be subject to any administrative or criminal liabilities.
Under Chinese law, Mr. Qiu’s failure of complying with Circular 75 will not affect his ability to serve as the registrant’s chief executive officer and sole director because the Circular 75 only regulates the matters relating to the administration of foreign exchange.
We face uncertainty from the Circular on Strengthening the Administration of Enterprise Income Tax on Non-resident Enterprises' Share Transfer, or Circular 698, released in December 2009 by China's State Administration of Taxation, or the SAT, effective as of January 1, 2010.
Pursuant to the Circular 698 effective on January 1, 2010, where a foreign investor transfers the equity interests of a Chinese resident enterprise indirectly via disposing of the equity interests of an overseas holding company, which we refer to as an Indirect Transfer, and such overseas holding company is located in a tax jurisdiction that: (i) has an effective tax rate less than 12.5% or (ii) does not tax foreign income of its residents, the foreign investor shall report such Indirect Transfer to the competent tax authority of the Chinese resident enterprise. The Chinese tax authority will examine the true nature of the Indirect Transfer, and if the tax authority considers that the foreign investor has adopted an abusive arrangement in order to avoid Chinese tax, they will disregard the existence of the overseas holding company and re-characterize the Indirect Transfer and as a result, gains derived from such Indirect Transfer may be subject to Chinese withholding tax at the rate of up to 10%. Circular 698 also provides that, where a non-Chinese resident enterprise transfers its equity interests in a Chinese resident enterprise to its related parties at a price lower than the fair market value, the competent tax authority has the power to make a reasonable adjustment to the taxable income of the transaction.
Wong Kwai Ho’s transfer of her 100% shareholding interest in China Flying to Golden Genesis may be deemed an indirect disposal of equity interest of Guangzhou Tanke, a Chinese resident enterprise, through China Flying. This transfer may be subject to examination by Chinese tax authorities and could be subject to Wong Kwai Ho been required to pay a withholding tax of 10%.
SAFE rules and regulations may limit our ability to transfer the net proceeds from future offerings to Guangzhou Tanke, which may adversely affect the business expansion of Guangzhou Tanke.
On August 29, 2008, SAFE promulgated Circular 142, a notice regulating the conversion by a foreign-invested company of foreign currency into Renminbi by restricting how the converted Renminbi may be used. The notice requires that the registered capital of a foreign-invested company settled in Renminbi converted from foreign currencies may only be used for purposes within the business scope approved by the applicable governmental authority and may not be used for equity investments within the PRC. In addition, SAFE strengthened its oversight of the flow and use of the registered capital of a foreign-invested company settled in Renminbi converted from foreign currencies. Violations of Circular 142 will result in severe penalties, such as heavy fines. As a result, Circular 142 may significantly limit our ability to transfer the net proceeds from future offerings.
We may be considered a resident enterprise of the PRC, and if so, the Enterprise Income Tax Law of PRC relating to PRC taxation on resident enterprise may subject us or our Shareholders to penalties, limit our ability to distribute dividend to our shareholders or otherwise adversely affect us.
The Enterprise Income Tax Law (the “EIT Law”) of the PRC and its implementing rules provide that enterprises established outside China whose “de facto management bodies” are located in China are considered “resident enterprises” and subject to the uniform 25% enterprise income tax rate on global income. Our management is substantially based in the PRC and expects to be based in the PRC in the future. It is unclear and uncertain how the PRC tax authorities would interpret and implement the EIT Law and its implementing rules and it remains uncertain whether the PRC tax authorities would determine that we are a “resident enterprise” or a “non-resident enterprise”. If we are deemed as resident enterprise, we will be subject to a 25% enterprise income tax rate. If we are deemed as resident enterprise, any failure to pay the enterprise income tax may result in a fine imposed by relevant PRC tax authorities in an amount from RMB2,000 to RMB10,000, and any failure to pay the income tax within a limited period of time as requested by the PRC tax authorities may result in a fine in amount from 50% to 500% of the taxes unpaid or underpaid.
Due to various restrictions under Chinese laws on the distribution of dividends by our Chinese operating companies, we may not be able to pay dividends to our stockholders.
The Wholly-Foreign Owned Enterprise Law (1986), as amended, the Wholly-Foreign Owned Enterprise Law Implementing Rules (1990), as amended and the Company Law of China (2006) contain the principal regulations governing dividend distributions by wholly foreign-owned enterprises. Under these regulations, wholly foreign-owned enterprises may pay dividends only out of their accumulated profits, if any, determined in accordance with Chinese accounting standards and regulations. Additionally, prior to the distribution of the dividend, wholly foreign-owned enterprises are required to set aside 10% of their annual net income as certain company statutory reserves, until the total amount of such reserves reach to 50% of the registered capital of the foreign-owned enterprises. These reserves can only be utilized to make up the loss or be converted to the registered capital of the foreign-owned enterprises and are not distributable as cash dividends except in the event of liquidation.
In accordance with these regulations, Kanghui Agriculture is required to remain 10% of its net income annually, as determined in accordance with the PRC’s accounting rules and regulations, as the statutory reserve fund until the amount of such statutory reserve reaches 50% of its registered capital. Such statutory reserve cannot be distributed in cash to China Flying and in turn to our common stock shareholders, until and unless Kanghui Agriculture is liquidated. To date, we have segregated $373,406 related to the statutory reserve requirements.
Additionally, the Circular 75 requires Chinese residents to register with the local SAFE branch before establishing or controlling any company outside of China for the purpose of capital financing with assets or equities of Chinese companies, referred to in the Circular 75 as special purpose vehicles, or SPVs. Chinese residents who are shareholders of SPVs established before November 1, 2005 were required to register with the local SAFE branch before June 30, 2006. Further, Chinese residents are required to file amendments to their registrations with the local SAFE branch if their SPVs undergo a material event involving changes in capital, such as changes in share capital, mergers and acquisitions, share transfers or exchanges, spin-off transactions or long-term equity or debt investments.
To date, the Chinese residents who are shareholders of Guangzhou Tanke do not own any equity in the Company, and for such reason such Chinese residents currently do not need to file registrations with SAFE pursuant to Circular 75. When the Chinese residents exercise their options in the future to receive any share of the Company pursuant to the Call Option Agreement, they will need to file registrations with SAFE. In that case, before the Chinese residents complete the registration with SAFE, Kanghui Agriculture cannot remit out of China its dividend and, as a result, we may experience delay or difficulty in paying the dividends on our common stock.
The Chinese government also imposes controls on the conversion of RMB into foreign currencies and the remittance of currencies out of China. We may experience difficulties in completing the administrative procedures necessary to obtain and remit foreign currency for the payment of dividends from the profits of Guangzhou Tanke. Furthermore, if our subsidiaries in China incur debt on their own in the future, the instruments governing the debt may restrict their ability to pay dividends or make other payments. If we unable to receive all of the revenues from our operations through these contractual or dividend arrangements, we may be unable to pay dividends on our common stock.
The State Administration of Foreign Exchange restrictions or changes in foreign exchange regulations in China may affect our ability to pay dividends in foreign currency or conduct other foreign exchange business.
We receive substantially all of our revenues in RMB, which is currently not a freely convertible currency. The restrictions on currency exchanges may limit our ability to use revenues generated in RMB to make dividends or other payments in United States dollars. The Chinese government strictly regulates conversion of RMB into foreign currencies. Over the years, foreign exchange regulations in China have significantly reduced the government’s control over routine foreign exchange transactions under current accounts. In China, SAFE regulates the conversion of the RMB into foreign currencies. Pursuant to applicable Chinese laws and regulations, foreign invested enterprises incorporated in China are required to apply for “Foreign Exchange Registration Certificates.” Currently, conversion within the scope of the “current account” (e.g. remittance of foreign currencies for payment of dividends, trade and service-related foreign exchange transactions, etc.) can be effected without requiring the approval of SAFE, instead, need to be registered with the SAFE. However, conversion of currency in the “capital account” (e.g. for capital items such as direct investments, loans, securities, etc.) still requires the approval of SAFE. In addition, failure to obtain approval from SAFE for currency conversion on the capital account may adversely impact our capital expenditure plans and our ability to expand in accordance with our desired objectives.
All of our income is derived from the consulting fees we receive from Guangzhou Tanke through the VIE Agreements. SAFE restrictions may delay the payment of dividends, since we have to comply with certain procedural requirement and we may experience difficulties in completing the administrative procedures necessary to obtain and remit foreign currency for the payment of dividends from the profits of Kanghui Agricultural, and it thus may delay our payment of dividend to the equity holders.
Foreign exchange transactions by Chinese operating subsidiaries under the capital account continue to be subject to significant foreign exchange controls and require the approval of and need to register with Chinese government authorities, including SAFE. In particular, if Guangzhou Tanke, which we control via the VIE Agreement, borrows foreign currency through loans from us or other foreign lenders, these loans must be registered with SAFE, and if we finance Guangzhou Tanke by means of additional capital contributions, these capital contributions must be approved by certain government authorities, including the Ministry of Commerce, or their respective local counterparts. These limitations could affect Guangzhou Tanke’s ability to obtain foreign exchange through debt or equity financing.
The Chinese government may also at its discretion restrict access in the future to foreign currencies for current account transactions. If the foreign exchange control system prevents us from obtaining foreign currency, we may be unable to pay dividends or meet obligations that may be incurred in the future that require payment in foreign currency.
We are subject to Chinese environmental laws that adversely affect our results of operations.
We are subject to multiple Chinese environmental laws, including the Law on Environmental Protection of China and the Law of Prevention of Effluent Pollution of China and other environmental regulation governing the classification and disposal of waste. We expect that national, provincial and local governmental agencies will adopt stricter pollution controls in the future. Our production process may produce waste which may be harmful to the environment. There can be no assurance that future changes in environmental laws and regulations will not impose costly compliance requirements on us or otherwise subject us to future liabilities. Our profitability may be adversely affected if additional or modified environmental control regulations are imposed upon us.
Our failure to fully comply with Chinese labor laws, including laws relating to social insurance, may expose us to potential liability and increased costs.
Companies operating in China must comply with a variety of labor laws, including the Labor Contract Law of China enacted in June 2007, or the New Labor Contract Law, and laws requiring us to make social insurance (including unemployment insurance, medical insurance, and pension) and other staff welfare-oriented payments (such as housing funds). Our failure to comply with these laws could have a material adverse effect on our business. The New Labor Contract Law, which became effective on January 1, 2008, imposes stricter obligations on employers including a requirement that employers execute written labor contracts with all of their employees. Among our 130 employees, we have paid social insurance for 116 of our employees and 14 employees participated in commercial insurance due to the fact that they are transferred to the Company from other companies who have paid their social insurance. Our failure to remain in compliance with Chinese labor laws including social insurance requirements in the future could adversely impact our results of operations.
Furthermore, the New Labor Contract Law governs standard terms and conditions for employment, including termination and lay-off rights, contract requirements, compensation levels and consultation with labor unions, among other topics. In addition, the law limits non-competition agreements with senior management and other employees who have access to confidential information to two years and imposes restrictions or geographical limits. This new labor contract law will increase our labor costs, which could adversely impact our results of operations.
We must comply with the Foreign Corrupt Practices Act.
We are required to comply with the United States Foreign Corrupt Practices Act, which prohibits U.S. companies from engaging in bribery or other prohibited payments to foreign officials for the purpose of obtaining or retaining business. Foreign companies, including some of our competitors, are not subject to these prohibitions. Corruption, extortion, bribery, pay-offs, theft and other fraudulent practices occur from time-to-time in mainland China. If our competitors engage in these practices, they may receive preferential treatment from personnel of some companies, giving our competitors an advantage in securing business or from government officials who might give them priority in obtaining new licenses, which would put us at a disadvantage. We have no formal policies in place to prevent our employees or other agents from engaging in such conduct. If such conduct is undertaken, we might be held responsible. If our employees or other agents are found to have engaged in such practices, we could suffer severe penalties, which could adversely impact our business and results of operations.
Risks Related to Our Common Stock
An active and visible trading market for our common stock may not develop.
We cannot predict whether an active market for shares of our common stock will develop in the future. In the absence of an active trading market:
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Investors may have difficulty buying and selling or obtaining market quotations;
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Market visibility for shares of our common stock may be limited; and
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A lack of visibility for shares of our common stock may have a depressive effect on the market price for shares of our common stock.
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The OTCQB is an unorganized, inter-dealer, over-the-counter market that provides significantly less liquidity than NASDAQ or the NYSE AMEX. The trading price of our common stock is expected to be subject to significant fluctuations in response to variations in quarterly operating results, changes in analysts’ earnings estimates, announcements of innovations by us or our competitors, general conditions in the industry in which we operate and other factors. These fluctuations, as well as general economic and market conditions, may have a material or adverse effect on the market price of shares of our common stock.
The market price for shares of our common stock may be volatile.
The market price for shares of our common stock may be volatile and subject to wide fluctuations in response to factors including the following:
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actual or anticipated fluctuations in our quarterly operating results;
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changes in financial estimates by securities research analysts;
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conditions in commodities markets;
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changes in the economic performance or market valuations of other feed additive technology companies;
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announcements by us or our competitors of new products, acquisitions, strategic partnerships, joint ventures or capital commitments;
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addition or departure of key personnel;
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fluctuations of exchange rates between RMB and the U.S. dollar;
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intellectual property litigation; and
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general economic or political conditions in China.
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In addition, the securities market has from time to time experienced significant price and volume fluctuations that are not related to the operating performance of particular companies. These market fluctuations may also materially and adversely affect the market price of shares of our common stock.
We do not anticipate paying cash dividends in the foreseeable future and, as a result, our investors’ sole source of gain, if any, will depend on capital appreciation, if any.
We do not plan to declare or pay any cash dividends on our shares of common stock in the foreseeable future and currently intend to retain any future earnings for funding growth. As a result, investors should not rely on an investment in our securities if they require the investment to produce dividend income. Capital appreciation, if any, of our shares may be investors’ sole source of gain for the foreseeable future. Moreover, investors may not be able to resell their shares of common stock at or above the price they paid for them.
We have considerable discretion in the use of proceeds from the selling stockholders’ conversion of the Notes and exercise of the Warrants, and we may use these proceeds in ways with which you may not agree.
Our Board of Directors and our management will have considerable discretion in the application of the net proceeds received by us from the selling stockholders’ conversion of the Notes and exercise of the Warrants. You will not have the opportunity, as part of your investment decision, to assess whether proceeds are being used appropriately. You must rely on the judgment of our Board of Directors and our management regarding the application of the net proceeds of this offering. The net proceeds may be used for corporate purposes that do not improve our efforts to maintain profitability or increase the price of our securities. The net proceeds from this offering may be placed in investments that do not produce income or that lose value. See “Use of Proceeds.”
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.
The former shareholders of Guangzhou Tanke are eligible to sell all or some of their shares of our 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 stockholder (or stockholders whose shares are aggregated) who has satisfied an one-year holding period may, under certain circumstances, sell within any three-month period a number of securities which does not exceed the greater of 1% of the then outstanding shares of common stock or the average weekly trading volume of the class during the four calendar weeks prior to such sale. As of the closing of the Private Placement, 1% of our issued and outstanding shares of common stock equals approximately 133,241 shares (without giving effect to any conversion of Notes or exercise of Warrants or Agent Warrants). Rule 144 also permits, under certain circumstances, the sale of securities, without any limitations, by a non-affiliate that has satisfied a one-year holding period. 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. A stockholder that is not an affiliate of the Company, and that acquired shares of common stock pursuant to its conversion of the Notes or its exercise of the Warrants, shall be permitted to sell its shares of common stock pursuant to Rule 144(i) on or after February 10, 2012.
We will incur increased costs as a result of being a public company.
As a public company, we will incur significant legal, accounting and other expenses, in excess of $400,000, that we did not incur as a private company. In addition, the Sarbanes-Oxley Act of 2002, as well as new rules subsequently implemented by the SEC, has required changes in corporate governance practices and internal control and procedures of public companies. We expect these new rules and regulations to increase our legal, accounting and financial compliance costs and to make certain corporate activities more time-consuming and costly. In addition, we will incur additional costs associated with our public company reporting requirements. We are currently evaluating and monitoring developments with respect to these new rules, and we cannot predict or estimate the amount of additional costs we may incur or the timing of such costs.
Failure to achieve and maintain effective internal controls in accordance with Section 404 of the Sarbanes-Oxley Act of 2002, or Sarbanes-Oxley, could have a material adverse effect on our business and stock price.
As a public company, we will be required to document and test our internal control procedures in order to satisfy the requirements of Section 404 of Sarbanes-Oxley, which will require annual management assessments of the effectiveness of our internal control over financial reporting. During the course of our testing, we may identify deficiencies, which we may not be able to remediate in time to meet our deadline for compliance with Section 404. Testing and maintaining internal control can divert our management’s attention from other matters that are important to the operation of our business. We also expect the new regulations to increase our legal and financial compliance costs, make it more difficult to attract and retain qualified officers and members of our Board of Directors, particularly to serve on our Audit Committee, and make some activities more difficult, time consuming and costly. We may not be able to conclude on an ongoing basis that we have effective internal controls over financial reporting in accordance with Section 404 and, although we are currently exempt from the requirement that our independent auditor provide a report addressing the effectiveness of internal control over financial reporting, our independent registered public accounting firm may not be able or willing to issue an qualified report on the effectiveness of our internal control over financial reporting if we become subject to such requirement in the future. If we conclude that our internal control over financial reporting is not effective, we cannot be certain as to the timing of completion of our evaluation, testing and remediation actions or their effect on our operations because there is presently no precedent available by which to measure compliance adequacy. If either we are unable to conclude that we have effective internal control over financial reporting, or to the extent we are subject to the requirement, our independent auditors are unable to provide us with an unqualified report as required by Section 404, then investors could lose confidence in our reported financial information, which could have a negative effect on the trading price of our 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, which is currently and will be quoted for trading on OTCBB, 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 of 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.
Our majority stockholder and its affiliates will control the outcome of matters requiring stockholder approval.
Golden Genesis is our majority stockholder and beneficially owns 9,011,469 shares of common stock or approximately 67.63% of the issued and outstanding shares of common stock (without giving effect to any conversion of Notes or exercise of Warrants or Agent Warrants). Golden Genesis is controlled (and will be majority owned, upon consummation of the transactions contemplated in the Call Option Agreement described herein) by our Chairman and Chief Executive Officer, Mr. Qiu. Consequently, Golden Genesis and Mr. Qiu will have the ability, when acting alone or with others, to control the election of our directors and the outcome of corporate actions requiring stockholder approval, such as changes to our Articles of Incorporation and Bylaws and a merger or a sale of our company or a sale of all or substantially all of our assets. This concentration of voting power and control could have a significant effect in delaying, deferring or preventing an action that might otherwise be beneficial to our other stockholders and be disadvantageous to our stockholders with interests different from those of our officers, directors and affiliates. Golden Genesis and Mr. Qiu also have significant control over our business, policies and affairs. Additionally, this significant concentration of share ownership may adversely affect the trading price for our common stock because investors often perceive disadvantages in owning stock in companies with controlling stockholders.
Provisions in our Bylaws could discourage, delay or prevent a change of control of our company and may result in an entrenchment of management and diminish the value of our common stock.
Our Bylaws provide that, unless otherwise prescribed by statute, special meetings of the stockholders can only be called by the Chairman of our Board of Directors, our President, or by the Board of Directors, or in their absence or disability, by any Vice President; and can be called by the President or, in his or her absence or disability, by a Vice President or by the Secretary upon the written request of the holders of not less than 15% of all the shares entitled to vote at the meeting. These provisions may discourage, delay or prevent a merger, acquisition or other change of control that our stockholders may consider favorable. Such provisions could impede the ability of our common stockholders to benefit from a change of control and, as a result, could materially adversely affect the market price of our common stock and your ability to realize any potential change-in-control premium.
Our employees and management do not have significant experience in the preparation or supervising the preparation of our financial statements in accordance with US GAAP.
Prior to the completion of this offering, Guangzhou Tanke operated as a private company located in China. In connection with the completion of the offering the Company acquired control of Guangzhou Tanke by virtue of VIE agreements. In the process of taking these steps to prepare our company for this offering, Guangzhou Tanke's senior management became the senior management of the Company. Guangzhou Tanke's senior management has limited experience managing a public company in the U.S. or complying with such U.S. laws, regulations and obligations. These obligations can be burdensome and complicated, and failure to comply with such obligations could have a material adverse effect on the Company. In addition, we expect that the process of learning about such new obligations as a public company in the United States will require senior management to devote time and resources to such efforts that might otherwise be spent on the operation of the business of the Company.
Historically our operations have been in China, and we have prepared our financial statements and maintained our books and records in accordance with China GAAP and have not previously been required to comply with U.S. GAAP. We hired a new Chief Financial Officer that is familiar with U.S. GAAP in 2011. In addition, we have engaged outside consultants who have significant experience with U.S. GAAP to prepare the conversion from China GAAP into U.S. GAAP. Furthermore, our financial statements are audited by our independent registered public accounting firm for compliance with U.S. GAAP standards. Yet, we cannot assure that our management has identified or fully remedied all material weaknesses in our internal controls of financial reporting pursuant to U.S. GAAP. If deficiencies go undetected or unremedied, our financial statements may not accurately reflect our financial condition as required by U.S. GAAP. We will evaluate these risk factors that impact our ability to prepare financial statements and maintain our books and records in accordance with U.S. GAAP in the future in concluding on the effectiveness of disclosure controls and procedures under Item 307 of Regulation S-K and internal control over financial reporting under Item 308 of Regulation S-K.