10-K 1 v216621_10k.htm 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, 2010
 
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
 
FEIHE INTERNATIONAL, 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 o
 
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 $177,850,000.
 
As of March 25, 2011, there were 22,306,291 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
 
21
Item 4.
 
(Removed and Reserved)
 
21
         
PART II
       
Item 5.
 
Market for the Registrant’s Common Stock, Related Shareholder Matters and Issuer Repurchases of Equity Securities
 
22
Item 6.
 
Selected Financial Data
 
23
Item 7.
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
25
Item 7A.
 
Quantitative and Qualitative Disclosures About Market Risk
 
40
Item 8.
 
Financial Statements and Supplementary Data
 
41
Item 9.
 
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
 
41
Item 9A.
 
Controls and Procedures
 
41
Item 9B.
 
Other Information
 
44
         
PART III
       
Item 10.
 
Directors, Executive Officers and Corporate Governance
 
45
Item 11.
 
Executive Compensation
 
45
Item 12.
 
Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters
 
45
Item 13.
 
Certain Relationships and Related Transactions, and Director Independence
 
45
Item 14.
 
Principal Accountant Fees and Services
 
45
         
PART IV
       
Item 15.
 
Exhibits and Financial Statement Schedules
 
46

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 “Feihe International,” “we,” “us” and “our” refer to Feihe International, 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 1,950 tons per day and an extensive distribution network that reaches over 80,000 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. In October 2010, we changed our name to Feihe International, Inc.
 
 
1

 
 
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;

 
·
Heilongjiang Flying Crane Trading Co., Limited, or Feihe Trading, which sells milk and soybean related products;
     
 
·
Qiqihaer Feihe Soybean Co., Limited, or Feihe Soybean, which manufactures and distributs soybean products; and
     
 
·
Beijing Feihe Biotechnology Scientific and Commercial Co., Limited, or Beijing Feihe, which markets and distributs dairy products.

The following chart reflects the current corporate structure of the Feihe International entities:

 
2

 
 
 
* 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.
 
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.
 
 
3

 

 
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 tables reflect the sales of our principal products during the fiscal years ended December 31, 2010, 2009 and 2008:

   
2010
 
2009
 
2010 over 2009
Product name
 
Quantity
(Kg’000)
 
Amount
($’000)
 
% of
Sales
 
Quantity
(Kg’000)
 
Amount
($’000)
 
% of
Sales
 
Quantity
(Kg’000)
 
Amount
($’000)
 
                                                       
Milk powder
   
22,816
     
180,218
     
70.1
     
28,783
     
216,230
     
79.8
     
(5,967
)
   
(36,012
)
   
(16.7
Raw milk powder
   
15,691
     
57,752
     
22.5
     
11,637
     
34,328
     
12.7
     
4,054
     
23,424
     
68.2
 
Soybean powder
   
4,917
     
10,812
     
4.2
     
3,349
     
7,319
     
2.7
     
1,568
     
3,493
     
47.7
 
Rice cereal
   
633
     
4,040
     
1.6
     
1,103
     
6,730
     
2.5
     
(470
)
   
(2,690
)
   
(40.0
Walnut products
   
263
     
1,511
     
0.6
     
601
     
3,070
     
1.1
     
(338
)
   
(1,559
)
   
(50.8
Other
   
2,207
     
2,767
     
1.0
     
543
     
3,401
     
1.2
     
1,664
     
(634
)
   
(18.6
Total  
   
46,527
     
257,100
     
100
     
46,016
     
271,078
     
100
     
511
     
(13,978
)
   
(5.2


   
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)
 
                                                       
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
 
 
Sources of Milk

We source our fresh milk from 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, which currently house a total of approximately 17,000 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.
 
 
4

 
 
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.  In March 2011, we successfully renewed our manufacturing licenses with Heilongjiang and Hebei Bureau of Quality and Technical Supervision. The renewal permit was granted under regulatory measure introduced by the General Administration of Quality Supervision, Inspection and Quarantine of China in 2010. 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 have 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.
 
 
5

 
 
Feihe Dairy
Located in Kedong, Heilongjiang Province, China, the Feihe Dairy premises are approximately 88,221 square meters.  The plant is approximately 10 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 Gannan, Heilongjiang Province, China, the Gannan Feihe premises are approximately 300,000 square meters.  The original plant is approximately 5 years old and commenced milk powder production in 2008.  In 2010, we completed an expansion of the plant, which we refer to as “Phase II,” which is currently in a trial run stage.  Gannan Feihe principally produces infant milk formula and has a production capacity of approximately 1,000 tons per day of milk powder, including the 700 tons per day added by Phase II.

Langfang Feihe
Located in Langfang, Hebei Province, China, the Langfang Feihe premises are approximately 80,243 square meters.  The plant is approximately 5 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 Licheng, Shanxi Province, China, the Shanxi Feihe premises are approximately 40,000 square meters.  The plant is approximately 7 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 Baiquan, Heilongjiang Province, China, the Baiquan Dairy premises are approximately 36,000 square meters.  The plant is approximately 19 years old, although it was completely remodeled in 2004.  Baiquan Dairy principally produces raw milk powder and has a production capacity of approximately 100 tons per day of milk powder.
 
Qiqihaer Feihe
Located in Qiqihaer, Heilongjiang Province, China, the Qiqihaer Feihe, a branch of Feihe Dairy, premises are approximately 90,000 square meters.  The plant is approximately 6 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 Longjiang, Heilongjiang Province, China, the Longjiang Feihe, a branch of Gannan Feihe, premises are approximately 29,690 square meters. The plant is approximately 20 years old and is currently under expansion which is expected to be complete before the end of 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. 
 
 
6

 

 
 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
 
1,000 (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
 
Raw milk powder
 
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;
 
16 (tons/day)
   
N/A
 
       
Raw milk powder
 
11 (tons/day)
       

Sources of Walnut and Soybeans

We order walnuts and soybeans from local farmers for delivery to 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 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 490 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 through an extensive distribution network that reaches over 80,000 retail outlets throughout China.

Customers

No single customer equaled or exceeded 10% of our sales during the years ended December 31, 2010, 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 “Xingfeifan” “Feifan,” “Feihui,” “Feirui,” “Feiyue,” and “Beidiqi” Chinese brands and our “Firmus,” “Astrobaby” 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 have obtained trademark registrations for the use of our trade name “Feihe” and “Firmus,” which have been registered with the United States Patent and Trademark Office.  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.  In the event any of our trademarks are challenged or infringed, we may not have the financial resources to defend against the 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.
 
 
7

 
 
Research and Development

As of March 10, 2011, we had eight 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, 2010 and 2009, we spent approximately $169,000 and $66,000, respectively, on research and development, representing amounts paid in compensation to our 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:
 
 
·
Strengthen distribution logistics in strategic PRC markets.  We plan to focus on improving sales at existing sales points, leveraging our extensive distribution network to generate revenues in a cost-effective manner.  Our distribution network has grown 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.  Our 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 improving our distribution logistics in our network is important driver of our gross margins.
 
 
·
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.
 
 
8

 
 
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 Yili, Beingmate, Synutra and Yashili, 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.
 
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.
 
 
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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 have worked with the PRC government and attended several emergency meetings to discuss ways to improve the dairy and overall food industry in China.

In 2010, the General Administration of Quality Supervision, Inspection and Quarantine of China, or AQSIQ, announced a nationwide renewal inspection for all infant formula manufacturing facilities in China.  In March 2011, we successfully renewed our manufacturing license.

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 20, 2011, we had approximately 3,219 employees on our payroll.  We had eight group administrators, approximately 626 employees were in marketing and sales, approximately 80 employees provided marketing support, approximately 210 employees were performing administrative functions, including financing, auditing and human resources, and approximately 2,295 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

We have two operating 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 normally do not provide milk to external customers. Please see Note 33 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 http://ady.feihe.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.
 
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 report 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.
 
 
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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 and 2010, new incidents of substandard milk formula contaminated with melamine and hydrolyzed leather protein also occurred in China.  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.  Furthermore, in 2010 there were widely publicized claims that certain Chinese infant formula products were linked to precocious puberty in female infants.  While governmental authorities concluded these claims were false, the operations of the companies involved were adversely effected.  The mere publication of information asserting that our milk powder, infant formula or other products contain melamine or other contaminants or have harmful health effects 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.
 
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 market our products as premium and super-premium products and have adopted 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.

We have recently incurred operating losses, which may have a harmful effect on the value of our common stock.

In the year ended December 31, 2010, we incurred a net loss of approximately $9.9 million, primarily attributable to a decrease in revenue, an increase in cost of goods sold, and an increase in operating expenses.   Under-producing cows at our company-owned dairy farms contributed to increased operating expenses.  We recognized a loss on disposal of cows of approximately $10.2 million in 2010. If our revenue does not grow as expected or if we fail to control and improve the effectiveness of our expenditures, including expenses associated with managing our dairy farms, we may not be able to achieve or sustain operating profitability on a consistent basis. Our lack of profitability may have an adverse effect on the market value of our common stock and on our cash flow and liquidity.
 
The report of our independent registered public accounting firm contains a reference raising substantial doubt about our ability to continue as a “going concern.”
 
Because of our deficiency of net current assets as of and significant net loss for the fiscal year ended December 31, 2010, we may not have sufficient cash to fund our expected cash flow requirements for the next 12 months including the maturity of our short-term loans, redemption of our redeemable common stock and planned capital expenditures.  Therefore, our independent registered public accounting firm has included a reference in its report on our consolidated financial statements for the fiscal year ended December 31, 2010 referring to substantial doubt regarding our ability to continue as a “going concern.”  As of and for the year ended December 31, 2010, we had net loss of approximately $9.9 million and deficiency of net current assets of approximately $59.3 million, with short-term loans of approximately $68.8 million that mature in the next 12 months and redeemable common stock of $63 million expected to be redeemed in the upcoming fiscal year.  While we believe we will be able to refinance much of our short-term bank loans when they become due and that our cash generated from operations, along with existing cash and our ability to draw down on unutilized credit lines, will be sufficient to fund our expected cash flow requirements for at least the next 12 months, including the redemption of our redeemable common stock and planned capital expenditures. Our belief may be mistaken.

Substantial doubt about our ability to continue as a going concern could affect our relationships with suppliers or customers.  In accordance with generally accepted accounting principles in the U.S., our balance sheet generally states the book value of our assets, which does not necessarily represent the value that could be realized from the assets if we could not continue as a going concern.

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 unable to become profitable.
  
 
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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 significant economic downturns following the housing crisis in the real estate and credit markets in both the United States and Europe, as well as natural disasters and related concerns in Asia.  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;
  
 
·
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 external raw milk unit purchase cost increased by approximately 24% in 2010 due to various factors, including, we believe, general economic conditions, such as inflation and fuel prices, and rising production costs 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.
 
 
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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.  

We have historically identified material weaknesses in our internal control over financial reporting. If we fail to remediate the material weaknesses or maintain an effective system of internal control over financial reporting, we may be unable to accurately report our financial results or prevent fraud, and investor confidence and the market price of our shares may be adversely affected.
 
We and our independent registered public accounting firm, in connection with the audit of internal control over financial reporting under Section 404 of the Sarbanes-Oxley Act for the fiscal year ended December 31, 2010, have identified the following material weaknesses in our internal control over financial reporting:  There was insufficient accounting personnel with appropriate knowledge of accounting principles generally accepted in the United States of America. A “material weakness” is a deficiency, or a combination of 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. We have taken measures and plan to continue to take measures to remedy this material weakness. However, the implementation of these measures may not fully address the material weakness in our internal control over financial reporting. Our failure to address any control deficiency could result in inaccuracies in our financial statements and could also impair our ability to comply with applicable financial reporting requirements and related regulatory filings on a timely basis. Moreover, effective internal control over financial reporting is important to prevent fraud. As a result, our business, financial condition, results of operations and prospects, as well as the trading price of our shares, may be materially and adversely affected.
 
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.
 
 
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We expect to incur costs related to expansion into new plants and ventures, which may not prove to be profitable. Moreover, any delays in our expansion plans could cause adversely impact our results of operations 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 prevent us from becoming profitable.

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 prove to be profitable.
 
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:
 
 
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·
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. 

Extensive regulation of the food processing and distribution industry in China could increase our expenses and make us unable to become profitable.

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 became effective in June 2010 for all dairy products.  Such requirements may have rapid implementation dates, require significant planning or expense, and 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. For instance, in 2010, AQSIQ announced a nationwide renewal inspection for all infant manufacturing facilities.  In March 2011, we successfully renewed our manufacturing license.  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.
 
 
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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 M&A Rules, in September 2006. The 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 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.
 
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.
 
 
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Governmental control of currency conversion may affect the value of your investment.

The PRC government imposes controls on the convertibility of the Renminbi into foreign currencies and, in certain cases, the remittance of currency out of China. We receive substantially all of our revenues in Renminbi. Under existing PRC foreign exchange regulations, payments of current account items, including profit distributions, interest payments and trade and service-related foreign exchange transactions, can be made in foreign currencies without prior SAFE approval by complying with certain procedural requirements. However, approval from or registration with appropriate government authorities is required where Renminbi is to be converted into foreign currency and remitted out of China to pay capital expenses such as the repayment of loans denominated in foreign currencies. The PRC government may also, at its discretion, restrict access to foreign currencies for current account transactions in the future. If the foreign exchange control system prevents us from obtaining sufficient foreign currencies to satisfy our foreign currency demands, we may not be able to pay dividends in foreign currencies to our shareholders,

Fluctuation in the value of the Renminbi against the U.S. dollar may have a material adverse effect on your investment.

The value of the Renminbi against the U.S. dollar and other currencies is affected by, among other things, changes in China’s political and economic conditions and China’s foreign exchange policies. The conversion of the Renminbi into foreign currencies, including the U.S. dollar, has been based on exchange rates set by the People’s Bank of China. On July 21, 2005, the PRC government changed its decade-old policy of pegging the value of the Renminbi solely to the U.S. dollar. Under this revised policy, the Renminbi is permitted to fluctuate within a narrow and managed band against a basket of certain foreign currencies. Following the removal of the U.S. dollar peg, the Renminbi appreciated approximately 21.5% against the U.S. dollar over the following three years. Since July 2008, however, the Renminbi has traded within a narrow range against the U.S. dollar, remaining within 1% of its July 2008 high. As a consequence, the Renminbi has fluctuated significantly since July 2008 against other freely traded currencies, in tandem with the U.S. dollar. On June 20, 2010, the People’s Bank of China announced that the PRC government will further reform the Renminbi exchange rate regime and enhance the Renminbi exchange rate flexibility. It is difficult to predict how this new policy may impact the Renminbi exchange rate going forward.

Significant revaluation of the Renminbi may have a material adverse effect on your investment. If we decide to convert our Renminbi into U.S. dollars for the purpose of making payments for dividends on our common shares or for other business purposes, appreciation of the U.S. dollar against the Renminbi would have a negative effect on the U.S. dollar amount available to us.
 
Under the 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 the new PRC Enterprise Income Tax Law, or the EIT Law, and its implementing rules, which became effective in 2008, an enterprise established outside of China with a “de facto management body” 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 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 EIT Law and its implementing rules are still new and there is limited guidance regarding tax residency determinations, it is unclear how tax authorities will determine tax residency based on the facts of each case.

If the PRC tax authorities determine that Feihe International, Inc. is a “resident enterprise” for PRC enterprise income tax purposes, unfavorable PRC tax consequences could follow. 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. Although under the 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. In addition, it is possible that the “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.
 
 
18

 
 
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 fully creditable against our U.S. tax.  

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, 2010, we held approximately $17.5 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, 2010, we held approximately $65,000 of cash balances within the United States, of which $ nil 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.
 
Limited and uncertain trademark protection in China makes the ownership and use of our trademark uncertain.

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 “Xingfeifan” “Feifan,” “Feihui,” “Feirui,” “Feiyue,” and “Beidiqi” Chinese brands and our “Firmus,” “Astrobaby” 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 have obtained trademark registrations for the use of our trade name “Feihe” and “Firmus,” which have been registered with the United States Patent and Trademark Office.  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. In the event any of our trademarks are challenged or infringed, we may not have the financial resources to defend against the 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 adversely impact our results of operations.

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 40% of our common stock as of March 25, 2011.  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.

 
19

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

As of December 31, 2010, we had approximately $106.7 million of bank loans. In addition, we expect to redeem our redeemable common stock for an aggregate amount of $63 million plus interest (see “—The terms of our agreements with the Purchasers may have adverse impacts on us.”).  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 agreements 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.  Because we did not meet certain earnings per share targets for 2009, we issued 525,000 additional shares to the Purchasers pursuant to the subscription agreement.  In February 2011, we entered into a redemption agreement with the Purchasers to redeem and purchase from the Purchasers the 2,625,000 shares issued pursuant to the subscription agreement in four equal installments on or around March 31, 2011, September 30, 2011, December 31, 2011 and March 31, 2012, for an aggregate payment on each such date of $15,750,000, together with interest accruing at the rate of 1.5% per annum, compounded annually from August 27, 2009 until such date.  This redemption could significantly impact our liquidity and capital resources.
 
 
20

 
 
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 1,950 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 17,000 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.

Item 3. Legal Proceedings

From time to time, we may become involved in various claims and lawsuits incidental to our business.  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 were 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 had alleged that Murrell, Hall, McIntosh & Co. LLP, or MHM, formerly our independent registered public accounting firm, 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 were seeking compensatory damages of not less than $10.0 million in connection with this suit.  In September 2010, we agreed, and the court entered an order, to dismiss our suit without prejudice.
 
Item 4. (Removed and Reserved)
 
 
21

 
 
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

Our common stock trades on the NYSE under the symbol “ADY.”  On March 25, 2011, there were 22,306,291 shares of our common stock issued and outstanding that were held by approximately 376 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, 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
 
                 
                 
Year Ended December 31, 2010:
               
1st Quarter
 
$
25.40
   
$
19.15
 
2nd Quarter
 
$
19.93
   
$
15.63
 
3rd Quarter
 
$
15.91
   
$
6.64
 
4th Quarter
 
$
13.22
   
$
9.49
 

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 wholly foreign-owned enterprises 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 Interwest Transfer Company, Inc., 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, 2005 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.
 
 
22

 
 
 
Securities Authorized for Issuance under Equity Compensation Plans

The following table sets forth information regarding issuances of securities pursuant to equity compensation plans as of December 31, 2010:
 
Plan Category
 
Number of
securities issued
and to be issued
upon exercise of
outstanding
options, warrants
and rights
 
 
Weighted-average
exercise price of
outstanding options,
warrants and rights
 
 
Number of
securities
remaining
available for
future issuance
 
Equity compensation plans approved by security holders
 
 
856,254
 
 
$
15.84
 
 
 
2,143,746
 
Total
 
 
856,254
 
 
$
15.84
 
 
 
2,143,746
 
 
Recent Sales of Unregistered Securities

In March 2010, we issued 525,000 shares of redeemable common stock to accredited investors, pursuant to a performance adjustment clause in a subscription agreement because we failed to meet certain performance targets set out in the subscription agreement as of December 31, 2009. 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.

In April 2010, we issued 8,000 shares of common stock upon the exercise of stock options granted pursuant to our stock incentive plans, in consideration for services provided to us by employees.  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.

During the year ended December 31, 2010, we issued 55,915 shares of our common stock to our directors and employees in consideration for their services to us.  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

The following table sets forth our selected consolidated financial data. The financial data set forth below should be read in conjunction with, and are qualified in their entirety by reference to “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation” of this report. The selected consolidated balance sheet data and statements of operations data in the table below have been derived from our audited consolidated financial statements. Historical results are not necessarily indicative of results to be expected in the future.  
 
 
23

 
 
   
For the Fiscal Years Ended December 31,
 
   
2010
   
2009
   
2008
   
2007
   
2006
 
   
(in thousands except earnings per share data)
Selected Consolidated Statements of Operations Data:
                             
Sales
 
$
257,100
   
$
271,078
   
$
193,192 
   
$
163,899
   
$
115,082
 
Cost of goods sold
   
(153,848
   
(140,427
   
(117,181
   
(19,430
   
(65,170
Gross profit
   
103,252
     
130,651
     
76,011
     
72,469
     
49,912
 
Sales and marketing expenses
   
(99,476
   
(105,109
   
(50,686
 )
   
(40,739
)
   
(40,740
General and administrative expenses
   
(23,380
   
(20,479
   
(19,047
   
(13,836
)
   
(13,840
Goodwill impairment
   
(1,437
)
   
(930
   
-
     
-
     
-
 
Loss on disposal of biological assets
   
(10,241
   
(1,740
   
(287
   
-
     
-
 
Operating (loss) income
   
(31,036
)
   
2,368
     
6,460
     
17,893
     
16,256
 
Interest and finance costs
   
(2,516
   
(6,139
   
(18,843
   
(13,405
   
(1,521
Registration rights penalty
   
-
     
-
     
(2,389
)
   
(2,540
)
       
Gain on extinguishment of debt
   
-
     
-
     
30,497
     
-
     
(688
)
(Loss) gain on derivatives
   
-
     
(2,162
)
   
(8,321
)
   
3,279
     
-
 
Government subsidy
   
23,462
     
21,177
     
6,810
     
8,140
     
7,492
 
(Loss) income before income taxes and discontinued operations
   
(10,175
)
   
15,427
     
14,137
     
13,507
     
21,280
 
Income tax (benefit) expenses
   
(280
)
   
(746
)
   
3,567
     
5,662
     
4,858
 
(Loss) income from continuing operations, net of tax
   
(9,895
)
   
16,173
     
10,570
     
7,842
     
16,422
 
Net income from discontinued operations, net of tax
   
-
     
3,290
     
6,463
     
442
     
-
 
Net (loss) income
   
(9,895
)
   
19,463
     
17,033
     
8,284
     
16,422
 
Net (income) loss attributable to the noncontrolling interest
   
311
     
118
     
(10
   
(4
   
11
 
Net (loss) income attributable to Feihe International, Inc.
 
$
(9,584
)
 
$
19,581
   
$
17,023
   
$
8,280
   
$
16,433
 
Net (loss) income from continuing operations per share of common stock
                                       
-Basic
 
$
(0.48
)
 
$
0.86
   
$
0.62
   
$
0.48
   
$
1.11
 
-Diluted
 
$
(0.48
)
 
$
0.81
   
$
0.60
   
$
0.46
   
$
0.98
 
Net income from discontinued operations per share of common stock
                                       
-Basic
 
$
-
   
$
0.17
   
$
0.38
   
$
0.03
   
$
-
 
-Diluted
 
$
-
   
$
0.16
   
$
0.37
   
$
0.02
   
$
-
 
Net (loss) income per share of common stock
                                       
-Basic
 
$
(0.48
)
 
$
1.03
   
$
1.00
   
$
0.51
   
$
1.11
 
-Diluted
 
$
(0.48
)
 
$
0.97
   
$
0.97
   
$
0.48
   
$
0.98
 
Net (loss) income per share of redeemable common stock
                                       
-Basic
 
$
(0.07
)
 
$
1.03
   
$
-
   
$
-
   
$
-
 
-Diluted
 
$
(0.07
)
 
$
0.97
   
$
-
   
$
-
   
$
-
 

   
December 31,
 
   
2010
   
2009
   
2008
   
2007
   
2006
 
   
(in thousands)
 
Selected Balance Sheets Data:
                             
Cash and cash equivalents
 
$
17,530
   
$
48,165
   
$
11,785
   
$
11,058
   
$
39,521
 
Working capital (deficit) (1)
   
(59,338
   
(5,499
)
   
(69,467
   
(49,356
)
   
24,694
 
Inventory
   
71,683
     
59,045
     
31,003
     
25,949
     
14,657
 
Trade receivables, net
   
15,886
     
27,495
     
12,275
     
4,519
     
5,566
 
Property, plant and equipment
   
213,507
     
177,743
     
117,137
     
85,289
     
44,699
 
Biological assets
   
54,398
     
48,904
     
25,268
     
-
     
-
 
Prepaid leases for land use right
   
29,754
     
29,016
     
29,148
     
20,968
     
6,063
 
Total assets
   
464,309
     
440,258
     
358,547
     
260,578
     
117,625
 
Short-term bank loans
   
68,816
     
58,182
     
7,737
     
8,214
     
11,115
 
Convertible debt
   
-
     
-
     
91,542
     
55,238
     
16,484
 
Long- term bank loans
   
37,859
     
39,740
     
13,165
     
484
     
1,581
 
Derivatives
   
-
     
-
     
-
     
50,019
     
-
 
Total liabilities
   
236,457
     
223,806
     
242,122
     
178,373
     
61,466
 
Redeemable common stock
   
66,114
     
53,645
     
-
     
-
     
-
 
Total equity
 
$
161,738
   
$
162,807
   
$
116,424
   
$
82,206
   
$
56,159
 

(1)      Working capital (deficit) represents current assets minus current liabilities.
 
 
24

 
 
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, 2010, 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 1,950 tons per day, and an extensive distribution network that reaches over 80,000 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 at times operated 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.
 
 
25

 
 
 
·
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%, in 2009 decreased by approximately 20% and in 2010 increased by approximately 24% 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.
 
 
·
Expenses Associated with Expansion and Competition.  In implementing our plan to expand our business, we face corresponding increases in expenses, especially for sales and marketing 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.

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 normally do not provide milk to external customers.

Results of Operations

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

   
Years Ended December 31,
 
   
2010
   
2009
   
2008
 
   
($ in thousands)
 
Statements of Operations Data
                 
Sales
    257,100       271,078       193,192  
Cost of goods sold
    (153,848 )     (140,427     (117,181 )
Gross profit
    103,252       130,651       76,011  
Operating expenses:
                       
Sales and marketing
    (99,476 )     (105,109     (50,686 )
General and administrative
    (23,380 )     (20,479     (19,047
Goodwill impairment
    (1,437 )     (930 )     -  
Loss on disposal of biological assets
    (10,241 )     (1,740 )     (287 )
Operating (loss) income
    (31,036 )     2,368       6,460  
Other income (expenses)
    20,861       13,059       7,676  
Income tax (benefit) expenses
    (280 )     (746     3,567  
Net income from discontinued operations, net of tax
    -       3,290       6,463  
Accretion of redemption premium on redeemable common stock
    (1,087 )     -       -  
Net (loss) income attributable to common shareholders of Feihe International, Inc.
    (10,670 )     19,581       17,023  
 
 
26

 
 
Comparison of Years Ended December 31, 2010 and 2009
 
Sales
Our sales consist primarily of revenues generated from sales of milk powder, raw milk powder, soybean powder, rice cereal, walnut products and fresh milk.  Sales decreased by approximately $14.0 million, or 5.2%, from approximately $271.1 million in 2009 to approximately $257.1 million in 2010.  This decrease was primarily attributable to decrease of sales of milk powder, offset in part by an increase in sales of raw milk powder, which reflected the fact that there were new competitors entering into our industry and old competitors aggressively attempting to reclaim market share following the melamine crisis. During 2010, we focused on improving sales of existing sales points and, accordingly, our expansion into new market areas was less rapid. While our full-year 2010 sales decreased, our sales in the quarterly period ended December 31, 2010 increased by approximately $18.3 million, or 41.6%, from approximately $44.0 million in the quarterly period ended December 31, 2009 to approximately $62.3 million in the quarterly period ended December 31, 2010.  We believe this increase reflects our improved control 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 which occurred during the fourth quarter of 2009.  Our inventories increased approximately $12.7 million, or 21.5%, from approximately $59.0 million as of December 31, 2009 to approximately $71.7 million as of December 31, 2010, reflecting our increased production during our first and second fiscal quarters of 2010 to prepare to meet expected sales demand.

The following table sets forth information regarding the sales of our principal products during the fiscal years ended December 31, 2010 and 2009:

   
2010
 
2009
 
2010 over 2009
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
   
22,816
     
180,218
     
70.1
     
28,783
     
216,230
     
79.8
     
(5,967
)
   
(36,012
)
   
(16.7
Raw milk powder
   
15,691
     
57,752
     
22.5
     
11,637
     
34,328
     
12.7
     
4,054
     
23,424
     
68.2
 
Soybean powder
   
4,917
     
10,812
     
4.2
     
3,349
     
7,319
     
2.7
     
1,568
     
3,493
     
47.7
 
Rice cereal
   
633
     
4,040
     
1.6
     
1,103
     
6,730
     
2.5
     
(470
)
   
(2,690
)
   
(40.0
Walnut products
   
263
     
1,511
     
0.6
     
601
     
3,070
     
1.1
     
(338
)
   
(1,559
)
   
(50.8
Other
   
2,207
     
2,767
     
1.0
     
543
     
3,401
     
1.2
     
1,664
     
(634
)
   
(18.6
Total  
   
46,527
     
257,100
     
100
     
46,016
     
271,078
     
100
     
511
     
(13,978
)
   
(5.2

While full-year 2010 sales of our higher-margin milk powder products decreased, our milk powder sales in the quarterly period ended December 31, 2010 increased by approximately $18.7 million, from approximately $20.7 million, or 47.0% of total sales, in the quarterly period ended December 31, 2009, to approximately $39.5 million or 63.4% of total sales, in the quarterly period ended December 31, 2010.  This shift in product mix reflects our improved control of cross-territory selling activities by distributors which occurred during the fourth quarter of 2009 and our efforts to reclaim market share during the year 2010.
 
In 2010, we also experienced a decrease in the average sales price per kilogram of our products, as demonstrated in the table below:
 
   
2010
   
2009
 
Sales revenues (in thousands)
 
$
257,100
   
$
271,078
 
Total sales volume (kilograms in thousands)
   
46,527
     
46,016
 
Average selling prices/kilogram
 
$
5.53
   
$
5.89
 
 
The decrease in average sales price per kilogram, as reflected in the table, was primarily attributable to a shift in product mix resulting from a decrease in sales of milk powder, a higher margin product.  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 2010 and 2009 and the percentage change in the sales price per kilogram.
 
 
27

 
 
   
Average Price Per Kilogram
   
Percentage
 
Product
 
2010
   
2009
   
Change
 
Milk powder
 
$
7.90
   
$
7.51
     
5.2
 
Raw milk powder
   
3.68
     
2.95
     
24.7
 
Soybean powder
   
2.20
     
2.19
     
0.5
 
Rice cereal
   
6.38
     
6.10
     
4.6
 
Walnut products
   
5.75
     
5.11
     
12.5
 
Other
   
1.25
     
6.27
     
(80.0
Total  
 
$
5.53
   
$
5.89
     
(6.1

The average selling price per kilogram of milk powder increased by 5.2% from $7.51 in the year ended December 31, 2009 to $7.90 in the year ended December 31, 2010.  This increase was primarily attributable to fewer promotional activities, including a decrease in sales discounts provided to distributors. The average selling price per kilogram for raw milk powder increased by 24.7%, from $2.95 in the year ended December 31, 2009 to $3.68 in the year ended December 31, 2010.  This increase was primarily attributable to increased demand and market prices of raw milk and raw milk powder.

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 $13.4 million, or 9.5%, from approximately $140.4 million in 2009 to approximately $153.8 million in 2010.  This increase was primarily attributable to general increases in raw milk and costs of added nutrients and approximately $0.4 million increase in provision for obsolete, slow moving, and excess inventory.

Operating Expenses
Our total operating expenses consist primarily of sales and marketing expenses, general and administrative expenses, goodwill impairment and disposal loss of biological assets.  Our total operating expenses increased by approximately $6.2 million, or 4.8%, from approximately $128.3 million in 2009 to approximately $134.5 million in 2010.

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 decreased approximately $5.6 million, or 5.3%, from approximately $105.1 million for 2009 to approximately $99.5 million for 2010. This decrease was primarily attributable to a decrease of approximately $9.5 million, or 30.4%, in advertising expense, which was offset in part by an increase of approximately $3.2 million, or 34%, in salary of marketing staff and an increase of approximately of $1.3 million, or 2.8%, in promotion costs. Total promotion costs include expenses related to promotion activities and wages of certain sales people. During the year 2010, we improved the effectiveness of sales and marketing expenses and our sales at existing sales points, rather than focusing on the expansion of our distribution network.

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 $2.9 million, or 14.1%, from approximately $20.5 million for 2009 to $23.4 million for 2010. The increase was primarily attributable to an increase of approximately $2.1 million, or 39.6%, in staff salary and welfare contributions and an increase of approximately $2.4 million, or 400% in travelling and office administrative expenses. The increase was partially offset by a decrease of approximately $1.6 million, or 40.0%, in professional service fees. General and administrative expenses are likely to increase as we continue to expand our production, sourcing capacity, and distribution capacity throughout China.

Goodwill Impairment Expense. We recognized a goodwill impairment charge of approximately $1.4 million, an increase of approximately $0.5 million or 55.6%, from approximately $0.9 million in 2009, related to Shanxi Feihe as a result of the stagnating growth of our walnut powder products.  As a result, goodwill related to Shanxi Feihe has been reduced to nil.
 
 
28

 

 
Loss on Disposal of Biological Assets. Our loss on disposal of biological assets increased by approximately $8.5 million, or 488.7%, from approximately $1.7 million in 2009 to approximately $10.2 million in 2010. The increase reflects our sale of under-producing cows at our company-owned dairy farms.

Operating (Loss) Income
As a result of the foregoing, our income from continuing operations decreased by approximately $33.4 million from income of approximately $2.4 million in 2009 to a loss of approximately $31.0 million in 2010.

Other Income (Expenses)
Our other income (expenses) consists primarily of interest and finance costs, loss on derivatives and government subsidies. Other income increased by approximately $7.8 million, or 59.8%, from approximately $13.1 million for 2009 to approximately $20.9 million for 2010. The increase was primarily attributable to a decrease of approximately $3.6 million, or 59.0%, in interest and finance costs, an increase of approximately $2.3 million, or 10.8%, in government subsidies and a decrease of approximately $2.2 million, or 100%, in loss on derivatives. Loss on derivatives in 2009 was primarily attributable to change of the fair value of the derivatives relating to our common stock financing.
 
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 benefits were approximately $0.7 million and $0.3 million in 2009 and 2010, respectively.  The decrease in income tax benefit was primarily due to the fact that certain PRC entities of ours which were tax exempt in 2009 become subject to income taxes at a rate of 12.5% in 2010.

Net Income from Discontinued Operations, Net of Tax
Due to a letter of intent we entered into in December 2008 to sell our former subsidiary Heilongjiang Moveup Co., Limited, or Moveup, accounts relating to Moveup are reflected in our financial statements as discontinued operations.  Our net income from discontinued operations decreased by approximately $3.3 million, or 100.0%, from approximately $3.3 million in 2009 to $nil in 2010.

Comparison of Years Ended December 31, 2009 and 2008

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.
 
 
29

 
 
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
 
$
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
     
12.6
 

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 Expenses
Our total operating expenses consist primarily of sales and marketing expenses and general and administrative expenses, goodwill impairment and disposal loss of biological assets.  Our total operating expenses increased by approximately $58.3 million, or 83.2%, from approximately $70.0 million in 2008 to approximately $128.3 million in 2009.
 
 
30

 
 
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 107.3%, 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 $1.5 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.

Goodwill Impairment Expense. We recognized a goodwill impairment charge of approximately $0.9 million, an increase of approximately $0.9 million or 100.0%, from approximately $nil in 2008, related to Shanxi Feihe as a result of the decline in sales of our walnut powder products.

Loss on disposal of biological assets. Our loss on disposal of biological assets increased by approximately $1.4 million, or 466.7%, from approximately $0.3 million in 2008 to approximately $1.7 million in 2009. The increase reflects our sale of under-producing cows at our company-owned dairy farms.

Operating Income
As a result of the foregoing, our operating income decreased by approximately $4.1 million, or 63.1%, from approximately $6.5 million in 2008 to approximately $2.4 million in 2009.

Other Income (Expenses)
Our other income (expenses) consists primarily of interest and finance costs, registration rights penalty, loss on derivatives and government subsidies. Other income increased by approximately $5.4 million, or 70.1%, from approximately $7.7 million for 2008 to approximately $13.1 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 subsidies and a decrease of approximately $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.

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.
 
 
31

 
 
Net Income from Discontinued Operations, Net of Tax
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.

Liquidity and Capital Resources

Overview
In general, our primary uses of cash are providing for working capital purposes, which principally represent the purchase of inventory, servicing debt and financing construction related to our expansion plans.  Capital expenditures for the years ended December 31, 2010, 2009 and 2008 amounted approximately to $45.3 million, $89.8 million and $35.3 million, respectively.  Our largest source of operating cash flows is cash collections from our customers. We have been able to meet our cash needs principally by using cash on hand, cash flows from operations, bank loans, proceeds from the sale of securities and borrowings under our line of credit.
 
The accompanying consolidated financial statements have been prepared assuming we will continue as a “going concern.”  We had a deficiency of net current assets of approximately $59.3 million as of December 31, 2010 and experienced a net loss of approximately $9.9 million in the year ended December 31, 2010. We have significant cash commitments in the upcoming fiscal year, including maturity of short-term loans of approximately $68.8 million and redemption of redeemable common stock of $63 million plus interest.  However, we believe we will be able to refinance much of our short-term bank loans when they become due and that our cash generated from operations, along with existing cash and ability to draw down on unutilized credit lines, will be sufficient to fund our expected cash flow requirements for at least next 12 months, including the redemption of our redeemable common stock and planned capital expenditures. Our minimum projected obligations for fiscal year 2011 and beyond are set forth below under “Contractual Obligations.”
 
Cash Flows
As of December 31, 2010, we had retained earnings of approximately $60.7 million, cash and cash equivalents of approximately $17.5 million, and total current assets of approximately $137.2 million and working capital deflict of approximately $59.3 million.  

Our summary cash flow information is as follows:
 
   
 
Year ended December 31
Net cash provided by (used in):
 
2010
 
2009
   
2008
 
   
($ in thousands)
Operating activities
    5,545       27,207       22,504  
Investing activities
    (42,878 )     (54,649 )     (23,282 )
Financing activities
    5,608       62,283       (279 )
 
Net Cash Provided by Operating Activities
Net cash provided by operating activities for fiscal year 2010 decreased approximately $21.7 million, from net cash provided by operating activities of approximately $27.2 million in 2009 to approximately $5.5 million in 2010. This decrease was primarily attributable to the following changes in working capital items:

 
·
increase in inventory purchases of approximately $6.4 million reflecting our increased production in preparation to meet expected sales demand;
 
·
increase in advances to suppliers of approximately $4.6 million as a result of increased production combined with the rising costs of raw material, especially purchased raw milk powder which prices increased approximately 24% in 2010;
 
·
increased payment of approximately $6.5 million in notes payable primarily as a result of increased inventory purchases;
 
·
decrease of government subsidies of approximately $11.5 million as a significant amount of government subsidy received in 2009 was related to the Longjiang Feihe acquisition; and
 
·
increase of approximately $8.2 million in advances from customers for raw milk powder primarily attributable to increased sales of raw milk powder despite an overall decrease in sales.
 
 
32

 
 
For the year ended December 31, 2009 net income increased by approximately $5.6 million, while net cash provided by operating activities increased approximately $4.7 million, from approximately $22.5 million in 2008 to approximately $27.2 million in 2009 due to the following changes in working capital items:

 
·
decrease of inventory purchases of approximately $20.1 million partially offset by decrease in accounts payable of $15.9 million as compared with 2008.  Because we intended to significantly expand the business in 2008 and believed our competitive position following the melamine crisis was favorable, we purchased significant amounts of raw material and accordingly produced increased levels of inventory in 2008.  Although our business plan in 2009 still includes expansion, we have shifted our product mix to higher-margin milk powder and therefore sold off excess inventory at lower margins to stabilize our inventory levels;
 
·
increase in trade receivables of approximately $6.3 million primarily due to increases in sales of higher-margin products in addition to our expansion within China during 2009 as compared to 2008. In 2009, we also increased credit limits available to long term customers, although we continue to require advance payments from new customers;
 
·
decrease in advances from customers of approximately $8.1 million, which reflected a higher balance of advance from distributors at the year end of 2008, ordering sufficient milk powder to meet the increased needs of 2009 first quarter’s sales which was a direct result of the melamine crisis;
 
·
increase in amounts due to related parties of approximately $8.9 million, relating to the advance received from one related company for the purchase of cattle; and
 
·
increase in advances to suppliers of approximately $9.7 million relating to our upcoming productions in the first half of 2010 to meet our increasing demands in the winter season.  Additionally, costs of raw material in 2009 have increased compared to 2008.

Net Cash Used in Investing Activities
Net cash used in investing activities decreased approximately $11.7 million, from approximately $54.6 million in 2009 to approximately $42.9 million in 2010. This decrease was primarily attributable to a decrease in purchase of property and equipment of approximately $34.7 million, a decrease in purchase of biological assets of approximately $9.7 million, an increase in the proceeds from sales of biological assets of approximately $4.5 million and purchase of our Longjiang Feihe dairy operations for approximately $4.4 million in 2009. This decrease was offset in part by an increase in restricted cash of approximately $2.6 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 expenditures associated with our construction and acquisition of new facilities.

Net cash used in investing activities increased approximately $31.3 million, from approximately $23.3 million in 2008 to approximately $54.6 million in 2009. This increase was primarily attributable to an increase in purchase of property and equipment of approximately $41.1 million, an increase in purchase of biological assets of approximately $13.5 million and our purchase in 2009 of our Longjiang Feihe dairy operations for approximately $4.4 million. This increase was offset in part by proceeds from sale of a subsidiary of approximately $39.0 million and a decrease in time deposit of approximately $8.4 million. Net cash used in investing activities primarily relates to our bank and expenditures associated with our construction and acquisition of new facilities.

Net Cash Provided by (used in) Financing Activities
Net cash provided by financing activities decreased by approximately $56.7 million, from approximately $62.3 million in 2009 to approximately $5.6 million in 2010. The decrease was primarily attributable to the proceeds of approximately $62.9 million from our common stock financing in 2009, a decrease in proceeds from long term bank loans of approximately $21.0 million and increases in repayment of short term bank loans and long term bank loans of approximately $51.4 million and $9.4 million, respectively. The decrease was offset in part by the repayment of short term debt of approximately $80.5 million in 2009 and an increase in proceeds from short term bank loans of approximately $10.0 million.
 
 
33

 
 
Net cash provided by financing activities increased by approximately $62.6 million, from cash used approximately $0.3 million in 2008 to cash provided approximately $62.3 million in 2009. The increase was primarily attributable to the proceeds of approximately $62.9 million from our common stock financing, an increase in proceeds from short term bank loans of approximately $50.3 million and an increase in proceeds from long term bank loans of approximately $15.8 million, respectively. The increase was offset in part by the repayment of short term debt of approximately $69.5 million and a decrease in the repayment of short term bank loans of approximately $1.5 million.
 
Outstanding Indebtedness

Redemption Obligation
In August 2009, pursuant to a subscription agreement, we issued 2,100,000 shares of our common stock to the Purchasers, for an aggregate purchase price of $63.0 million.  Because we did not meet certain earnings per share targets for 2009, we issued 525,000 additional shares to the Purchasers pursuant to the subscription agreement.  In February 2011, we entered into a redemption agreement with the Purchasers to redeem and purchase from the Purchasers the 2,625,000 shares issued pursuant to the subscription agreement in four equal installments on or around March 31, 2011, September 30, 2011, December 31, 2011 and March 31, 2012, for an aggregate payment on each such date of $15,750,000, together with interest accruing at the rate of 1.5% per annum, compounded annually from August 27, 2009 until such date.
 
Short and Long Term Loans Payable
As of December 31, 2010, we had short term loans of approximately $68.8 million and long term loans of approximately $37.9 million from PRC banks.  Our bank loans do not contain financial covenants.  During the three and twelve month periods ended December 31, 2010, the largest aggregate amount of short term bank loans was approximately $71.5 million and $71.5 million, respectively.  The maturity dates of the short term bank loans outstanding from PRC banks as of December 31, 2010 ranged from January 13, 2011 to December 23, 2011.  All short term bank loans that have become due have been repaid.  During the three and twelve month periods ended December 31, 2010, the largest aggregate amount of long term loans was approximately $37.9 million and $37.9 million, respectively.  The maturity dates of the long term loans outstanding from PRC banks as of December 31, 2010 ranged from October 28, 2014 to December 24, 2015.   The weighted average interest rate on short term bank loans and long term loans from PRC banks outstanding as of December 31, 2010 was 5.46% and 6.3%, respectively.  The loans were secured by pledges of certain fixed assets held by our subsidiaries or by guarantees of certain of our subsidiaries.   Our ability to incur additional secured indebtedness depends in part on the value of our assets, which depends, in turn, on the strength of our cash flows, results of operations, economic and market conditions and other factors.
 
Line of Credit
We also have a one year, unsecured line of credit with a bank of approximately $102 million (RMB 677 million) scheduled to expire in the last fiscal quarter of 2011. The line of credit entitles us to draw demand loans for general corporate purposes. If we were to draw on the line of credit, interest would be a base rate established by the People’s Bank of China on the unpaid principal amount.  As of December 31, 2010, there were borrowings of approximately $30 million under the line of credit. The net availability of the line of credit was approximately $72 million as of December 31, 2010.

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.   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. As of December 31, 2009, there was approximately $4.0 million in principal payable under this loan.  The loan was fully repaid in June 2010.

In November 2009, we entered into a six-year capital lease agreement for certain equipment under construction. The terms of the lease required an initial payment of approximately $756,200 and a payment of approximately $151,200 on January 30th of each year after successful completion of production quality tests. The equipment has been successfully installed and put into production as of December 31, 2010, and was depreciated over an estimated productive life of 14 years. As of December 31, 2010 and 2009, we had approximately $1.5 million and $nil, respectively, of equipment subject to the capital lease.
 
 
34

 
 
Contractual Obligations

Our contractual obligations consist mainly of payments related to long-term debt and related interest, capital leases to purchase certain equipment, FIN 48 obligations, capital purchase of property, plant and equipment, and product purchase obligations.  The following table sets forth information regarding our outstanding contractual obligations by maturity as of December 31, 2010, as well our obligation to redeem $63 million redeemable common stock plus interest as a result of entering into a redemption agreement in February 2011:
 
Payment due by period
(amounts in thousands of US$)
 

   
Total
   
Less than
1 year
   
1-3 years
   
3-5 years
   
More than
5 years
 
   
(in thousands)
 
Short-term debt obligations   $ 68,816     $ 68,816     $ -     $ -     $ -  
Long-term debt obligations
 
 
37,859
   
 
9,756
   
 
-
   
 
28,103
   
 
-
 
Capital lease obligations
   
756
     
151
     
454
     
151
     
-
 
FIN 48 obligations
   
5,062
     
-
     
-
     
-
     
-
 
Purchase obligations
   
7,028
     
2,188
     
3,630
     
1,210
     
-
 
Capital obligations
   
5,098
     
-
     
-
     
-
     
-
 
Redemption of redeemable stock and interest
   
65,080
     
48,701
     
16,379
     
-
     
-
 
Total
 
$
189,699
   
$
129,612
   
$
45,201
   
$
4,726
   
$
-
 

Selected Unaudited Quarterly Results of Operations

The following table sets forth unaudited quarterly statements of operations data for the eight quarters ended December 31, 2010. We believe this unaudited information has been prepared substantially on the same basis as the annual audited consolidated financial statements appearing elsewhere in this report. We believe this data includes all necessary adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation. You should read the quarterly data in conjunction with our audited consolidated financial statements and related notes appearing elsewhere in this Annual Report. The consolidated results of operations for any quarter are not necessarily indicative of the operating results for any future period. We expect that our quarterly revenues may fluctuate significantly.

For our 2010 and 2009 fiscal years, our quarterly results of operations were summarized as follows:
 
   
Three Months Ended (Unaudited)
 
Fiscal 2010
 
December 31
   
September 30
   
June 30
   
March 31
 
   
US$
   
US$
   
US$
   
US$
 
Sales
   
62,328,127
     
61,141,112
     
52,194,506
     
81,435,903
 
Gross profit
   
19,036,835
     
27,312,648
     
18,464,339
     
38,437,721
 
Net income (loss) from continuing operations, net of tax
   
1,708,270
     
3,645,057
     
(20,720,485
   
5,471,903
 
Net income (loss) from discontinued operations, net of tax
   
-
     
-
     
-
     
-
 
                                 
Net income (loss) attributable to Feihe International, Inc.
   
793,239
     
3,577,264
     
(20,574,592
   
5,533,596
 
                                 
Earnings per share – Basic
                               
Net income (loss) from continuing operations
   
0.08
     
0.16
     
(0.92
   
0.25
 
Net income from discontinued operations
   
-
     
-
     
-
     
-
 
Net income (loss)
   
0. 08
     
0.16
     
(0.92
   
0.25
 
                                 
Earnings per share – Diluted
                               
Net income (loss) from continuing operations
   
0. 08
     
0.16
     
(0.92
   
0.25
 
Net income from discontinued operations
   
-
     
-
     
-
     
-
 
Net income (loss)
   
0. 08
     
0.16
     
(0.92
   
0.25
 
                                 
Earnings per redeemable common share – Basic
                               
Net income (loss) from continuing operations
   
0.45
     
 0.16
     
 (0.92
   
0.25
 
Net income from discontinued operations
   
-
     
 -
     
 -
     
 -
 
Net income (loss)
   
0.45
     
 0.16
     
 (0.92
   
0.25
 
 
Earnings per redeemable common share – Diluted
                               
Net income (loss) from continuing operations
   
0.45
     
0.16
     
 (0.92
   
0.25
 
Net income from discontinued operations
   
-
     
-
     
-
     
-
 
Net income (loss)
   
       0.45
     
0.16
     
(0.92
)
   
0.25
 
 
 
35

 

 
   
Three Months Ended (Unaudited)
 
Fiscal 2009
 
December 31
   
September 30
   
June 30
   
March 31
 
   
US$
   
US$
   
US$
   
US$
 
Sales
   
43,958,701
     
72,110,934
     
41,186,466
     
113,821,847
 
Gross (loss) profit
   
(3,040,156)
     
36,981,402
     
24,132,413
     
72,577,578
 
Net (loss) income from continuing operations
   
(27,046,014)
     
11,133,549
     
4,328,252
     
27,757,421
 
Net income from discontinued operations