10KSB 1 v015094_10-k.txt U.S. Securities and Exchange Commission Washington, D.C. 20549 Form 10-KSB |X| ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 for the fiscal year ended December 31, 2004 |_| TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ______________ to ________________ Commission File Number: 0-27351 American Diary, Inc. -------------------- (Name of small business issuer in its charter) Utah 87-0445575 ---- ---------- (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) C-16 Shin Chen International Building, No. 10, Jiu-shen Road, Zho Yan Chu, Beijing The People's Republic of China ---------------------------------- (Address of principal executive offices) 011-0452-4312688 ---------------- (Issuer's telephone number) Securities registered under Section 12(b) of the Exchange Act: Title of each class Name of each exchange on which registered ------------------- ----------------------------------------- N/A N/A Securities registered under Section 12(g) of the Exchange Act: Common Stock, par value $.001 Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No |_| Check if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-B is not contained in this form, and no disclosure will be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB. |X| State issuer's revenues for its most recent fiscal year: $37,416,223 The aggregate market value of voting and non-voting equity held by non-affiliates of the registrant as of December 31, 2004: Common stock, $.001 par value: $20,254,458 ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PAST FIVE YEARS Check whether the issuer has filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Exchange Act after the distribution of securities under a plan confirmed by a court. Yes |_| No |_| The number of shares of the registrant's common stock outstanding as of March 25, 2005: 13,556,354 shares. Documents incorporated by reference: None Transitional Small Business Disclosure Format: Yes |_| No |X| 2 TABLE OF CONTENTS PART I Item 1. Description of Business....................................................................... 4 Item 2. Description of Property.......................................................................17 Item 3. Legal Proceedings.............................................................................18 Item 4. Submission of Matters to a Vote of Security Holders...........................................18 PART II Item 5. Market for Common Equity, Related Stockholder Matters and Small Business Issuer Purchaser of Equity Securities................................................................18 Item 6. Management's Discussion and Analysis or Plan of Operations....................................20 Item 7. Financial Statements..........................................................................24 Item 8. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure..........24 Item 8A. Controls and Procedures.......................................................................24 Item 8B. Other Information ............................................................................24 PART III Item 9. Directors and Executive Officers of the Registrant............................................25 Item 10. Executive Compensation........................................................................26 Item 11. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters...............................................................28 Item 12. Certain Relationships and Related Transactions................................................30 Item 13. Exhibits .....................................................................................30 Item 14. Principal Accountant Fees and Services........................................................32 Financial Statements...................................................................................F-1 Signatures.............................................................................................33 Exhibit Index..........................................................................................
3 PART I Item 1. Description of Business. General American Dairy, Inc. ("American Dairy") was incorporated under the corporate laws of the State of Utah on December 31, 1985, originally with the corporate name of Gaslight, Inc. It was inactive until March 30, 1988 when it changed its corporate name to Lazarus Industries, Inc. and engaged in the business of manufacturing and marketing medical devices. This line of business was discontinued in 1991, and it became a non-operating public company shell. Effective May 7, 2003, American Diary completed the acquisition of 100% of the issued and outstanding capital stock of American Flying Crane Corporation (formerly called American Dairy Holdings, Inc.) ("AFC"), a Delaware corporation. As a result, AFC become a wholly-owned subsidiary of American Dairy. In addition, American Dairy amended its Articles of Incorporation to change its name to "American Dairy, Inc." and completed a one-for-nineteen (1-for-19) reverse split of its Common Stock. AFC holds 100% of the issued and outstanding capital of Heilongjiang Feihe Dairy Co., Limited ("Feihe Dairy") in The People's Republic of China. The principal activity of Feihe Dairy is the production and distribution of milk powder and other dairy products. Feihe Dairy has three wholly-owned subsidiaries, Heilongjiang Sanhao Dairy Co., Limited ("Sanhao Dairy") and BaiQuan Feihe Dairy Co., Limited ("BaiQuan Dairy"), that are engaged in the production and supply of processed milk and soybean products for Feihe Dairy, and has a subsidiary Beijing Feihe Biotechnology Scientific and Commercial Co., which is the markeitng company for Feihe Diary. American Dairy purchased all of the outstanding capital stock of AFC from its stockholders in exchange for 9,650,000 restricted shares (post-split) of the Common Stock of American Dairy. Pursuant to a written consent by stockholders holding approximately 66% of the outstanding Common Stock of American Dairy, the stockholders approved: 1. an amendment to the Articles of Incorporation of American Dairy to change its corporate name to "American Dairy, Inc."; 2. a one-for-nineteen (1-for-19) reverse split of the Common Stock of American Dairy; and 3. the establishment of its 2003 Stock Incentive Plan covering 3,000,000 shares of Common Stock for its key employees, including officers, employees, directors and consultants. In addition to these actions, at the closing of the transaction effective May 7, 2003, all of the directors of American Dairy resigned and Leng You-Bin, Liu Sheng-Hui, Lee Hui-Lan, and Liu Hua were elected as the new directors and officers of American Dairy. Current Corporate Structure The following chart reflects the current corporate structure of the American Dairy entities: 4 ------------------------------------------ American Dairy, Inc. (formerly named "Lazarus Industries, Inc.) ------------------------------------------ 0wns 100% of ------------------------------------------ American Flying Crane Corporation ------------------------------------------ Owns 100% of ------------------------------------------ Heilongjiang Feihe Dairy Co., Limited ------------------------------------------ Owns 60% of Owns 100% of Owns 100% of ------------------------ -------------------- ------------------------ Shanxi Feihesantai BaiQuan Feihe Dairy Beijing Feihe Biotechnology Scientific Co., Limited Biotechnology Scientific and Commercial Co., and Commercial Co., Limited Limited ------------------------ -------------------- ------------------------ Heilongjiang Feihe Dairy Co., Limited and Subsidiaries Heilongjiang Feihe Dairy Co., Limited ("Feihe Dairy") and its subsidiaries are companies organized under the laws of The People's Republic of China ("China" or "PRC"). The history of Feihe Dairy commenced in 1962 when its predecessor, Heilongjiang Zhaoguang Hongguang Dairy Plants ("Hongguang Dairy Plan") was established as a wholly - owned State Enterprise, whose principal activities were the production and distribution of powdered milk in China. Hongguang Dairy Plants was located at Zhaoguang Livestock Farm of Zhaoguang Agro-Cultivated Bureau and its production capability was five tons a day and its main sales territory was Shangdong Province. In 1982, Heilongjiang Zhaoguang Dairy Plants ("Zhaoguang Dairy"), another State Enterprise, was established at Zhaoguang Plantation near BeiAn City. In 1984,Hongguang Dairy Plants and Zhaoguang Dairy were merged into Heilongjiang Zhaoguang Dairy Plants. The State continued to retain ownership of the merged Heilongjiang Zhaoguang Dairy Plants. In 1997, the merged Heilongjiang Zhaoguang Dairy Plants were further reorganized and changed its name to Heilongjiang Feihe Dairy Group Limited. In February 2000, Heilongjiang Feihe Dairy Group Limited completed its registered capital restructuring to become a private company with registered capital of $894,226. In March 2001, the restructured Heilongjiang Feihe Dairy Group Limited changed its name to its present name of Heilongjiang Feihe Dairy Co., Limited and acquired all of the fixed assets (including land use rights, plants and equipment and factory buildings) of Kedong Gongmu Dairy Plants. Feihe Dairy holds 99% (1% of the equity is held in trust by Fu Man Guo) of the registered equity of Heilongjiang Sanhao Dairy Co., Limited ("Sanhao Dairy"), which is considered to be a wholly - owned subsidiary). 5 In August 2001, Feihe Dairy's new production facilities in Kedong County commenced production of milk powder. Sanhao Dairy was incorporated in March 28, 2001 with registered capital of $433,110. Feihe Dairy owned 99% of Sanhao Dairy and Fu Man Guo held the remaining 1% in trust for Feihe Dairy. Under a Sale and Purchase Agreement dated February 6, 2001 between Feihe Dairy and Kedong County Economic Committee, Feihe Dairy agreed to acquire all the fixed assets including land use rights from Kedong Gongmu Dairy Plants at a consideration of $364,269. Following the incorporation of Sanhao Dairy, Feihe Dairy, as its contribution towards the registered capital, injected all the fixed assets from Kedong Gongmu Dairy Plants, except for its land uses rights to 47,640 square meters of land, into Sanhao Dairy, plus cash of $68,841. Pursuant to a Sale and Purchase Agreement dated January 3, 2003, between Feihe Dairy Co. and BaiQuan County Economic Planning Council (the "Council"), Feihe Dairy agreed to acquire all the fixed assets including the factory site, production facilities, land use rights and buildings from BaiQuan County Dairy Factory at a consideration of $700,483 (Rmb.5,800,000), which is payable in two installments totaling $603,864 (Rmb.5.0 million) on or before March 31, 2003 and a final installment of $96,618 (Rmb.800,000) is due on or before March 31, 2004. As of December 31, 2003, Feihe Dairy had paid $338,164 (Rmb.2.8 million) of the consideration to the Council. Pursuant to a supplemental agreement with the Council on March 31, 2003, Feihe Dairy agreed to repay the balance of the consideration of $362,318 (Rmb.3.0 million) as follows: On or before January 3, 2004 $ 72,464 On or before January 3, 2005 96,618 On or before January 3, 2006 96,618 On or before January 3, 2007 96,618 -------- $362,318 ======== During 2004, American Dairy merged Sanhao Dairy into BaiQuan Feihe Dairy Co., Limited and consolidated their operations. Sources of Milk Under supply contracts with numerous small dairy farmers who have cattle grazing rights and use rights to approximately 514,640 acres of land in Kedong County in northeastern China, American Dairy has been able to receive supplies of raw milk without having to make capital investments in farms and cattle. Historically, the milk industry in China has been very fragmented and segmented with most production being generated by farmers owning and milking one to ten cows. Approximately 27% of this acreage is arable pasture land, and approximately 30% is planted with beans and corn. The dairy farms under contract with American Dairy have approximately 13,000 producing milk cows as of December 31, 2004. American Dairy presently purchases approximately 130 tons of raw milk daily. 6 American Dairy has been informed that the Kedong County government intends to invest in additional milk cow breeding operations to increase the presently available number of mature milk cows from 13,000 to 30,000 during 2005, and such an increase in the number of milk cows is anticipated to increase daily milk production from approximately 130 tons to approximately 400 tons of fresh milk. Milk Processing Facilities American Dairy presently has two principal operating milk powder production and packaging plants. American Dairy has a milk powder processing plant called Sanhao Dairy in Kedong County in the City of QiQiHaEr, in Heilongjiang Province, China. American Dairy acquired this plant in March 2001 for $461,632. The land is approximately 47,640 square meters. The plants building has approximately 4,500 square meters of production space and has 720 square meters of office space, and is approximately 13 years old. Sanhao Dairy has approximately 236 production and packaging employees at this plant. American Dairy also has a milk powder processing plants called BaiQuan Dairy. American Dairy acquired this plant in January 2003 for $700,483. Additional land was subsequently acquired for $293,450 in March 2004. The land is approximately 40,000 square meters. The plant building has approximately 5,458 square meters of production space and has 800 square meters of office space, and is approximately 14 years old. BaiQuan Dairy has approximately 62 production and packaging employees. American Dairy has a milk powder packaging plant called Feihe Dairy in Kedong County in China that commenced milk powder processing production in August 2001. This plant is located at 1st Qingxiang Street, Kedong County, in the City of QiQiHaEr, in Heilongjiang Province, China. Geihe Dairy has approximately 134 packaging employees at this plant. American Dairy began building an additional new milk powder processing plant during 2004 in close proximity to its Sanhao Dairy plant in Kedong County. American Dairy acquired the land use rights to this location for $400,966. American Dairy entered into a construction contract to build the new plant for $4,210,870 (Rmb.34,866,000). American Dairy has incurred construction costs and has ordered new milk powder processing machines and equipment from suppliers at a cost of $10,757,620 through December 31, 2004. The existing production facilities of American Dairy employ approximately 432 total production personnel. All aspects of production of American Dairy's products are based on traditional practices designed to yield premium quality, wholesome and superior tasting foods. The two existing and operating production facilities of American Dairy have a daily milk processing capability of 150 tons of fresh milk. American Dairy has: 1. production lines for processing liquid milk into powdered milk; 2. production lines for processing bean-milk powders; and 3. production lines for processing milk Crowley bean, milk Crowley, and solid milk. 7 Because of the consistent quality of the milk powder products of American Dairy, it was awarded an ISO9002 quality Assurance Certificate in October 2000. In accordance with the requirements of ISO9002, American Dairy established a "Quality Assurance Handbook" that provides standardized requirements and procedures regarding the purchase of raw milk, its milk processing systems, storage and packaging standards, the distribution of its products, and employee training. Milk Processing. American Dairy believes that through purchasing raw milk locally and employing minimal processing techniques, it is able to preserve the fresh taste of milk. American Dairy's dairy processes raw milk within 24 to 36 hours after milking. Most large regional dairies, it believes, process raw milk which may be three to four days old. Milk processed by conventional farms for sale to regional dairies is typically stored at the farm for a minimum of two days, commonly spends a full day in transit to the dairy facility, and is only processed the following day. American Dairy's milk is not homogenized. During homogenization, pressurized milk is forced through openings smaller than the size of the fat globules present in milk, breaking them into smaller particles. Thus treated, the milk fat remains suspended and does not separate out in the form of cream. American Dairy believes that this process adversely affects the taste and feel of milk. In addition, American Dairy's milk is pasteurized at the lowest temperatures allowed by law to avoid imparting a cooked flavor to the milk. When the milk is clarified and the butterfat removed to yield cream and skim milk, a process of cold separation is used, rather than the more commonly employed hot separation which it believes adversely affects the favor of the milk. Dairy Product Processing. American Dairy's products are made in small batches using minimal processing techniques to maintain freshness and allow maximum flavor and nutrition retention. They are made with wholesome ingredients. No chemicals or additives are employed. Because they are produced locally, our dairy products arrive to consumers in American Dairy's marketing area sooner after production than most other dairy products. To assure product quality, the beginning of each production run is sampled for flavor, aroma, texture and appearance. In addition, inspectors conduct spot-checks for bacteria and butterfat content in its products, as well as sanitary conditions in its facilities. 8 Customers No customers of American Dairy equaled or exceeded 10% of its sales during the years ended December 31, 2004 or 2003. American Dairy distributed its products to 25 provinces in China during 2004. No province exceeded 10% of sales, except the Beijing area which comprised 24.8% of the sales of American Dairy. Research and Development American Diary has six technicians engaged in research and development activities. These technicians monitor quality control at the milk processing plants of American Diary to ensure that the processing, packaging and distribution of the milk products result in high quality premium milk products that are safe and healthy for its customers. These technicians also pursue methods and techniques to improve the taste and quality of its milk products and to evaluate new milk products for further production based upon changes in consumer tastes, trends and the introduction of competitive products by other milk producers. Growth Strategy American Dairy believes that its products enjoy a reputation among those people who are familiar with its milk powder products for being high quality products. American Dairy believes that this reputation has spread principally by word-of-mouth and also as a result of favorable press coverage. American Dairy has also increased its marketing efforts through national television. Pursuant to its marketing plan, American Dairy will seek to build upon the reputation of its products and create strong brand identities, making its products more widely recognizable. American Dairy will seek to extend the distribution of its products to contiguous markets with high population concentrations. If American Dairy can successfully implement its growth strategy, American Dairy will also seek to enter other markets through joint ventures, licensing or other arrangements with local dairy farms which it believes would benefit significantly from selling their raw milk to newly established local dairies that will produce and sell American Dairy brand milk powder products and soybean products in their local markets. The key elements of American Dairy's growth strategy to reach its goal, include: * emphasizing local production and distribution. Its marketing efforts will continue to emphasize the local production and distribution of its products, which begins with purchasing raw milk from local farmers, resulting in premium quality milk powder products. * increasing regional and national television advertising to better establish the "Feihe" brand name and increase the scope of its market area. 9 Brand Development and Marketing Brand Identity. American Dairy's marketing will emphasize the local production and national distribution of its products, which begins with local dairy herds and results in premium quality products to a national market. It believes that its story adds legitimacy to its marketing claim that it produces farm fresh products and helps to instill confidence in consumers as to the purity and wholesomeness of its products. American Dairy also seeks to convey its story through the packaging it uses for its products. Its products have also received marketing benefits from a considerable volume of favorable press and other publications of mass circulation which has rated its products highly. American Dairy's marketing and promotional efforts will continue to include: * Redesigning packaging of non-fluid products to promote a premium quality image. * Refining and targeting its message, which to date has largely been the product of work-of-mouth and product reviews. * Developing trade material, including four-color trade sell sheets and brochures. * Further distinguishing its products from other dairy products. * Expanding retail advertising, including print advertising, televised advertising and focused public relations. Competition The food and beverage business is highly competitive and, therefore, American Dairy faces substantial competition in connection with the marketing and sale of its milk powder products and soybean products. Its products are positioned as premium products and, accordingly, are generally priced higher than certain similar competitive products. American Dairy believes that the principal competitive factors in marketing its products are quality, taste, freshness, price and product recognition. While American Dairy believes that it competes favorably in terms of quality, taste and freshness, its products are more expensive and less well known than certain other established brands. Its premium products may also be considered in competition with non-premium quality dairy products for discretionary food dollars. Walnut Powder Operations During April 2004, the Company established a 60% owned subsidiary called Shanxi Feihesantai Biotechnology Scientific and Commercial Co., Limited ("Shanxi Feihesantai"), a limited liability company registered in Shanxi Province in The People's Republic of China. The business of Shanxi Feihesantai is the production and distribution of walnut powder and other walnut products. Shanxi Feihesantai was organized with $402,174 in registered capital. 10 Shanxi Feihesantai is currently building a walnut powder production and distribution facility. The total expenditures for the construction of this facility as of December 31, 2004, were $3,963,121. It is expected that this plant will be completed and begin operations during 2005. Government Regulation American Dairy is regulated under national and county laws in China. The following information summarizes certain aspects of those regulations applicable to American Dairy and is qualified in its entirety by reference to all particular statutory or regulatory provisions. Regulations at the national, province and county levels are subject to change. To date, compliance with governmental regulations has not had a material impact on American Dairy's level of capital expenditures, earnings or competitive position, but, because of the evolving nature of such regulations, management is unable to predict the impact such regulation may have in the foreseeable future. As a manufacturer and distributor of food products, American Dairy is subject to regulations of China's Agricultural Ministry. This regulatory scheme governs the manufacture (including composition and ingredients), labeling, packaging and safety of food. It also regulates manufacturing practices, including quality assurance programs, for foods through its current good manufacturing practices regulations, and specifies the standards of identity for certain foods, including the products sold by American Dairy, and prescribes the format and content of many of the products sold by American Dairy, prescribes the format and content of certain nutrition information required to appear on food products labels and approves and regulates claims of health benefits of food products. In addition, China's Agricultural Ministry authorizes regulatory activity necessary to prevent the introduction, transmission or spread of communicable diseases. These regulations require, for example, pasteurization of milk and milk products. American Dairy and its products are also subject to province and county regulations through such measures as the licensing of dairy manufacturing facilities, enforcement of standards for its products, inspection of its facilities and regulation of its trade practices in connection with the sale of dairy products. Borrowing Policies American Dairy may borrow at competitive rates of interest. Borrowed funds will not be used for dividends to the shareholders. The precise amount, if any, borrowed by American Dairy will depend in part upon the availability of financing, and prevailing interest rates and other loan costs. There is no assurance that such financing, if any, will be available to American Dairy in the amounts desired or on terms considered reasonable by the Board of Directors. Loan agreements may require that American Dairy maintain certain reserves or compensating balances and may impose other obligations on American Dairy. Moreover, since a significant proportion of American Dairy's revenues may be reserved for repayment of debt, the use of financing may reduce the cash that might otherwise be available for dividends until the debt has been repaid and may reduce total cash flow for a significant period. 11 American Dairy may, under appropriate circumstances, attempt to cause American Dairy to borrow funds at fixed interest rates. However, American Dairy may borrow funds at rates that vary with a "prime" or "base" rate, particularly on an interim basis or when interest rates are believed to be trending downward. A rise in the indexed rate may increase borrowing costs and reduce the amount of its income and cash available for distribution. In past years, the prime rates charged by major banks have fluctuated significantly; as a result, the precise amount of interest that American Dairy might be charged cannot be predicted with any certainty. Risk Factors Expansion Risks. American Dairy anticipates that its proposed expansion of its milk processing plants may include the construction of new or additional facilities. American Dairy's cost estimates and projected completion dates for construction of new production facilities may change significantly as the projects progress. In addition, American Dairy's projects will entail significant construction risks, including shortages of materials or skilled labor, unforeseen environmental or engineering problems, weather interferences and unanticipated cost increases, any of which could have a material adverse effect on the projects and could delay their scheduled openings. A delay in scheduled openings will delay American Dairy's receipt of increased sales revenues. New Projects. The projects of American Dairy to finance, develop, and expand its milk processing facilities will be subject to the many risks inherent in the rapid expansion of a high growth business enterprise, including unanticipated design, construction, regulatory and operating problems, and the significant risks commonly associated with implementing a marketing strategy in changing and expanding markets. There can be no assurance that any of these projects will become operational within the estimated time frames and projected budgets at the time American Dairy enters into a particular agreement, or at all. In addition, American Dairy may develop projects as joint ventures in an effort to reduce its financial commitment to individual projects. There can be no assurance that the significant expenditures required to expand its milk processing plants will ultimately result in the establishment of increased profitable operations. When American Dairy's future expansion projects become operational, American Dairy will be required to add and train personnel, expand its management information systems and control expenses. If American Dairy does not successfully address American Dairy's increased management needs or American Dairy otherwise is unable to manage its growth effectively, American Dairy's operating results could be materially and adversely affected. Uncertainty of Market Acceptance. American Dairy is currently selling its products principally in northern China. Achieving market acceptance for American Dairy's products, particularly in new markets, will require substantial marketing efforts and the expenditure of significant funds. There is substantial risk that any new markets may not accept or be as receptive to American Dairy's products. Market acceptance of American Dairy's current and proposed products will depend, in large part, upon the ability of American Dairy to inform potential customers that the distinctive characteristics of its products make them superior to competitive products and justify their pricing. There can be no assurance that American Dairy's current and proposed products will be accepted by consumers or that any of American Dairy's current or proposed products will be able to compete effectively against other premium or non-premium dairy products. Lack of market acceptance of American Dairy's products would have a material adverse effect on American Dairy. 12 Changing Consumer Preferences. As is the case with other companies marketing dairy products, American Dairy is subject to changing consumer preferences and nutritional and health-related concerns. American Dairy believes that minimal processing and the absence of preservatives, additives, artificial sweeteners or artificial flavorings increases the attractiveness of its products to consumers. American Dairy's business could be affected by certain consumer concerns about dairy products, such as the fat, cholesterol, calorie, sodium, lactose content or contamination of such products. There is a significant percentage of customers in China who are lactose intolerant, and may therefore prefer other beverages. American Dairy could become subject to increased competition from companies whose products or marketing strategies address these consumer concerns more effectively. Effect of Adverse Medical Research Relating to Milk and Demand for Milk. Periodically, medical and other studies are released and announcements by medical and other groups are made which raise concerns over the healthfulness of cow's milk in the human diet. To date, American Dairy does not believe that any such studies have had a material effect on milk consumption rates in China. However, a study may be published or an announcement made concerning the healthfulness of cow's milk which may result in a decrease in demand for dairy products in China. Production Capacity. There is no assurance that American Dairy will be able to increase its production capacity to a level sufficient to meet anticipated increased demand for its products associated with its marketing and promotional efforts. American Dairy currently manufactures dairy products at a rate which utilizes approximately 130 tons of raw milk per year. American Dairy believes that it currently has the capacity, based on an assumed mix of products, to manufacture dairy products at a rate which utilizes approximately 450 tons of raw milk per week. American Dairy plans to purchase equipment and make improvements to its dairy plants which, it believes, should increase its capacity to manufacture products to a rate which utilizes approximately 162,000 tons of raw milk per week. There is no assurance, however, that American Dairy's contemplated improvements to its dairy plants will increase production capacity to the level anticipated or that production can be increased at a rate sufficient to meet anticipated increased demand for its products. There can be no assurance, further, that the product mix which American Dairy anticipates achieving and, therefore, which it has used in determining the equipment requirements of its dairy processing plants will prove to be accurate, making uncertain the future capacity of its dairy plant. Failure to meet possible increased demand for its products, on a timely basis, could have a material adverse effect on American Dairy's business, operations and finances. Impact of Growth on Quality of Dairy Products. American Dairy's products are manufactured in small batches with milk from the farms of local farmers. American Dairy believes that the small batch production methods it employs and the quality of the raw milk it uses contribute to the quality of its dairy products. There can be no assurance that the quality of American Dairy's dairy products will be maintained at increased levels of production. Increased production levels may cause American Dairy to modify its current manufacturing methods and will necessitate the use of milk from other additional sources. A decline in the quality of American Dairy's products could have a material adverse effect on American Dairy's business, operations and finances. Sales Force. American Dairy has hired additional sales personnel during 2004. There is no assurance that hiring these additional sales people will result in increased sales. American Dairy anticipates using independent dairy distributors to sell and distribute its products in new contiguous expansion markets, including Beijing. American Dairy cannot predict whether it will be able to obtain and maintain satisfactory sales and distribution arrangements and the failure to do so could have a material adverse effect on its business, operations and finances. 13 Limited Delivery Capacity; Delays in Delivery of Products. If sales increase, there is no assurance that American Dairy will be able to deliver increased product volumes on a timely and efficient basis. Further, there can be no assurance that American Dairy will be able to deliver its products "fresh" to customers on a consistent basis, especially with increased product volumes, and a failure to do so could have a material adverse effect on its business, operations and finances. Supply of Raw Milk. The raw milk used in our products is supplied to American Dairy by numerous local farms under output contracts. American Dairy's farmers are currently producing 30 tons of milk per day. American Dairy believes that its farmers can more than double their production of raw milk. American Dairy further believes, however, that this supply may not be sufficient to meet increased demand for its products associated with its proposed marketing efforts. American Dairy believes that the supply of raw milk from its farmers should satisfy its requirements for raw milk for at least the next 12 months. Though American Dairy believes that additional raw milk is available locally, if needed, there is no assurance that American Dairy will be able to enter into arrangements with the producers of such milk on terms acceptable to American Dairy, if at all. An inadequate supply of raw milk will have a material adverse effect on its business, operations and finances. Possible Volatility of Raw Milk Costs. The current policy of China since the mid-1990s has focused on moving the industry in a more market oriented direction. These reforms have resulted in the potential for greater price volatility relative to past periods, as prices are more responsive to the fundamental supply and demand aspects of the market. These changes in China's dairy policy could increase the risk of price volatility in the dairy industry. There can be no assurance that a significant volatility in milk prices will not occur or that any such volatility would not have a material adverse effect on its business, operations and finances. Geographic Concentration; Fluctuations in Regional Economic Conditions. Nearly all of American Dairy's sales are concentrated in the northern area of China. Accordingly, American Dairy is susceptible to fluctuations in its business caused by adverse economic conditions in this region. American Dairy's products are priced higher than non-premium quality dairy products. Although American Dairy believes that the quality, freshness, flavor and absence of artificial ingredients in its products compensate for this price differential, there can be no assurance that consumers will be willing to pay more for such products in unfavorable economic conditions, or at all. Difficult economic conditions in other geographic areas into which American Dairy may expand may also adversely affect its business, operations and finances. Dependence on Executives. American Dairy is highly dependent on the services of Leng You-Bin and Liu Hua, and the loss of their services would have a material adverse impact on the operations of American Dairy. They have been primarily responsible for the development of American Dairy and the development and marketing of its products. American Dairy has not applied for key-man life insurance on the lives of these executives, but may do so in the future. Competition. The milk business is highly competitive and, therefore, American Dairy faces substantial competition in connection with the marketing and sale of its products. In general, milk products are price sensitive and affected by many factors beyond the control of American Dairy, including changes in consumer tastes, fluctuating commodity prices and changes in supply due to weather, production, feed costs and natural disasters. American Dairy's products compete with other premium quality dairy brands as well as less expensive, non-premium brands. American Dairy's milk faces competition from non-premium milk producers distributing milk in its marketing area; other milk producers packaging their milk in glass bottles, and other special packaging, which serve portions of its marketing area. Most of American Dairy's competitors are well established, have greater financial, marketing, personnel and other resources, have been in business for longer periods of time than American Dairy, and have products that have gained wide customer acceptance in the marketplace. The largest competitors of American Dairy are state-owned dairies owned by the government of China. Large foreign milk companies have also entered the milk industry in China. The greater financial resources of such competitors will permit them to procure retail store shelf space and to implement extensive marketing and promotional programs, both generally and in direct response to advertising claims by American Dairy. The milk industry is also characterized by the frequent introduction of new products, accompanied by substantial promotional campaigns. There can be no assurance that American Dairy will be able to compete successfully or that competitors will not develop products which will have superior qualities or which will gain wider market acceptance than its products. 14 Consolidation of Dairy Industry. American Dairy established its dairy plants at a time when local dairies were being consolidated into large dairies due to the market and the efficiencies of larger operations. This consolidation trend is continuing and the forces responsible for it, including increased efficiencies and economies of scale that are present in large regional dairies, may put American Dairy at a competitive disadvantage. Lack of Property and General Liability Insurance. American Dairy and its subsidiaries are self-insured, and they do not carry any property insurance, general liability insurance, or any other insurance that covers the risks of their business operations. As a result, any material loss or damage to its properties or other assets, or personal injuries arising from its business operations would have a material adverse affect on its financial condition and operations. Potential Product Liability Associated with Food Products. American Dairy faces the risk of liability in connection with the sale and consumption of milk products and soybean products should the consumption of such products cause injury, illness or death. Such risks may be particularly great in a company undergoing rapid and significant growth. American Dairy currently maintains no product liability insurance. There can be no assurance that any insurance will be sufficient to cover potential claims or that the level of such coverage to be acquired and maintained by American Dairy will be available in the future at a reasonable cost. A partially or completely uninsured successful claim against American Dairy could have a material adverse effect on American Dairy. Government Regulation. American Dairy is subject to extensive regulation by China's Agricultural Ministry, and by other county and local authorities in jurisdictions in which its products are processed or sold, regarding the processing, packaging, storage, distribution and labeling of its products. Applicable laws and regulations governing its products may include nutritional labeling and serving size requirements. American Dairy was awarded the ISO 9002 Quality Assurance Certificate in October 2000 and is in compliance with the ISO 9002 requirements with respect to its production processes. American Dairy's processing facilities and products are subject to periodic inspection by national, county and local authorities. American Dairy believes that it is currently in substantial compliance with all material governmental laws and regulations and maintains all material permits and licenses relating to its operations. Nevertheless, there can be no assurance that American Dairy will continue to be in substantial compliance with current laws and regulations, or whether American Dairy will be able to comply with any future laws and regulations. To the extent that new regulations are adopted, American Dairy will be required to conform its activities in order to comply with such regulations. Failure by American Dairy to comply with applicable laws and regulations could subject American Dairy to civil remedies, including fines, injunctions, recalls or seizures, as well as potential criminal sanctions, which could have a material adverse effect on its business, operations and finances. 15 Doing Business in China. Doing business in China involves various risks including internal and international political risks, evolving national economic policies as well as financial accounting standards, expropriation and the potential for a reversal in economic conditions. Since the late 1970s, the government of the PRC has been reforming the Chinese economic system. These reforms have resulted in significant economic growth and social progress. Although we believe that economic reform and the macroeconomic policies and measures adopted by the current Chinese government will continue to have a positive effect on economic development in China and that we will continue to benefit from such policies and measures. These policies and measure may from time to time be modified or revised. Adverse changes in economic policies of the Chinese government or in the laws and regulations, if any, could have a material adverse effect on the overall economic growth of China, and could adversely affect our business operations. The Chinese currency, "Renminbi", is not a freely convertible currency, which could limit our ability to obtain sufficient foreign currency to support our business operations in the future. We rely on the Chinese government's foreign currency conversion policies, which may change at any time, in regard to our currency exchange needs. We receive substantially all of our revenues in Renminbi, which is not freely convertible into other foreign currencies. In China, the government has control over Rennminbi reserves through, among other things, direct regulation of the conversion or Renminbi into other foreign currencies and restrictions on foreign imports. Although foreign currencies which are required for "current account" transactions can be bought freely at authorized Chinese banks, the proper procedural requirements prescribed by Chinese law must be met. At the same time, Chinese companies are also required to sell their foreign exchange earnings to authorized Chinese banks and the purchase of foreign currencies for capital account transactions still requires prior approval of the Chinese government. This type of heavy regulation by the Chinese government of foreign currency exchange restricts certain of our business operations and a change in any of these government policies, or any other, could further negatively impact our operations. Fluctuations in the exchange rate between the Chinese currency and the United States dollar could adversely affect our operating results. The functional currency of our operations in China is "Renminbi". Results of our operations are translated at average exchange rates into United States dollars for purposes of reporting results. As a result, fluctuations in exchange rates may adversely affect our expenses and results of operations as well as the value of our assets and liabilities. Fluctuations may adversely affect the comparability of period-to-period results. Although we may use hedging techniques in the future (which we currently do not use), we may not be able to eliminate the effects of currency fluctuations. Thus, exchange rate fluctuations could have a material adverse impact on our operating results and stock prices. As a company based in China, our shareholders may have greater difficulty in obtaining information about us on a timely basis than would shareholders of a U.S.-based company. Our operations will continue to be conducted in China and shareholders may have difficulty in obtaining information about us from sources other than us. Information available from newspapers, trade journals, or local, regional or national regulatory agencies such as issuance of construction permits, contract awards for development projects, etc. will not be readily available to shareholders. Shareholders will be dependent upon our management for reports of our progress, development, activities and expenditure of proceeds. 16 In order for the China subsidiaries of American Dairy to pay dividends to American Dairy, a conversion of Renminbi into US dollars is required. Under current Chinese law, the conversion of Renminbi into foreign currency generally requires government consent. Government authorities may impose restrictions that could have a negative impact in the future on the conversion process and upon the ability of American Dairy to meet its cash needs, and to pay dividends to its shareholders. However, the subsidiaries of American Dairy are presently classified as a wholly - owned foreign enterprise ("WOFE") in the PRC that have verifiable foreign investment in the PRC, funding having been made through an official PRC banking channel. Because the subsidiaries of American Dairy qualify for treatment as a WOFE, the subsidiaries can declare dividends and their funds can be repatriated to American Dairy in the United States under current laws and regulations in the PRC. Limited Trademark Protection. American Dairy has obtained trademark registrations for the use of its tradename "Feihe", which has been registered with the Trademark Bureau of the State Administration for Industry and Commerce with respect to its milk products. American Dairy believes its trademark is important to the establishment of consumer recognition of its products. However, there can be no assurance as to the breadth or degree of protection that the trademarks may offer American Dairy, that American Dairy will have the financial resources to defend the trademarks against any infringement, or that such defense will be successful. Moreover, any events or conditions that negatively impact its trademarks could have a material adverse effect on its business, operations and finances. Proprietary Knowledge and Absence of Patent Protection. American Dairy has no patents covering its products or production processes and expects to rely principally on know-how and the confidentiality of its formulae and production processes for its products and its flavoring formulae in producing a competitive product line. There is no assurance that any of these factors can be maintained or that they will afford American Dairy a meaningful competitive advantage. Item 2. Description of Property The principal executives of American Dairy are located at C-16 Shin Chen International Building, No. 10, Jiu- shen Road, Zho Yan Chu, Beijing, The People's Republic of China. The building was acquired during 2003 at a purchase price of $1,200,861. American Dairy presently operates two milk powder processing plants and various warehouses in northern China, known as Feihe Dairy and BaiQuan Dairy. American Dairy is in the process of constructing a new milk powder production facility in Kedong County, Heilongjiang Province in The People's Republic of China which is expected to be completed during 2005. As of December 31, 2004, American Dairy has expended $10,757,620 in construction and equipment costs. American Dairy is in the process of completing the construction of a new plant in Shenyang in northeast China to produce walnut powder, a new product of American Dairy. As of December 31, 2004, American Dairy has expended $3,963,121 in construction costs. It is expected this facility will be completed during 2005. There is no private ownership of land in the PRC and all land ownership is held by the government of the PRC, its agencies and collectives. Land use rights are obtained from the government for periods ranging from 40 to 50 years, and are typically renewable. Land use rights can be transferred upon approval by the land administrative authorities of the PRC (State Land Administration Bureau) upon payment of the required land transfer fees. 17 Item 3. Legal Proceedings From time to time, American Dairy may become involved in various claims and lawsuits incidental to its business. There are presently no material legal proceedings pending or threatened against American Dairy. American Dairy is not a party to any material litigation, and there are no material outstanding claims against American Dairy or its assets. Item 4. Submission of Matters to a Vote of Security Holders None PART II Item 5. Market for Common Equity, Related Shareholder Matters and Small Business Issuer Purchases of Equity Securities General American Dairy is authorized to issue 50,000,000 shares of Common Stock, $.001 par value per share. At December 31, 2004, there were 13,556,354 shares of Common Stock issued and outstanding that were held by 299 stockholders of record. The Common Stock of American Dairy is traded on the NASD Electronic Bulletin Board over-the-counter market (OTC-BB), and is quoted under the symbol "ADIY". Common Stock Holders of Common Stock are entitled to one vote for each share held on all matters voted upon by stockholders, including the election of directors. The holders of Common Stock have no preemptive rights to purchase or subscribe for any stock of American Dairy now or hereafter authorized or for securities convertible into such stock. All of the outstanding shares of Common Stock are fully paid and nonassessable. Upon any liquidation of American Dairy, the holders of Common Stock are entitled to share ratably in assets available for distribution to suck stockholders. Holders of Common Stock are entitled to receive dividends out of assets legally available therefore at such times and in such amounts as the Board of Directors may from time to time determine. Shareholders are not entitled to cumulative voting rights, and accordingly, the holders of a majority of the voting power of the shares voting for the election of directors can elect the entire class of directors to be elected each year if they choose to do so and, in that event, the holders of the remaining shares will not be able to elect any person as a director of such class. Dividend Restrictions The terms of the instruments governing the future indebtedness of American Dairy may contain restrictions on the payment of dividends and the making of distributions on its Common Stock and the purchase or redemption of outstanding capital stock of American Dairy. By reason of these restrictions, American Dairy may be unable to pay dividends on its Common Stock for some period in the future, which cannot presently be estimated. American Dairy has not declared or paid any dividends on its Common Stock and presently does not presently expect to declare or pay any such dividends in the foreseeable future. America Dairy has not yet formulated a future dividend policy in the event restrictions on its ability to pay dividends are created. Transfer Agent and Registrar The Transfer agent and registrar for American Dairy in Interwest Stock Transfer Co., 1981 E. Murray Road, #100, Halladay, Utah 84117-5148; telephone (801) 272-9294. Market for Common Stock. The following table sets forth the range of high and low closing bid prices per share of the Common Stock (trading symbol ADIY)of American Dairy for the periods indicated (reflecting inter-dealer prices without retail mark-up, mark-down or commission and may not represent actual transactions). High Closing Low Closing Bid Prices (1) Bid Prices (1) -------------- -------------- Year Ended December 31, 2002 1st Quarter .................... $0.05 $0.04 2nd Quarter .................... $0.06 $0.03 3rd Quarter .................... $0.06 $0.05 4th Quarter .................... $0.08 $0.06 ---------------------- Year Ended December 31, 2003 1st Quarter .................... $0.11 $0.05 2nd Quarter (1) ............... $2.00(2) $0.01 3rd Quarter .................... $1.30 $0.10 4th Quarter .................... $3.00 $1.30 ---------------------- Year Ended December 31, 2004 1st Quarter .................... $2.00 $2.00 2nd Quarter (1) ............... $3.00 $2.00 3rd Quarter .................... $3.90 $2.50 4th Quarter .................... $5.02 $3.30 ---------------------- (1) On May 7, 2003, the Company had a one-for-nineteen (1-for-19) reverse stock split of its Common Stock. 18 The closing sales price of the Common Stock of American Dairy on March 28, 2005 was $4.60 per share. If the trading price of American Dairy's Common Stock is below $5.00 per share, the Common Stock is considered to be "penny stocks" that are subject to rules promulgated by the Securities and Exchange Commission (Rule 15-1 through 15g-9) under the Securities Exchange Act of 1934. These rules impose significant requirements on brokers under these circumstances, including: (a) delivering to customers the Commission's standardized risk disclosure document; (b) providing customers with current bid and ask prices; (c) disclosing to customers the broker-dealer's and sales representatives compensation; and (d) providing to customers monthly account statements. Compensation Plan. American Dairy has a 2003 Incentive Plan that authorizes the issuance of up to 3,000,000 shares of its Common Stock for stock options, SAR's and stock bonuses to its directors, officers, employees and consultants. As of December 31, 2004, no awards have been made under the Plan.
Number of securities remaining available for future issuance Number of securities to Weighted-average under equity be issued upon exercise exercise price of compensation plans of outstanding options, outstanding warrants (excluding securities warrants and rights and rights reflected in column a) ------------------- ---------- ---------------------- (a) (b) (c) Equity compensation plans approved by security holders -0- -0- 3,000,000 Equity compensation plans not approved by security holders None None None Total -0- -0- 3,000,000
Sale of Unregistered Securities. During the three months ended December 31, 2004, American Dairy sold shares of its restricted Common Stock that were not registered under the Securities Act of 1933, as described below: During the three months ended December 31, 2004, American Dairy sold 1,025,147 shares of Common Stock and warrants to purchase 1,025,147 shares of Common Stock at $2.25 per share to 42 investors at $2.25 per share in the aggregate amount of $2,306,581, in reliance upon Rule 506 of Regulation D under the Securities Act of 1933, as amended. In connection with this offering, the underwriters were issued warrants to purchase 237,591 shares of restricted Common Stock at $1.50 per share for a term of three years. During the three months ended December 31, 2004, American Dairy sold 571,429 shares of its Common Stock and a warrant to purchase Common Stock to one institutional investor for $2,000,000, in reliance upon Section 4(2) of the Securities Act of 1933. The underwriter was issued a warrant to purchase 114,286 shares of Common Stock at $2.70 per share for a term of three years regarding this placement. 19 Item 6. Management's Discussion and Analysis or Plan of Operations Significant Accounting Estimates and Policies The discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates including the allowance for doubtful accounts, the saleability and recoverability of inventory, income taxes and contingencies. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form our basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We must make estimates of the collectability of accounts receivable. We analyze historical write-offs, changes in our internal credit policies and customer concentrations when evaluating the adequacy of our allowance for doubtful accounts. Differences may result in the amount and timing of expenses for any period if we make different judgments or use difference estimates. As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes. This process involves estimating our current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income, and, to the extent we believe that recovery is not likely, we must establish a valuation allowance. To the extent that we establish a valuation allowance or increase this allowance in a period, we must include a tax provision or reduce our tax benefit in the statements of operations. We use our judgment to determine our provision or benefit for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. We believe, based on a number of factors including historical operating losses, that we will not realize the future benefits of a significant portion of our net deferred tax assets and we have accordingly provided a full valuation allowance against our deferred tax assets. However, various factors may cause those assumptions to change in the near term. We cannot predict what future laws and regulations might be passed that could have a material effect on our results of operations. We assess the impact of significant changes in laws and regulations on a regular basis and update the assumptions and estimates used to prepare our financial statements when we deem it necessary. Comparison of Years Ended December 31, 2004 and 2003 The following table sets forth certain operating information regarding American Dairy,Inc., including its subsidiaries. Year Ended Year Ended December 31, 2004 December 31, 2003 ----------------- ----------------- Revenues $37,416,223 $26,635,832 Cost of goods sold $18,006,918 $15,732,640 Distribution expenses $13,486,232 $ 7,899,265 General and administrative $ 1,313,358 $ 1,699,435 Depreciation $ 54,419 $ 131,302 Other Income $ 1,489,767 $ 1,196,939 Gain on disposal of assets $ 693 $ -- Interest expense $ 49,353 $ 24,809 Net Income $ 6,258,380 $ 2,036,807 20 Net income increased by 207% from $2,036,807 in 2003 to $6,258,380 for 2004. This increase in net income is attributable primarily to the following factors: (1) a 40% increase in sales; (2) a 35% increase in gross profit margins from 41% in 2003 to 52% in 2004; and (3) a 70% increase in distribution expenses, offset in part by: (i) a 21% decrease in general and administrative expenses, and (ii) a $600,134 decrease in enterprise income tax expense. Revenues. Revenues increased by $10,780,391 or 40% from $26,635,832 in 2003 to $37,416,223 in 2004. This increase was due primarily to expanding market areas and adding new value added products. Increase in sales is due to the following factors: * Increased popularity of "Feihi" brand of mainland China following the successful advertising campaigns in the previous year and extensive networks of Agencies in 25 provinces; * Demands boosted by improved and high quality ingredients for several products such as Ca+Zn CPP series and nucleotides series and families or markets mostly accepted these products; * Increase in overall sales quantity by 2,975,862 kilograms or 28% year-on-year to 13,478,645 kilograms for the year ended December 31, 2004 compared to the same corresponding period of 10,502,782 kilograms in 2003; and * The dairy milk industry scandal in China in 2003 and the resulting strict control over dairy producers (quality and ingredient contains) drove many unscrupulous diary producers and their tainted dairy products out of the market. Consumers concentrated on dairy products produced by such reputable dairy producers as Feihe Dairy. Increase in sales quantities of several high profit margin major products such as: * Milk powder with Ca+Zn totaling 4,719,669 kilograms (2003: 3,718,421 kilograms) by 26.9% year-on-year; * CPP services totaling 2,398,578 kilograms (2003: 785,483 kilograms) by 205% year-on-year; and * Nucleotides series totaling 219,152 kilograms in 2004 (2003: 27,155 kilograms) by 707% year-on-year. 21 Cost of Goods Sold. Cost of goods sold increased 14% or $2,274,278 from $15,732,640 in 2003 to $18,006,918 in 2004. This increase is due primarily to a 28% increase in sales volume offset in part by a 38% improvement in unit gross profit margins from $1.04 kilogram in 2003 to $1.44 per kilogram in 2004. The improved gross profit margins were due to increases in sales of high gross profit product and improved manufacturing efficiencies which were obtained as new processing facilities came on line during the year, offset in part by an overall 10% increase in the cost of raw materials. Distribution Expenses. Distribution expenses for the year ended December 31, 2004 were $13,486,232, an increase of $5,586,967 or 71% from the prior year's distribution expenses of $7,899,265. The principal reasons for the increase were substantial increases in advertising expense, distribution salaries, and transportation expense which were incurred to expand market areas. General and Administrative Expenses. General and administrative expenses for the year ended December 31, 2004 were $1,313,358, a decrease of $356,077 or 21% from the prior year's general and administrative expenses of $1,669,435. The principal reason for the decrease was a reduction in consulting fees incurred at the parent company level from 2003 to 2004. Depreciation Expense. Depreciation expense for the year ended December 31, 2004 was $54,419 and $206,875, respectively, for the year ended December 31, 2004, an increase of $129,992 from the prior years depreciation expense of $131,302 which was included in operating and administrative expenses. This increase is due primarily to substantial additions of buildings, plant and machinery in Feihe Dairy and BaiQuan Feihe during 2004. Other Income. Other income which consist primarily of VAT tax rebates provided by the provinces as an economic incentive, increased by $292,828 or 24% from $1,196,939 in 2003 to $1,489,767 in 2004 due primarily to increased sales volumes. Interest Expense. Interest expense for the year ended December 31, 2004 was $49,353 as compared to only $24,809 for the prior year. This increase was due primarily to increases in exchange loss and interest expenses arising from short-term loans repaid in 2004 and a bank loan to finance the acquisition of the Beijing office. Income Taxes. Income tax expense decreased by $600,134 from $338,513 of expense in 2003 to $261,621 of income tax benefit in 2004. This was due primarily to reversal of prior year's tax actual on BiaQuan Dairy which was waived by the taxing authorities in 2004. Liquidity and Capital Resources Operating Activities. Net cash flows provided by operating activities for the year ended December 31, 2004 was $16,358,496 compared with net cash flows provided by operating activities of $6,036,761 for the year ended December 31, 2003. This increase in cash flows from operating activities was attributable primarily to net income of $6,258,380, and augmented by a decrease in accounts receivable of $537,762, increases of $2,533,031 in accounts payable and $4,826,778 in deferred income, decreases in advances to suppliers of $322,559, inventories in the amount of $32,073, and tax refunds due of $522,562. 22 Sale of Stock. During the fiscal year ended December 31, 2004, American Dairy realized $4,672,906 from the sale of its restricted Common Stock made in reliance upon Rule 506 of Regulation D, Regulation S and Section 4(2) under the Securities Act of 1933, as amended. Working Capital - At December 31, 2004, the Company had a negative working capital of $(6,797,709). Contract Obligations - As of December 31, 2004, the Company had the following contractual obligations:
Contractual Less than One to Four to After Five Obligation Total one year Three Years Five Years Years Notes Payable $ 957,561 $ 359,686 $ 183,032 $ 179,952 $ 234,891 Commitments on con- struction in prograss 2,241,174 2,241,174 -- -- -- Obligations to purchase land 1,120,772 1,120,772 -- -- -- and building Commitments for advertising 1,652,556 1,652,556 -- -- -- Operating lease comittments 269,872 2,542 11,816 11,816 243,698 ----------- ---------- --------- --------- --------- Totals $ 6,241,935 $5,376,730 $ 194,848 $ 191,768 $ 478,589 =========== ========== ========= ========= =========
New Accounting Pronouncements In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities (SFAS 149)". SFAS 149 amends and clarifies certain derivative instruments embedded in other contracts, and for hedging activities under SFAS 133. SFAS 149 is effective for certain contracts entered into or modified by the Company after June 30, 2003. The adoption of SFAS 149 had no impact on the Company's financial position, results of operations, or cash flows. In May 2003, the FASB issued SFAS No. 150, "Accounting for Instruments with Characteristics of Both Debt and Equity" (SFAS 150). Statement 150 requires liability classification for three types of instruments: 1) Mandatory redeemable shares that obligate the company to deliver cash or other assets to shareholders on fixed or determinable dates; 2) Freestanding written put options and forward purchase contracts on a company's own shares that obligate the company to deliver cash or other assets, and 3) Contracts that obligate a company to issue its own shares in amounts that are unrelated to, or inversely related to, the value of the shares. The adoption of SFAS 150 had no impact on the Company's financial position, results of operations, or cash flows. In November 2004, the FASB issued SFAS No. 151 "Inventory Costs - an amendment of ARB No. 43, Chapter 4". Statement No. 151 requires that certain abnormal costs associated with the manufacturing, freight, and handling costs associated with inventory be charged to current operations in the period in which they are incurred. The adoption of SFAS 151 had no impact on the Company's financial position, results of operations, or cash flows. 23 In December 2004, the FASB issued a revision of SFAS No. 123 "Share-Based Payment". The statement establishes standards for the accounting for transactions in which an entity exchanges its equity investments for goods and services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity's equity instruments or that may be settled by the issuance of those equity instruments. The statement does not change the accounting guidance for share-based payments with parties other than employees. The statement requires a public entity to measure the cost of employee service received in exchange for an award of equity instruments based on the grant-date fair value of the award (with limited exception). That cost will be recognized over the period during which an employee is required to provide service in exchange for the award (usually the vesting period). A public entity will initially measure the cost of employee services received in exchange for an award of liability instrument based on its current fair value; the fair value of that award will be remeasured subsequently at each reporting date through the settlement date. Changes in fair value during the requisite service period will be recognized as compensation over that period. The grant-date for fair value of employee share options and similar instruments will be estimated using option- pricing models adjusted for the unique characteristics of these instruments. The statement is effective for the quarter beginning January 1, 2006. In December 2004, the FASB issued SFAS No. 153 "Exchanges of Nonmonetary Assets-amendment of APB Opinion No. 29". Statement 153 eliminates the exception to fair value for exchanges of similar productive assets and replaces it with a general exception for exchange transactions that do not have commercial substance, defined as transactions that are not expected to result in significant changes in the cash flows of the reporting entity. This statement is effective for exchanges of nonmonetary assets occurring after June 15, 2005. Item 7. Financial Statements The consolidated financial statements of American Dairy for its fiscal year ended December 31, 2004 are provided with this Form 10-KSB. Item 8. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure There have been no disagreements regarding accounting and financial disclosure matters with the independent certified public accountants of American Dairy. Item 8A. Controls and Procedures Evaluation of Disclosure Controls and Procedures. American Dairy's Chief Executive Officer and American Dairy's principal financial officer, after evaluating the effectiveness of American Dairy's disclosure controls and procedures (as defined in the Securities Exchange Act of 1934 Rule 13a-14(c)and 15d-14(c) as of a date within 90 days of the filing date of this report on Form 10-KSB for its fiscal year ended December 31, 2004, have concluded that as of the Evaluation Date, American Dairy's disclosure controls and procedures were adequate and effective to ensure that material information relating to American Dairy and American Dairy's consolidated subsidiaries would be made known to them by others within those entities, particularly during the period in which this annual report on Form 10-KSB was being prepared. 24 Changes in Internal Controls. There were no significant changes in American Dairy's internal controls or in other factors that could significantly affect American Dairy's disclosure controls and procedures subsequent to the Evaluation Date, nor any significant deficiencies or material weaknesses in such disclosure controls and procedures requiring corrective actions. As a result, no corrective actions were taken. Item 8B. Other Information Not applicable. PART III Item 9. Directors and Executive Officers of the Registrant The following table sets forth certain information regarding the executive officers and directors of American Dairy. All officers serve at the pleasure of the Board of Directors. Directors serve until the election and qualification of their successors.
Name Age Position ---- --- -------- Leng You-Bin 35 Chairman, Chief Executive Officer and President Liu Hua 32 Chief Financial Officer, Secretary, Treasurer and Director Liu Sheng-Hui 34 Director Hui-Lan Lee 55 Director Dr. Kevil L. Tseng 41 Director Kirk G. Downing 51 Director
Leng You-Bin has been the Chairman, Chief Executive Officer, President, and General Manager of American Dairy since May 7, 2003. He is responsible for the overall strategic planning, management and business development of Feihe Dairy. Mr. Leng has been in the dairy industry for more than 13 years. He obtained his Bachelor of Science degree in Food Engineering from Northeast Agriculture University, China. From 1989 to 1997, Mr. Leng acted as technician, deputy director and director of ZhaoGuang Dairy Plants, the predecessor of Feihe Dairy. From 1997 to 2000, Mr. Leng was the General Manager of Feihe Dairy. He became the Chairman and General Manager in 2000. He has researched and patented the "liver protection milk powder" (GanBao Milk Powder). Liu Hua has been the Chief Financial Officer, Secretary, Treasurer and a director of American Dairy since May 7, 2003, and has been the Financial Officer of Feihe Dairy from November 2000 to the present. From June 1998 to November 2000, he was the Chief Executive Officer of Shenzhen Cima Limited. From September 1993 to January 1996, he was the Chief Executive Officer of Zhengzhou Huacheng Limited. Mr. Liu received a degree from Xian Traffic University in 1993. 25 Liu Sheng-Hui has been a director of American Dairy since May 7, 2003. He is responsible for the overall financial planning and management of Feihe Dairy. He joined Feihe Dairy in 1992. He has held his current position since 1998. He graduated from Northeast Agriculture University with a Bachelor of Economics degree in Economic Management in 1992. Hui-Lan Lee (also known as "Tracy Lee") has been a director of American Dairy since May 7, 2003. She has been the Assistant Vice President-Taxation of Countrywide Home Loan, Inc. from April 2003 to the present. She was the Tax Manager of Watson Pharmaceuticals, Inc. from October 26, 1996 to March 2003. From 1979 to 1996, Ms. Lee was employed by major fortune 500 companies including The Flying Tiger Line Inc. (a Tiger International Company), Quotron Systems, Inc. (a subsidiary of the Citigroup, Inc.) and Lear Siegler, Inc. in various management positions. Ms. Lee holds a Master of Science degree in Taxation from Golden Gate University, and a Master of Business Administration degree from Indiana University. Dr. Tseng became a director of American Dairy on February 21, 2005. From May 1997 to the present, he has been an advanced analyst with Boeing Aerospace engaged in technology development. From January 1994 to May 1997, Dr. Tseng was an Assistant Professor at Purdue University. From October 1991 to January 1994, he was a Research Fellow at the University of Michigan. He graduated in 1985 from Tamkang University majoring in aerospace technology. Dr. Tseng received his M.S.E. degree in 1990 and his Ph.D degree in 1991 from the University of Michigan. He received a M.B.A. degree in management in 2002 from the Marshall School of Business of the University of Southern California. Mr. Downing became a director of American Dairy on February 21, 2005. From December 1980 to the present, he has been practicing law in Los Angeles, California. From January 1989 to June 1997, Mr. Downing also engaged in ranching, farming, logging and property development. Mr. Downing received his B.A. degree in liberal arts from Portland State University in 1976. He received his Juris Doctorate degree in 1980 from Loyola Law School. Item 10. Executive Compensation The officers and directors of American Diary received compensation during the three fiscal years ended December 31, 2004, as follows: SUMMARY COMPENSATION TABLE
ANNUAL COMPENSATION LONG TERM COMPENSATION ---------------------- AWARDS PAYOUTS ------------------------------- OTHER RESTRICTED SECURITIES ALL NAME AND ANNUAL STOCK UNDERLYING LTIP OTHER PRINCIPAL FISCAL SALARY BONUS COMPENSATION AWARDS OPTIONS PAYOUTS COMPESATION POSITION YEAR ($) ($) ($) ($) SARS (#) ($) ($) --------------------------------------------------------------------------------------------------------------------------- Leng You-Bin, Chief 2004 $ -0- $ -0- $ -0- $ -0- $ -0- $ -0- $ -0- Executive Officer 2003 $6,884 $ -0- $ -0- $ -0- $ -0- $ -0- $ -0- and President --------------------------------------------------------------------------------------------------------------------------- Jack Gertino 2004 $ -0- $ -0- $ -0- $ -0- $ -0- $ -0- $ -0- FORMER Chief 2003 $6,884 $ -0- $ -0- $ -0- $ -0- $ -0- $ -0- Executive Officer 2002 $ -0- $ -0- $ -0- $ -0- $ -0- $ -0- $ -0- ---------------------------------------------------------------------------------------------------------------------------
26 American Dairy presently has no employment agreements with its officers or key employees, but may enter into such agreements in the future. Board Compensation American Dairy plans to provide its non-management directors, if any, a competitive directors' compensation package comparable to programs offered by similarly situated corporations. Benefit Plans American Dairy does not have any profit sharing plan or similar plans for the benefit of its officers, directors or employees. However, American Dairy reserves the right to establish any such plans in the future. Incentive Stock Plan Effective April 1, 2003, American Dairy adopted and approved its 2003 Incentive Stock Plan (the "Plan") which reserves 3,000,000 shares of Common Stock for issuance under the Plan. The Plan allows us to issue awards of incentive or non-qualified stock options, stock appreciation rights, and stock bonuses which may be subject to restrictions. No awards of stock options, stock appreciation rights, or stock bonuses have been granted to employees as of December 31, 2004. Mr. Leng You-Bin and Mr. Liu Hua are the members of the Committee that administers the Plan. Compliance with Section 16(a) of the Securities Exchange Act Section 16(a) of the Exchange Act requires American Dairy's executive officers and directors, and persons who beneficially own more than ten percent (10%) of its equity securities, to file reports of ownership and changes in ownership with the U.S. Securities and Exchange Commission. Officers, directors and greater than ten percent shareholders are required by SEC regulation to furnish American Dairy with copies of all Section 16(a) forms they file. Based on its review of the copies of such forms received by it, American Dairy believes that during the year ended December 31, 2004, all such filing requirements applicable to its officers, directors and 10% owners of its Common Stock were complied with. Limited Liability and Indemnification Section 16-10a-840 of the Utah Revised Business Corporation Act (the "URBC") requires directors and officers to perform their duties in good faith and with the care that an ordinary person would exercise under similar circumstances in a manner reasonably believed to be in the best interest of the corporation. A director or officer of a corporation is not liable to the corporation, its shareholders or others for any action taken or any failure to act as an officer or director unless he has breached or failed or failed to perform his duties as described above and the breach or failure to perform constitutes gross negligence, wilful misconduct, or intentional infliction of harm on the corporation or its shareholders. 27 Section 16-10a-841 of the URBC provides that the articles of incorporation of a Utah corporation may eliminate or limit the liability of a director to the corporation or its shareholders for monetary damages, except for (I) a financial benefit to which is not entitled; (ii) an intentional infliction of harm; (iii) unlawful distributions of the corporation constituting a violation of Section 16-10a-842 of the URBC; or (iv) an intentional violation of criminal law. Section 16-10a-902 of the URBC permits a Utah corporation to indemnify directors made a party to a proceeding because he is or was a director if (i) his conduct was in, or not opposed to, the corporation's best interest; and (ii) he reasonably believed his conduct was in, or not opposed to, the corporation's best interests; and (iii) in the case of a criminal proceeding, he had no reasonable cause to believe his conduct was unlawful. However, a Utah corporation may not indemnify a director if he was adjudged liable to the corporation, or if he was adjudged liable on the basis that he derived an improper personal benefit; and such indemnification in any action brought by the corporation is limited to reasonable expenses incurred in connection with the proceedings. Article VI of the Articles of Incorporation and Article VIII of the By-Laws of American Dairy provide for the indemnification of directors and officers of American Dairy. Indemnification is mandatory regarding reasonable expenses incurred in connection with proceedings or claims with respect to which he has been successful. Officers, employees, fiduciaries and agents of a Utah corporation may be entitled to indemnification to a greater extent that directors, if not inconsistent with public policy, if provided for in the Articles of Incorporation, By-Laws, the general or specific action of its board of directors or contract. Consultants American Dairy intends to retain consultants to the extent necessary and appropriate. American Dairy will not delegate its authority and responsibility to make management decisions to consultants or any other persons, nor shall any consultant have any discretionary authority or the authority to bind American Dairy in any material respect. Item 11. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The following table sets forth certain information concerning the beneficial ownership of American Dairy's shares of Common Stock by directors and officers of American Dairy, and by each person known to American Dairy to be a beneficial owner of five percent (5%) or more of its outstanding Common Stock as of December 31, 2004. 28
Percentage Number of of Outstanding Name and Address Shares(1) Shares ---------------- --------- ------ Leng You-Bin (4)..................... 8,869,635 65.4% C-16 Shin Chen International Bldg. No. 10, Jiu-shen Road Zho Yan Chu Beijing The People's Republic of China Liu Hua.............................. 7,000 0.05% C-16 Shin Chen International Bldg. No. 10, Jiu-shen Road Zho Yan Chu Beijing The People's Republic of China Hui-Lan Lee.......................... 7,000 0.05% 232 Alabama Street San Gabriel, California 91775 Liu Sheng-Hui........................ 269,576 1.99% C-16 Shin Chen International Bldg. No. 10, Jiu-shen Road Zho Yan Chu Beijing The People's Republic of China Belmont Capital Group Limited 863,357(2) 6.1% Suite A-C, 20/F Neich Tower 128 Gloucester Road, Wanchai Hong Kong Pike Capital Partners LP............. 821,429 6.1% 275 Madison Avenue Suite 418 New York, NY 10016 All executive officers and directors 9,153,211 67.5% as a group (4 persons)
---------- (1) They have sole voting and dispositive power with respect to their shares of Common Stock of American Dairy. (2) Includes warrants to purchase 571,428 shares of the Common Stock of American Dairy. 29 Item 12. Certain Relationships and Related Transactions Effective May 7, 2003, Mr. Leng You-Bin and Mr. Liu Sheng-Hui, directors and officers of American Dairy, received 8,129,032 shares and 387,476 shares, respectively, of the Common Stock of American Dairy in exchange for all of their registered capital stock of Heilongjiang Feihe Dairy Co., Limited under the terms of a Stock Exchange Agreement. Effective May 7, 2003, American Dairy acquired 100% of American Dairy Holdings, Inc. ("ADH") in a stock- for-stock exchange. ADH had previously acquired 100% of the ownership of the registered capital of Heilongjiang Feihe Dairy Co., Limited ("Feihe Diary") in February 2002 for $2,586,311 (U.S.) from the registered owners of Feihe Dairy, owned primarily by Mr. Leng You-Bin who is the principal stockholder, director, Chief Executive Officer and President of American Dairy. As a result of this acquisition of ADH, American owed approximately $1,866,311 to Mr. Leng You-Bin after approximately $700,000 having been paid to him by American Dairy. During June 200, American Dairy and Mr. Leng You-Bin agreed to cancel the remaining debt of $1,866,311 in exchange for the issuance of 933,156 shares of the Common Stock of American Dairy. In May 2003, American Dairy entered into a consulting agreement (the "Consulting Agreement") with Danbury Properties, LLC, a Utah limited liability company ("Danbury"), of which Jack M. Gertino, the former President and a director of American Dairy, and James C. Lewis, a former director of American Dairy, are members. During the one year period of Danbury's engagement, Danbury has agreed to provide to American Dairy consulting services in the areas of financial and management planning, financing assistance and capital formation. In exchange for such services, Danbury will receive $60,000 in cash compesation, and 240,000 shares of post-split Common Stock. In addition, American Dairy has greed to pay the sum of $12,000 for the cancellation of all outstanding options held by Messrs. Gertino and Lewis. This transaction cannot be considered the result of arms' length negotiations. American Dairy also issued 240,000 shares of Common Stock and paid $60,000 in cash plus the obligation to pay another $12,000 in cash in May 2003 in connection with a consulting agreement entered into with existing shareholders, including Jack Gertino, then a director and the Chief Executive Officer of American Dairy. This stock was valued at $270,000 for financial reporting purposes. The consulting agreement is to cover a period of one year commencing May 7, 2003. For financial reporting purposes $228,011 was charged to consulting fee expense in 2003 with the balance of $113,989 being treated as a prepaid expense at December 31, 2003. During the fiscal years ended December 31, 2003 and 2004, Mr. Leng You-Bin, the Chairman of the Board and Chief Executive Officer of American Dairy, made advances to American Dairy in the amount of $846,228 and $1,133,822, respectively. These advances were unsecured and did not bear interest. Item 13. Exhibits (a) Reports on Form 8-K American Dairy filed a Form 8-K current report dated October 16, 2004, regarding the closing of a Regulation D Common Stock offering, and the move of its principal executive offices to Beijing, China. American Dairy filed a Form 8-K current report dated December 6, 2004, regarding the closing of a private placement of its Common Stock to an institutional investor. 30 (b) Exhibits 2.1 Stock Exchange Agreement Stock Exchange Agreement dated January 15, 2003, is incorporated herein by reference to Exhibit 2.1 to American Dairy's Form 8-K current report as filed with the Securities and Exchange Commission on January 21, 2003. 2.2 Amendment to Stock Exchange Agreement Amendment to Stock Exchange Agreement dated March 5, 2003 is incorporated herein by reference to Exhibit 2.2 of American Dairy's Form 8-K current report as filed with the Securities and Exchange Commission on March 5, 2003. 3.1 Articles of Incorporation Articles of Incorporation of American Dairy, as amended, are incorporated herein by reference to Exhibit 3.1 to its registration statement on Form 10-SB, as filed with the Securities and Exchange Commission on September 16, 1999. 3.2 Amendment to Articles of Incorporation Amendment to Articles of Incorporation of American Dairy dated May 6, 2003 is incorporated herein by reference to Exhibit 3.2 to the Form 10-KSB of American Dairy for its fiscal year ended December 31, 2003. 3.3 By-Laws By-Laws of American Dairy are incorporated herein by reference to Exhibit 3.2 to its registration statement on Form 10-SB, as filed with the Securities and Exchange Commission on September 16, 1999. 10. Material Contracts 10.1 2003 Stock Incentive Plan. 14. Code of Ethics Code of Business Conduct and Ethics 31 Item 14. Principal Accountant Fees and Services Fees paid to principal accountants are as follows:
-------------------------------------------------------------------------------------------------------------------- Name Audit Fees Audit Related Fees Tax Fees All Other Fees -------------------------------------------------------------------------------------------------------------------- Weinberg & Company, P.A. for fiscal year ended December 31, 2003 $23,513 $11,045 $ -0- $ -0- December 31, 2004 $ 8,044 $ -0- $ -0- $ -0- -------------------------------------------------------------------------------------------------------------------- Murrell, Hall, McIntosh & Co., PLLP for fiscal year ended December 31, 2003 $3,770 $ -0- $ -0- $ -0- December 31, 2004 $19,000 $1,250 $5,000 $ -0- --------------------------------------------------------------------------------------------------------------------
As of December 31, 2004, American Dairy had not established an audit committee of the Board of Directors, and the entire Board of Directors performed the duties of an audit committee. The Board of Directors evaluated the scope and cost of the audit for its fiscal year ended December 31, 2004 before its auditor rendered its audit and non-audit services. 32 SIGNATURES In accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. March 30, 2005 AMERICAN DAIRY, INC. By: /s/ Leng You-Bin ----------------------------------- Len You-Bin, Chief Executive Officer, and President By: /s/ Liu Hua ----------------------------------- Liu Hua, Chief Financial Officer, Principal Accounting and Financial Officer, and Treasurer In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. March 30, 2005 By: /s/ Leng You-Bin ----------------------------------- Leng You-Bin, Director, Chief Executive Officer and President March 30, 2005 By: /s/ Liu Hua ----------------------------------- Liu Hua, Director, Chief Financial Officer, Principal Accounting and Financial Officer, Secretary and Treasurer March 30, 2005 By: /s/ Liu Sheng-Hui ----------------------------------- Liu Sheng-Hui, Director March 30, 2005 By: /s/ Hui-Lan Lee ----------------------------------- Hui-Lan Lee, Director March 30, 2005 By: /s/ Kevin L. Tseng ----------------------------------- Dr. Kevin L. Tseng March 30, 2005 By: /s/ Kirk G. Downing ----------------------------------- KIrk G. Downing, Director Supplemental Information to be Furnished with Reports filed Pursuant to Section 15(d) of the Exchange Act by Non-Reporting Issuers The registrant is a reporting issuer under the Exchange Act and, therefore, this section is not applicable. 33 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM TO THE BOARD OF DIRECTORS AMERICAN DAIRY, INC. We have audited the accompanying consolidated balance sheet of American Dairy, Inc. and subsidiaries (the "Company") as of December 31, 2004 and the related consolidated statements of operations, stockholders' equity and cash flows for each the two years in the period ended December 31, 2004. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit. We conducted our audit in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of American Dairy, Inc. and subsidiaries as of December 31, 2004 and the results of their operations and cash flows for each of the two years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. /s/ Murrell, Hall, McIntosh & Co., PLLP Oklahoma City, Oklahoma January 31, 2005 F-1 AMERICAN DAIRY INC. CONSOLIDATED BALANCE SHEET DECEMBER 31, 2004 ASSETS Current assets: Cash $ 6,645,197 Accounts receivable Trade 670,580 Other 600,219 Commercial note receivable - unsecured 217,391 Inventories 5,042,398 Prepaid expenses 565,069 Advances to suppliers 307,667 Other tax refundable 37,381 ----------- Total current assets 14,085,902 ----------- Property and equipment: Fixed assets, net of accumulated depreciation 9,027,394 Construction-in-progress 14,720,742 ----------- 23,748,136 Other assets: Goodwill 7,000 ----------- Total assets $37,841,038 =========== See accompanying summary of accounting policies and notes to financial statements. F-2 AMERICAN DAIRY INC. CONSOLIDATED BALANCE SHEET DECEMBER 31, 2004 LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable and accrued expenses $ 9,033,956 Current portion of long-term debt 118,140 Advances from related parties, net 1,141,581 Advances from employees 653,865 Deferred income 9,694,523 Short-term loan - unsecured 241,546 ----------- Total current liabilities 20,883,611 ----------- Long-term debt, net of current portion shown above 597,875 ----------- Minority interest 180,458 ----------- Stockholders' equity: Common stock, $.001 par value; 50,000,000 shares authorized; 13,556,354 issued and outstanding 13,556 Additional paid-in capital 7,526,174 Retained earnings 8,639,364 ----------- Total stockholders' equity 16,179,094 ----------- Total liabilities and stockholders' equity $37,841,038 =========== See accompanying summary of accounting policies and notes to financial statements. F-3 AMERICAN DAIRY INC. CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2004 AND 2003 2004 2003 ------------ ------------ SALES $ 37,416,223 $ 26,635,832 COST OF GOODS SOLD 18,006,918 15,732,640 ------------ ------------ Gross Profit 19,409,305 10,903,192 ------------ ------------ OPERATING AND ADMINISTRATIVE EXPENSES: Distribution expenses 13,486,232 7,899,265 General and administrative expenses 1,313,358 1,669,435 Depreciation 54,419 131,302 ------------ ------------ 14,854,009 9,700,002 ------------ ------------ Income from operations 4,555,296 1,203,190 ------------ ------------ OTHER INCOME (EXPENSE): Other income (expenses) 1,489,767 1,196,939 Gain on disposal of assets 693 -- Interest and finance costs (49,353) (24,809) ------------ ------------ 1,441,107 1,172,130 ------------ ------------ MINORITY INTEREST IN SHANXI LOSS 356 -- ------------ ------------ INCOME BEFORE INCOME TAXES 5,996,759 2,375,320 (PROVISION FOR) BENEFIT FROM INCOME TAXES 261,621 (338,513) ------------ ------------ NET INCOME $ 6,258,380 $ 2,036,807 ============ ============ BASIC NET INCOME PER COMMON SHARE $ 0.52 $ 0.19 ============ ============ WEIGHTED AVERAGE BASIC SHARES OUTSTANDING 12,077,085 10,535,964 ============ ============ DILUTED NET INCOME PER COMMON SHARE $ 0.47 $ 0.19 ============ ============ WEIGHTED AVERAGE DILUTED SHARES OUTSTANDING 13,455,700 10,535,964 ============ ============ See accompanying summary of accounting policies and notes to financial statements. F-4 AMERICAN DAIRY, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 2004 AND 2003
Common Stock ---------------------------------- Number $0.001 Additional of par Paid-In Retained Shares Value Capital Earnings Totals ------------ ------------ ------------ ------------ ------------ Balance, December 31, 2002 9,650,000 $ 9,650 $ (9,649) $ 344,177 $ 344,178 Recapitalization 135,530 135 11,148 -- 11,283 Share issued for consulting services 240,000 240 269,760 -- 270,000 Share issued in exchange for conversion of shareholder loans 933,155 933 1,865,379 -- 1,866,312 Stock issued for cash 792,285 793 1,499,207 -- 1,500,000 Less offering costs -- -- (400,547) -- (400,547) Net income for the year ended December 31, 2003 -- -- -- 2,036,807 2,036,807 ------------ ------------ ------------ ------------ ------------ Balance, December 31, 2003 11,750,970 11,751 3,235,298 2,380,984 5,628,033 Shares issued for services 46,000 46 96,554 -- 96,600 Stock issued for cash 1,759,384 1,759 4,671,147 -- 4,672,906 Less offering costs -- -- (476,825) -- (476,825) Net income for the year ended December 31, 2004 -- -- -- 6,258,380 6,258,380 ------------ ------------ ------------ ------------ ------------ Balance, December 31, 2004 13,556,354 $ 13,556 $ 7,526,174 $ 8,639,364 $ 16,179,094 ============ ============ ============ ============ ============
See accompanying summary of accounting policies and notes to financial statements. F-5 AMERICAN DAIRY INC. CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2004 AND 2003
2004 2003 ------------ ------------ CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 6,258,380 $ 2,036,807 Adjustments to reconcile net income to operating activities - Depreciation 261,294 131,302 Provision for doubtful accounts 83,677 426,124 Consulting fees -- 179,982 Compensation expense for stock issued 96,600 -- Gain on disposal of assets (693) -- Changes in assets and liabilites: (Increase) decrease in - Accounts and notes receivable 537,762 1,681,220 Inventories 32,073 (3,086,370) Prepaid expenses 672,711 (11,472) Advances to suppliers 322,559 (630,226) Other tax refundable 522,563 (457,811) Increase (decrease) in - Accounts payable and accrued expenses 2,533,031 3,531,577 Deferred income 4,826,778 2,071,175 Tax payable 211,761 164,453 ------------ ------------ Net cash provided by operating activities 16,358,496 6,036,761 ------------ ------------ CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of fixed assets (5,241,177) (3,671,926) Disposal of assets 33,816 87,974 Cash received in merger and recapitalization -- 17,906 Deposit on land, building and equipment 417,678 (417,678) Minority interest 180,458 -- Construction in progress (12,685,851) (2,034,891) ------------ ------------ Net cash used in investing activities (17,295,076) (6,018,615) ------------ ------------ CASH FLOWS FROM FINANCING ACTIVITIES: Loan proceeds 1,660,194 483,092 Loan repayments (1,185,726) -- (Repayment of) advance from shareholder 232,946 (52,515) Proceeds from sale of common stock 4,672,906 1,500,000 Payment of offering costs (476,825) (396,264) Purchase obligation (repayment) (362,318) 362,318 ------------ ------------ Net cash provided by financing activities 4,541,177 1,896,631 ------------ ------------ NET INCREASE IN CASH AND EQUIVALENTS 3,604,597 1,914,777 CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 3,040,600 1,125,823 ------------ ------------ CASH AND CASH EQUIVALENTS, END OF PERIOD $ 6,645,197 $ 3,040,600 ============ ============
See accompanying summary of accounting policies and notes to financial statements. F-6 AMERICAN DAIRY INC. CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2004 AND 2003 (Continued)
2004 2003 ------------ ------------ SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Interest paid, net of capitalized amounts $ 37,076 $ 19,630 ============ ============ Income taxes paid $ -- $ 338,513 ============ ============
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES: During the year ended December 31, 2004, the Company issued 46,000 shares of its common stock valued at $96,600 for consulting services. During the year ended December 31, 2004, the Company issued 523,305 warrants to underwriters as additional consideration for funds raised in private placements during the year. The exercise price on these warrants ranged from $1.50 per share to $2.70 per share and all had a three year life. The fair market value at the date of issuance of these warrants totalled $862,245. The effect of the issuance is to increase additional paid in capital by the fair value of the warrants issued with an offset to additional paid in capital in the same amount, since offering costs are treated as reductions in additional paid in capital. During 2004, the net assets of Sanhao Dairy were transferred to Feihe Dairy by way of distribution to members effective July 1, 2004. See accompanying summary of accounting policies and notes to financial statements. F-7 AMERICAN DAIRY, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 -------------------------------------------------------------------------------- 1. DESCRIPTION OF BUSINESS Organizational structure American Dairy, Inc. ("American Dairy" or the "Company") was incorporated in the State of Utah on December 31, 1985, originally with the name of Gaslight, Inc. It was inactive until March 30, 1988 when it changed its corporate name to Lazarus Industries, Inc. and engaged in the business of manufacturing and marketing medical devices. This line of business was discontinued in 1991, and it became a non-operating public company shell. During 2003, the Company changed its name to American Dairy, Inc. Effective May 7, 2003, American Dairy completed the acquisition of 100% of the issued and outstanding capital stock of American Flying Crane Corporation ("AFC"), a Delaware corporation. As a result, AFC became a wholly - owned subsidiary of American Dairy. In preparation for this acquisition, which was treated as a reverse merger for financial reporting purposes, American Dairy completed a 1 to 19 reverse stock split reducing the number of shares of common stock outstanding from 7,485,147 to 394,168. In addition, American Dairy shareholders canceled 258,638 shares reducing the number of shares outstanding at the acquisition date to 135,530 shares. American Dairy purchased all of the outstanding capital stock of AFC from its shareholders in exchange for 9,650,000 shares of restricted common stock. This acquisition was treated as a purchase for financial reporting purposes with AFC being the purchaser and American Dairy being the purchased entity. This purchase resulted in the creation of $7,000 in goodwill. AFC was incorporated on January 15, 2002 in Delaware, with 50,000,000 authorized shares of common stock at a par value of $0.0001 per share and 10,000 of which authorized shares are currently issued and outstanding. AFC owns 100% of the registered capital of Heilongjiang Feihe Dairy Co., Limited ("Feihe Dairy") and Feihe Dairy in turn owns 100% of the registered shares of BaiQuan Feihe Dairy Co. Limited ("BiaQuan Dairy") and Heilongjiang Sanhao Dairy Co., Limited ("Sanhao Dairy") which was merged into BiaQuan Dairy during 2004, , and 95% of Beijing Feihe Biotechnology Scientific and Commercial Co., Limited ("Beijing Feihe") with the other 5% being held in trust for the Company. AFC also owns 60% of the registered capital of Shanxi Feihesantai Biotechnology Scientific and Commercial Co., Limited ("Shanx"i) formed to develop and operate a walnut processing plant.. Currently, the principal core activity of AFC is investment holdings, while the principal core activities of Feihe Dairy and BiaQuan Dairy are manufacturing and distribution of milk powder products and soybean products under the Feihe trademarks. The principal core activity of Shanxi is the production and distribution of walnut powder. The subsidiaries' principal country of operations is The People's Republic of China ("PRC"). Heilongjiang Feihe Dairy Co. Limited ("Feihe Dairy") was registered in Heilongjiang Province, in the People's Republic of China ("PRC") as a limited liability company on August 21, 1996 with a registered capital of $894,226 (Rmb. 7,404,193). Feihe Dairy's wholly-owned subsidiaries, Heilongjiang Sanhao Dairy Co. Limited ("Sanhao Dairy") was registered in Heilongjiang Province in the People's Republic of China as a limited liability company on March 28, 2001 with registered capital of $433,110 (Rmb.3,586,150) and a defined period of existence of four years to February 28, 2005 and BaiQuan Feihe Dairy Co. Limited ("BaiQuan Dairy") were registered on September 16, 2002 with a registered capital of $120,773 (Rmb.1,000,000) and a defined period of existence of one year to September 15, 2003. Upon an application by the Company, BaiQuan Dairy's defined period of existence was extended for a further period of three years to October 20, 2006. During 2004, Sanhao Dairy was liquidated into BaiQuan Dairy. 8 AMERICAN DAIRY, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 -------------------------------------------------------------------------------- Feihe Dairy's subsidiary Beijing Feihe Biotechnology Scientific and Commercial Co., Limited ("Beijing Feihe") was registered on June 8, 2004, in The People's Republic of China as a limited liability Company with registered share capital of $1,207,729 (Rmb 10,000,000) and a defined period of existence of 20 years to June 7, 2024. AFC's 60% owned subsidiary Shanxi Feihesantai Biotechnology Scientific and Commercial Co., Limited ("Shanxi") was registered in Shanxi Province, in the People's Republic of China ("PRC") as a limited liability company on April 15, 2004, with a registered capital of $402,174 (Rmb.3,330,000) and a defined period of existence of 15 years to April 15, 2019. Shanxi's remaining 40% of registered capital of $402,174 (Rmb.3,330,000) is owned by Licheng Shantai Technology Enterprises Co., Limited. Included in the consolidated financial statements are the following subsidiaries: o American Flying Crane Corporation o Heilongjiang Feihe Dairy Co., Limited o Heilongjiang Sanhao Dairy Co., Limited o BaiQuan Feihe Dairy Co., Limited o Beijing Feihe Biotechnology Scientific and Commercial Co., Limited o Shanxi Feihesantai Biotechnology Scientific and Commercial Co., Limited As of December 31, 2004, Feihe Dairy had a new milk powder production facility, Feihe Industrial Park, under construction. Construction is expected to be complete during the first quarter of 2005. Additionally, Shanxi's principal walnut powder production facility was still under construction at December 31, 2004, with completion of the facility expected by the end of 2005. 2. BASIS OF PREPARATION OF CONSOLIDATED FINANCIAL STATEMENTS The Company's consolidated financial statements include the accounts of American Dairy, Inc., its wholly-owned subsidiaries, AFC, Feihe Dairy, Sanhao Dairy, and BaiQuan Dairy and its 60% owned subsidiary, Shanxi. The consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The consolidated financial statements are prepared using the historical cost convention. This basis of accounting differs from that used in the preparation of the Company's statutory financial statements which are prepared in accordance with generally accepted accounting principles and the relevant financial regulations applicable to enterprises in the PRC. On May 7, 2003, American Dairy, Inc. acquired all of the outstanding common stock of American Flying Crane Corporation. For accounting purposes, the acquisition has been treated as a recapitalization of American Flying Crane Corporation with American Flying Crane Corporation as the acquirer. The historical financial statements prior to May 7, 2003 are those of American Flying Crane Corporation. 9 AMERICAN DAIRY, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 -------------------------------------------------------------------------------- 3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The following is a summary of significant accounting policies: Consolidation policy - All significant inter-company transactions and balances within the Company are eliminated on consolidation. Cash and equivalents - The Company considers all highly liquid debt instruments purchased with maturity period of three months or less to be cash equivalents. The carrying amounts reported in the accompanying consolidated balance sheet for cash and cash equivalents approximate their fair value. Accounts receivable - Provision is made against accounts receivable to the extent which they are considered to be doubtful. Accounts receivable in the balance sheet is stated net of such provision. As of December 31, 2004, no provision for doubtful accounts was considered necessary. Inventories - Inventories comprise raw materials, consumables and goods held for resale and are stated at the lower of cost or market value. Cost is calculated using the weighted average method and includes any overhead costs incurred in bringing the inventories to their present location and condition. Market value represents the estimated selling price in the ordinary course of business less the estimated costs necessary to complete the sale. Construction-in-progress - All facilities purchased for installation, self-made or subcontracted are accounted for as construction-in-progress. Construction-in-progress is recorded at acquisition cost, including cost of facilities, installation expenses and the interest capitalized during the course of construction for the purpose of financing the project. Upon completion and readiness for use of the project, the cost of construction-in-progress is to be transferred to fixed assets. Long-lived assets and depreciation - The Company recognizes impairment losses on long-lived assets used in operations when impairment indicators are present and the undiscounted cash flows estimated to be generated by these assets are less than their carrying values. Long-lived assets held for disposal are valued at the lower of carrying amount or fair value less cost to sell. The cost of property, plant and equipment less anticipated salvage values of 10% is being depreciated on a straight-line basis over the estimated useful lives of the related assets. Land use rights are being amortized on a straight-line basis over the term of the use agreement. Estimated useful lives used for computing depreciation are as follows: Buildings 33 years Plant and machinery 20 years Motor vehicles 9 years Computers and equipment 5 years 10 AMERICAN DAIRY, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 -------------------------------------------------------------------------------- Deferred Revenues - Revenue from the sale of goods or services is recognized when goods are delivered or services are rendered. Receipts in advance for goods to be delivered or services to be rendered in the subsequent year are carried forward as deferred revenue. Revenue recognition - Revenue from the sale of goods is recognized on the transfer of risks and rewards of ownership, which generally coincides with the time when the goods are delivered to customers and the title has passed. Interest income is recognized when earned, taking into account the principal amounts outstanding and the interest rates applicable. Sundry income includes compensation received from the State Bureau as an incentive to relocate from the previous factory premises, profit from the sales of raw materials to third parties and write down of long outstanding trade payables. Foreign currencies - The financial position and results of operations of the Company are determined using the local currency ("Renminbi" or "Yuan") as the functional currency. Foreign currency transactions during the year are converted at the average rate of exchange during the reporting period. Monetary assets and liabilities denominated in foreign currencies at the balance sheet date are translated at the market rate of exchange ruling at that date. All exchange differences are dealt with in the statements of operation. The Company's principal country of operations is The People's Republic of China. The registered equity capital and fixed assets denominated in the functional currency are translated at the historical rate of exchange at the time of capital contribution and purchases of fixed assets and exchange differences arising from translating equity capital, reserves and fixed assets at the exchange rate ruling at the balance sheet date are dealt with as an exchange fluctuation reserve in shareholders' equity. Taxation - Taxation on overseas profits has been calculated on the estimated assessable profits for the year at the rates of taxation prevailing in the country in which the Company operates. Provision for the PRC income tax is calculated at the prevailing rate based on the estimated assessable profits less available tax relief for losses brought forward. Enterprise income tax Under the Provisional Regulations of the PRC Concerning Income Tax on Enterprises promulgated by the State Council and which came into effect on January 1, 1994, income tax is payable by enterprises at a rate of 33% of their taxable income. Preferential tax treatment may, however, be granted pursuant to any law or regulations from time to time promulgated by the State Council. Enterprise income tax ("EIT") is provided on the basis of the statutory profit for financial reporting purposes, adjusted for income and expense items, which are not assessable or deductible for income tax purposes. Under the Business Promotion Policy Concerning Income Tax on Foreign Enterprises promulgated by the QiQiHaEr City Municipal Government, foreign owned enterprises registered in QiQiHaEr City are entitled to a tax holiday of seven years for full EIT exemption as though the EIT has been paid during the tax holiday periods. The preferential tax treatment will commence when the Company commences to generate assessable income after all accumulated tax losses have been deducted from the assessable income. 11 AMERICAN DAIRY, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 -------------------------------------------------------------------------------- Value added tax The Provisional Regulations of the PRC Concerning Value Added Tax promulgated by the State Council came into effect on January 1, 1994. Under these regulations and the Implementing Rules of the Provisional Regulations of the PRC Concerning Value Added Tax, value added tax is imposed on goods sold in or imported into the PRC and on processing, repair and replacement services provided within the PRC. Value added tax payable in the PRC is charged on an aggregated basis at a rate of 13% or 17% (depending on the type of goods involved) on the full price collected for the goods sold or, in the case of taxable services provided, at a rate of 17% on the charges for the taxable services provided, but excluding, in respect of both goods and services, any amount paid in respect of value added tax included in the price or charges, and less any deductible value added tax already paid by the taxpayer on purchases of goods and services in the same financial year. During 2003 and 2004, the Kendong County Government had a policy of refunding amounts equal to 50% of the value added tax paid as an economic incentive to support the local economy. These refunds which amounted to $1,144,060 and $942,907 for the fiscal years ended December 31, 2004 and 2003 respectively are included in tax incentives and other income on the financial statements. Deferred taxes - Deferred taxes are accounted for at the current tax rate in respect of timing differences between profit as computed for taxation purposes and profit as stated in the accounts to the extent that a liability or asset is expected to be payable or receivable in the foreseeable future. Advertising costs - Advertising costs, except for costs associated with direct-response advertising, are charged to operations when incurred. The costs of direct-response advertising are capitalized and amortized over the period during which future benefits are expected to be received. Advertising expenses of the Company were $2,742,257 and $1,627,458 in 2004 and 2003, respectively. Retirement benefit cost - According to The People's Republic of China regulations on pension, a company contributes to a defined contribution retirement plan organized by municipal government in the province in which the Company was registered and all qualified employees are eligible to participate in the plan. Contributions to the plan are calculated at 20% of the employees' salaries above a fixed threshold amount and the employees contribute 4% while the Company contributes the balance contribution of 16%. wholly - owned foreign enterprises such as Feihe Dairy are exempted from contributions to the retirement plan. Fair value of financial statements - The carrying amounts of certain financial instruments, including cash, accounts receivable, note receivable, other receivables, accounts payable, accrued expenses, advances from staff, notes payable and other payables approximate their fair values as of December 31, 2004 because of the relatively short-term maturity of these instruments. Foreign currencies - The financial position and results of operations of the Company are determined using the local currency ("Renminbi" or "Yuan") as the functional currency. Foreign currency transactions during the year are converted at the average rate of exchange during the reporting period. Monetary assets and liabilities denominated in foreign currencies at the balance sheet date are translated at the market rate of exchange ruling at that date. All exchange differences are dealt with in the statements of operation. The Company's principal country of operations is The People's Republic of China. 12 Use of estimates - The preparation of financial statements in accordance with generally accepted accounting principles require management to make estimates and assumptions that affect reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Recent accounting pronouncements - In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities (SFAS 149)". SFAS 149 amends and clarifies certain derivative instruments embedded in other contracts, and for hedging activities under SFAS 133. SFAS 149 is effective for certain contracts entered into or modified by the Company after June 30, 2003. The adoption of SFAS 149 had no impact on the Company's financial position, results of operations, or cash flows. In May 2003, the FASB issued SFAS No. 150, "Accounting for Instruments with Characteristics of Both Debt and Equity" (SFAS 150). Statement 150 requires liability classification for three types of instruments: 1) mandatory redeemable shares that obligate the company to deliver cash or other assets to shareholders on fixed or determinable dates; 2) freestanding written put options and forward purchase contracts on a company's own shares that obligate the company to deliver cash or other assets, and 3) contracts that obligate a company to issue its own shares in amounts that are unrelated to, or inversely related to, the value of the shares. The adoption of SFAS 150 had no impact on the Company's financial position, results of operations, or cash flows. In November 2004, the FASB issued SFAS No. 151 "Inventory Costs - an amendment of ARB No. 43, Chapter 4". Statement No. 151 requires that certain abnormal costs associated with the manufacturing, freight, and handling costs associated with inventory be charged to current operations in the period in which they are incurred. The adoption of SFAS 151 had no impact on the Company's financial position, results of operations, or cash flows. In December 2004, the FASB issued a revision of SFAS No. 123 "Share-Based Payment". The statement establishes standards for the accounting for transactions in which an entity exchanges its equity investments for goods and services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity's equity instruments or that may be settled by the issuance of those equity instruments. The statement does not change the accounting guidance for share-based payments with parties other than employees. The statement requires a public entity to measure the cost of employee service received in exchange for an award of equity instruments based on the grant-date fair value of the award (with limited exception). That cost will be recognized over the period during which an employee is required to provide service in exchange for the award (usually the vesting period). A public entity will initially measure the cost of employee services received in exchange for an award of liability instrument based on its current fair value; the fair value of that award will be remeasured subsequently at each reporting date through the settlement date. Changes in fair value during the requisite service period will be recognized as compensation over that period. 13 AMERICAN DAIRY, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 -------------------------------------------------------------------------------- The grant-date for fair value of employee share options and similar instruments will be estimated using option-pricing models adjusted for the unique characteristics of these instruments. The statement is effective for the quarter beginning January 1, 2006. In December 2004, the FASB issued SFAS No. 153 "Exchanges of Nonmonetary Assets-amendment of APB Opinion No. 29". Statement 153 eliminates the exception to fair value for exchanges of similar productive assets and replaces it with a general exception for exchange transactions that do not have commercial substance, defined as transactions that are not expected to result in significant changes in the cash flows of the reporting entity. This statement is effective for exchanges of nonmonetary assets occurring after June 15, 2005. Management believes adoption of these new statements will not have any significant effect on the Company's financial condition or results of operations. 4. CONCENTRATIONS OF BUSINESS AND CREDIT RISK The Company maintains certain bank accounts in the PRC which are not protected by FDIC insurance or other insurance. Geographic Concentration; Fluctuations in Regional Economic Conditions. Nearly all of American Dairy's sales are concentrated in the northern area of China. Accordingly, American Dairy is susceptible to fluctuations in its business caused by adverse economic conditions in this region. American Dairy's products are priced higher than non-premium quality dairy products. Although American Dairy believes that the quality, freshness, flavor and absence of artificial ingredients in its products compensate for this price differential, there can be no assurance that consumers will be willing to pay more for such products in unfavorable economic conditions, or at all. Difficult economic conditions in other geographic areas into which American Dairy may expand may also adversely affect its business, operations and finances. The Company provides credit in the normal course of business. Substantially all customers are located in The Peoples Republic of China. The Company performs ongoing credit evaluations of its customers and maintains allowances for doubtful accounts based on factors surrounding the credit risk of specific customers, historical trends, and other information. The Company is self insured for all risks and carries no liability or property insurance coverage of any kind. 5. NOTES RECEIVABLE - UNSECURED As of December 31, 2004, the Company held commercial notes receivable totaling $217,391 that were issued or endorsed by a third party. The commercial notes are drawn against various banks with varying maturity periods of one month to one and one-half months. The commercial notes, which are unsecured, bear no interest and are receivable on maturity, are endorsable to third parties. 14 AMERICAN DAIRY, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 -------------------------------------------------------------------------------- 6. INVENTORIES Inventories consist of the following as of December 31, 2004: Raw and partially processed materials $4,072,999 Finished goods 969,399 ---------- $5,042,398 ========== 7. TAX REFUNDABLE Tax refundable represents valued-added tax refundable from the local governments in The People's Republic of China. 8. TRANSACTIONS WITH RELATED PARTIES As of December 31, 2004 the Company had the following balances due to its officers and directors: December 31 ----------- Name 2004 2003 ---- ---- ---- Leng You-bin $1,133,822 $ 846,228 Other officers and directors 7,759 -- ---------- ---------- $1,141,581 $ 846,228 ========== ========== 9. FIXED ASSETS December 31 ----------- 2004 ---- Buildings $ 4,857,971 Plant and machineries 3,931,651 Motor vehicles 292,372 Computers and equipment 298,787 ----------- 9,380,781 Less: Accumulated depreciation (353,387) ----------- $ 9,027,394 =========== Following the full settlements of short-term borrowings from a bank and a financial institution during the year ended December 31, 2004, BaiQuan Dairy's buildings, computer and equipment, plant and machineries and motor vehicles, which were previously pledged to secure the short-term borrowings, were released. 15 AMERICAN DAIRY, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 -------------------------------------------------------------------------------- 10. CONSTRUCTION-IN-PROGRESS The Company had two major construction projects in progress at December 31, 2004 as detailed below: December 31 ----------- 2004 ---- Feihe Dairy milk powder processing facilities $10,757,621 Shanxi walnut processing facility 3,963,121 ----------- Total $14,720,742 =========== Pursuant to the Sale and Purchase Agreement (the "Agreement") dated July 25, 2003, the Company purchased from Kedong County Beibei Food Industry ([chinese characters]) (the "Vendor") the land use rights and factory adjacent to Company's existing factory in Kedong County at a total consideration of $400,966 (Rmb.3,320,000) for the purpose of constructing new production factory facilities to increase production capacity. In accordance with an appraisal report issued by An Luan Certified Public Accountants in QiQiHaEr City, the land use right and factory were evaluated at $1,003,623 (Rmb.8,310,000). Under the terms and conditions of the Agreement, Feihe Dairy agreed to settle the consideration in full within one year commencing within one year (by July 24, 2004) commencing from the date of the Agreement or the Vendor has the option to request/demand the issuance of 200,000 shares of common stock of American Dairy, Inc. at the option price of $2 per share as full and final settlement of the consideration of $400,000 (Rmb. 3,312,000). As of December 31, 2004, the Vendor has demanded the issuance of the 200,000 shares of common stock as full and final settlement and $400,000 has been accrued in the accompanying financial statements accordingly. Pursuant to a Construction Contract dated July 25, 2003 with Heilongjiang Cultivation Co., Limited for the construction of new production factory facilities in Kedong County, Heilongjiang Province at the contract sum of $4,210,870 (Rmb.34,866,000), the construction of the new production factory facilities was supposed to be completed by September 1, 2004. The Directors expect that the construction of the new production factory facilities including refurbishment, decoration and installation of production plant and machineries will be completed during the first quarter of 2005. As of December 31, 2004, the Company has paid $5,036,965 (Rmb.41,706,070) as a result of overruns and additional requirements by the Company. Total expenditures for the construction of this facility through December 31, 2004, were $10,757,621. Construction-in-progress also includes construction of the new walnut powder production and distribution facility of the Company's 60% owned subsidiary, Shanxi. Total expenditures for the construction of this facility through December 31, 2004, were $3,963,121. 11. ADVANCES FROM EMPLOYEES Advances from employees represented temporary funding by employees to finance a temporary working capital shortfall experienced by the Company. The advances were unsecured, interest free and repayable within one year. 16 AMERICAN DAIRY, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 -------------------------------------------------------------------------------- 12. DEFERRED INCOME Receipts in advance represent advances from new customers and for which goods have not been delivered as of the balance sheet date. Receipts in advance for goods to be delivered or services to be rendered in the subsequent year are carried forward as deferred revenue. 13. TAX PAYABLES Tax payables which are included in accounts payable on the December 31, 2004 financial statements consist of the following: Value added tax $ 481,483 City construction tax and education surcharge 425 Others (410) --------- $ 481,499 ========= 14. NOTES PAYABLE As of December 31, 2004, the Company had the following notes payable: Bank $ 684,771 County finance department 241,546 Finance company 31,244 --------- 957,561 Short-term loan (241,546) Current portion of notes payable (118,140) --------- Long-term portion of notes payable $ 597,875 ========= The bank loan is secured, bears interest at 5.76% per annum with monthly principal payments of $7,498 plus interest until September 30, 2012. The loan is guaranteed by a vendor of the Company. The county finance department loan is unsecured, bears no interest and has no fixed terms of repayment. Notes payable to banks ($483,092 at December 31, 2003) bearing interest at rates ranging from 6.9035% and 5.7525% per annum, were fully repaid during 2004. The collateral (buildings and plant and machinery) pledged as security for these loans has been released by the banks. Principal balances due by year of the Company's long-term debt as of December 31, 2004 are as follows: Year Ended December 31, Amount ----------------------- ------ 2005 $118,140 2006 93,056 2007 89,976 2008 89,976 2009 89,976 Thereafter 234,891 -------- Total $716,015 ======== 17 AMERICAN DAIRY, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 -------------------------------------------------------------------------------- In accordance with the terms of a Sale and Purchase Agreement dated September 28, 2003, the Company has agreed to purchase land use rights in Beijing for a total consideration of $1,200,861 of which three installments totalling $481,055 have been paid as of December 31, 2003. The balance of $719,806 shall be settled through a mortgage loan expected to be arranged with a bank. This liability has been accrued on the Company's financial statements at December 31, 2004. 15. MINORITY INTEREST Minority interest represents the proportionate share (40%) of equity of Shanxi Feihesantai Biotechnology Scientific and Commercial Co., Limited (Shanxi) owned by Licheng Shantai Technology Enterprises Co., Limited. At December 31, 2004, the Company owned 60% of Shanxi's registered capital stock. Shanxi was registered as a limited liability company in The People's Republic of China on April 15, 2004, with a registered capital of $402,174 (Rmb.3,330,000) and a defined period of existence of 15 years to April 15, 2019. 16. CAPITAL STOCK The Company has 50,000,000 shares of authorized Common Stock with a par value of $.001 per share. During 2003, the Company had stock transactions as detailed below: In anticipation of the merger with AFC, the Company affected a 1 for 19 reverse stock split, which decreased the number of shares of outstanding common stock from 7,485,147 to 394,168. Then certain shareholders contributed 258,638 shares of common stock back to the Company further reducing the outstanding shares to 135,530. The Company issued 9,640,000 shares of restricted common stock in exchange for all of the outstanding capital stock of AFC. The Company also issued 240,000 shares of common stock and paid $60,000 in cash plus the obligation to pay another $12,000 in cash in connection with a consulting agreement entered into with existing shareholders. This stock was valued at $270,000 for financial reporting purposes. The consulting agreement is to cover a period of one year commencing May 7, 2003. For financial reporting purposes $228,011 was charged to consulting fee expense in 2003 with the balance of $113,989 being treated as a prepaid expense at December 31, 2003. A shareholder converted advances to the Company in the amount of $1,866,312 into 933,155 shares of restricted common stock. Additionally, a total of 792,285 shares of common stock were sold for a total cash consideration of $1,500,000. Offering and syndication costs totaling $374,402 were treated as reductions in additional paid-in capital for financial reporting purposes. As of December 31, 2003, the Company had 11,750,970 shares of common stock issued and outstanding. 18 AMERICAN DAIRY, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 -------------------------------------------------------------------------------- During 2004, the Company had stock transactions detailed below: The Company issued 46,000 shares of its restricted common stock valued at $96,600 for consulting services. In connection with two private placements, the Company issued 1,759,384 shares of restricted common stock purchased for total cash consideration of $4,672,906. Offering and syndication costs totaling $476,825 were treated as reductions in additional paid-in capital for financial reporting purposes. The Company also issued 1,825,546 warrants in connection with the private placements, 1,302,241 of which went to the purchasers and 523,305 went to the underwriters as additional consideration for funds raised in the private placements. The exercise price of these warrants ranged from $1.50 to $3.80 and the warrants expire in three years. The 523,305 warrants issued to underwriters had a market value at the issuance date of $862,245. The effect of the issuance is to increase additional paid-in capital by the fair value of the warrants issued with an offset to additional paid in capital in the same amount, since offering costs are treated as reductions in additional paid-in capital. No warrants were exercised during the year ended December 31, 2004. 17. STOCK OPTIONS AND WARRANTS Effective May 7, 2003, the Company adopted and approved its 2003 Incentive Stock Plan (the "Plan") which reserved 3,000,000 shares of Common Stock for issuance under the Plan. The Plan allows the Company to issue awards of incentive non-qualified stock options, stock appreciation rights, and stock bonuses to directors, officers, employees and consultants of the Company which may be subject to restrictions. As of December 31, 2004, the Company had not granted any incentive stock options, stock appreciation rights, or stock bonuses under the Plan. As of December 31, 2004, the Company had 2,868,402 warrants outstanding at an average exercise price of $2.40 per warrant for one share each of the Company's common stock. The warrants will expire three years from the issuance date, with 1,042,856 expiring in 2006 and the balance of 1,825,546 expiring in 2007. Information with respect to outstanding warrants to service providers is as follows: Average Exercise Shares Price ------ ----- Outstanding warrants at beginning of year 1,042,856 $1.75 Warrants granted 1,825,546 2.42 Exercised -- -- Expired -- -- --------- ----- Outstanding warrants at the end of year 2,868,402 $2.15 ========= =====
Warrants Outstanding Warrants Exercisable --------------------------------- ----------------------------- Shares Average Average Shares Average Outstanding Remaining Exercise Outstanding Exercise 12/31/04 Life (Years) Price 12/31/04 Price -------- ------------ ----- -------- ----- 2,868,402 2.5 $2.15 2,868,402 $2..15 ========= === ===== ========= ======
19 AMERICAN DAIRY, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 -------------------------------------------------------------------------------- 18. EARNINGS PER SHARE Statement of Financial Accounting Standards No. 128, Earnings Per Share, requires presentation of basic and diluted earnings per share (EPS), as defined, on the face of the statements of operations for all entities with complex capital structures. SFAS 128 requires a reconciliation of the numerator and denominator of the basic and diluted EPS computations. The effect of outstanding warrants to purchase common stock at December 31, 2003, were not included in the calculation of diluted earnings per share as their effect was anti-dilutive.
Per Income Shares Share (Numerator) (Denominator) Amount ----------- ------------- ------ For the Year Ended December 31, 2004: Basic EPS Income available to common shareholders $6,258,380 12,077,085 $ .52 Effect of Dilutive Securities -- 1,378,615 -- ---------- ---------- ----- Diluted EPS Income available to common shareholders $6,258,380 13,455,700 $ .47 ========== ========== ===== Per Income Shares Share (Numerator) (Denominator) Amount ----------- ------------- ------ For the Year Ended December 31, 2003: Basic EPS Income available to common shareholders $2,036,807 10,535,964 $0.19 Effect of Dilutive Securities -- -- -- ---------- ---------- ----- Diluted EPS Income available to common shareholders $2,036,807 10,535,964 $0.19 ========== ========== =====
20 AMERICAN DAIRY, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 -------------------------------------------------------------------------------- 18. Income Tax Pretax income (loss) for 2004 was $6,616,708 from foreign sources and ($619,950) from U.S. sources. Pretax income (loss) for 2003 was $3,103,046 from foreign sources and ($727,726) from U.S. sources. A reconciliation of tax at the statutory rates to the Company's effective rate are as follows:
Year Ended December 31, 2004 2003 ---- ---- Computed expected tax expense $ 2,368,719 $ 902,622 Increases (reductions) in taxes result from: Add back effect of U.S. losses 244,880 276,535 Foreign income subject to foreign income tax but not expected to be subject to U.S. tax in foreseeable future - Adjustment due to change in effective tax rates (430,086) (155,152) BaiQuan Dairy 2003 tax liability waived by province (261,621) -- Foreign income subject to foreign tax holiday but not expected to be subject to U.S. tax in foreseeable future (2,183,513) (685,492) ----------- ----------- Actual income tax expense (benefit) $ (261,621) $ 338,513 =========== ===========
Under the Provisional Regulation of the PRC, income tax is payable by enterprises at a rate of 33% of their taxable income. Feihe Dairy has been granted a tax holiday of seven years for full enterprise income paid during that period. This tax holiday will expire in April of 2009. The enterprise taxes paid during 2004 and 2003 were accrued (waived) by Sanhao Dairy and BaiQuan Dairy as follows: Year Ended December 31, ----------------------------- 2004 2003 --------- --------- Sanhao Dairy $ -- $ 76,892 BaiQuan Dairy (261,621) 261,621 --------- --------- Total $(261,621) $ 338,513 ========= ========= The tax holiday resulted in tax savings of $2,445,134 or $0.20 basic benefit per share in 2004 and $685,492 or $.06 basic benefit per share in 2003. 21 AMERICAN DAIRY, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 -------------------------------------------------------------------------------- The Company has a U.S net operating loss carryforward of approximately $1,518,000 which will begin expiring in 2023. For financial reporting purposes the deferred tax asset of $516,135 associated with this loss carryforward is fully reserved as of December 31, 2004. Although it is not anticipated in the foreseeable future, should the parent company receive dividends from its foreign subsidiaries, these dividends would be fully taxable, subject to an offset for foreign taxes paid on these earnings. The Company has not provided any accrual for any tax liabilities that might be incurred for the receipt of dividends from its foreign subsidiaries. 19. COMMITMENTS As of December 31, 2004, the Company has future commitments for construction-in-progress of $2,241,174, to acquire land and buildings totaling $1,120,772, and to pay future advertising costs totaling $1,657,556. Minimum future rental payments under non-cancelable operating leases having remaining terms in excess of one year as of December 31, 2004 for each of the next five years and in the aggregate are: December 31, 2005 $ 2,542 December 31, 2006 5,908 December 31, 2007 5,908 December 31, 2008 5,908 December 31, 2009 5,908 Thereafter 243,698 -------- $269,872 ======== Rent expense incurred during the years ended December 31, 2004 and 2003 totalled $22,536 and $5,967, respectively. In accordance with the terms and conditions of a Sale and Purchase Agreement dated February 23, 2004 between Feihe Dairy and a vendor for the sale and purchase of a land use right in Beijing, in the People's Republic of China, Feihe Dairy agreed to acquire the commercial property for consideration of $987,863 of which three installments totaling $396,075 have been paid as of December 31, 2004. 22 AMERICAN DAIRY, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004 -------------------------------------------------------------------------------- In accordance with the terms and conditions of a Sale and Purchase Agreement dated July 25, 2003, the Company has agreed to acquire land use rights and a factory in Kedong County for a total consideration of $400,966. If payment is not made by July 24, 2004, the Company has agreed to issue 200,000 shares of its common stock in full and final settlement of the consideration. A liability in the amount of $400,996 has been accrued on the Company's books at December 31, 2004, however, stock had not been issued in fulfilment of this obligation as of that date. In accordance with the terms and conditions of a Construction Contract (the "Contract") dated October 2, 2004 between Feihe Dairy and Eastern Liaoning Construction Co., Limited for the construction of the steel frame of the new factory, the Company agreed to pay total construction costs of $724,638 of which deposits totaling $241,546 have been paid as of December 31, 2004. The balance of $483,092 shall be settled based on the progress of the construction. In accordance with the terms and conditions of a Contract dated October 1, 2004, Feihe Dairy entered into a Sales and Purchase Contract (the "Contract") with Heilongjiang Da San Yuan Dairy Machinery Co., Limited for the design, manufacture and installation of production plant and machineries at Feihe Dairy for a consideration of $7,234,300 of which $4,863,687 have been paid. The balance of $2,370,613 shall be settled based on the progress of the construction. 23 INDEX OF EXHIBITS ATTACHED
Exhibit Description ------- ----------- 10.1 2003 Stock Incentive Plan 14 Code of Business Conduct and Ethics 21. Subsidiaries of American Dairy Description of the subsidiaries of American Dairy. 31.1 Certification of Leng You-Bin 31.2 Certification of Liu Hua 32.1 Certification of Leng You-Bin and Liu Hua