10-K 1 v177416_10k.htm 2009 FORM 10-K Unassociated Document
 
U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-K
 
x
ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934
 
For the fiscal year ended December 31, 2009
 
o
TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from ______________ to ________________

Commission File Number: 001-32473
 
AMERICAN DAIRY, INC.
(Exact name of registrant as specified in its charter)
 
Utah
90-0208758
(State or other jurisdiction of  Incorporation or organization)
(I.R.S. Employer Identification No.)
 
Star City International Building, 10 Jiuxianqiao Road, C-16th Floor
Chaoyang District, Beijing, China 100016
(Address of principal executive offices)
 
Registrant’s telephone number, including area code: 86 (10) 6431-9357
 
Securities registered under Section 12(b) of the Exchange Act:
 
Title of each class
Name of each exchange on which registered
Common Stock
New York Stock Exchange, Inc.
 
Securities registered under Section 12(g) of the Exchange Act:  None
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.   o  Yes   x  No
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.   o  Yes    x  No
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed pursuant to Section 13 or Section 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     x  Yes    o  No
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). o  Yes    o  No
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not 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-K or any amendment to this Form 10-K.  x
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer o  
Accelerated filer x  
Non-accelerated filer o    
Smaller Reporting Company x
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).   o  Yes   x  No
 
The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant as of the last business day of the registrant’s most recently completed second fiscal quarter, based upon the closing sale price of the registrant’s common stock on June 30, 2009 as reported on the NYSE, was approximately $267,000,000.
 
As of March 10, 2010, there were 21,707,376 shares of the registrant’s common stock outstanding.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Certain information is incorporated by reference to the Proxy Statement for the registrant’s 2010 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this Form 10-K.
 

 
TABLE OF CONTENTS
 
PART I
       
Item 1.
 
Business
 
 1
Item 1A.
 
Risk Factors
 
 11
Item 1B.
 
Unresolved Staff Comments
 
 21
Item 2.
 
Properties
 
 21
Item 3.
 
Legal Proceedings
 
 22
Item 4.
 
(Removed and Reserved)
 
22
         
PART II
       
Item 5.
 
Market for the Registrant’s Common Stock, Related Shareholder Matters and Issuer Repurchases of Equity Securities
 
 23
Item 6.
 
Selected Financial Data
 
 25
Item 7.
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
 26
Item 7A.
 
Quantitative and Qualitative Disclosures About Market Risk
 
 36
Item 8.
 
Financial Statements and Supplementary Data
 
 37
Item 9.
 
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
 
 37
Item 9A.
 
Controls and Procedures
 
 37
Item 9B.
 
Other Information
 
39
         
PART III
       
Item 10.
 
Directors, Executive Officers and Corporate Governance
 
40
Item 11.
 
Executive Compensation
 
40
Item 12.
 
Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters
 
40
Item 13.
 
Certain Relationships and Related Transactions, and Director Independence
 
40
Item 14.
 
Principal Accountant Fees and Services
 
40
         
PART IV
       
Item 15.
 
Exhibits and Financial Statement Schedules
 
41

In this Annual Report on Form 10-K, references to “dollars” and “$” are to United States dollars and, unless the context otherwise requires, references to “American Dairy,” “we,” “us” and “our” refer to American Dairy, Inc. and its consolidated subsidiaries.

 
PART I
 
Item 1. Business

Overview

We are a leading producer and distributor of milk powder, soybean milk powder, and related dairy products in the People’s Republic of China, or the PRC.  Using proprietary processing techniques, we make products that are specially formulated for particular ages, dietary needs and health concerns.  We have over 200 company-owned milk collection stations, two company-owned dairy farms, seven production facilities with an aggregate milk powder production capacity of approximately 1,234 tons per day and an extensive distribution network that reaches over 95,000 retail outlets throughout China.

Corporate History and Structure

We were incorporated in the State of Utah on December 31, 1985, originally under the corporate name of Gaslight, Inc. We were inactive until March 30, 1988, when we changed our corporate name to Lazarus Industries, Inc. and engaged in the business of manufacturing and marketing medical devices.  We discontinued this business in 1991 and became a non-operating public company shell.  Effective May 7, 2003, we acquired 100% of the issued and outstanding capital stock of American Flying Crane Corporation, or AFC, a Delaware corporation that operates a dairy business in China through various subsidiaries.  In connection with that acquisition, we changed our name to American Dairy, Inc.
 
Today, we own various subsidiaries in the PRC that operate our business, including:

 
·
Heilongjiang Feihe Dairy Co., Limited, or Feihe Dairy, which produces, packages and distributes milk powder and other dairy products;

 
·
Gannan Flying Crane Dairy Products Co., Limited, or Gannan Feihe, which produces milk products;

 
·
Shanxi Feihesantai Biotechnology Scientific and Commercial Co., Limited, or Shanxi Feihe, which produces walnut and soybean products;
 
 
·
Langfang Flying Crane Dairy Products Co., Limited, or Langfang Feihe, which packages and distributes finished products;

 
·
Baiquan Feihe Dairy Co., Limited, or Baiquan Dairy, which produces milk products;

 
·
Heilongjiang Feihe Kedong Feedlots Co., Limited, or Kedong Farms, which operates dairy farms;

 
·
Heilongjiang Feihe Gannan Feedlots Co., Limited, or Gannan Farms, which operates dairy farms;

 
·
Heilongjiang Aiyingquan International Trading Co., Limited, or Aiyingquan, which markets and distributes water and cheese, specifically marketed for consumption by children; and

 
·
Heilongjiang Flying Crane Trading Co., Limited, or Heilongjiang Trading, which sells milk and soybean related products.
 
1


The following chart reflects the current corporate structure of the American Dairy entities:

 
 
*  Indicates a nominee shareholder who, pursuant to a former requirement under the PRC Company Law that certain PRC companies have at least two shareholders, holds its equity interest for the benefit of the majority shareholder.
 
Principal Products

Our products fall into four main product categories: milk powder, soybean powder, rice cereal and walnut and other products.

Milk Powder
Milk powder is our primary product and is divided into several sub-categories.  We produce milk powder for infants and young children formulated for zero to six months, six months to one year, one to three years and three to six years of age.  We also produce milk powder for expectant mothers, students and for the middle-aged and elderly populations.  In addition, we occasionally purchase semi-finished milk powder, which we refer to as “raw milk powder,” from third parties, which we then process and distribute to beverage manufacturers and other wholesalers for use in their blended drink products.
 
2


Soybean Powder
Soybean powder is an auxiliary product to our milk powders and represents a low fat, high calcium alternative to milk powder, particularly for seniors.

Rice Cereal
Rice cereal is an auxiliary product to our milk powders and represents a low fat, high calcium alternative to milk powder, particularly for young children, teenagers, and seniors.  We purchase semi-finished rice cereal from third parties, process it, and then distribute it to wholesalers and retailers.

Walnut and Other Products
We produce other auxiliary products that we market in conjunction with our infant milk powder, as well as to health-conscious adults.  Walnut products include walnut powder and walnut oil.  Other products include cream, skim milk powder, full milk powder, butter, cheese and other related milk powder products and water and cheese marketed specifically for children.

Product Sales

The following table reflects the sales of our principal products during the fiscal years ended December 31, 2009 and 2008:

   
2009
 
2008
 
2009 over 2008
Product name
 
Quantity
(Kg’000)
 
Amount
($’000)
 
% of
Sales
 
Quantity
(Kg’000)
 
Amount
($’000)
 
% of
Sales
 
Quantity
(Kg’000)
 
Amount
($’000)
 
% of 
Sales
                                                       
Milk powder
   
28,783
     
216,230
     
79.8
     
16,311
     
121,255
     
62.8
     
12,472
     
94,975
     
78.3
 
Raw milk powder
   
11,637
     
34,328
     
12.7
     
16,572
     
60,753
     
31.4
     
(4,935)
     
(26,425)
     
(43.5)
 
Soybean powder
   
3,349
     
7,319
     
2.7
     
2,153
     
4,400
     
2.3
     
1,196
     
2,919
     
66.3
 
Rice cereal
   
1,103
     
6,730
     
2.5
     
816
     
4,631
     
2.4
     
287
     
2,099
     
45.3
 
Walnut products
   
601
     
3,070
     
1.1
     
327
     
1,663
     
0.9
     
274
     
1,407
     
84.6
 
Other
   
543
     
3,401
     
1.3
     
727
     
490
     
0.3
     
(184)
     
2,911
     
594.1
 
Total  
   
46,016
     
271,078
     
100
     
36,906
     
193,192
     
100
     
9,110
     
77,886
     
40
 
 
Sources of Milk

We have entered into supply contracts with numerous small dairy farmers that have provided us access to over 200,000 cows that provide milk to our over 200 company-owned milk collection stations.  On average, each cow provides four tons of milk per year, which farmers deliver to our milk collection stations.  In addition, we own two dairy farms, Gannan Farms and Kedong Farms, construction of which we completed in the fourth quarter of 2009.   Gannan Farms and Kedong Farms currently house a total of approximately 14,000 Australian Holstein cows, each of which, on average, provides us with 8-10 tons of milk per year.  We expect that each of our dairy farms will have annual capacity to source up to 70,000 tons of fresh milk per year.
  
Raw Milk Processing

We believe that, through purchasing raw milk locally and employing minimal processing techniques, we are able to preserve the fresh taste of milk.  The industry standard for the time it takes for raw milk to be converted to milk powder is approximately 48 hours.  Many large regional dairies, we believe, process raw milk that 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 processed the following day.
 
3


However, our standard is to process the raw milk within 6-24 hours after milking, depending upon the time of day the raw milk is delivered to us.  Within this time, the milk is chilled, transported, separated, sterilized and spray-dried.  The raw milk is first received from milk collection centers or from our company-owned dairy farms.  Fully enclosed, stainless-steel vacuum milking machines are used to receive the raw milk.  Once received, the raw milk will no longer have any contact with air and is immediately processed with refrigeration equipment that cools the raw milk within four seconds to approximately zero to four degrees Celsius.  The raw milk is then stored in air-tight tanks in preparation for advanced processes, which include milk fat separation, sterilization and spray-drying.

The milk used in our products 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.  We believe that this process adversely affects the taste and feel of milk.  In addition, our 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 we believe adversely affects the flavor of the milk.

Dairy Product Processing

Our 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 and no chemicals or additives are employed.  Our dairy products arrive to consumers in our marketing area sooner after production than most other dairy products because they are produced locally.  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 our products, as well as sanitary conditions in our facilities.

Quality Assurance

We are committed to delivering high-quality dairy products.  We apply a 25-step quality control process that involves over a hundred points of testing from the feed for the dairy cows, throughout our manufacturing process, and extending to semi-finished products, which we purchase from third parties for further processing, and finished products.

The production facilities we have constructed comply with pharmaceutical good manufacturing practice, or GMP, standards, a higher level of quality control than required for consumer goods manufacturing facilities.  Since 2000, our production facilities have obtained ISO 9002 and HACCP quality assurance certifications, as well as quality certifications from the PRC regulatory authorities.  Our processing equipment is manufactured by well-known European manufacturing companies.  We use whole-sealing and mechanized vacuum milk-pressing devices with freezing equipment for each milk station, which allows us to reduce the temperature of raw milk to zero to four degrees Celsius within seconds for storage.  Our equipment also eliminates external air contact from the time milk is collected through the time that it is fully processed.  We employ automated processes and scientific parameters throughout the manufacturing process that are designed to ensure that all products meet our quality requirements.  We have in-house laboratories that utilize proprietary in-line sampling techniques to ensure the quality and safety of the entire production process, from raw materials to semi-finished products to finished products.  We believe that our rigorous testing and inspection procedures have been critical in ensuring that our products are free from melamine and other contaminants, are premium quality products and are safe and healthy for customers.

Production and Packaging Facilities

We own and operate seven production and packaging facilities.  The production facilities we have constructed comply with pharmaceutical GMP standards, a higher level of quality control than required for consumer goods manufacturing facilities.  Since 2000, our production facilities have obtained ISO 9002 and HACCP quality assurance certifications, as well as quality certifications from the PRC regulatory authorities.  We believe that our design standards help us assure our product quality.  We believe that we are one of the few PRC milk producers that has processing areas that meet a 300,000 cleanliness purification standard, which means that there are less than 300,000 dust particles per cubic centimeter of air.  In a standard room, dust particles can reach over two million dust particles per cubic centimeter of air.  Continuing our commitment to quality, we have also added testing equipment and other quality control procedures to our processing equipment manufactured by known European and American manufacturing companies.
 
4


Feihe Dairy
Located in Kedong, Heilongjiang Province, China, the Feihe Dairy premises comprise approximately 88,221 square meters.  The plant is approximately 9 years old, although it was completely remodeled in 2005.  Feihe Dairy principally produces infant milk formula and has a production capacity of 550 tons per day of milk powder.  In addition, Feihe Dairy serves as a packaging facility and packages approximately 22,000 tons of products per year.

Gannan Feihe
Located in Heilongjiang Province, China, the Gannan Feihe premises comprise approximately 300,000 square meters.  The plant is approximately 4 years old and commenced milk powder production in 2008.  It is currently under expansion and is expected to be finished in August 2010.  Gannan Feihe principally produces infant milk formula and has a production capacity of approximately 300 tons per day of milk powder.

Langfang Feihe
Located in Hebei Province, China, the Langfang Feihe premises comprise approximately 80,243 square meters.  The plant is approximately 4 years old and commenced operations in 2007.  Langfang Feihe primarily serves as a packaging and distribution facility and packages approximately 50,000 tons of products per year.

Shanxi Feihe
Located in Shanxi Province, China, the Shanxi Feihe premises comprise approximately 40,000 square meters.  The plant is approximately 6 years old.  Shanxi Feihe principally produces soybean powder, walnut powder and walnut oil and has a production capacity of approximately 5,000 tons per year of soybean powder and walnut powder combined, and 1,000 tons per year of walnut oil.

Baiquan Dairy
Located in Heilongjiang Province, China, the Baiquan Dairy premises comprise approximately 36,000 square meters.  The plant is approximately 18 years old, although it was completely remodeled in 2004.  Baiquan Dairy principally produces infant milk formula and has a production capacity of approximately 100 tons per day of milk powder.
 
Qiqihaer Feihe
Located in Heilongjiang Province, China, the Qiqihaer Feihe premises comprise approximately 90,000 square meters.  The plant is approximately 5 years old.  Qiqihaer Feihe principally produces infant milk formula and adult milk formula and has a production capacity of approximately 270 tons per day of milk powder.  Qiqihaer Feihe also produces butter and has a production capacity of approximately 15 tons per day.

Longjiang Feihe
Located in Heilongjiang Province, China, the Longjiang Feihe premises comprise approximately 29,690 square meters. The plant is approximately 19 years old and is currently under expansion which is expected to be complete in May 2011. Longjiang Feihe produces adult milk formula and has a production capacity of approximately 16 tons per day of milk powder. Longjiang Feihe also produces raw milk powder and has a production capacity approximately 11 tons per day. 
 
5


The table below summarizes key information regarding our production and packaging plants.
 
Facility
 
Province/
Region
 
Products
 
Production
Capacity
 
Packaging Capacity
(tons/year)
 
Feihe Dairy
 
Heilongjiang
 
Infant milk formula
 
550 (tons/day)
   
22,000
 
Gannan Feihe
 
Heilongjiang
 
Infant milk formula
 
300 (tons/day)
   
N/A
 
Langfang Feihe
 
Hebei
 
N/A
 
N/A
   
50,000
 
Shanxi Feihe
 
Shanxi
 
Walnut powder & Soybean powder;
 
5,000 (tons/year)
   
N/A
 
        Walnut oil  
1,000 (tons/year)
       
Baiquan Dairy
 
Heilongjiang
 
Infant milk formula
 
100 (tons/day)
   
N/A
 
Qiqihaer Feihe
 
Heilongjiang
 
Infant milk formula; Adult milk powder
 
270 (tons/day)
   
N/A
 
        Butter  
15 (tons/day)
       
Longjiang Feihe
 
Heilongjiang
 
Adult milk powder;
 
14 (tons/day)
   
N/A
 
        Raw milk powder  
10 (tons/day)
       

Sources of Walnut and Soybeans

We order walnuts and soybeans from local farmers for delivery to the Feihe Dairy.  We then distribute these raw materials to our facilities as necessary.

Product Distribution

Currently, our products are sold in stores nationwide throughout China, except in Hong Kong SAR, Macau SAR and Taiwan.  Prior to distribution, we route our products to our Feihe Dairy and Langfang Feihe for final packaging.  Feihe Dairy then distributes our finished products primarily in northeastern China, including Heilongjiang, Jilin and Liaoning Provinces, and Langfang Feihe distributes our finished products throughout the rest of China.  We have a distribution team based in our corporate headquarters that coordinates with a network of over 450 dealers or representatives in key provinces across China.  The dealers, in turn, each typically hire one or two secondary agents who assist in the distribution process, including inventory management, product sales, customer service and payments.  Dealer agents display and sell our products in specially designated areas in stores.  In addition, in 2008 we began distributing our raw milk powder to beverage manufacturers and other wholesalers for use in their blended drink products. In 2010, we established a system to monitor distributor inventory levels and cross-territory selling activity.

Generally, we deliver our products only after receipt of payment from the dealer.  We typically enter into new agreements with our dealers each year that specify sales targets and territories, among other provisions.  We seek to expand the number of key provinces served by our dealer network as part of our growth strategy and ultimately to establish a distribution system based upon local production at local dairies.  We currently distribute our products to 29 provinces in China and to over 95,000 retail outlets.

Customers

No single customer equaled or exceeded 10% of our sales during the years ended December 31, 2009 or 2008.
 
Intellectual Property

We rely principally on trade secrets and confidentiality agreements to protect our proprietary product formulations and production processes.  We have obtained trademark registrations for the use of our trade name “Feihe,” as well as our “Feifan,” “Feihui,” “Feirei,” “Feiyue,” and “Beidiqi” Chinese brands and our “Firmus” and “Babyrich” English brand names, which have been registered with the PRC Trademark Bureau of the State Administration for Industry and Commerce with respect to our milk products.  We believe our trademarks are important to the establishment of consumer recognition of our products.  However, due to uncertainties in PRC trademark law, the protection afforded by our trademarks may be less than we currently expect and may, in fact, be insufficient.  Moreover, even if it is sufficient, in the event any of our trademarks are challenged or infringed, we may not have the financial resources to defend it against any challenge or infringement and such defense could in any event be unsuccessful.  Moreover, any events or conditions that negatively impact our trademark could have a material adverse effect on our business, operations and finances.
 
6


Research and Development

As of March 10, 2010, we had six technicians engaged in research and development activities.  These technicians monitor quality control at our production facilities to ensure that the processing, packaging and distribution of our milk products result in high quality premium milk products that are safe and healthy for customers.  These technicians also pursue methods and techniques to improve the taste and quality of our 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.

During the fiscal years ended December 31, 2009 and 2008, we spent approximately $66,000 and $137,000, respectively, per year on research and development, representing amounts paid in compensation to our six quality control technicians described above.

Growth Strategy

We believe the market for dairy products in China is growing rapidly, including the market for high quality dairy products.  Our growth strategy involves increasing market share during this rapid growth phase.  To implement this strategy, we plan to:
 
 
·
Enhance distribution capabilities in PRC markets.  We plan to expand our distribution network in first-tier markets in the PRC, including Beijing, Shanghai, Guangzhou, Shenzhen and other major second and third-tier cities in the Pearl River Delta.  In addition, we plan to further increase our sales points across China, focusing on southern and western China.  Our currently extensive distribution network, which reaches many provincial capital and sub-provincial cities, has special channels into first-tier markets that we plan to expand.  We believe that positioning our brand as a high-quality line of products in these markets will facilitate our expansion.
 
 
·
Strengthen our premium quality brand awareness.  We believe that our products enjoy a reputation for high quality among those familiar with them, and our products routinely pass government and internal quality inspections.  We have increased our advertising expenses and plan to continue advertising on China Central Television, or CCTV, as well as provincial stations in China, in order to market our products as premium and super-premium products.  We believe many consumers in China tend to regard higher prices as indicative of higher quality and higher nutritional value, and as a result consumers with higher disposable incomes are increasingly inclined to purchase higher priced products, particularly in the areas of infant formula and nutritional products.
 
 
·
Align sourcing, production and distribution by region.  We believe that we can increase our efficiency and decrease our costs if our products are produced from local sources and sold in local markets.  We plan to select strategic locations for our company-owned collection stations and production facilities that will enhance this efficiency.
 
 
·
Maintaining quality through world-class production processes.  We believe we can maintain our production of high quality dairy products by continuing to enter exclusive contracts with dairy farmers who can deliver quality milk, strengthening our company-owned large-scale dairy farm operations, expanding our company-owned collection stations and production facilities, and employing comprehensive testing and quality control measures.
 
7

 
Competition

The dairy industry in China is highly competitive.  We face significant competition from large multinational producers, such as Dumex, Mead Johnson, Abbott and Wyeth, and large national milk companies, such as Synutra, Yashili and Yili, particularly in more affluent major urban areas.  Many of our competitors have greater resources and sell more products than we do.  We believe that our competitive position has improved following the melamine crisis in 2008, which did not involve any of our products.  Our products are positioned as premium products and, accordingly, are generally priced higher than many similar competitive products.  We believe that the principal competitive factors in marketing our products are quality, taste, freshness, price and product recognition.  While we believe that we compete favorably in terms of quality, taste and freshness, our products are more expensive and less well known than certain other established brands.  Our premium products may also be considered in competition with non-premium quality dairy products for discretionary food dollars.

Government Regulation

We are regulated under national, provincial and local laws in China.  The following information summarizes aspects of those regulations that apply to us and is qualified in its entirety by reference to all particular statutory or regulatory provisions.  Regulations at the national, provincial and local levels in China are subject to change.  To date, compliance with governmental regulations has not had a material impact on our level of capital expenditures, earnings or competitive position, but, because of the evolving nature of such regulations, we are unable to predict the impact such regulations may have in the foreseeable future.

As a producer and distributor of nutritional products, and particularly dairy-based food products in China, we are subject to the regulations of China’s Agricultural Ministry.  This regulatory scheme governs the manufacture (including composition and ingredients), labeling, packaging and safety of food.  Specific PRC laws and regulations we face include:
 
 
·
the PRC Product Quality Law;
 
 
·
the PRC Food Hygiene Law;
 
 
·
the Access Conditions for Dairy Products Processing Industry;
 
 
·
the Implementation Rules on the Administration and Supervision of Quality and Safety in Food Producing and Processing enterprises;
 
 
·
the Regulation on the Administration of Production Licenses for Industrial Products;
 
 
·
the General Measure on Food Quality Safety Market Access Examination;
 
 
·
the General Standards for the Labeling of Prepackaged foods;
 
 
·
the Implementation Measures on Examination of Dairy Product Production Permits;
 
 
·
the Standardization Law;
 
 
·
the Raw Milk Collection Standard;
 
 
·
the Whole Milk Powder, Skimmed Milk Powder, Sweetened Whole Milk Powder and Flavored Milk Powder Standards; and
 
 
·
the General Technical Requirements for Infant Formula Powder and Supplementary Cereal for Infants and Children.
 
8

 
We and our products are also subject to provincial and local regulations through such measures as the licensing of dairy manufacturing facilities, enforcement of standards for our products, inspection of our facilities and regulation of our trade practices in connection with the sale of dairy products.

In March 2008, the PRC National Development and Reform Commission, or the NDRC, promulgated the Access Conditions for Dairy Products Processing Industry, or the Access Conditions.  The Access Conditions set forth the conditions an entity must satisfy in order to engage, or continue to engage, in the dairy products processing business in China, including technique and equipment, product quality, energy and water consumption, sanitation and environmental protection, as well as production safety.  Any new or continuing dairy products processing projects or enterprises will be required to meet all the conditions and requirements set forth in the Access Conditions.  For projects or enterprises that already commenced operations before the promulgation of the Access Conditions, improvements or rectification actions may need to be taken in order to have such projects or enterprises meet the conditions within two years of the effective date of the Access Conditions on April 1, 2010.

The Access Conditions also set forth requirements relating to the location, processing capacity and raw milk source for any new or continuing dairy products processing project or enterprise.  Any new or continuing dairy processing projects or enterprises that fail to meet the requirements will not be able to procure land, license, permits, loan facilities and electricity necessary for the processing of dairy products, and those projects or enterprises already in operation before the promulgation of the Access Conditions will be deregistered and ordered to shut down if they fail to meet the conditions within a two-year rectification period.

In May 2008, the NDRC issued the Dairy Industry Policies, or the Policies.  According to the PRC government, the Policies are the first set of comprehensive government policies on the dairy industry in China, covering a broad range of matters such as industry planning, closure of inefficient capacity, milk supply, quality control and product safety, environmental protection and promotion of milk consumption.  Moreover, the Policies provide conditions that new entrants to the dairy industry must meet in addition to the conditions set forth in the Access Conditions.

As a result of the melamine crisis, PRC governmental authorities have conducted several dairy industry inspections.  In addition to the initial 22 companies implicated in the melamine crisis, these subsequent government inspections have identified other companies with unacceptable contaminants in dairy products.  The melamine crisis did not involve any of our products, and we have passed all of these government inspections.  In addition, we are working with the PRC government and attended several emergency meetings to discuss ways to improve the dairy and overall food industry in China.

Environmental Matters

Our manufacturing facilities are subject to various pollution control regulations with respect to noise, water and air pollution and the disposal of waste and hazardous materials.  We are also subject to periodic inspections by local environmental protection authorities.  Our operating subsidiaries have received certifications from the relevant PRC government agencies in charge of environmental protection indicating that their business operations are in material compliance with the relevant PRC environmental laws and regulations.  We are not currently subject to any pending actions alleging any violations of applicable PRC environmental laws.

Employees

As of March 10, 2010, we had approximately 3,411 employees on our payroll.  We had eight group administrators, approximately 634 employees were in marketing and sales, approximately 79 employees provided marketing support, approximately 320 people were working in our Nutrition Department as consultants and managers, approximately 236 employees were performing administrative functions, including financing, auditing and human resources, and approximately 2,134 employees were in production, storage and distribution.  Our employees are not represented by a labor union or covered by a collective bargaining agreement.  We have not experienced any work stoppages.  We believe that our relations with our employees are good.
 
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Financial Information about Segments and Geographic Areas

Although we have historically operated and managed our business as a single reportable segment, in 2008, with the initial operations of our dairy farms, we have two reportable segments:  dairy products and dairy farm. Our dairy products segment produces and sells dairy products, such as wholesale and retail milk powders, as well as soybean powder, rice cereal, walnut powder and walnut oil.  Our dairy farm segment operates our two company-owned dairy farms, Gannon Farms and Kedong Farms, construction of which we completed in the fourth quarter of 2009.  Our dairy farms provide milk to us and not to external customers. Please see Note 30 to our audited financial statements included elsewhere in this report for further discussion about segments. As we primarily generate our revenues from customers in the PRC, we do not present geographical segments.

Available Information

Our website is www.americandairyinc.com.  We provide free access to various reports that we file with, or furnish to, the U.S. Securities and Exchange Commission, or the SEC, through our website, as soon as reasonably practicable after they have been filed or furnished.  These reports include, but are not limited to, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports.  Also available on our website are printable versions of our Code of Business Conduct and Ethics and charters of our Audit Committee, Compensation Committee, Nominating/Corporate Governance Committee and other committees of our board of directors.  Information on our website does not constitute part of and is not incorporated by reference into this Annual Report on Form 10-K or any other report we file or furnish with the SEC.  Our SEC reports can also be accessed through the SEC’s website at www.sec.gov and may be read or copied at the SEC’s Public Reference Room located at 100 F Street, NE, Washington, D.C., 20549.  Information regarding the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330.
 
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FORWARD-LOOKING STATEMENTS

The statements included in this report that are not purely historical are forward-looking statements within the meaning of Section 21E of the Exchange Act, and Section 27A of the Securities Act of 1933, as amended, or the Securities Act. These statements include, but are not limited to, statements about our plans, objectives, expectations, strategies, intentions or other characterizations of future events or circumstances and are generally identified by the words “may,” “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “could,” “would,” and similar expressions. Because these forward-looking statements are subject to a number of risks and uncertainties, our actual results could differ materially from those expressed or implied by these forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed under the heading “Risk Factors” and in other documents we file from time to time with the Securities and Exchange Commission. All forward-looking statements included in this report are based on information available to us on the date hereof. Our business and the associated risks may have changed since the date this report was originally filed with the SEC. We assume no obligation to update any such forward-looking statements.

Item 1A. Risk Factors

Investing in our common stock involves a high degree of risk. You should carefully consider the following risk factors and all other information contained in this prospectus before purchasing our common stock. If any of the following events were to occur, our business, financial condition or results of operations could be materially and adversely affected. In these circumstances, the market price of our common stock could decline, and you could lose some or all of your investment. Additional risks and uncertainties not currently known to us or that we currently believe to be immaterial could also materially and adversely affect our business, financial condition, operating results and/or cash flow.

Any negative public perception regarding our products or industry, or any ill effects or product liability claims, could harm our reputation, damage our brand, result in costly and damaging recalls, and expose us to government investigations and sanctions, which would materially and adversely affect our results of operations.

We sell products for human consumption, which involves risks such as product contamination, spoilage and tampering. In 2008, sales in China of substandard milk formula contaminated with a substance known as melamine caused the death of six infants as well as illness of nearly 300,000 others.  In 2009, new incidents of substandard milk formula contaminated with melamine also appeared and again, none of our products were involved.  Although our products were not involved in these incidents, China’s Administration of Quality Supervision, Inspection and Quarantine found that the products of at least 22 Chinese milk and formula producers were contaminated by melamine, a substance not approved for use in food, which caused significant negative publicity for the entire dairy industry in China.  The mere publication of information asserting that our milk powder, infant formula or other products contain melamine or other contaminants could have a material adverse effect on us, regardless of whether these reports are scientifically supported or concern our products or the raw materials used in our products.  In addition, if the consumption of any of our products causes injury, illness or death, we may face product liability claims, product recalls, temporary or permanent suspensions of operations, government investigations or sanctions, any of which could be extremely expensive and damaging to our business.

Prior to the 2008 melamine crisis, there have also been widely publicized occurrences of counterfeit, substandard milk products in China.  For example, in April 2004, such sales of counterfeit and substandard infant formula in Anhui Province, China caused the deaths of 13 infants and harmed many others.  Counterfeiting or imitation of our products may occur in the future, and we may not be able to detect it and deal with it effectively. Any occurrence of counterfeiting or imitation could negatively impact our corporate brand and image or consumers’ perception of our products or similar nutritional products generally, particularly if the counterfeit or imitation products cause injury or death to consumers.
 
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Our products may not achieve market acceptance.

We are currently selling our products principally in northern, central, and eastern China.  Achieving market acceptance for our 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 our products.  In addition, we intend to market our products as premium and super-premium products and to adopt a corresponding pricing model, which may not be accepted in new or existing markets.  Market acceptance of our current and proposed products will depend, in large part, upon our ability to inform potential customers that the distinctive characteristics of our products make them superior to competitive products and justify their pricing.  Our current and proposed products may not be accepted by consumers or able to compete effectively against other premium or non-premium dairy products. Lack of market acceptance would limit our revenues and profitability.

Our planned growth may require more raw milk than is available and could diminish the quality of our dairy products.

Our business requires a supply of raw milk. Our growth will be limited if the supply of raw milk is insufficient to meet demand. Moreover, as we attempt to implement our growth strategy, it may become difficult to maintain current levels of quality control. Inadequate quality control could harm our reputation and the demand for our products, which would also limit our growth. A significant amount of the raw milk used in our products is supplied to us by numerous local farms under output contracts. We believe that our farmers can increase their production of raw milk. We further believe, however, that this supply may not be sufficient to meet increased demand for our products associated with our proposed marketing efforts and that such increase may compromise quality. Though we believe that additional raw milk is available locally, if needed, we may not be able to enter into arrangements with the producers of such milk on terms acceptable to us, if at all. Our efforts to source milk through our company-owned dairy farms are new, may involve unforeseen difficulties, and may not supply the quantity of raw milk we need to maintain and expand our levels of production. An inadequate supply of raw milk, coupled with concern over quality control, could increase costs for raw milk or decrease the sales price for our products, which could limit our ability to grow, cause our earnings to decline and make our business less profitable.
  
The recent global economic and financial market crisis could significantly impact our financial condition.

Current global economic conditions could have a negative effect on our business and results of operations. Economic activity in China, the United States and throughout much of the world has undergone a sudden, sharp economic downturn following the recent housing crisis in the real estate and credit markets in both the United States and Europe.  Market disruptions have included extreme volatility in securities prices, as well as severely diminished liquidity and credit availability.  The economic crisis may adversely affect us in a variety of ways. Access to lines of credit or the capital markets may be severely restricted, which may preclude us from raising funds required for operations and to fund continued expansion.  It may be more difficult for us to complete strategic transactions with third parties. The financial and credit market turmoil could also negatively impact our suppliers and customers, which could decrease our ability to source, produce and distribute our products and could decrease demand for our products. While it is not possible to predict with certainty the duration or severity of the current disruption in financial and credit markets, if economic conditions continue to worsen, it is possible these factors could significantly impact our financial condition.

Our results of operations may be affected by fluctuations in availability and price of raw materials.

The raw materials we use are subject to price fluctuations due to various factors beyond our control, including, among other pertinent factors:
 
 
·
increasing market demand;
 
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·
inflation;
 
 
·
severe climatic and environmental conditions;

 
·
seasonal factors, with dairy cows generally producing more milk in temperate weather as opposed to cold or hot weather and extended unseasonably cold or hot weather potentially leading to lower than expected production;

 
·
commodity price fluctuations;

 
·
currency fluctuations; and
 
 
·
changes in governmental and agricultural regulations and programs.

For example, our raw milk cost increased by approximately 45% in 2008 due to various factors, including, we believe, general economic conditions, such as inflation and fuel prices, and rising production costs and decreased by approximately 20% in 2009 due to various other factors, including increased competition abroad and currency appreciation.  We also expect that our raw material prices will continue to fluctuate and be affected by all of these factors in the future.  Changes to our raw materials prices may result in increases in production and packaging costs, and we may be unable to raise the prices of our products to offset such increases in the short term or at all. As a result, our results of operations may be materially and adversely affected.

We are subject to public company reporting and other requirements for which we will incur substantial costs and our accounting and other management systems and resources may not be adequately prepared.

We incur significant legal, accounting, insurance and other expenses as a result of being a public company.  For example, laws and regulations affecting public companies, including the provisions of the Sarbanes-Oxley Act of 2002, or SOX, and rules related to corporate governance and other matters subsequently adopted by the SEC and the NYSE, result in substantial costs to us, including legal and accounting costs, and may divert our management’s attention from other matters that are important to our business.  Compliance with Section 404 of SOX requires that our management annually assess the effectiveness of our internal control over financial reporting and that our independent auditors report on management’s assessment.  During our review of our financial statements and results for the year ended December 31, 2008, our management identified several internal control matters that constituted material weaknesses and significant deficiencies and, consequently, concluded that our internal control over financial reporting was not effective at December 31, 2008.  In addition, management concluded, based primarily on the identification of the material weaknesses and significant deficiencies, that our disclosure controls and procedures were not effective at December 31, 2008.  Since the end of 2008, we implemented remedial measures described below under “Management’s Report on Internal Control Over Financial ReportingChanges in Internal Controls,” including hiring additional accounting, internal audit and finance staff, engaging consultants to assist with these functions, upgrading our systems, and implementing additional financial and management controls and reporting systems and procedures, as well as improving certain processes surrounding our Audit Committee activities.  These measures have cost us an aggregate of approximately $1.0 million to date.  Although management has concluded the measures have partially remediated many of our historical material weaknesses, as of December 31, 2009 our management concluded we had a material weakness relating to the accounting and treatment of routine and non-routine transactions:  we did not effectively and timely assess the accounting treatment for certain transactions, including sales, purchases, government subsidy income, and operating expenses. The measures we take to remediate material weaknesses may not ensure the adequacy of our internal controls over our financial processes and reporting in the future.
 
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A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our company have been detected.

We significantly depend on our management team.

Each of our executive officers is responsible for an important aspect of our operations.  In addition, we rely on management and senior personnel to ensure that our sourcing, production, sales, distribution and other business functions are effective.  Losing the services of our executive officers or key personnel could be detrimental to our operations.  We do not have key-man life insurance for any of our executive officers or other employees.

Investors may not be able to enforce judgments entered by United States courts against certain of our officers and directors.

We are incorporated in the State of Utah.  However, a majority of our directors and executive officers, and certain of our principal shareholders, live outside of the U.S., principally in China. As a result, you may not be able to effect service of process upon those persons within the U.S. or enforce against those persons judgments obtained in U.S. courts.

We face substantial competition in connection with the marketing and sale of our products.

Our products compete with other premium quality dairy brands as well as less expensive, non-premium brands. Our products face competition from non-premium producers distributing in our marketing area and other producers packaging their products in our marketing area. Many of our competitors are well established, have greater financial, marketing, personnel and other resources, have more established distribution channels into major markets, and have products that have gained wide customer acceptance in the marketplace. Our largest competitors are multi-national dairy companies owned by the government of 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 efforts by us. The dairy industry in China is also characterized by the frequent introduction of new products, accompanied by substantial promotional campaigns, such as large discounts to distributors. In addition, distributors in China often engage in cross-territory selling activities, which involves their diversion of products into different geographic regions, which can disrupt the price of our products and adversely impact our revenues. We may be unable to compete successfully with our competitors in some or all of our markets, and our competitors may develop products which have superior qualities or gain wider market acceptance than ours.

We expect to incur costs related to potential acquisitions and expansion into new plants and ventures, which may not prove to be profitable. Moreover, any delays in our expansion plans could cause our profits to decline and jeopardize our business.

We anticipate that any proposed expansion of our milk production facilities may include the acquisition and construction of new or additional facilities. Our cost estimates and projected completion dates for construction of new production facilities may change significantly as the projects progress. In addition,  projects could 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 of production facilities could delay our receipt of sales revenues from such facilities, which, when coupled with the increased costs and expenses of our expansion, could cause a decline in our profits.

Our plans to finance, develop, and expand our production facilities could 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. These projects may not become operational within their estimated time frames and budgets as projected at the time we enter into a particular agreement, or at all. In addition, we may develop projects as joint ventures in an effort to reduce our financial commitment to individual projects. The significant expenditures required to expand our production plants may not ultimately result in increased profits.
 
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When our future expansion projects become operational, we will be required to add and train personnel, expand our management information systems and control expenses. If we do not successfully address our increased management needs or are otherwise unable to manage our growth effectively, our operating results could be materially and adversely affected.
 
We face the potential risk of product liability associated with food products.

We face the risk of liability in connection with the sale and consumption of dairy products and other 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. The successful assertion of product liability claims against us could result in potentially significant monetary damages, divert management resources and require us to make significant payments and incur substantial legal expenses. We do not currently maintain product liability insurance. Any insurance that we may obtain in the future may be insufficient to cover potential claims or the level of insurance coverage needed may be unavailable at a reasonable cost. Even if a product liability claim is not successfully pursued to judgment by a claimant, we may still incur substantial legal expenses defending against such a claim and our brand image and reputation would suffer. Finally, serious product quality concerns could result in governmental action against us, which, among other things, could result in mandatory recalls of our products, the suspension of production or distribution of our products, loss of certain licenses, or other governmental penalties, including possible criminal liability.

Doing business in China involves various political and economic risks.

We conduct substantially all of our operations and generate most of our revenue in China. Accordingly, our business, financial condition, results of operations and prospects are affected significantly by economic, political and legal developments in China. China’s economy differs from the economies of most developed countries in many respects, including:

 
·
the higher level of government involvement and regulation;

 
·
the early stage of development of the market-oriented sector of the economy;

 
·
the rapid growth rate;

 
·
the higher level of control over foreign exchange; and

 
·
government control over the allocation of many resources.

As China’s economy has been transitioning from a planned economy to a more market-oriented economy, the government of China has implemented various measures to encourage economic growth and guide the allocation of resources. While these measures may benefit the overall economy of China, they may also have a negative effect on us.

Although the government of China has in recent years implemented measures emphasizing the utilization of market forces for economic reform, the PRC government continues to exercise significant control over economic growth in China through the allocation of resources, controlling payment of foreign currency-denominated obligations, setting monetary policy and imposing policies that impact particular industries or companies in different ways.  Any adverse change in the economic conditions or government conditions or government policies in China could have a material adverse effect on the overall economic growth and the level of consumer spending in China, which in turn could lead to a reduction in demand for our products and consequently have a material adverse effect on our business and prospects. 

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Extensive regulation of the food processing and distribution industry in China could increase our expenses resulting in reduced profits.

We are subject to extensive regulation by China’s Agricultural Ministry, and by other provincial and local authorities in jurisdictions in which our products are processed or sold, regarding the processing, packaging, storage, distribution and labeling of our products.  For instance, in June 2009, regulatory requirements became effective in China requiring new package labeling for dairy products, which we believe impacted our sales cycles during the three months ended June 30, 2009.  Additional labeling requirements are scheduled to become effective on June 10, 2010 for all dairy products, which could have an adverse impact on our sales, inventory levels, or packing and distribution.

Other applicable laws and regulations governing our products may include nutritional labeling and serving size requirements. Our processing facilities and products are subject to periodic inspection by national, provincial and local authorities. We believe that we are currently in substantial compliance with all material governmental laws and regulations and maintain all material permits and licenses relating to our operations. Nevertheless, we may fall out of substantial compliance with current laws and regulations or may be unable to comply with any future laws and regulations. To the extent that new regulations are adopted, we will be required, possibly at considerable expense, to adjust our activities in order to comply with such regulations. Our failure to comply with applicable laws and regulations could subject us to civil remedies, including fines, injunctions, recalls or seizures, as well as potential criminal sanctions, which could have a material adverse effect on our business, operations and finances.
 
Regulations affecting acquisitions of PRC companies by foreign entities may make it more difficult for us to complete acquisitions and grow our business.

In 2005, the PRC State Administration of Foreign Exchange, or SAFE, issued a public notice, known as “Circular 75,” concerning the application of foreign exchange regulations to mergers and acquisitions involving foreign investment in China.  Among other things, the public notice provides that if an offshore company controlled by PRC residents intends to acquire a PRC company, such acquisition will be subject to strict examination by the relevant foreign exchange authorities.  Under Circular 75, if an acquisition of a PRC company by an offshore company controlled by PRC residents occurred prior to the issuance of Circular 75, certain PRC residents were required to submit a registration form to the local SAFE branch to register their ownership interests in the offshore company before March 31, 2006.  Such PRC residents must also amend the registration form if there is a material event affecting the offshore company, such as, among other things, a change of the company’s share capital, a transfer of shares, or if the company is involved in a merger, an acquisition or a spin-off transaction or uses its assets in China to guarantee offshore obligations.  In the past, we have acquired a number of assets from, or equity interests in, PRC companies.

There is still significant uncertainty in China regarding the interpretation and implementation of Circular 75.  Nevertheless, we have requested that our shareholders who are PRC residents make the necessary applications, filings and amendments that  required under Circular 75 and related regulations. However, all of our PRC-resident shareholders may not comply with such requirements.  We also cannot predict how these regulations will affect our future acquisition strategy and business operations. For example, if we decide to acquire additional PRC companies, we or the owners of such companies may not be able to complete the filings and registrations, if any, required by the SAFE notices. Failure to complete Circular 75 registrations may limit the ability of our PRC subsidiaries to issue dividends to us, limit our ability to inject additional capital into our subsidiaries, restrict our ability to implement our acquisition strategy and adversely affect our business and prospects.

In addition, in 2006 six PRC regulatory authorities, including the PRC Ministry of Commerce and the PRC Securities Regulatory Commission, jointly promulgated a rule entitled “Provisions regarding Mergers and Acquisitions of Domestic Enterprises by Foreign Investors,” or the New M&A Rules, in September 2006. The New M&A Rules establish additional procedures and requirements that could make merger and acquisition activities by foreign investors more time-consuming and complex, including, in some circumstances, advance notice to the Ministry of Commerce of any change-of-control transaction in which a foreign investor takes control of a PRC domestic enterprise. Compliance with the New M&A Rules, and any related approval processes, including obtaining approval from the Ministry of Commerce, may delay or inhibit our ability to complete such transactions, which could affect our ability to expand our business or maintain our market share.
 
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Furthermore, in August 2008, SAFE issued a notice, known as “Circular 142,” regulating the conversion by a foreign-invested company of foreign currency into PRC currency, the Reminbi or RMB, by restricting the uses for the converted RMB. Circular 142 requires that the registered capital of a foreign-invested company denominated in RMB but converted from a foreign currency may only be used pursuant to the purposes set forth in the foreign-invested company’s business scope as approved by the applicable governmental authority. Such registered capital may not be used for equity investments within the PRC. In addition, SAFE strengthened its oversight of the flow and use of the registered capital of a foreign-invested company that was denominated in RMB but converted from foreign currency. Violations of Circular 142 may result in severe penalties, including significant fines. As a result, Circular 142 may significantly limit our ability to invest in or acquire other PRC companies using the RMB-denominated capital of our PRC subsidiaries.

The PRC government’s recent measures to curb inflation rates could adversely affect future results of operations.

China has faced rising inflation in recent years. The government of China undertook various measures to alleviate the effects of inflation, especially with respect to key commodities. In January 2008, the PRC National Development and Reform Commission announced national price controls on various products, including milk. Similarly, the government of China may conclude that the prices of infant formula or other of our products are too high and may institute price controls that would limit our ability to set prices for our products as we might wish. The government of China has also encouraged local governments to institute price controls on similar products. Such price controls could adversely affect our future results of operations and, accordingly, the price of our common stock.

The PRC currency is not a freely convertible currency, which could limit our ability to obtain sufficient foreign currency to support our business operations in the future.

The PRC currency is not a freely convertible currency. We rely on the PRC 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 Renminbi reserves through, among other things, direct regulation of the conversion of Renminbi into other foreign currencies and restrictions on foreign imports. Although foreign currencies that are required for current account transactions can be bought freely at authorized PRC banks, the proper procedural requirements prescribed by PRC law must be met. At the same time, PRC companies are also required to sell their foreign exchange earnings to authorized PRC banks and the purchase of foreign currencies for capital account transactions still requires prior approval of the PRC government. This substantial regulation by the PRC government of foreign currency exchange may restrict our business operations and a change in any of these government policies could negatively impact our operations, which could result in a loss of profits.

In order for our China subsidiaries to pay dividends to us, a conversion of Renminbi into U.S. dollars is required, which, if not permitted by the PRC government, would interrupt our cash flows. Under current PRC law, the conversion of Renminbi into foreign currency for capital account transactions generally requires approval from SAFE and, in some cases, other government agencies. Government authorities may impose restrictions that could have a negative impact in the future on the conversion process and upon our ability to meet our cash needs and to pay dividends to our shareholders. Although, our subsidiaries’ classification as wholly foreign-owned enterprises, or WFOEs, under PRC law permits them to declare dividends and repatriate their funds to us in the United States, any change in this status or the regulations permitting such repatriation could prevent them from doing so. Any inability to repatriate funds to us would in turn prevent us from utilizing our PRC cash to pay creditors in U.S. dollars or other currencies or to pay dividends to our shareholders.
 
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Fluctuations in the exchange rate between the PRC currency and the U.S. dollar could adversely affect our operating results.

The functional currency of our operations in China is the Renminbi. However, results of our operations are translated at average exchange rates into U.S. 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. We do not currently use hedging techniques, and any hedging techniques we may use in the future may not eliminate and may exacerbate the effects of currency fluctuations. Thus, exchange rate fluctuations could cause our profits, and therefore our stock prices, to decline.
 
Under the New EIT Law, we may be classified as a “resident enterprise” of China, which would likely result in unfavorable tax consequences to us and our non-PRC shareholders.

Under China’s Enterprise Income Tax Law, or the New EIT Law, and its implementing rules, which became effective in 2008, an enterprise established outside of China with “de facto management bodies” within China is considered a “resident enterprise,” meaning that it can be treated in a manner similar to a Chinese enterprise for enterprise income tax purposes.  Under the implementing rules of the New EIT Law, de facto management means substantial and overall management and control over the production and operations, personnel, accounting, and properties of the enterprise.  Because the New EIT Law and its implementing rules are new, it is unclear how tax authorities will determine tax residency based on the facts of each case.

If the PRC tax authorities determine that American Dairy, Inc. is a “resident enterprise” for PRC enterprise income tax purposes, unfavorable PRC tax consequences could follow. First, we may be subject to enterprise income tax at a rate of 25% on our worldwide taxable income as well as PRC enterprise income tax reporting obligations. Second, although under the New EIT Law and its implementing rules dividends paid to us from our PRC subsidiaries would qualify as “tax-exempt income,” such dividends may be subject to a 10% withholding tax, as the PRC foreign exchange control authorities, which enforce the withholding tax, have not yet issued guidance with respect to the processing of outbound remittances to entities that are treated as resident enterprises for PRC enterprise income tax purposes. Finally, it is possible that future guidance issued with respect to the new “resident enterprise” classification could result in a situation in which a 10% withholding tax is imposed on dividends we pay to our non-PRC shareholders and with respect to gains derived by our non-PRC shareholders from transferring our shares. We are actively monitoring the possibility of “resident enterprise” treatment for the 2008 and 2009 tax years and are evaluating appropriate organizational changes to avoid this treatment, to the extent possible.
 
If we were treated as a “resident enterprise” by PRC tax authorities, we would be subject to tax in both the U.S. and China, and our PRC tax may not be creditable against our U.S. tax.  

We do not intend to pay and may be restricted from paying dividends on our common stock.

We have never declared or paid dividends on our capital stock and we do not intend to declare dividends in the foreseeable future. We currently intend to retain future earnings to fund our continued growth. Furthermore, if we decide to pay dividends, foreign exchange and other regulations in China may restrict our ability to distribute retained earnings from China or convert those payments from Renminbi into foreign currencies.

Lack of bank deposit insurance puts our funds at risk of loss from bank foreclosures or insolvencies.

We maintain certain bank accounts in China that are not protected by FDIC insurance or other insurance. As of December 31, 2009, we held approximately $48 million in bank accounts in China.  If a PRC bank holding our funds experienced insolvency, it may not permit us to withdraw our funds, which would result in a loss of such funds and reduction of our net assets.  As of December 31, 2009, we held approximately $964,000 of cash balances within the United States, of which $714,000 was in excess of FDIC insurance limits, and exposes us to risk of loss of such funds and a resulting reduction of our net assets.
 
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Limited and uncertain trademark protection in China makes the ownership and use of our trademark uncertain.

We have obtained trademark registrations for the use of our trade name “Feihe,” as well as our “Feifan,” “Feihui,” “Feirei,” “Feiyue,” and “Beidiqi” Chinese brands and our “Firmus” and “Babyrich” English brand names, which have been registered with the PRC Trademark Bureau of the State Administration for Industry and Commerce with respect to our milk products.  We believe our trademark is important to the establishment of consumer recognition of our products.  However, due to uncertainties in PRC trademark law, the protection afforded by our trademark may be less than we currently expect and may, in fact, be insufficient. Moreover, even if it is sufficient, in the event it is challenged or infringed, we may not have the financial resources to defend it against any challenge or infringement and such defense could in any event be unsuccessful. Moreover, any events or conditions that negatively impact our trademark could have a material adverse effect on our business, operations and finances.

Our lack of patent protection could permit our competitors to copy our trade secrets and formula and thus gain a competitive advantage.

We have no patents covering our products or production processes, and we expect to rely principally on know-how and the confidentiality of our formula and production processes for our products and our flavoring formula in producing competitive product lines. Any breach of confidentiality by our executives or employees having access to our formula could result in our competitors gaining access to such formula. The ensuing competitive disadvantage could reduce our revenues and our profits.

One of our shareholders owns a significant percentage of our stock and will be able to exercise significant influence over our affairs.

Leng You-Bin, our Chairman, Chief Executive Officer, President, and General Manager, beneficially owned approximately 41% of our common stock as of March 10, 2010.  Consequently, Mr. Leng will likely be able to determine the composition of our board of directors, to approve certain matters requiring shareholder approval and to have significant influence over our operations.  Mr. Leng’s interests may be different than the interests of other shareholders on these matters.  This concentration of ownership could also have the effect of delaying or preventing a change in our control or otherwise discouraging a potential acquirer from attempting to obtain control of us, which in turn could reduce the price of our common stock.

Failure to comply with the U.S. Foreign Corrupt Practices Act could subject us to penalties and other adverse consequences.

Since we are a Utah corporation and a public company in the United States, we are subject to the U.S. Foreign Corrupt Practices Act, which generally prohibits U.S. companies from engaging in bribery or other prohibited payments to foreign officials for the purpose of obtaining or retaining business. Non-U.S. companies, including some that may compete with our company, are not subject to these prohibitions. Corruption, extortion, bribery, pay-offs, theft and other fraudulent practices may occur in China. Although such practices are prohibited at our company, our employees or other agents may engage in such conduct for which we might be held responsible.  If our employees or other agents are found to have engaged in such practices, we could suffer severe penalties and other consequences that may have a material adverse effect on our business, financial condition and results of operations.

19

 
We have a significant amount of indebtedness, which may limit our operating flexibility.

As of December 31, 2009, we had approximately $220.7 million of total liabilities. Although all of our 7.75% Convertible Notes due 2009, or the 2009 Notes, have converted into shares of our common stock and we have repurchased all of our 1.00% Guaranteed Senior Secured Convertible Notes due 2012, or the 2012 Notes, we expect to continue to incur debt to fund capital and operating expenses.  Our high level of indebtedness could have important consequences, including the following:
 
 
·
it may be difficult for us to satisfy our obligations with respect to our indebtedness;
 
 
·
our ability to obtain additional financing for working capital, capital expenditures, or general corporate or other purposes may be impaired;
 
 
·
a substantial portion of our cash flow from operations must be dedicated to the payment of principal and interest on our indebtedness, reducing the funds available to us for other purposes;
 
 
·
it may cause our trade creditors to change their terms for payment on goods and services provided to us, thereby negatively impacting our ability to receive products and services on acceptable terms;
 
 
·
it may place us at a competitive disadvantage compared to our competitors that have less debt or are less leveraged; and
 
 
·
we may be more vulnerable to economic downturns, may be limited in our ability to respond to competitive pressures and may have reduced flexibility in responding to changing business, regulatory and economic conditions.

Our ability to pay interest on and to satisfy our debt obligations will depend upon, among other things, our future operating performance and our ability to refinance indebtedness when necessary.  Each of these factors is, to a large extent, dependent upon economic, financial, competitive and other factors beyond our control.  If, in the future, we cannot generate sufficient cash from operations to meet our debt obligations, we will need to refinance our existing debt, obtain additional financing or sell assets.  Our business may not generate sufficient cash flows to satisfy our existing indebtedness and funding sufficient to satisfy our debt service requirements may not be available on satisfactory terms, if at all.

The terms of our subscription agreement with the Purchasers may have adverse impacts on us.

In August 2009, pursuant to a subscription agreement, we issued 2,100,000 shares of our common stock to Sequoia Capital China Growth Fund I, L.P. and certain of its affiliates, or the Purchasers, for an aggregate purchase price of $63.0 million.  The subscription agreement includes several provisions that could have an adverse effect on us.  We have agreed not to issue new shares of our common stock at a price below $30.00 per share without the prior written consent of a majority in interest of the Purchasers, subject to certain exceptions, which could preclude us from raising additional funds.  In addition, because we did not meet certain earnings per share targets for 2009, we must issue 525,000 additional shares of our common stock to the Purchasers pursuant to the agreement, which will result in immediate and substantial dilution to our shareholders.  Furthermore, if the average closing prices of our common stock for the fifteen trading days commencing on the third anniversary of the closing date is less than $39.00 per share, the purchasers will have the right to cause us to repurchase all of the securities acquired in connection with the agreement, which could significantly impact our liquidity and capital resources.

 
20


Financial covenants in our loan agreement could restrict our ability to obtain new debt and our failure to comply with it could adversely affect our business and financial condition.
 
In October 2009, we entered into a loan agreement with a bank in the PRC for a principal amount of up to $9.2 million for the purpose of financing the purchase of certain equipment.  As of December 31, 2009, there was approximately $4.0 million in principal payable under this loan.  The loan agreement contains a financial covenant requiring us to maintain a debt to earnings ratio.  At December 31, 2009, we were in technical default of the financial covenant under the loan agreement.  The bank did not provide notice of default, waived the technical default at December 31, 2009, and agreed to revise the financial covenant to measure compliance on a 12-month rolling basis rather than quarter by quarter.  However, we may be unable to comply with the revised financial covenant in the future or to obtain a waiver from the bank.  Our inability to comply with the covenant may impact our ability to draw against the facility, constitute an event of default under the loan agreement, impact our ability to obtain additional debt, and have an adverse effect on our business and financial condition.

We are at risk of securities litigation.

We are at risk of being subject to securities litigation, including possible enforcement action or class action lawsuits.  Following notification by the SEC in 2007 of an informal investigation related to our former independent registered public accountants, we dismissed our former auditors, sued our former auditors, engaged new independent registered public accountants, commenced a re-audit of historical financial statements, and restated our financial statements as of and for our fiscal years ended December 31, 2005 and 2006.  Accordingly, we were unable to file Exchange Act reports for 2007 and 2008 in a timely manner.  In addition, we have restated our quarterly financial statements for the quarter ended March 31, 2009 to reclassify certain items from operating activities to investing activities, and we have amended our Form 10-K for the 2008 fiscal year to restate items in our statements of cash flows and to revise the note to our financial statements regarding quarterly operating results.  Securities class action litigation has often been brought against companies who have been unable to provide current public information or who have restated previously filed financial statements.  Such litigation is complex and could result in substantial costs, divert management’s attention and resources, and seriously harm our business, financial condition and results of operations.

Item 1B. Unresolved Staff Comments

None.

Item 2. Properties

Our principal executives are located at Star City International Building, 10 Jiuxianqiao Road, C-16th Floor, Chaoyang District, Beijing, China 100016.  We have seven production and packaging facilities, which have an aggregate milk powder production capacity of 1,234 tons per day, encompass an aggregate of approximately 664,153 square meters of office, plant, and warehouse space, and are located in the Heilongjiang, Shanxi and Hebei Provinces in China.  For additional information on our production and packaging facilities, see “Item 1. Business—Production and Packaging Facilities” above.  In addition, we own two dairy farms, Gannan Farms and Kedong Farms, construction of which we completed in the fourth quarter of 2009, and which each consist of approximately 986,300 and 385,000 total square meters of cattle houses and administrative facilities, respectively.  Gannan Farms and Kedong Farms currently house a total of approximately 14,000 Australian Holstein cows, each of which, on average, provides us with 8-10 tons of milk per year.  We expect that each of our dairy farms will have annual capacity to source up to 70,000 tons of fresh milk per year.

There is no private ownership of land in China.  All land is owned by the government of China, its agencies and collectives. Land use rights are obtained from the government for period ranging from 50 to 70 years, and are typically renewable. Land use rights can be transferred upon approval by the land administrative authorities of China (such as the State Land Administration Bureau) upon payment of the required land transfer fee.

We believe that our facilities are suitable for our current operations.  As part of our growth strategy, we are in the process of expanding our production capacity and plan to strengthen our dairy farm operations.

21

 
Item 3. Legal Proceedings

From time to time, we may become involved in various claims and lawsuits incidental to our business.  Other than as disclosed below, we know of no material existing or pending legal proceedings against us, nor are we involved as a plaintiff in any material proceeding or pending litigation.

We are a plaintiff in a lawsuit entitled American Dairy, Inc. v. Murrell, Hall, McIntosh & Co. PLLP et al., filed on April 15, 2008 in the United States District Court for the Western District of Oklahoma. This suit alleges that our previous independent auditor, Murrell, Hall, McIntosh & Co. PLLP, or MHM, breached its duties of due care and professional competence by failing to perform its audits in accordance with professional standards of care in that MHM improperly and negligently (i) accepted Henny Wee & Co.’s representation that it was independent and otherwise failed to make sufficient inquiries concerning Henny Wee & Co.’s independence, and (ii) permitted Henny Wee & Co. to perform such a significant and material part of the audit work that MHM should have evaluated whether it could act as principal auditor and report on our financial statements. We are seeking compensatory damages of not less than $10.0 million in connection with this suit. We continue to vigorously pursue damages under this lawsuit.

Item 4. (Removed and Reserved)
 
22

 
PART II

Item 5.  Market for the Registrant’s Common Stock, Related Shareholder Matters and Issuer Repurchases of Equity Securities

Price Range of Our Common Stock

American Dairy common stock trades on the NYSE under the symbol “ADY.”  At March 10, 2010, there were 21,707,376 shares of our common stock issued and outstanding that were held by approximately 411 shareholders of record.  The table below lists the high and low closing prices per share of our common stock for each quarterly period during the past two fiscal years as reported on the NYSE.

   
Closing Price Range of Common Stock
 
   
High
   
Low
 
Year Ended December 31, 2008:
               
1st Quarter
 
$
12.91
   
$
7.00
 
2nd Quarter
 
$
13.91
   
$
7.88
 
3rd Quarter
 
$
11.34
   
$
6.74
 
4th Quarter
 
$
17.02
   
$
8.32
 
                 
Year Ended December 31, 2009:
               
1st Quarter
 
$
17.08
   
$
9.77
 
2nd Quarter
 
$
43.16
   
$
15.25
 
3rd Quarter
 
$
39.95
   
$
20.08
 
4th Quarter
 
$
34.85
   
$
20.25
 

Dividend Policy

We have not declared or paid any dividends on our common stock and presently do not expect to declare or pay any such dividends in the foreseeable future.  Payment of dividends to our shareholders would require payment of dividends by our PRC subsidiaries to us.  This, in turn, would require a conversion of Renminbi into US dollars and repatriation of funds to the US.  Under current PRC law, the conversion of Renminbi into foreign currency for capital account transactions generally requires approval from SAFE and, in some cases, other government agencies.  Government authorities may impose restrictions that could have a negative impact in the future on the conversion process and upon our ability to meet our cash needs, and to pay dividends to our shareholders.  Although our subsidiaries’ classification as WFOEs under PRC law permits them to declare dividends and repatriate their funds to us in the United States, any change in this status or the regulations permitting such repatriation could prevent them from doing so.  Any inability to repatriate funds to us would in turn prevent payments of dividends to our shareholders.

Transfer Agent and Registrar

Our transfer agent and registrar is Progressive Transfer Co., 1981 Murray Holladay Road, Suite 100, Salt Lake City, Utah 84117-5148; telephone 1 (801) 272-9294.

Performance Graph

The following graph compares the annual cumulative total shareholder return on an investment on December 31, 2004 of $100 in our common stock with the annual cumulative total return on the same investment in the S&P 500 Index and the S&P Packaged Foods and Meats Index for the five subsequent fiscal years.
 
23



Recent Sales of Unregistered Securities

In November 2008, pursuant to an agreement regarding our 2009 Notes, we issued to holders of our 2009 Notes an aggregate amount of 216,639 shares of our common stock.  In connection with the agreement, we amended and restated the 2009 Notes and the warrants issued therewith.  The amended and restated 2009 Notes had an aggregate principal amount of $18.2 million, accrued interest at an annual rate of 7.75%, matured in October 2009, and could be converted at the option of the holder into shares of our common stock at a conversion price of $14.50 per share.  The warrants issued with the amended and restated 2009 Notes permit the holders to acquire approximately 251,000 shares of our common stock at an exercise price of $14.50 per share at any time prior to October 2012.  We issued these securities pursuant to the exemptions from registration under Section 3(a)(9) of the Securities Act for certain exchange offers and Section 4(2) of the Securities Act for transactions by an issuer not involving any public offering.
 
In November 2008, we entered into a supplemental indenture with respect to the 2012 Notes, which amended the terms of the 2012 Notes to provide for our early repurchase of the 2012 Notes and to provide certain waivers and consents to us, in offshore transactions not requiring registration under the Securities Act pursuant to Regulation S, and pursuant the exemptions from registration under Section 3(a)(9) of the Securities Act for certain exchange offers and under Section 4(2) of the Securities Act for transactions by an issuer not involving any public offering.

From January 2008 to December 2008, we issued 8,000 restricted shares of our common stock to each of our directors in consideration for their services to us, and an additional 2,000 restricted shares of our common stock to Hui-Lan Lee, a director and the chairperson of our Audit Committee.  In addition, from January 2008 to December 2009, we issued 22,500  restricted shares of our common stock, and options to purchase up to an aggregate of 2,233,190 shares of our common stock at exercise prices ranging from $12.00 to $27.69 per share, subject to various vesting requirements, to employees in consideration for their services to us.  We issued these securities in offshore transactions not requiring registration under the Securities Act and pursuant to the exemption from registration under Section 4(2) of the Securities Act for transactions by an issuer not involving any public offering.

In August 2009, we issued 2,100,000 shares of our common stock to accredited investors for an aggregate purchase price of $63.0 million, including $47.0 million in cash and the conversion of a $16.0 million bridge loan, pursuant to the exemptions from registration provided by Section 4(2) under the Securities Act and Rule 506 promulgated thereunder for transactions by an issuer not involving any public offering.
 
24


In July, August and October 2009, the holders of the 2009 Notes elected to convert the 2009 Notes into shares of our common stock.  In connection with these conversions, $18.2 million in principal and approximately $4.3 million in accrued interest on the 2009 Notes was converted into 1,549,122 shares of our common stock at a conversion price of $14.50 per share.  We issued these securities pursuant to the exemption from registration under Section 4(2) of the Securities Act for transactions by an issuer not involving any public offering.

From January 2008 to December 2009, we issued 807,347 shares of our common stock, at various exercise prices, upon exercise of warrants, resulting in aggregate proceeds to us of approximately $1.8 million.  We issued these securities pursuant to the exemption from registration under Section 4(2) of the Securities Act for transactions by an issuer not involving any public offering.

Item 6. Selected Financial Data

Not applicable.
 
25

 
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Annual Report contains our audited consolidated financial statements for the years ended December 31, 2009 and 2008 and data derived therefrom.

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our audited consolidated financial statements and related notes appearing elsewhere in this Annual Report.  In addition to historical financial information, the following discussion contains forward-looking statements that reflect our plans, estimates and beliefs.  Our actual results could differ materially from those discussed in the forward-looking statements.  Factors that could cause or contribute to these differences include those discussed below and elsewhere in this Annual Report, particularly in “Item 1A. Risk Factors” above.

Overview

We are a leading producer and distributor of milk powder, soybean milk powder, and related dairy products in the PRC.  Using proprietary processing techniques, we make products that are specially formulated for particular ages, dietary needs and health concerns.  We have over 200 company-owned milk collection stations, seven production and distribution facilities with an aggregate milk powder production capacity of 1,234 tons per day, and an extensive distribution network that reaches over 95,000 retail outlets throughout China.
 
Factors Affecting our Results of Operations

Our operating results are primarily affected by the following factors:
 
 
·
Dairy Industry Growth.  We believe the market for dairy products in China for the long term will be growing rapidly, driven by China’s economic growth, increased penetration of infant formula, and a growing female working population.  Despite the damage to the industry as a result of the melamine crisis in 2008, we expect these factors to continue to drive industry growth. We believe that the rapid economic growth of our primary markets has become an increasingly important driver of growth.
 
 
·
Production Capacity. We believe much of the dairy market in China is still underserved, particularly with respect to infant formula.  In addition, since the melamine crisis in 2008, which did not involve any of our products, we have been able to operate our milk production facilities at maximum capacity.  Accordingly, we believe that the ability to increase production of high quality dairy products will allow well positioned companies to significantly increase revenues and market share.
     
 
·
Perceptions of Product Quality and Safety. We believe that rising consumer wealth in China has contributed to a greater demand for higher-priced products with perceived quality advantages.  We believe many consumers in China tend to regard higher prices as indicative of higher quality and higher nutritional value, particularly in the areas of infant formula and nutritional products.  Accordingly, we believe our reputation for quality and safety allows us to command higher average selling prices and generate higher gross margins than competitors who do not possess the same reputation.  Conversely, any decrease in consumer perceptions of quality and safety could adversely impact us.

 
·
Seasonality.  The dairy industry remains seasonal, with higher production in the summer season and greater demand in winter months. This seasonality is offset by production of powder products with longer shelf lives.
     
 
·
Raw Material Supply and Prices.  The per unit costs of producing our infant formula are subject to the supply and price volatility of raw milk and other raw materials, which are affected by the PRC and global markets. For example, in 2008 our raw milk prices increased by approximately 45% and in 2009 decreased by approximately 20% and we expect they will continue to be affected by factors such as geographic location, rising feed prices, general economic conditions such as inflation and fuel prices, and fluctuations in production, rising production costs and competition, as well as increased competition abroad and currency fluctuations.
 
26

 
 
·
Expenses Associated with Expansion.  In implementing our plan to expand our business, we face corresponding increases in expenses in order to attract and retain qualified talent, monitor our sales by region and address potential cross-territory selling activities by distributors, implement strategic advertising campaigns, and finance our expansion.  In addition, we faced various one-time, non-cash charges associated with the convertible notes we have issued to finance our business plans.

As further explained below under “—Ausnutria Transaction,” due to a letter of intent we entered into in December 2008, accounts relating to our subsidiary Heilongjiang Moveup Co., Limited, or Moveup, are reflected in our financial statements as discontinued operations.  In addition, in 2008, with the initial operations of our dairy farms, we have two reportable segments: dairy products and dairy farm. Our dairy products segment produces and sells dairy products, such as wholesale and retail milk powders, as well as soybean powder, rice cereal, walnut powder and walnut oil.  Our dairy farm segment operates our two company-owned dairy farms, Gannan Farms and Kedong Farms, construction of which we completed in the fourth quarter of 2009.  Our dairy farms provide milk to us and not to external customers.

Results of Operations

The following table sets forth certain information regarding our results of operations.

   
Years Ended December 31
 
   
2009
   
2008
 
   
($ in thousands)
 
Statements of Operations Data
           
Sales
   
271,078
     
193,192
 
Cost of goods sold
   
140,427
     
117,181
 
Gross profit
   
130,651
     
76,011
 
Operating and administrative expenses:
               
Sales and marketing
   
105,109
     
50,686
 
General and administrative
   
20,479
     
19,047
 
Income from continuing operations
   
5,063
     
6,278
 
Other income (expenses)
   
10,364
     
7,849
 
Income tax (benefit) expenses
   
(746
   
3,567
 
Net income from discontinued operations
   
3,290
     
6,463
 
Net income attributable to common shareholders
   
19,581
     
17,023
 
Other comprehensive income:
               
Cumulative currency translation adjustments
   
447
     
13,169
 
Change in fair value of available for sale investments
   
59
     
(105
Total comprehensive income
   
20,087
     
30,088
 

Comparison of Years Ended December 31, 2009 and 2008

Total Comprehensive Income
Total comprehensive income decreased by approximately $10.0 million, or 33.2%, from approximately $30.1 million in 2008 to approximately $20.1 million in 2009. The decrease was primarily attributable to an increase of approximately $23.2 million, or 19.8%, in cost of goods sold, an increase of approximately $54.4 million, or 107.4%, in sales and marketing expense, a decrease of approximately $3.2 million, or 49.1%, in net income from discontinued operations, and a decrease of approximately $12.7 million, or 96.6%, in cumulative currency translation adjustments, partly offset by an increase of approximately $77.9 million, or 40.3%, in sales, an increase of approximately $2.5 million, or 31.9%, in other income, and a decrease of $4.3 million, or 120.9%, in income tax expense. Our gross profit margin increased from 39.3% in 2008 to 48.2% in 2009.
 
27


Sales
Our sales consist primarily of revenues generated from sales of milk powder, raw milk powder, soybean powder, rice cereal, and walnut products.  Sales increased by approximately $77.9 million, or 40.3%, from approximately $193.2 million in 2008 to approximately $271.1 million in 2009.  This increase was primarily attributable to expanding our market areas and distribution network throughout China, increased demand for high quality products and strong market acceptance of these products, and increased sales quantities of several high profit margin products. While our full-year 2009 sales increased, our sales in the quarterly period ended December 31, 2009 decreased by approximately $35.6 million, or 44.8%, from approximately $79.6 million in the quarterly period ended December 31, 2008 to approximately $44.0 million in the quarterly period ended December 31, 2009.  We believe this decrease reflects the impact of cross-territory selling activities by distributors, as well as our sales of excess inventory as lower-margin raw milk powder in an effort to manage inventory levels.  Our inventories increased approximately $6.7 million, or 13%, from approximately $52.3 million as of December 31, 2008 to approximately $59.0 million as of December 31, 2009, reflecting our increased production during our first and second fiscal quarters of 2009 to prepare to meet expected sales demand during our third and fourth fiscal quarters of 2009.

The following table sets forth information regarding the sales of our principal products during the fiscal years ended December 31, 2009 and 2008:

   
2009
 
2008
 
2009 over 2008
Product name
 
Quantity
(Kg’000)
 
Amount
($’000)
 
% of
Sales
 
Quantity
(Kg’000)
 
Amount
($’000)
 
% of
Sales
 
Quantity
(Kg’000)
 
Amount
($’000)
 
% of 
Sales
                                                       
Milk powder
   
28,783
     
216,230
     
79.8
     
16,311
     
121,255
     
62.8
     
12,472
     
94,975
     
78.3
 
Raw milk powder
   
11,637
     
34,328
     
12.7
     
16,572
     
60,753
     
31.4
     
(4,935
)
   
(26,425
)
   
(43.5
Soybean powder
   
3,349
     
7,319
     
2.7
     
2,153
     
4,400
     
2.3
     
1,196
     
2,919
     
66.3
 
Rice cereal
   
1,103
     
6,730
     
2.5
     
816
     
4,631
     
2.4
     
287
     
2,099
     
45.3
 
Walnut products
   
601
     
3,070
     
1.1
     
327
     
1,663
     
0.9
     
274
     
1,407
     
84.6
 
Other
   
543
     
3,401
     
1.2
     
727
     
490
     
0.2
     
(184
)
   
2,911
     
594.1
 
Total  
   
46,016
     
271,078
     
100
     
36,906
     
193,192
     
100
     
9,110
     
77,886
     
40
 

While full-year 2009 sales of our higher-margin milk powder products increased, our milk powder sales in the quarterly period ended December 31, 2009 decreased by approximately $38.6 million, from approximately $59.3 million, or 74.5% of total sales, in the quarterly period ended December 31, 2008, to approximately $20.7 million or 47.2% of total sales, in the quarterly period ended December 31, 2009.  This shift in product mix reflects our sales of excess inventory as lower-margin raw milk powder in an effort to manage inventory levels.
 
In 2009, we also experienced an increase in the average sales price per kilogram of our products, as demonstrated in the table below:
 
   
2009
   
2008
 
Sales revenues (in thousands)
 
$
271,078
   
$
193,192
 
Total sales volume (kilograms in thousands)
   
46,016
     
36,906
 
Average selling prices/kilogram (in thousands)
 
$
5.89
   
$
5.23
 
 
The increase in average sales price per kilogram, as reflected in the table, is relatively small and primarily attributable to the shift in product mix to higher end products rather than an increase in the sales price of individual products.  Prices per kilogram increased in our most significant product line, as demonstrated in the following table, which reflects the average sales price per kilogram by product for 2009 and 2008 and the percentage change in the sales price per kilogram.
 
   
Average Price Per Kilogram
   
Percentage
 
Product
 
2009
   
2008
   
Change
 
Milk powder
 
$
7.51
   
$
7.43
     
1.1
 
Raw milk powder
   
2.95
     
3.67
     
(19.5
Soybean powder
   
2.19
     
2.04
     
7.4
 
Rice cereal
   
6.10
     
5.68
     
7.4
 
Walnut products
   
5.11
     
5.09
     
0.4
 
Other
   
6.27
     
0.67
     
829.6
 
Total  
 
$
5.89
   
$
5.23
     
13
 

28

 
Cost of Goods Sold
Our costs of goods sold consist primarily of direct and indirect manufacturing costs, including production overhead costs, and shipping and handling costs for the products sold.  Cost of goods sold increased approximately $23.2 million, or 19.8%, from approximately $117.2 million in 2008 to approximately $140.4 million in 2009.  This increase was primarily attributable to increased sales volume and promotional activities, as well as general increases in costs of added nutrients. Cost of sales as a percentage of sales decreased due to the decreased raw milk powder pricing compared to the previous year.

Operating and Administrative Expenses
Our total operating expenses consist primarily of sales and marketing expenses and general and administrative expenses.  Our total operating expenses increased by approximately $56.0 million, or 80.1%, from approximately $69.7 million in 2008 to approximately $125.7 million in 2009.

Sales and marketing. Our sales and marketing expenses consist primarily of advertising and market promotion expenses, and other overhead expenses incurred by our sales and marketing personnel. Sales and marketing expenses increased approximately $54.4 million, or 107.4%, from approximately $50.7 million for 2008 to approximately $105.1 million for 2009. This increase was primarily attributable to an increase of approximately $20.1 million, or 180.6%, in advertising expense, an increase of approximately $18.7 million, or 134.5%, in total promotion costs, an increase of approximately $10.1 million, or 74.6%, in salary of marketing staff, and an increase of approximately $3.0 million, or 59.9%, in transportation costs. Total promotion costs include expenses related to promotion activities and wages of certain sales people. Sales and marketing expenses are likely to increase as we continue to expand our distribution network throughout China and seek to increase our market share and awareness of our premium quality products.

General and Administrative. Our general and administrative expenses consist primarily of salary, travel expenses, entertainment expenses, benefits, share-based compensation, and professional service fees. General and administrative expenses increased approximately $1.4 million, or 7.5%, from approximately $19.0 million for 2008 to $20.5 million for 2009. The increase was primarily attributable to an increase of approximately $1.8 million, or 51.6%, in staff salary and welfare contributions and an increase of approximately $1.2 million, or 96.1%, in share-based compensation expenses. The increase was partially offset by a decrease of approximately $1.0 million, or 57.2%, in amortization expenses and a decrease of approximately $0.7 million, or 453.9%, in provisions for bad debt. Decrease in provisions for bad debt was primarily attributable to decreases in receivables from raw milk powder customers as the industry recovered from the melamine crisis. General and administrative expenses are likely to increase as we continue to expand our production, sourcing capacity, and distribution capacity throughout China.

Income from Continuing Operations
As a result of the foregoing, our income from continuing operations decreased by approximately $1.2 million, or 19.0%, from approximately $6.3 million in 2008 to approximately $5.1 million in 2009.

Other Income (Expenses)
Our other income (expenses) consists primarily of interest and finance costs, registration rights penalty, goodwill impairment, loss on derivatives and government subsidized tax refunds. Other income increased by approximately $2.5 million, or 31.6%, from approximately $7.9 million for 2008 to approximately $10.4 million for 2009. The increase was primarily attributable to a decrease of approximately $12.7 million, or 67.4%, in interest and finance costs, an increase of approximately $14.4 million, or 211.0%, in government subsidized tax refunds and a decrease of $2.4 million, or 100%, in registration penalty rights which were a one-off penalty expense. The decrease was partially offset by a decrease of approximately $6.2 million, or 74.0%, in loss on derivatives. Loss on derivatives in 2008 was primarily attributable to our repurchase of all of our 2012 Notes, which we completed in the third quarter of 2009, while the loss in 2009 was primarily attributable to our common stock financing.
 
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Income Tax (Benefit) Expenses
We are subject to U.S. federal and state income taxes, and our subsidiaries incorporated in the PRC are subject to enterprise income taxes in the PRC.  Our income tax expenses decreased by approximately $4.3 million, or 120.9%, from an expense of approximately $3.6 million in 2008 to a benefit of approximately $0.7 million in 2009.  The decrease was primarily attributable to losses experienced in our fourth quarter which reduced our overall tax for the year.

Net Income from Discontinued Operations
As further explained below under “—Ausnutria Transaction,” due to a letter of intent we entered into in December 2008 to sell Moveup, accounts relating to our subsidiary Moveup are reflected in our financial statements as discontinued operations.  Our net income from discontinued operations decreased by approximately $3.2 million, or 49.2%, from approximately $6.5 million in 2008 to approximately $3.3 million in 2009.

Cumulative Currency Translation Adjustments
Our principal country of operations is the PRC and our functional currency is the Renminbi, but our reporting currency is the U.S. dollar.  All translation adjustments resulting from the translation of our financial statements into U.S. dollars are reported as cumulative currency translation adjustments.  Our cumulative currency translation adjustments decreased by approximately $12.7 million, or 96.6%, from approximately $13.2 million in 2008 to approximately $0.5 million in 2009.

Liquidity and Capital Resources
As of December 31, 2009, we had retained earnings of approximately $73.7 million, cash and cash equivalents of approximately $48.9 million and total current assets of approximately $177.6 million.  As of December 31, 2009, we had a working capital of approximately $12.9 million.  We have financed our activities to date principally from cash generated from operations, the sale of securities, and bank loans.

Our summary cash flow information is as follows:
 
   
Year ended December 31
Net cash provided by (used in):
 
2009
   
2008
 
   
($ in thousands)
Operating activities
   
17,188
     
29,899
 
Investing activities
   
(48,449
)
   
(32,259
)
Financing activities
   
65,714
     
713
 
 
Net Cash Provided by Operating Activities
Net cash provided by operating activities decreased approximately $12.7 million, from approximately $29.9 million in 2008 to approximately $17.2 million in 2009. This decrease was primarily attributable to a decrease in interest expenses from accrual of guaranteed redemption value related to our convertible debt of approximately $13.6 million, a decrease in loss on derivatives of approximately $6.2 million, an increase in net trade receivables of approximately $6.3 million, a decrease in inventories, net of approximately $20.1 million, an increase in advances to suppliers of approximately $5.6 million, an increase in prepayments and other assets of approximately $4.1 million, an increase in VAT refundable taxes of approximately $8.7 million, a decrease in accounts payable of approximately $22.9 million, and a decrease in advances from customers of approximately $8.1 million.  This decrease was offset in part by a decrease in gain on debt extinguishment of approximately $30.5 million, an increase of net income from continuing operations of approximately $5.6 million, an increase from loss on disposal of biological assets of approximately $1.5 million, an increase in compensation expense for option awards of approximately $2.1 million, increase in amounts due to related parties of approximately $8.9 million, and increase in deferred income of approximately $6.9 million.
 
Net Cash Used in Investing Activities
Net cash used in investing activities increased approximately $16.2 million, from approximately $32.3 million in 2008 to approximately $48.4 million in 2009. This increase was primarily attributable to an increase in purchase of property and equipment of approximately $45.1 million, and our purchase in 2009 of our Longjiang Feihe dairy operations for approximately $4.4 million. This increase was offset in part by a decrease in purchase of biological assets of approximately $5.9 million and proceeds from sale of a subsidiary of approximately $39.0 million. Net cash used in investing activities primarily relates to our bank and other cash management vehicles and expenditures associated with our construction and acquisition of new facilities.
 
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Net Cash Provided by Financing Activities
Net cash provided by financing activities increased by approximately $65.0 million, from approximately $0.7 million in 2008 to approximately $65.7 million in 2009. The increase was primarily attributable to the proceeds of approximately $62.9 million from our common stock financing and increases in short term and long term debts of approximately $53.8 million and approximately $14.8 million, respectively. The increase was offset in part by the repayment of short term debt of approximately $69.5 million and the repayment of short term notes and loans payable of approximately $1.5 million.
 
Outstanding Indebtedness

7.75% Convertible Notes Due 2009
In October 2006, pursuant to a subscription agreement, we issued an aggregate principal amount of $18.2 million in 2009 Notes, and warrants to purchase up to an aggregate of approximately 251,000 shares of our common stock at a purchase price of $14.50 per share.  In October 2009, all of the 2009 Notes had been converted into 1,549,122 shares of stock at a conversion price of $14.50 per share.

1.00% Guaranteed Senior Secured Convertible Notes Due 2012
In June 2007, pursuant to a notes purchase agreement and related agreements, we issued an aggregate principal amount of $80.0 million in 2012 Notes.  Pursuant to a supplemental indenture entered into in November 2008, we repurchased all of the 2012 Notes for an aggregate amount of $92.0 million.  Of this amount, in 2009 we paid $80.5 million and recorded as other income a gain on waived interest of $550,000.  Accordingly, we have repurchased all of the 2012 Notes. As part of the first repurchase payment, we also paid $407,000 in accrued and unpaid interest and accrued registration rights penalty to holders of the 2012 Notes.  Costs of $124,000 associated with the 2012 Notes restructuring were capitalized as a deferred charge and are shown as another asset in the consolidated balance sheets. These costs were amortized over the term of the restructured 2012 Notes.  Amortization of $107,000 and $17,000 was charged to expense during the years ended December 31, 2009 and 2008.

Equipment Financing
In October 2009, we entered into a loan agreement with a bank in the PRC for a principal amount of up to $9.2 million for the purpose of financing the purchase of certain equipment.  As of December 31, 2009, there was approximately $4.0 million in principal payable under this loan.  The loan bears interest at the six-month LIBOR rate plus 1.95%, with principal payable in 10 equal semi-annual installments and interest payable semi-annually.  The loan agreement contains certain customary events of default, including failure to pay any interest or principal on the loan, failure to comply with any provision under the agreement, the occurrence of certain insolvency events, and other material adverse events.  The loan agreement also contains a financial covenant requiring us to maintain a debt to earnings ratio.  At December 31, 2009, we were in technical default of the financial covenant.  The bank did not provide notice of default, waived the technical default at December 31, 2009, and agreed to revise the financial covenant to measure compliance on a 12-month rolling basis rather than quarter by quarter.  However, we may be unable to comply with the revised financial covenant in the future or to obtain a waiver from the bank.  Our inability to comply with the covenant in the future may impact our ability to draw against the facility, constitute an event of default under the loan agreement, impact our ability to obtain additional debt, and have an adverse effect on our business and financial condition.

Other Factors Affecting our Liquidity and Capital Resources
 
Expansion Strategy
We believe the market for dairy products in China is growing rapidly, including the market for high quality dairy products.  Our growth strategy involves capturing as much of this market as possible during this rapid growth phase.  To implement this strategy we plan to expand our sales and marketing capabilities by implementing new targeted strategies and promotions as well as strengthen and expand our distribution points.  We will also invest in marketing which will strengthen our premium quality brand awareness, and to strategically align sourcing, production and distribution by region.  Our expansion strategy will require the continued retention and investment of our earnings from operations and, we believe, additional funding from private debt and equity financing.  In general, the commitment of funds towards expansion tends to impair liquidity.  However, we believe that because of the upward trend in our revenues in recent years, even if this trend levels off, our income from continuing operations coupled with such additional financing should provide sufficient liquidity to meet our overall needs.  As of December 31, 2009, we had working capital of $12.9 million.  We believe our cash and cash equivalents are adequate to satisfy our working capital needs and sustain our ongoing operations for the next twelve months.  
 
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Ausnutria Transaction
Moveup was initially formed in October 2007 to serve as an acquisition vehicle in connection with our proposed acquisition of 100% of the outstanding equity interest in Ausnutria Dairy (Hunan) Company Ltd., or Ausnutria, a distributor of dairy products focused on the high-end segment of the dairy products market in the PRC.   In 2007, we entered into several agreements with Ausnutria in connection with this transaction, which did not close.  In February 2008, we made a deposit payment of approximately $1.4 million to Ausnutria Holding Co., Ltd., which indirectly owns Ausnutria, in connection with our efforts to resolve the incomplete transactions in 2007.  The transaction did not close and we entered into renegotiations.  In connection with this transaction, we recorded a total deposit for investment of $31.5 million as of December 31, 2008, of which $1.9 million related to changes in exchange rates.

In December 2008, we and Ausnutria’s owners entered into a letter of intent to unwind the transactions.  Accordingly, the prior transactions to acquire Ausnutria were effectively cancelled and Moveup is reflected in our financial statements as discontinued operations.  In February 2009, we, through our subsidiary Feihe Dairy, entered into an equity purchase agreement pursuant to which Feihe Dairy and the minority shareholder of Moveup, Liu Sheng-Hui, one of our directors and Vice President of Finance of Feihe Dairy, each agreed to sell to Hunan Xindaxin Co., Ltd. 100% of their equity interests in Moveup for an aggregate consideration of approximately $43.3 million.  The purchase price was payable in two tranches.  We received approximately $11.0 million from the purchasers in 2008 and the second tranche of approximately $32.3 million was released from an escrow account to Feihe Dairy and Mr. Liu in 2009.

Longjiang Feihe Acquisition
In January 2009, our subsidiary Gannan Feihe entered into a letter of intent with Heilongjiang Xin Tian Dairy Co., Ltd., to acquire Longjiang Feihe for approximately $4.4 million.  We paid this amount in three tranches during the year ended December 31, 2009 and received the business license in May 2009.

In January 2009, Gannan Feihe entered into an agreement with the Government of Longjiang County, Heilongjiang Province, China, to provide subsidy support, subject to certain provisions, to Gannan Feihe for its planned acquisition of Longjiang Feihe.  Pursuant to the agreement, we received approximately $4.4 million in subsidy support during the year ended December 31, 2009.

Investments in new subsidiaries
In October 2009, our subsidiary Aiyingquan was registered in Heilongjiang Province, China.  As of December 31, 2009, we paid approximately $293,000 of the total registered capital requirement of approximately $1.5 million, and we will hold a 100% equity interest in this subsidiary.  The primary business of Aiyingquan is to market and distribute water and cheese, specifically marketed for consumption by children.

In January 2010, our subsidiary Heilongjiang Trading was registered in Heilongjiang Province, China.  As of December 31, 2009, we paid approximately $293,000 of the total registered capital requirement of approximately $1.5 million, and we will hold an 85% equity interest in this subsidiary.  The primary business of Heilongjiang Trading is to sell milk and soybean related products.
 
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Common Stock Financing
In August 2009, we entered into a subscription agreement pursuant to which we issued 2,100,000 shares of our common stock to the Purchasers for an aggregate purchase price of $63.0 million, including $47.0 million in cash and the conversion of a $16.0 million bridge loan we previously received from the Purchasers. We used a portion of the proceeds from the transaction to repurchase our 2012 Notes.  In connection with the subscription agreement, we entered into a registration rights agreement, pursuant to which we have registered the resale of the securities issued or issuable pursuant to the subscription agreement.  

In the subscription agreement, we also agreed, until August 2012, not to issue new shares of our common stock at a price below $30.00 per share without the prior written consent of a majority in interest of the Purchasers, subject to certain exceptions.  We also granted each of the Purchasers a participation right to purchase up to such person’s pro rata share of any new securities we may, from time to time, propose to issue after the closing date, subject to certain exceptions.  Furthermore, if the average of closing prices of our common stock for the fifteen trading days commencing on the third anniversary of the closing date is less than $39.00 per share, the Purchasers will have the right to cause us to repurchase all (but not less than all) of the securities acquired by the Purchasers in connection with the agreement.  The repurchase price would be an amount equal to the issuance price plus a 5% annual compounded return, subject to certain adjustments if there is a performance adjustment event.  In addition, because we did not meet certain earnings per share targets for 2009, we must issue 525,000 additional shares of our common stock to the Purchasers pursuant to the agreement, although we will have no earnings per share targets for 2010 to satisfy under the agreement.
 
Off Balance Sheet Arrangements
 
We have no off-balance sheet arrangements.
 
Critical Accounting Policies

The consolidated financial statements include the financial statements of us and our subsidiaries.  All transactions and balances among us and our subsidiaries have been eliminated upon consolidation. Certain amounts included in or affecting our consolidated financial statements and related disclosures must be estimated, requiring us to make certain assumptions with respect to values or conditions that cannot be known with certainty at the time the financial statements are prepared. These estimates and assumptions affect the amounts we report for assets and liabilities, our disclosure of contingent assets and liabilities at the date of our financial statements, and the reported amounts of revenues and expenses during the reported periods. We routinely evaluate these estimates, utilizing historical experience, consulting with experts and utilizing other methods we consider reasonable in the particular circumstances. Nevertheless, actual results may differ significantly from our estimates. Any effects on our business, financial position or results of operations resulting from revisions to these estimates are recorded in the period in which the facts that give rise to the revision become known.

Estimates of allowances for bad debts – We must periodically review our trade and other receivables to determine if all are collectible or whether an allowance is required for possible uncollectible balances.  When determining the allowances, a number of factors are considered, including the length of time the receivable is past due, past loss history, the counter party’s current ability to pay and the general condition of the economy and industry.  We perform this review quarterly. Although our write-offs of bad debts have been minimal in recent years and we had no write-off in the year ended December 31, 2009, events and circumstances could occur that would require that we increase our allowance in the future.

Estimate of the useful lives of property and equipment and biological assets – We must estimate the useful lives and residual values of our property and equipment and biological assets. We must also review property and equipment and biological assets for possible impairment whenever events and circumstances indicate that the carrying value of those assets may not be recovered from the estimated future cash flows expected to result from their use and eventual disposition.  We recognized no impairments in the years ended December 31, 2009 and 2008.
 
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Inventory – We value inventories at the lower of cost or market value.  We determine the cost of inventories using the weighted average cost method and include any related production overhead costs incurred in bringing the inventories to their present location and condition.  We must determine whether we have any excessive, slow moving, obsolete or impaired inventory.  We perform this review quarterly, which requires management to estimate the future demand of our products and market conditions.  We make provisions on the value of inventories at period end equal to the difference between the cost and the estimated market value.  If actual market conditions change, additional provisions may be required.  In addition, we may write off some provisions if we later sell some of the subject inventory.  As a result of these reviews, we reduced our estimated reserve for obsolescence by $57,355 and $168,151 for the years ended December 31, 2009 and 2008, respectively.

Goodwill – We must test goodwill annually for impairment or more frequently if events or changes in circumstances indicate that it might be impaired.  We perform impairment tests at the reporting unit level to identify potential goodwill impairment.  We recognize a goodwill impairment loss in our statements of operations and comprehensive income when the carrying amount of goodwill exceeds its implied fair value.  We perform the impairment test at the end of the fourth quarter each year.  As a result of this impairment testing, we recognized an estimate of $929,526 and $nil in goodwill impairment expense for the years ended December 31, 2009 and 2008, respectively.  For additional details, see Note 17 to the audited financial statements contained elsewhere in this report.

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 shipped to customers and the title has passed.  Revenue is shown net of sales returns, which amounted to less than 0.02% of total sales in each of the years ended December 31, 2009 and 2008, and net of sales rebates, which is determined based on our distributors’ sales volumes.
 
New Accounting Pronouncements

In December 2007, the FASB issued authoritative guidance on noncontrolling interests in consolidated financial statements.  The guidance established new accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. Specifically, the guidance requires the recognition of a noncontrolling interest (minority interest) as equity in the consolidated financial statements that is presented separate from the parent’s equity. The amount of net income attributable to the noncontrolling interest will be included in consolidated net income on the face of the income statement. The guidance clarifies that changes in a parent’s ownership interest in a subsidiary that do not result in deconsolidation are equity transactions if the parent retains its controlling financial interest. In addition, the guidance requires that a parent recognize a gain or loss in net income when a subsidiary is deconsolidated. Such gain or loss will be measured using the fair value of the noncontrolling equity investment on the deconsolidation date. The guidance also includes expanded disclosure requirements regarding the interests of the parent and its noncontrolling interest. The guidance is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008.  The adoption of the guidance resulted in the reclassification of minority interest into equity.

In December 2007, FASB issued authoritative guidance on accounting for business combinations, including the measurement of acquirer shares issued in consideration for a business combination, the recognition of contingent consideration, the accounting for pre-acquisition gain and loss contingencies, the recognition of capitalized in-process research and development, the accounting for acquisition-related restructuring cost accruals, the treatment of acquisition related transaction costs and the recognition of changes in the acquirer’s income tax valuation allowance. The requirements are effective for fiscal years beginning after December 15, 2008.  The adoption of these requirements did not have a material impact on our financial statements.
 
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In February 2008, the FASB issued a deferral for the fair value requirements for non-financial assets and liabilities not required to be stated at fair value on a recurring basis (at least annually) until fiscal years beginning after November 15, 2008. This deferral primarily impacts assets such as property, plant and equipment, intangible assets and goodwill upon non-recurring events such as business combinations, asset impairments and goodwill impairment, among others. The adoption of the deferral did not have a material impact on our financial statements.

In March 2008, the FASB issued new disclosure requirements for an entity’s derivative and hedging activities. These disclosure requirements are effective for periods beginning after November 15, 2008 and the adoption of the disclosure requirements did not have a material impact on our financial statements.

In May 2008, the FASB issued guidance that requires an issuer of certain convertible debt instruments that may be settled in cash, or other assets, on conversion to separately account for the debt and equity components in a manner that reflects the issuer’s non-convertible debt borrowing rate. We adopted this guidance in the first quarter of 2009 on a retrospective basis. The adoption of this guidance did not have a material impact on our financial statements. 

In June 2008, the FASB issued guidance which requires entities to apply the two-class method of computing basic and diluted earnings per share for participating securities that include awards that accrue cash dividends (whether paid or unpaid) any time common shareholders receive dividends and those dividends will not be returned to the entity if the employee forfeits the award. The guidance is effective for fiscal years beginning after December 15, 2008, and the interim periods within those years. Retroactive disclosure is required. The adoption of this guidance did not have a material impact on our financial statements.

In June 2008, the FASB ratified certain authoritative guidance regarding determining whether an instrument (or embedded feature) is indexed to an entity’s own stock. This guidance is effective for years beginning after December 15, 2008 and the adoption of the guidance did not have a material impact on our financial statements.

In July 2008, the FASB issued new guidance regarding fair value measurements. This new guidance defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. The new guidance was effective for us beginning July 1, 2008, for certain financial assets and liabilities. The new guidance was effective for non-financial assets and liabilities recognized or disclosed at fair value on a non-recurring basis beginning July 1, 2009. The adoption of this guidance did not have a material impact on our financial statements.

In April 2009, the FASB issued additional guidance on estimating fair value when the volume and level of transaction activity for an asset or liability have significantly decreased in relation to normal market activity for the asset or liability, or on circumstances that may indicate that a transaction is not orderly. This guidance also addresses when the use of multiple, or different, valuation techniques may be warranted and considerations for determining the weight that should be applied to the various techniques. The guidance is effective for the interim and annual reporting periods ending after June 15, 2009, and must be applied prospectively. The adoption of this guidance did not have a material impact on our financial statements.

In May 2009, the FASB issued authoritative accounting guidance on subsequent events, a topic that was previously only addressed by auditing literature. The guidance clarified that subsequent events are either recognized or non-recognized and modified the definition of subsequent events to refer to events or transactions that occur after the balance sheet date but before the financial statements are issued.

In June 2009, the FASB amended the accounting and disclosure requirements for transfers of financial assets. This amendment requires greater transparency and additional disclosures for transfers of financial assets and the entity’s continuing involvement with them, and it changes the requirements for derecognizing financial assets. In addition, this amendment eliminates the concept of a qualifying special-purpose entity, or QSPE. This amendment is effective for financial statements issued for fiscal years beginning after November 15, 2009. This amendment is not expected to have a material impact on our financial statements.
 
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In June 2009, the FASB amended the accounting and disclosure requirements for the consolidation of variable interest entities, or VIEs. The elimination of the concept of a QSPE, as discussed above, removes a prior exception to consolidation. This amendment requires an enterprise to perform a qualitative analysis when determining whether or not it must consolidate a VIE. The amendment also requires an enterprise to continuously reassess whether it must consolidate a VIE. Additionally, the amendment requires enhanced disclosures about an enterprise’s involvement with VIEs and any significant change in risk exposure due to that involvement, as well as how its involvement with VIEs impacts the enterprise’s financial statements. Finally, an enterprise will be required to disclose significant judgments and assumptions used to determine whether or not to consolidate a VIE. This amendment is effective for financial statements issued for fiscal years beginning after November 15, 2009. This amendment is not expected to have a material impact on our financial statements.
  
In July 2009, the FASB adopted the FASB Accounting Standards CodificationTM, or the Codification, as the single source of authoritative nongovernmental U.S. GAAP. The Codification is effective for interim and annual periods ending after September 15, 2009. All existing accounting standards documents, with a few grandfathered exceptions, are superseded.  All other accounting literature not included in the Codification is nonauthoritative.  The Codification did not have an impact on our financial statements.

In August 2009, the FASB issued guidance regarding accounting for redeemable equity instruments that was effective upon issuance. The guidance updates prior guidance regarding how to distinguish liabilities from equity, in accordance with guidance from the Emerging Issues Task Force on classification and measurement of redeemable securities. The adoption of this guidance did not have a material impact on our financial statements.

In August 2009, the FASB issued guidance regarding the fair value measurement of liabilities. The update was effective for the first reporting period (including interim periods) beginning after August 28, 2009.  The adoption of this update did not have a material impact on our financial statements.

In September 2009, the FASB issued guidance to provide technical corrections regarding the computation of earnings per share for a period that includes a redemption or an induced conversion of a portion of a class of preferred stock and the effect of the calculation of earnings per share for the redemption or induced conversion of preferred stock.  The guidance was effective upon issuance and adoption of it did not have material impact on our financial statements.

In February, 2010, the FASB amended and clarified certain recognition and disclosure requirements for public and certain other entities. Under these amendments, certain entities are required to evaluate subsequent events through the date that the financial statements are issued. Further, an entity that is an SEC filer is not required to disclose the date through which subsequent events have been evaluated. This amendment is effective for financial statements issued for interim or annual periods ending after June 15, 2010. This amendment is not expected to have a material impact on our financial statements.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

We conduct all of our operations in the PRC, and the Renminbi is the national currency in which our operations are conducted. We have not utilized any derivative financial instruments or any other financial instruments, nor do we utilize any derivative commodity instruments in our operations, nor any similar market sensitive instruments.

The exchange rate between the Renminbi and the U.S. dollar is subject to the PRC government’s foreign currency conversion policies, which may change at any time.  The exchange rate at December 31, 2008 was approximately 6.8 Renminbi to 1 U.S. dollar.  The exchange rate at December 31, 2009 was approximately 6.83 Renminbi to 1 U.S. dollar.  The exchange rate is currently permitted to float within a very limited range.

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Item 8. Financial Statements and Supplementary Data

Financial Statements

Please see the accompanying audited consolidated financial statements attached hereto beginning on page F-1.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

On December 7, 2007, we dismissed MHM as our independent auditor following notification of an informal SEC investigation related to individuals and entities that provided accounting or certain advisory services to us, including MHM and Henny Wee & Co.  The report of MHM on our financial statements for the two most recent fiscal years did not contain an adverse opinion or disclaimer of opinion, nor was it qualified or modified as to uncertainty, audit scope or accounting principles. The decision to dismiss MHM was approved by our Audit Committee.  During our two most recent fiscal years and the subsequent interim period through the date of dismissal, there were no reportable events as the term is described in Item 304(a)(1)(iv) or (v) of Regulation S-K.  Effective January 25, 2008, we engaged Grant Thornton, the Hong Kong member firm of Grant Thornton International Ltd., as our new independent registered public accountants.

Item 9A. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Our disclosure controls and procedures are designed to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in SEC rules and forms and that such information is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosures.

Management has evaluated the effectiveness of our disclosure controls and procedures for the year ended December 31, 2009, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, and identified a material weakness in our internal control over financial reporting which we view as an integral part of our disclosure controls and procedures.  Consequently, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were not effective at December 31, 2009.  This weakness is discussed below under “— Management’s Report on Internal Control Over Financial Reporting.”

Because of this weakness and our historical weaknesses and deficiencies, management took additional steps to ensure the reliability of our financial reporting.  These steps included additional internal review, additional Audit Committee review, efforts to remediate historical material weaknesses and significant deficiencies in internal control over financial reporting, and the performance of additional procedures by management with respect to the financial statements contained in this report.

Management’s Report on Internal Control Over Financial Reporting

Management, under the supervision of our Chief Executive Officer and Chief Financial Officer, is responsible for establishing and maintaining adequate internal control over financial reporting.  Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles in the United States, or GAAP.  Internal control over financial reporting includes those policies and procedures that (a) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of assets, (b) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, (c) provide reasonable assurance that receipts and expenditures are being made only in accordance with appropriate authorization of management and the board of directors, and (d) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of assets that could have a material effect on the financial statements.    
 
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Management conducted an assessment on the effectiveness of our internal control over financial reporting based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, or COSO, for the year ended December 31, 2009, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer and concluded that these controls were not effective at December 31, 2009.  As a result of that assessment, we identified that we did not effectively and timely assess the accounting treatment for certain routine and non-routine transactions, including sales, purchases, government subsidy income, and operating expenses, which we consider to constitute a material weakness in our internal control over financial reporting. 

A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected.

Our internal control over financial reporting as of December 31, 2009 has been audited by Grant Thornton, the Hong Kong member firm of Grant Thornton International Ltd., an independent registered public accounting firm, as stated in their report which is included herein.

Remediation Plan

We are devoting significant resources to remediating the material weakness identified above and to improving our internal controls, including hiring additional accounting, internal audit and finance staff, engaging consultants to assist with these functions, upgrading our systems, and implementing additional financial and management controls, reporting systems and procedures. Since the year ended December 31, 2007, we have spent an aggregate of approximately $1 million to date on improving our controls. However, we do not expect that our plan will fully remediate the material weakness identified above until at least June 30, 2010, and it may not ensure the adequacy of our internal controls over our financial reporting and processes in the future.

If we experience additional material weaknesses and significant deficiencies in our internal controls over financial reporting in the future, investors may lose confidence in our reported financial information, which could lead to a decline in our stock price, limit our ability to access the capital markets in the future, and require us to incur additional costs to further improve our internal control systems and procedures.

Changes in Internal Controls

Since the year ended December 31, 2007, we have been implementing the remedial measures described above, including hiring additional accounting, internal audit and finance staff, engaging consultants to assist with these functions, training our staff, upgrading our systems, and implementing more rigorous and additional financial and management controls, reporting systems, policies and procedures and increasing our corporate audit focus on key accounting controls and processes, including documentation requirements.   We expect to continue to implement additional financial and management controls, reporting systems and procedures.  
 
38


Item 9B. Other Information

Not applicable.
 
39

 
PART III

Item 10.  Directors, Executive Officers and Corporate Governance

The information required by this item regarding our directors, director nominees, and committees of the board of directors is incorporated by reference to our definitive Proxy Statement for our 2010 Annual Meeting of Shareholders to be filed with the SEC not later than 120 days after the end of our fiscal year ended December 31, 2009, or the 2010 Proxy Statement, under the heading “Election of Directors” and “Corporate Governance.” Information regarding Section 16(a) beneficial ownership reporting compliance is incorporated by reference to our 2010 Proxy Statement under the heading “Section 16(a) Beneficial Ownership Reporting Compliance.”  Information regarding our executive officers is incorporated by reference to our 2010 Proxy Statement under the heading “Management—Executive Officers.”

Code of Ethics

We have adopted a Code of Ethics that applies to all of our officers, directors and employees. The most recent version is available on the Investor Relations section of our website at www.americandairyinc.com.  The information contained on our website is not incorporated by reference into this Annual Report on Form 10-K.  If we make any substantive amendments to the code or grant any waiver from a provision of the code to any executive officer or director, we will promptly disclose the nature of the amendment or waiver on our website, as well as via any other means required by applicable law.

Item 11. Executive Compensation

The information required by this item is incorporated by reference to the 2010 Proxy Statement under the heading “Executive Compensation.”

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters

The information required by this item is incorporated by reference to the 2010 Proxy Statement under the headings “Security Ownership of Certain Beneficial Owners and Management” and “Equity Compensation Plan Information.”

Item 13. Certain Relationships and Related Transactions, and Director Independence

The information required by this item is incorporated by reference to the 2010 Proxy Statement under the captions “Certain Relationships and Related Transactions” and “Corporate Governance.”


The information required by this item is incorporated by reference to the 2010 Proxy Statement under the caption “Ratification of Appointment of Independent Registered Public Accounting Firm.”
 
40

 
 
Item 15. Exhibits and Financial Statement Schedules

Financial Statements
The financial statements required by this item are included herein:
 
      F-1  
 
Audited Financial Statements
    F-3  
 
Consolidated Balance Sheets
    F-3  
 
Consolidated Statements of Operations and Comprehensive Income
    F-5  
 
Consolidated Statements of Changes in Shareholders’ Equity
    F-7  
 
Consolidated Statements of Cash Flows
    F-8  
 
Notes to the Consolidated Financial Statements
    F-11  

Exhibits
The following exhibits are filed as a part of this Annual Report.
 
           
 Incorporated by Reference
Exhibit No.
 
Exhibit Title
 
Filed
Herewith
 
 
Form
 
Exhibit 
No.
 
 
File No.
 
 
Filing Date
                         
2
 
Stock Exchange Agreement, dated as of January 15, 2003, by and among the registrant, the registrant’s shareholders and Lazarus Industries, Inc.
     
8-K
 
2.1
 
000-27351
 
1/21/03
                         
2.1
 
Amendment to Stock Exchange Agreement, dated as of March 5, 2003, by and among the registrant, the registrant’s shareholders and Lazarus Industries, Inc
     
8-K/A
 
2.2
 
000-27351
 
3/5/03
                         
3.1
 
Articles of Incorporation
     
10-SB
 
1
 
000-27351
 
9/16/99
                         
3.2
 
Amendment to Articles of Incorporation
     
10-KSB/A
 
3.2
 
000-27351
 
5/25/04
                         
3.3
 
Bylaws
     
10-SB
 
2
 
000-27351
 
9/16/99
                         
4.1
 
Specimen certificate evidencing shares of common stock
     
S-1/A
 
4.1
 
333-158777
 
5/28/09
                         
4.2
 
Form of 7.75% Convertible Note
     
8-K/A
 
4.1
 
001-32473
 
10/6/06
                         
4.3
 
Form of Common Stock Purchase Warrant
     
8-K/A
 
4.2
 
001-32473
 
10/6/06
                         
10.1
 
Joint Venture Agreement to organize Beijing Feihe
     
10-QSB
 
10.1
 
000-27351
 
5/17/04
                         
10.2
 
2003 Stock Incentive Plan
     
S-8
 
10
 
333-123932
 
4/7/05
                         
10.3
 
Asset Purchase Agreement, dated as of May 20, 2005, by and between the registrant and Nutricia Nutritionals Col, Ltd.
     
8-K
 
10.1
 
001-32473
 
5/26/05
                         
 10.4
 
Form of Subscription Agreement, dated as of October 3, 2006, by and between the registrant and investors listed therein
     
8-K/A
 
10.1
 
333-128075
 
10/6/06
                         
10.5
 
Form of Registration Rights Agreement, dated as of October 3, 2006, by and between the registrant and investors listed therein
     
8-K/A
 
10.2
 
333-128075
 
10/6/06
                         
10.6
 
Share Transference Agreement, dated as of July 1, 2006, by and between the registrant and Shanxi Li Santai Science and Technology Co., Ltd.
     
S-1/A
 
10.16
 
333-128075
 
4/17/07
                         
10.7
 
Amended and Restated Notes Purchase Agreement, dated as of June 1, 2007, by and among the registrant, Leng You-Bin, Liu Hua and Citadel Equity Fund
     
8-K
 
10.1
 
001-32473
 
6/4/07
                         
10.8
 
Indenture, dated as of June 1, 2007, by and between the registrant and The Bank of New York.
     
8-K
 
10.2
 
001-32473
 
6/4/07
 
41

 
           
Incorporated by Reference
Exhibit No.
 
Exhibit Title
 
Filed
Herewith
   
Form
 
Exhibit 
No.
 
File No.
   
Filing Date
                         
10.9
 
Form of Note (attached as exhibit to the Indenture filed as Exhibit 10.19)
     
8-K
 
10.2
 
001-32473
 
6/4/07
                         
10.10
 
Registration Rights Agreement
     
8-K
 
10.3
 
001-32473
 
6/4/07
                         
10.11
 
Investor Rights Agreement
     
8-K
 
10.4
 
001-32473
 
6/4/07
                         
10.12
 
Share Pledge Agreement
     
8-K
 
10.5
 
001-32473
 
6/4/07
                         
10.13
 
Indenture, dated as of June 27, 2007, by and among the registrant, the holders listed therein and The Bank of New York
     
S-1/A
 
10.25
 
333-128075
 
6/28/07
                         
10.14
 
Form of 1% Guaranteed Senior Secured Convertible Note (attached as an exhibit to the Indenture filed as exhibit 10.25)
     
S-1/A
 
10.25
 
333-128075
 
6/28/07
                         
10.15
 
Form of Accession Letter
     
S-1/A
 
10.26
 
333-128075
 
6/28/07
                         
10.16
 
Form of Non-Competition Agreement, by and between the registrant and each of Mr. Leng You-Bin and Roger Liu
     
S-1/A
 
10.27
 
333-128075
 
6/28/07
                         
10.17
 
Joinder Agreement
     
S-1/A
 
10.28
 
333-128075
 
6/28/07
                         
10.18
 
Loan Agreement, dated as of June 27, 2007, by and between the registrant and Moveup
     
10-Q/A
 
10.1
 
001-32473
 
8/22/07
                         
10.19
 
Equity Purchase Agreement, dated as of August 2, 2007, by and among Moveup, Hunan Mulin Modern Food Company, Ltd., Australia Ausnutria Dairy Pty., Chen Yuanrong and Ausnutria
     
10-Q/A
 
10.2
 
001-32473
 
8/22/07
                         
10.20
 
Share Subscription Agreement, dated as of August 12, 2007, by and between Moveup and Ausnutria
     
10-Q/A
 
10.3
 
001-32473
 
8/22/07
                         
10.21
 
Share Subscription Agreement, by and between the registrant and Ausnutria
     
10-Q/A
 
10.4
 
001-32473
 
8/22/07
                         
10.22
 
Equity Purchase Agreement, dated as of October 25, 2007, by and among Moveup, Hunan Mulin Modern Food Company, Ltd Chen Yuanrong and Ausnutria
     
8-K
 
10.1
 
001-32473
 
10/31/07
                         
10.23
 
Employment Agreement, dated as of April 15, 2008 by and between the registrant and Jonathan H. Chou
     
8-K
 
10.1
 
001-32473
 
4/18/08
                         
10.24
 
Supplemental Indenture, dated as of November 12, 2008, by and between the registrant and The Bank of New York Mellon, as Trustee, as amended
     
8-K/A
 
10.1
 
001-32473
 
11/21/08
                         
10.25
 
Agreement Regarding 2009 Notes, dated as of November 12, 2008, by and among the registrant, Leng You-Bin and the investors named therein
     
8-K/A
 
10.2
 
001-32473
 
11/21/08
                         
10.26
 
Share Pledge Agreement, dated as of November 12, 2008, by and among the registrant, Leng You-Bin and The Bank of New York, Mellon, as collateral agent
     
8-K/A
 
10.3
 
001-32473
 
11/21/08
                         
10.27
 
First Amendment to Registration Rights Agreement, dated as of November 12, 2008, by and between the registrant and the investors named therein.
     
8-K/A
 
10.4
 
001-32473
 
11/21/08
                         
10.28
 
Waiver Letter to Registration Rights Agreement, dated as of November 12, 2008, by and between the registrant and the investors named therein
     
8-K/A
 
10.5
 
001-32473
 
11/21/08
                         
10.29
 
Form of Amended and Restated 7.75% Convertible Note due October 2, 2009
     
8-K/A
 
10.6
 
001-32473
 
11/21/08
                         
10.30
 
Form of Amended and Restated Common Stock Purchase Warrant
     
8-K/A
 
10.7
 
001-32473
 
11/21/08
                         
10.31
 
Form of 2009 Stock Incentive Plan and related agreements
     
8-K/A
 
10.1
 
001-32473
 
5/14/09
                         
10.32
 
Subscription Agreement, dated as of August 12, 2009, by and among American Dairy, Inc. and the Purchasers
     
8-K
 
10.1
 
001-32473
 
8/12/09
                         
 
42

 
           
Incorporated by Reference
 
Exhibit No.
 
Exhibit Title
 
Filed
Herewith
   
Form
 
Exhibit 
No.
   
File No.
   
Filing Date
 
10.33
 
Registration Rights Agreement, dated as of August 26, 2009, by and among American Dairy, Inc. and the Purchasers
     
8-K
 
10.1
 
001-32473
 
8/26/09
 
                           
14.1
 
Code of Business Conduct and Ethics
     
10-KSB
 
14
 
000-27351
 
3/31/05
 
                           
14.2
 
Amended and Restated Code of Business Conduct and Ethics
     
8-K
 
14
 
001-32473
 
5/12/08
 
                           
16.1
 
Letter of HJ & Associates, L.L.C. regarding change in certifying accountant
     
8-K
 
16
 
000-27351
 
8/6/03
 
                           
16.2
 
Letter of Weinberg & Company, regarding change in certifying accountant
     
8-K
 
16
 
000-27351
 
11/17/03
 
                           
16.3
 
Letter of Murrell, Hall, McIntosh & Co., PLLP, regarding change in certifying accountant
     
8-K
 
16.1
 
001-32473
 
12/13/07
 
                           
21.1
 
Subsidiaries of the registrant
 
X
                 
                           
23.1
 
Consent of Grant Thornton
 
X
                 
                           
24.1
 
Power of Attorney (included on signature page)
 
X
                 
                           
31.1
 
Certification of Principal Executive Officer pursuant to Rules 13a-14 and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
X
                 
                           
31.2
 
Certification of Principal Financial Officer pursuant to Rules 13a-14 and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
X
                 
                           
32.1
 
Certification of Principal Executive Officer and Principal Financial Officer pursuant to 18 U.S.C. § 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
X
                 
 
43

 
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 16, 2010
AMERICAN DAIRY, INC.
 
     
 
By:
/s/ Leng You-Bin
 
   
Leng You-Bin, Chief Executive
 
   
Officer and President (Principal Executive Officer)
 
       
 
By:
/s/ Jonathan H. Chou
 
   
Jonathan H. Chou, Chief Financial Officer
 
   
(Principal Accounting and Financial Officer)
 
 
POWER OF ATTORNEY

KNOW BY ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Leng You-Bin as his or her true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution, for him or her and in his or her name, place and stead, in any and all capacities, to sign any and all Amendments hereto, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that said attorney-in-fact and agent, or his substitute or substitutes, may lawfully do or cause to be done by virtue thereof.
 
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.
 
 
/s/ Leng You-Bin
March 16, 2010
Leng You-Bin, Director, Chief Executive
 
Officer and President (Principal Executive Officer)
 
   
/s/ Liu Hua
March 16, 2010
Liu Hua, Director, Vice Chairman, Secretary and Treasurer
 
 
 
/s/ Liu Sheng-Hui
March 16, 2010
Liu Sheng-Hui, Director
 
   
/s/ Hui-Lan Lee
March 16, 2010
Hui-Lan Lee, Director
 
   
/s/ Kirk Downing
March 16, 2010
Kirk Downing, Director
 
   
/s/ James Lewis
March 16, 2010
James Lewis, Director
 
 
/s/ Neil Shen
March 16, 2010
Neil Shen, Director
 

45

 
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
 
Reports of Independent Registered Public Accounting Firm
    F-1  
Audited Financial Statements
    F-3  
Consolidated Balance Sheets
    F-3  
Consolidated Statements of Operations and Comprehensive Income
    F-5  
Consolidated Statements of Changes in Shareholders’ Equity
    F-7  
Consolidated Statements of Cash Flows
    F-8  
Notes to the Consolidated Financial Statements
    F-11  
 

 

Board of Directors and
Shareholders of American Dairy, Inc.
 
We have audited the accompanying consolidated balance sheets of American Dairy, Inc. (a Utah Corporation) and subsidiaries (the “Company”) as of December 31, 2009 and December 31, 2008 and the related consolidated statements of operations and comprehensive income, changes in shareholders' equity, and cash flows for each of the years in the two year period ended December 31, 2009.  These financial statements are the responsibility of the Company's management.  Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audits 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 the Company as of December 31, 2009 and December 31, 2008 and the results of their operations and their cash flows for each of the years in the two year period ended December 31, 2009 in conformity with accounting principles generally accepted in the United States of America. 

As discussed in Note 3 to the Notes to the Consolidated Financial Statements, the Company adopted new accounting guidance for business acquisitions, effective January 1, 2009.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), American Dairy, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 16, 2010 expressed an adverse opinion.


/s/  GRANT THORNTON

Hong Kong
March 16, 2010
 
F-1

 
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
Board of Directors and
Shareholders of American Dairy, Inc.

We have audited American Dairy, Inc. (a Utah Corporation) and subsidiaries’ (the “Company”) internal control over financial reporting as of December 31, 2009, based on criteria established in  Internal Control—Integrated Framework  issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

A material weakness is a deficiency, or combination of control deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis.  If one or more material weaknesses exist, a company’s internal control over financial reporting cannot be considered effective.  The following material weakness has been identified and included in management’s assessment: Accounting treatment for routine and non-routine transactions – The Company did not effectively and timely assess the accounting treatment for transactions, including sales, purchases, government subsidy income, and operating expenses.

In our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, American Dairy, Inc. and subsidiaries has not maintained an effective internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control—Integrated Framework  issued by COSO.
 
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of American Dairy, Inc. and subsidiaries as of December 31, 2009 and 2008, and the related consolidated statements of operations, stockholders’ equity and comprehensive loss, and cash flows for each of the two years in the period ended December 31, 2009.  The material weakness identified above was considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2009 financial statements, and this report does not affect our report dated March 16, 2010, which expressed an unqualified opinion on those financial statements.


/s/ GRANT THORNTON

Hong Kong
March 16, 2010
 
F-2

 
AMERICAN DAIRY, INC.
CONSOLIDATED BALANCE SHEETS
 
   
Note
   
December 31,
2009
   
December 31,
2008
 
         
US$
   
US$
 
ASSETS
                 
Current assets:
                 
Cash and cash equivalents
         
48,949,524
     
11,785,408
 
Notes and loans receivable, net of allowance of $4,000,000
   
  8
     
438,776
     
1,493,245
 
Trade receivables, net of allowance of $791,119 and $1,311,331, respectively
   
  9
     
27,495,190
     
12,275,497
 
Due from related parties
   
19
     
2,188,243
     
265,479
 
Employee receivables
           
396,724
     
307,249
 
Advances to suppliers
   
12
     
24,417,968
     
24,943,046
 
Receivable from discontinued operations
   
13
     
-
     
31,002,897
 
Inventories, net of allowance of $518,561 and $575,916, respectively
   
10
     
59,044,665
     
52,330,333
 
Prepayments and other current assets
           
1,814,472
     
63,711
 
VAT refundable taxes
           
8,532,629
     
488,938
 
Other receivables
           
4,307,680
     
4,598,359
 
Current assets of discontinued operations
   
13
     
-
     
12,392,384
 
Total current assets
           
177,585,871
     
151,946,546
 
                         
Investments:
                       
Investment in mutual funds – available for sale
   
11
     
136,466
     
77,504
 
Investment at cost
           
263,264
     
262,611
 
             
399,730
     
340,115
 
Property and equipment:
                       
Property and equipment, net
   
14
     
154,572,409
     
88,289,858
 
Construction in progress
   
15
     
23,170,909
     
28,847,959
 
             
177,743,318
     
117,137,817
 
Biological assets:
                       
Immature biological assets
   
16
     
35,672,123
     
23,784,479
 
Mature biological assets, net
   
16
     
13,232,124
     
1,483,355
 
             
48,904,247
     
25,267,834
 
Other assets:
                       
Deferred tax assets
   
  5
     
3,632,815
     
730,490
 
Prepaid leases
           
29,016,486
     
29,146,748
 
Other intangible assets
   
  7
     
821,331
     
 -
 
Goodwill
   
17
     
1,784,331
     
2,282,838
 
Deferred charges, net
           
369,608
     
107,396
 
Long term assets of discontinued operations
   
13
     
-
     
31,587,018
 
Total assets
           
440,257,737
     
358,546,802
 
                         
 
F-3

 
LIABILITIES AND SHAREHOLDERS’ EQUITY
                       
Liabilities
                       
Current liabilities:
                       
Current maturities of long term debt
   
22
     
7,312,935
     
4,018,704
 
Convertible debt redeemable within one year
   
23
     
-
     
17,732,033
 
Short term debt
   
22
     
-