10-Q 1 v221680_10q.htm Unassociated Document
 


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the three months ended: March 31, 2011                           

¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ____________ to ____________

Commission file number: 001-34080                      

CHINA SKY ONE MEDICAL, INC.
(Exact name of registrant as specified in its charter)

Nevada
 
87-0430322
(State or other jurisdiction of
 
(I.R.S. Employer
incorporation or organization)
 
Identification No.)
     
No. 2158, North Xiang An Road, Song Bei District,
Harbin, People’s Republic of China
 
150028
(Address of principal executive offices)
 
(Zip Code)
     
Registrant’s telephone number, including area code:
 
86-451-87032617 (China)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 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.
Yes x    No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, 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).
Yes  o   No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a small reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 
Large accelerated filer o
Accelerated filer x
 
       
 
Non-accelerated filer o
(Do not check if a smaller reporting company)
Smaller reporting company ¨
 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes ¨     No x

As of May 1, 2011, the registrant had 16,940,539 shares of common stock issued and outstanding.

 
 

 

QUARTERLY REPORT ON FORM 10-Q

OF CHINA SKY ONE MEDICAL, INC. AND SUBSIDIARIES
FOR THE PERIOD ENDED MARCH 31, 2011

TABLE OF CONTENTS

       
PAGE
         
PART I
 
FINANCIAL INFORMATION
   
Item 1.
 
Financial Statements
 
2
   
Condensed Consolidated Statements of Operations and Comprehensive Income for the Three Months Ended March 31, 2011 (unaudited) and 2010 (unaudited)
 
2
   
Condensed Consolidated Balance Sheets as of March 31, 2011 (unaudited) and December 31, 2010
 
3
   
Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2011 (unaudited) and 2010 (unaudited)
 
4
   
Notes to Condensed Consolidated Financial Statements (unaudited)
 
5
Item 2.
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
24
Item 3.
 
Quantitative and Qualitative Disclosures About Market Risk
 
37
Item 4.
 
Controls and Procedures
 
37
PART II
 
OTHER INFORMATION
  38
Item 1.
 
Legal Proceedings
  38
Item 1A.
 
Risk Factors
  38
Item 2.
 
Unregistered Sales of Equity Securities and Use of Proceeds
  38
Item 3.
 
Defaults Upon Senior Securities
  38
Item 4.
 
Removed and Reserved
  38
Item 5.
 
Other Information
  38
Item 6.
 
Exhibits
  38
Signatures
  39

 
-i-

 

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q (“Form 10-Q”), together with other statements and information we publicly disseminate, contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended.  We intend such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, and include this statement for purposes of complying with these safe harbor provisions.

Forward-looking statements, which are based on certain assumptions and describe our future plans, strategies and expectations, are generally identifiable by use of the words “believe,” “expect,” “intend,” “anticipate,” “estimate,” “should”, “would”, “could”, “may”, “plan”, “possible”, “project” or similar expressions.  You should not rely on forward-looking statements since they involve known and unknown risks, uncertainties and other factors that are, in some cases, beyond our control and which could materially affect actual results, performances or achievements.

Factors that may cause actual results to differ materially from current expectations include, but are not limited to the “Risk Factors” discussed in our Annual Report on Form 10-K, for the year ended December 31, 2010. Accordingly, there is no assurance that our expectations will be realized.  Except as otherwise required by the federal securities laws, we disclaim any obligations or undertaking to publicly release any updates or revisions to any forward-looking statement contained herein (or elsewhere) to reflect any change our expectations with regard thereto, or any change in events, conditions or circumstances on which any such statement is based.

The terms “the Company,” “we,” “us” and “our” refer to China Sky One Medical, Inc., together with our consolidated subsidiaries.

 
1

 

PART I. FINANCIAL INFORMATION

Item 1.  Financial Statements

China Sky One Medical, Inc. and Subsidiaries
Condensed Consolidated Statements of Operations and Comprehensive Income
(Unaudited, $ in thousands except share and per share data)
 
   
Three Months Ended March 31,
 
   
2011
   
2010
 
Revenues
  $ 28,365     $ 28,903  
Cost of Goods Sold
    9,064       7,275  
Gross Profit
    19,301       21,628  
Operating Expenses
               
Depreciation and amortization
    1,334       841  
Research and development
    4,112       3,764  
Selling
    6,300       5,911  
General and administrative
    920       990  
Total operating expenses
    12,666       11,506  
Income from Operations
    6,635       10,122  
Other Income
               
Interest income
    32       29  
Change in fair value of derivative warrant liability
    1,377       4,927  
Total other income
    1,409       4,956  
Net Income Before Provision for Income Tax
    8,044       15,078  
Provision for Income Taxes
    1,921       2,489  
Net Income
  $ 6,123     $ 12,589  
Basic Earnings Per Share
  $ 0.36     $ 0.75  
Basic Weighted Average Shares Outstanding
    16,940,539       16,776,864  
Diluted Earnings Per Share
  $ 0.36     $ 0.74  
Diluted Weighted Average Shares Outstanding
    16,940,539       16,955,535  
Other Comprehensive Income
               
Foreign currency translation adjustment
  $ 1,415     $ 21  
Net Income
    6,123       12,589  
                 
Comprehensive Income
  $ 7,538     $ 12,610  
 
 See accompanying summary of accounting policies and notes to the condensed consolidated financial statements.

 
2

 
 
China Sky One Medical, Inc. and Subsidiaries
Condensed Consolidated Balance Sheets
($ in thousands, except share data)
 
   
March 31,
   
December 31,
 
   
2011
(Unaudited)
   
2010
 
ASSETS
           
Current Assets
           
Cash and cash equivalents
  $ 48,058     $ 43,124  
Accounts receivable, net
    16,678       20,080  
Inventories
    6,589       2,409  
Prepaid and other current assets
    34       21  
Total current assets
    71,359       65,634  
Property and equipment, net
    28,906       28,960  
Intangible assets, net
    26,997       23,155  
Construction in progress
    40       19  
Land use rights, net
    40,860       40,844  
Land and construction deposit
    13,727       13,612  
Total Assets
  $ 181,889     $ 172,224  
LIABILITIES AND STOCKHOLDERS' EQUITY
               
Current Liabilities
               
Accounts payable and accrued expenses
  $ 6,738     $ 3,309  
Taxes payable
    3,300       3,225  
Derivative warrant liability
    297       1,674  
Total current liabilities
    10,335       8,208  
                 
Commitments and Contingencies
    -       -  
                 
Stockholders' Equity
               
Preferred stock ($0.001 par value, 5,000,000 shares authorized, none issued and outstanding)
    -       -  
Common stock ($0.001 par value, 50,000,000 shares authorized, 16,940,539 issued and outstanding)
    17       17  
Additional paid-in capital
    39,252       39,252  
Retained earnings
    119,865       113,742  
Accumulated other comprehensive income
    12,420       11,005  
Total stockholders' equity
    171,554       164,016  
                 
Total Liability and Shareholders' Equity
  $ 181,889     $ 172,224  
 See accompanying summary of accounting policies and notes to the condensed consolidated financial statements.

 
3

 

 
China Sky One Medical, Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(Unaudited, $ in thousands)

   
Three Months Ended March 31,
 
   
2011
   
2010
 
             
Cash flows from operating activities
           
Net Income
  $ 6,123     $ 12,589  
Adjustments to reconcile net cash provided by (used in) operating activities:
               
Depreciation and amortization
    1,461       944  
Change in fair value of derivative liability
    (1,377 )     (4,927 )
Net change in assets and liabilities:
               
Accounts receivable
    3,557       2,563  
Inventories
    (4,143 )     190  
Prepaid expenses and other current assets
    (13 )     (24 )
Accounts payable and accrued expenses
    3,387       1,143  
Taxes payable
    48       138  
Net cash provided by operating activities
    9,043       12,616  
                 
Cash flows from investing activities
               
Purchase of fixed assets
    (93 )     (77 )
Purchase of intangible assets
    (4,389 )     -  
 Purchase of construction in process
    (19 )        
Net cash used in investing activities
    (4,501 )     (77 )
                 
Cash flows from financing activities
               
Proceeds from warrants conversion
    -       94  
Net cash provided by financing activities
    -       94  
                 
Effect of exchange rate changes on cash and cash equivalents
    392       10  
                 
Net increase in cash and cash equivalents
    4,934       12,643  
Cash and cash equivalents at beginning of period
    43,124       52,756  
Cash and cash equivalents at end of period
  $ 48,058     $ 65,399  
                 
Supplemental disclosure of cash flow information
               
Interest paid
  $ -     $ -  
Taxes paid
  $ 1,894     $ 2,452  

See accompanying summary of accounting policies and notes to the condensed consolidated financial statements.

 
4

 

China Sky One Medical, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)

1.
Description of Business

China Sky One Medical, Inc. (“China Sky One” or the “Company”), a Nevada corporation, was formed on February 7, 1986, and formerly known as Comet Technologies, Inc. (“Comet”).  On July 26, 2006, the Company changed the name of the reporting company from "Comet Technologies, Inc." to "China Sky One Medical, Inc."

China Sky One is a holding company whose principal operations are conducted through its wholly-owned subsidiaries.  The Company has no revenues separate from its subsidiaries, and has expenses related to its status as a public reporting company and to its ownership interest in American California Pharmaceutical Group, Inc. (“ACPG”) and Harbin City Tian Di Ren Medical Co. (“TDR”).

ACPG, the Company’s non-operating United States holding company subsidiary, was incorporated on December 16, 2003, in the State of California, under the name “QQ Group, Inc.” QQ Group, Inc. changed its name to “American California Pharmaceutical Group, Inc.” in anticipation of the Stock Exchange Agreement with China Sky One (then known as “Comet Technologies, Inc.”) and TDR, described herein. On December 8, 2005, ACPG completed a stock exchange transaction with TDR, a People’s Republic of China (“China” or “PRC”) based operating company and TDR’s subsidiaries (the “TDR Acquisition”), each of which were fully operating companies in the PRC. Under the terms of the agreement, ACPG exchanged 100% of its issued and outstanding common stock for 100% of the capital stock of TDR and its subsidiaries, described below.

Thereafter, on May 11, 2006, ACPG entered into a Stock Exchange Agreement (the “Exchange Agreement”) with the shareholders of China Sky One. The stock exchange transaction was consummated and the acquisition was completed on May 30, 2006. As a result of the transaction, the Company issued a total of 10,193,377 shares of its common voting stock to the stockholders of ACPG, in exchange for 100% of the capital stock of ACPG resulting in ACPG becoming the Company’s wholly-owned subsidiary. The transaction was treated as a reverse merger for accounting purposes.

TDR, formerly known as “Harbin City Tian Di Ren Medical Co.,” was originally formed in 1994 and its principal executive office is located in Harbin City of Heilongjiang Province, in the PRC. TDR was reorganized and incorporated as a limited liability company on December 29, 2000, under the “Corporation Laws and Regulations” of the PRC. At the time of the TDR Acquisition by ACPG in December of 2005, TDR had two wholly-owned subsidiaries, Harbin First Bio-Engineering Company Limited (“First”) and Kangxi Medical Care Product Factory, until July, 2006, when the two were merged, with First as the surviving subsidiary of TDR. The principal activities of TDR and First are the research, manufacture and sale of over-the-counter non-prescription health care products. TDR commenced its business in the sale of branded nutritional supplements and over-the-counter pharmaceutical products in the Heilongjiang Province. TDR has subsequently evolved into an integrated manufacturer, marketer, and distributor of external use natural Chinese medicine products sold primarily to and through independent agents and China’s large pharmaceutical chains.

As of October 16, 2006, the Company organized Harbin Tian Qing Biotech Application Company as a wholly-owned PRC subsidiary of TDR (“Tian Qing”), to conduct research and development in the areas of tissue and stem cell banks. As of March 31, 2011, Tian Qing had insignificant operations.

 
5

 
China Sky One Medical, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)

On April 3, 2008, TDR completed an acquisition pursuant to an Equity Transfer Agreement dated February 22, 2008, between TDR and Heilongjiang Tianlong Pharmaceutical, Inc., a corporation with a multitude of medicines approved by the PRC’s State Food and Drug Administration (“SFDA”) and new medicine applications, organized under the laws of the PRC (“Tianlong”), which is in the business of manufacturing external-use pharmaceuticals. TDR previously acquired the Beijing sales office of Tianlong in mid-2006. Pursuant to the Equity Transfer Agreement, TDR acquired 100% of the issued and outstanding capital stock of Tianlong from Tianlong’s sole stockholder, in consideration for an aggregate purchase price of approximately $8,300,000, consisting of (i) $8,000,000 in cash, and (ii) 23,850 shares of China Sky One (at $12 per share). The acquisition received regulatory approval and closed on April 3, 2008.

The following table summarizes the approximate estimated fair values of the assets acquired in the Tianlong acquisition.

   
($ in thousands)
 
Property and equipment
 
$
6,315
 
Intangible assets – SFDA licenses for drug batch numbers
   
1,787
 
Other
   
170
 
Net assets acquired
 
$
8,272
 

On April 18, 2008, China Sky One through its subsidiary TDR consummated a share acquisition pursuant to an Equity Transfer Agreement with the shareholders of Heilongjiang Haina Pharmaceutical Inc., a recently formed corporation organized under the laws of the PRC (“Haina”) licensed as a wholesaler of TCDs, bio-medicines, bio-products, medicinal devices, antibiotics and chemical medicines. At the time, Haina did not have an established sales network and was acquired for its primary asset, a Good Supply Practice (GSP) license (License No. A-HLJ03-010) issued by the Heilongjiang office of the SFDA. The SFDA had recently started issuing such licenses to resellers of medicines that maintain certain quality controls. The GSP license, which was issued as of December 21, 2006 and will expire on January 29, 2012, enabled the Company to expand its sales of medicinal products without having to go through a lengthy license application process.

The following table summarizes the approximate estimated fair values of the assets acquired in the Haina acquisition:

   
($ in thousands)
 
Cash
 
$
84
 
Intangible assets – Goodwill
   
353
 
Net assets acquired
 
$
437
 

Pursuant to the Equity Transfer Agreement, TDR acquired 100% of the issued and outstanding capital stock of Haina from its three stockholders in consideration for payment of 3,000,000 RMB (approximately $437,000). TDR has been overseeing the operations of Haina since January of 2008 as part of its due diligence prior to closing of this acquisition.

On June 9, 2008, TDR entered into a Merger and Acquisition Agreement (the “Acquisition Agreement”) with Peng Lai Jin Chuang Company, a corporation organized under the laws of the People’s Republic of China (“Peng Lai”), which was organized to develop, manufacture and distribute pharmaceutical, medicinal and diagnostic products in the PRC. Pursuant to the Acquisition Agreement, TDR acquired all of the assets of Peng Lai in consideration for an aggregate of approximately (i) $2,500,000 in cash, and (ii) 381,606 shares of the Company’s common stock with a fair value of approximately $4,600,000 million (at $12 per share). The acquisition of Peng Lai closed on September 5, 2008.

The following table summarizes the approximate estimated fair values of the assets acquired in the Peng Lai acquisition.

   
($ in thousands)
 
Property and equipment
 
$
4,177
 
Intangible assets - SFDA licenses for drug batch numbers
   
2,917
 
Net assets acquired
 
$
7,094
 


 
6

 
China Sky One Medical, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)

All of the Company’s significant operations and long lived assets are located in the PRC.

On December 21, 2010, TDR, entered into an agreement with Heilongjiang Tang Wang He Forest Bureau, pursuant to which the Company acquired the rights to grow and harvest herbs and other plants on approximately 74,000 acres of forest land in the Xiao Xing’an Mountain region in Heilongjiang Province, China, for a 30-year term expiring December 20, 2040.  Pursuant to the agreement, the Company may utilize the herbs and other plants it grows on the forest land as raw materials in connection with the production of the Company’s products, as well as the sale to third parties.  The Company’s total rent for the 30-year term is approximately $36 million (RMB 240 million). This new arrangement is intended to provide our TCM business a hedge against fluctuations in raw material prices.

2.
Summary of Significant Accounting Policies

The Company has established various accounting policies that govern the application of accounting principles generally accepted in the United States of America (“U.S.”), which are utilized in the preparation of the Company’s financial statements. Certain accounting policies involve significant judgments and assumptions by management that have a material impact on the carrying value of certain assets and liabilities.  The judgments and assumptions used by management are based on the Company’s historical experience and other factors, which are believed to be reasonable under the circumstances. Because of the nature of the judgments and assumptions made by management, actual results could differ from these judgments and estimates, which could have a material impact on the carrying values of assets and liabilities and the results of operations.

Principles of Consolidation – The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, ACPG, TDR, First, Tian Qing, Tianlong, Haina and Peng Lai. All significant inter-company transactions and balances were eliminated.

These financial statements are stated in U.S. Dollars and have been prepared in accordance with accounting principles generally accepted in the United States of America. This basis of accounting differs from that used under applicable accounting requirements in the PRC. No material adjustment was required.

Management acknowledges its responsibility for the preparation of the accompanying interim consolidated financial statements, which reflect all adjustments, consisting of normal recurring adjustments, considered necessary, in its opinion, for a fair statement of its consolidated financial position and the results of its operations for the interim period presented. These consolidated financial statements should be read in conjunction with the summary of significant accounting policies and notes to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010.

The accompanying unaudited condensed consolidated financial statements for China Sky One Medical, Inc. and Subsidiaries have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Regulation S-X. Operating results for interim periods are not necessarily indicative of results that may be expected for the fiscal year as a whole.

Use of estimates – The preparation of these financial statements in conformity with U.S. GAAP, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the dates of the financial statements, and the reported amounts of revenues and expenses during the reported periods.

Significant estimates include values and assigned lives to acquired tangible and intangible assets, uncollectible accounts receivable, impairment testing of goodwill and other long-lived assets, the valuation allowance for income taxes, and the evaluation and estimate for contingencies.  Actual results may differ from these estimates.

 
7

 
China Sky One Medical, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)

Earnings per share - Basic earnings per common share is computed by dividing net earnings applicable to common shareholders by the weighted-average number of common shares outstanding during the period. When applicable, diluted earnings per common share is determined using the weighted-average number of common shares outstanding during the period, adjusted for the dilutive effect of common stock equivalents, consisting of shares that might be issued upon exercise of common stock options and warrants.

Potential common shares issued are calculated using the treasury stock method, which recognizes the use of proceeds that could be obtained upon the exercise of options and warrants in computing diluted earnings per share. It assumes that such proceeds would be used to purchase common stock at the average market price of the common stock during the period.

Cash and cash equivalents – The Company considers all highly liquid instruments purchased with a maturity period of three months or less to be cash equivalents. The carrying amounts reported in the accompanying consolidated balance sheets for cash and cash equivalents approximate their fair value.

A significant amount of the Company’s cash and cash equivalents are held in commercial bank checking accounts in the PRC and earn interest income (annual yield of approximately 0.36% for the year ended December 31, 2010, and approximately 0.40% for the three months ended March 31, 2011). For all the bank accounts in the PRC and in the U.S., the Company earned interest income of approximately $32,000 and $29,000 for the three months ended March 31, 2011 and 2010, respectively. Management believes it is beneficial to retain sufficient cash in checking accounts so it is readily available for working capital and general corporate purposes, and to fund potential business and asset acquisitions and other opportunities which may arise.

Accounts receivable – Accounts receivable are stated at net realizable value, net of an allowance for doubtful accounts. The allowance for estimated bad debts is based upon the periodic analysis of individual customer balances including an evaluation of days of sales outstanding, payment history, recent payment trends, and perceived credit worthiness. As of March 31, 2011 and December 31, 2010, the Company’s allowance for doubtful accounts was $58,000 and $-0-, respectively.

Inventories – Inventories include finished goods, raw materials, freight-in, packing materials, labor, and overhead costs and are valued at the lower of cost or market using the weighted-average method. Inventories are valued using the weighted average method. Provisions are made for slow moving, obsolete and/or damaged inventory based upon the periodic analysis of individual inventory items including an evaluation of historical usage and/or movement, age, expiration date, and general conditions. The Company recorded no inventory reserve position as of March 31, 2011 and December 31, 2010.

Property and equipment – Property and equipment are stated at historical cost less accumulated depreciation. Depreciation on property and equipment is provided using the straight-line method over the estimated useful lives of the assets. The Company uses an estimated residual value of 5% of cost, or valuation for both financial and income tax reporting purposes. The estimated lengths of the useful lives of our property and equipment are as follows:

Building and Improvements
30 years
Land use rights
50 years
Furniture and Equipment
5 to 7 years
Transportation Equipment
5 to 15 years
Machinery and Equipment
7 to 14 years

Expenditures for renewals and betterments are capitalized while repairs and maintenance costs are charged to the consolidated statement of operations in the year in which they were incurred. In situations where it can be clearly demonstrated that the expenditure has resulted in an increase in the future economic benefits expected to be obtained from the use of the asset, the expenditure is capitalized as an additional cost of the asset. Upon sale or disposal of an asset, the historical cost and related accumulated depreciation or amortization of such asset is removed from their respective accounts, and any gain or loss is recorded in the consolidated statements of operations.

 
8

 
China Sky One Medical, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)

Property and equipment are evaluated for impairment in value whenever an event or change in circumstances indicates that the carrying values may not be recoverable. If such an event or change in circumstances occurs and potential impairment is indicated because the carrying value exceeds the estimated future undiscounted cash flows of the asset, the Company will measure the impairment loss as the amount by which the carrying value of the asset exceeds its fair value. The Company did not record any impairment charges of property and equipment in the three months ended March 31, 2011 and 2010.

Construction-in-progress – Properties currently under development are accounted for as construction-in-progress. Construction-in-progress includes the acquisition and land right costs, development expenditures, professional fees, and capitalized interest costs during the period of construction.

Upon completion and readiness for use of the project, the cost of construction-in-progress is transferred as part of property and equipment. In the case of construction-in-progress, management takes into consideration the estimated cost to complete the project when making the lower of cost or market calculation.

Intangible assets – Intangible assets are accounted for in accordance with ASC topic 350, “Intangibles – Goodwill and Other.” Intangible assets with finite useful lives are amortized while intangible assets with indefinite useful lives are not amortized. The Company reviews its long-lived assets and finite-lived intangible assets for impairment on at least an annual basis or whenever events or changes in circumstances indicate that the carrying amount of the assets may not be fully recoverable. To determine recoverability of its long-lived assets, the Company evaluates the probability that future undiscounted net cash flows will be less than the carrying amount of the assets. Impairment costs, if any, are measured by comparing the carrying amount of the related assets to their fair value. The Company recognizes an impairment loss based on the excess of the carrying amount of the assets over their respective fair values. Fair value is determined by the use of undiscounted future cash flows, independent appraisals or other appropriate methods. The Company did not record any impairment charges for the three months ended March 31, 2011 and 2010.

The Company’s intangible assets consist of proprietary technologies, SFDA licenses for drug batch numbers and goodwill. Proprietary technologies are technologies that we acquired either from the business acquisition of Tianlong or in the normal course of business.  The SFDA licenses for drug batch numbers were acquired in connection with the Company’s business acquisitions of Tianlong and Peng Lai in 2008, as well as from Heilongjiang Traditional Chinese Medical University in the first quarter of 2011.  We have registered “Kang Xi” as our trademark, which is used for all of the Company’s Tradition Chinese Medicine (“TCM”) products. The “Kang Xi” trademark was developed internally and registered by TDR before the Company became a public company. As a result, the Company’s cost basis in the trademark is nominal. Therefore, the Company did not have its “Kang Xi” trademark appraised, or recorded an intangible asset for it. Additionally, none of the costs associated with the trademark have been capitalized. As of March 31, 2011, the weighted average amortization period for the Company’s intangible assets is approximately 8 years.

Derivative warrant liability– The Class A Warrants (“the Warrants”) issued in connection with our January 31, 2008 private placement include a reset provision which would be triggered if we issue common shares below the exercise price of $12.50 as defined in the Warrant. Effective January 1, 2009 the reset provision of these warrants preclude equity accounting treatment under ASC 815 (formerly EITF 07-5). Accordingly, ASC 815-40 which was effective as of January 1, 2009, has been applied resulting in a reclassification of the warrants as a derivative liability, measured at fair value, with changes in fair value recognized as part of other income or expense for each reporting period thereafter. The Company used the Monte Carlo valuation model to estimate the fair value of the Warrants. Significant assumptions used at March 31, 2011 include a term of approximately 2.7 years; volatility of 70.0% and a risk free interest rate of 1.16%. Changes in fair value of the Warrants are recognized in earnings each reporting period.

 
9

 
China Sky One Medical, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)

Foreign Currency - The Company’s principal country of operations is in the PRC. The financial position and results of operations of the Company are recorded in Renminbi (“RMB”) as the functional currency. The results of operations denominated in foreign currency are translated at the average rate of exchange during the reporting period. Assets and liabilities denominated in foreign currencies at the balance sheet date are translated at the market rate of exchange at that date. The registered equity capital denominated in the functional currency is translated at the historical rate of exchange at the time of the capital contribution. All translation adjustments resulting from the translation of the financial statements into U.S. Dollars are recorded as accumulated other comprehensive income, a component of stockholders’ equity. At March 31, 2011 the exchange rate was 6.56 RMB to one U.S. dollar compared to 6.61 RMB to one U.S. dollar at December 31, 2010. For the three months ended March 31, 2011, the average exchange rate was 6.58 RMB to one U.S. dollar compared to 6.84 RMB to one U.S. dollar for the same period of 2010.

Revenue recognition - Revenue is recognized when the following criteria are met: (1) persuasive evidence of an arrangement exists; (2) the product has been shipped and the customer takes ownership and assumes the risk of loss; (3) the selling price is fixed or determinable; and (4) collection of the resulting receivable is reasonably assured. The Company believes that all of these criteria are satisfied upon shipment from its facilities. Historically, the Company’s estimated returns, allowances and claims have been deemed immaterial. The Company’s sale agreements only allow a return if the product has quality related issues. In such event, the Company accepts the return for equivalent product exchange from inventory only. The Company’s revenues do not include multiple deliverable arrangements.

The Company occasionally applies to various government agencies for research grants. Revenue from such research grants is recognized when earned. In situations where the Company receives payment in advance for the performance of research and development services, such amounts are deferred and recognized as revenue as the related services are performed.

Research and development - Research and development expenses include the costs associated with the Company’s internal research and development as well as research and development conducted by third parties. These costs primarily consist of salaries, clinical trials, outside consultants, and materials. All research and development costs are expensed as incurred.
 
Third-party expenses reimbursed under non-refundable research and development contracts are recorded as a reduction to research and development expense in the consolidated statement of operations.

The Company recognizes in-process research and development in accordance with ASC topic 730, “Research and Development.” Assets to be used in research and development activities, specifically, compounds that have yet to receive new drug approval and would have no alternative use, should approval not be given, are immediately charged to expense when acquired. Certain assets and other technologies acquired that has foreseeable future cash flows are capitalized as intangible assets. Such intangible assets are amortized starting from the year revenue is generated and amortized over the estimated stream of revenues derived from the product sale. Should under any circumstances these capitalized intangible assets have no future benefit; the Company will record an immediate write-off for the remaining net carrying value within the consolidated statement of operations.

The Company incurred research and development expenses of approximately $4,112,000 and $3,764,000, for the three months ended March 31, 2011 and 2010, respectively.

Advertising – The Company signs contracts with agents who then place its advertising in the mediums of television, radio and newspaper. Advertising expense is incurred in the period the advertisements take place. Thus, costs of advertising are expensed as incurred. Advertising costs for the three months ended March 31, 2011 and 2010 were approximately $2,994,000 and $2,686,000, respectively. An immaterial amount of the Company’s advertisement expenses were related to advertising production costs. Advertising costs are reported as part of selling expenses in the consolidated statements of operations.

Taxation – The Company uses the asset and liability method of accounting for deferred income taxes. The Company’s provision for income taxes includes income taxes currently payable and those deferred because of temporary differences between the financial statement and tax bases of assets and liabilities. The Company records liabilities for income tax contingencies based on the Company’s best estimate of the underlying exposures.

 
10

 
China Sky One Medical, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)

The Company periodically estimates its tax obligations using historical experience in tax jurisdictions and informed judgments. There are inherent uncertainties related to the interpretation of tax regulations in the jurisdictions in which the Company transacts business. The judgments and estimates may change based on the outcome of tax audits, as well as changes to, or further interpretations of, regulations. The Company adjusts income tax expense in the period in which these events occur.

Provision for the PRC enterprise income tax is calculated at the prevailing rate based on the estimated assessable profits less available tax relief for losses brought forward. The Company does not accrue taxes on unremitted earnings from foreign operations as it is the Company’s intention to invest these earnings in the foreign operations indefinitely.

Enterprise income tax

According to “Enterprise Income Tax and Certain Preferential Policies Notice” published by the Ministry of Finance and the National Tax Affairs Bureau, if the enterprise is authorized by the State Council as a special entity, the enterprise income tax rate is reduced to 15%. The following table sets forth the Company’s income tax rate for TDR and its subsidiaries for the three months ended March 31, 2011 and 2010:

Income Tax Rate
 
As of March 31,
 
for Subsidiaries
 
2011
   
2010
 
TDR
   
15
%
   
15
%
First
   
15
%
   
15
%
Tianlong
   
15
%
   
15
%
Haina
   
25
%
   
25
%
Peng Lai
 
2% of Revenue
 *
 
2% of Revenue
 *
 
 
*
Reflects a 25% tax rate on 8% of Peng Lai’s revenue, regardless of its taxable income. As authorized by Peng Lai Municipal Tax Bureau, Peng Lai was not required to pay tax on the remaining 92% of revenue.

The Company’s management is confident these favorable tax rates will be renewed. If the Company failed to obtain these favorable tax rates, the impact to the Company’s financial results for the three months ended March 31, 2011 would be immaterial.

Value added tax

The Provisional Regulations of PRC Concerning Value Added Tax promulgated by the State Council came into effect on January 1, 1994. Under these regulations and the Implementing Rules of the Provisional Regulations of the PRC Concerning Value Added Tax, value added tax is imposed on goods sold in, or imported into, the PRC and on processing, repair and replacement services provided within the PRC.

Value added tax payable in the PRC is charged on an aggregated basis at a rate of 13% or 17% (depending on the type of goods involved) on the full price collected for the goods sold or, in the case of taxable services provided, at a rate of 17% on the charges for the taxable services provided, but excluding, in respect of both goods and services, any amount paid in respect of value added tax included in the price or charges, and less any deductible value added tax already paid by the taxpayer on purchases of goods and services in the same financial year.

According to “Agriculture Product Value Added Tax Rate Adjustment and Certain Items’ Value Added Tax Waiver” published by the Ministry of Finance and the National Tax Affairs Bureau, the value added tax for agriculture related products is to be taxed at 13%. Furthermore, traditional Chinese medicine and medicinal plant are by definition agriculture related products.

 
11

 
China Sky One Medical, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)

The Company may from time-to-time be assessed interest or penalties by major tax jurisdictions, although such assessments historically have been minimal and immaterial to the Company’s financial results. The Company’s policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of income tax expense.

The Company files corporate income tax returns in the U.S. for China Sky One and ACPG. ACPG wholly owns 100% of TDR and subsidiaries in the PRC. China Sky One and ACPG are holding companies and do not generate business revenues and management’s intent is not to distribute dividend income from TDR and subsidiaries to either China Sky One or ACPG. As such, management has established a full valuation allowance for the net operating losses incurred by China Sky One and ACPG. The Company files income tax returns in the PRC for TDR and its subsidiaries.

Comprehensive income – Comprehensive income consists of net income and other gains and losses affecting stockholders’ equity that, under generally accepted accounting principles are excluded from net income. For the Company, such items consist entirely of foreign currency translation gains and losses.

Retirement benefit costs – According to the PRC regulations on pension plans, the Company contributes to a defined contribution retirement plan organized by municipal government in the province in which the Company is registered and all qualified employees as defined by statutory regulations are eligible to participate in the plan.

Contributions to the pension or retirement plan are calculated at 22% of the employees’ salaries above a fixed threshold amount. The employees contribute between 2% to 8% to the pension plan, and the Company contributes the balance. The Company has no other material obligations for the payment of retirement benefits beyond the annual contributions under this plan. The Company incurred costs of $59,000 and $44,000 for each of the three months ended March 31, 2011 and 2010, respectively.

Fair value of financial instruments – The carrying amounts of certain financial instruments, including cash and cash equivalents, accounts receivable, other receivables, accounts payable and accrued expenses, and other payables approximate their fair values at March 31, 2011 and 2010 because of the relatively short-term maturity of these instruments. The fair value of derivative instruments is provided by an independent third party valuation expert.  Certain derivatives with limited market activity are valued using externally developed models that consider unobservable market parameters.

Subsequent Events

The Company evaluated subsequent events through the date of filing of this Form 10-Q in accordance with the Subsequent Events Topic of the FASB Accounting Standards Codification under ASC topic 855 and determined that there were no subsequent events that need to be reported.

Recent accounting pronouncements

The Financial Accounting Standards Board (“FASB”) has codified a single source of authoritative nongovernmental U.S. GAAP, the “Accounting Standards Codification”   (the “Codification” or “ASC”). While the Codification does not change U.S. GAAP, it introduces a new structure that is organized in an easily accessible, user-friendly on-line research system. The Codification supersedes all existing accounting standards documents. All other accounting literature not included in the Codification will be considered non-authoritative.

 
12

 
China Sky One Medical, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)

In December 2010, the FASB issued new accounting guidance related to the goodwill impairment test for reporting units with zero or negative carrying values.  The amendments in ASU 2010-28 modify Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts by requiring an entity to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. In determining whether it is more than likely than not that goodwill impairment exists, an entity should consider whether any adverse qualitative factors indicate that impairment may exist. The qualitative factors are consistent with existing guidance and examples in paragraph 350-20-35-30 which requires that goodwill of a reporting unit be tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below carrying value. The new accounting guidance is to be applied prospectively for fiscal years, and interim periods within those years beginning after December 15, 2010 for public entities. The new accounting guidance did not have a material impact on the Company’s consolidated financial statements.

In December 2010, the FASB issued new accounting guidance on business combinations (Topic 805). The amendments in ASU 2010-29 specify that if a public entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business combination(s) that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. ASU 2010-29 also expands supplemental pro forma disclosures under Topic 805 to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in reported pro forma revenue and earnings. The new accounting guidance is to be applied prospectively for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010; however, as the provision of the guidance will be applied prospectively to business combinations with an acquisition date on or after the guidance becomes effective, the impact to the Company cannot be determined until a transaction occurs. Early adoption is permitted.

3.
Revenue by Product Category and Geographic Region

For the three months ended March 31, 2011 and 2010, overseas sales were approximately $1,039,000, or 3.7%, and $816,000, or 2.8%, respectively.

Our total revenues for the three month periods ended March 31, 2011 and 2010 were approximately $28,365,000 and $28,903,000, respectively. The following table sets forth our principal product categories based on application type and the approximate amount and percentage of revenue from each of such product categories, during the three months ended March 31, 2011 and 2010:
 
For the Three Months Ended March 31,
 
($ in thousands) (Unaudited)
 
   
2011
   
2010
   
Variance
 
                               
Product Category
 
Sales
   
% of Sales
   
Sales
   
% of Sales
       
Ointments
  $ 6,669       23.5 %   $ 7,805       27.0 %   $ (1,136 )
Patches
    4,771       16.8 %     8,218       28.4 %     (3,447 )
Wash Fluids
    2,707       9.5 %     883       3.1 %     1,824  
Sprays
    2,541       9.0 %     2,999       10.4 %     (458 )
Drops
    2,269       8.0 %     1,809       6.3 %     460  
Diagnostic Kits
    1,935       6.8 %     1,460       5.1 %     475  
Suppositories
    1,933       6.8 %     1,208       4.2 %     725  
Others
    5,540       19.6 %     4,521       15.5 %     1,019  
Total
  $ 28,365       100 %   $ 28,903       100 %   $ (538 )

 Please refer to “Part I, Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” for an analysis on changes in revenue by product category.

 
13

 
China Sky One Medical, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)

4.
Concentrations of Business and Credit Risk

Substantially all of the Company's long-lived assets and business operations are located in the PRC.

The Company maintains certain bank accounts in the PRC which are not protected by FDIC insurance or other insurance. As of March 31, 2011, the Company held approximately $428,000 of cash and cash equivalent account balances within the U.S. and all of the deposits were within the FDIC insurance limits. As of March 31, 2011, the Company had approximately $47,621,000 in China bank deposits, which is not insured.

A significant amount of the Company’s sales are concentrated in China. Accordingly, the Company is susceptible to fluctuations in its business caused by adverse economic conditions in China. Difficult economic conditions in other geographic areas into which the Company may expand may also adversely affect its business, operations and finances.

The Company provides credit in the normal course of business. The Company performs ongoing credit evaluations of its customers and maintains allowances for doubtful accounts based on factors surrounding the credit risk of specific customers, historical trends, and other information.

The Company does not require collateral for financial instruments subject to credit risk.

The Company is self-insured for all risks and carries no liability or property insurance coverage of any kind. The Company does not set aside any reserves for product liability risks or other potential claims. The Company’s policy is to record losses associated with its lack of insurance coverage at such time as a realized loss is incurred. Historically, the Company has not had any material losses in connection with its lack of insurance coverage and was not party to any material pending legal proceedings as of March 31, 2011. Management’s intention is to use the Company’s working capital to fund any such losses incurred due to the Company’s exposure to inadequate insurance coverage.

Payments of dividends may be subject to some restrictions due to the Company’s operating subsidiaries all being located in the PRC.

Major Customers

For the three months ended March 31, 2011, no customer accounted for 10% or more of our total revenues or accounts receivable. For the three months ended March 31, 2010, Harbin Shiji Baolong Medicine Company accounted for approximately 13% of total revenues. At March 31, 2010, Harbin Shiji Baolong Medicine Company, Hangzhou Jiupin Medical Trading Company, and Harbin Baoda Medicine Company accounted for approximately 20%, 12%, and 11% of all accounts receivable. No other customers accounted for 10% or more of our total revenues or accounts receivable for the three months ended March 31, 2010.

Major Suppliers

For the three months ended March 31, 2011, Heilongjiang Kangda Medicine Company, Shenzhen Hongyuan Plastic Packaging Company, Harbin Zhongjia Chemical Company and Zhejiang Shunfu Printing Company accounted for approximately 34%, 15%, 12% and 12% of the Company’s total inventory purchases, respectively. For the three months ended March 31, 2010, Heilongjiang Kangda Medicine Company and Zhejiang Shunfu accounted for approximately 55% and 10% of the Company’s total inventory purchases, respectively.  No other suppliers accounted for 10% or more of our total inventory purchases for the three months ended March 31, 2011 and 2010. We believe alternative local suppliers are available to meet our fulfillment needs if necessary.

5.
Earnings Per Share

Basic earnings per share are computed by dividing net earnings available to common shareholders (the numerator) by the weighted average number of common shares (the denominator) for the period presented. The computation of diluted earnings per share is similar to basic earnings per share, except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potentially dilutive common shares had been issued.

 
14

 
China Sky One Medical, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)

Warrants to purchase 593,800 shares of common stock with exercise prices of $12.50 were outstanding and exercisable as of March 31, 2011. These stock warrants to purchase 593,800 shares of common stock were excluded from the computation of diluted earnings per share due to the exercise price being above the average market price of our common stock for the quarter ended March 31, 2011. These stock warrants may dilute earnings per share in the future. Warrants to purchase 593,800 shares of common stock with an exercise price of $12.50 were outstanding and exercisable as of March 31, 2010.

The dilutive potential common shares on warrants and options is calculated in accordance with the treasury stock method, which assumes that proceeds from the exercise of all warrants and options are used to repurchase common stock at the average market price of the common stock during the relevant period. The amount of shares remaining after the proceeds are exhausted represents the potential dilutive effect of the securities.

The following table sets forth the Company’s computation of basic and diluted net income per share for the three months ended March 31, 2011 and 2010:

For the three months ended March 31,
($ in thousands, except share and per
share data) (Unaudited)

 
   
2011
   
2010
 
Numerator:
               
                 
Net income used in calculation of basic and diluted earnings per share
 
$
6,123
*
 
$
12,589
**
                 
Denominator:
               
                 
Weighted-average common shares outstanding used in calculation of basic earnings per share
   
16,940,539
     
16,776,864
 
Effect of dilutive securities:
               
Warrants and Options
   
-
     
178,671
 
                 
Weighted-average common shares used in calculation of diluted earnings per share
   
16,940,539
     
16,955,535
 
                 
Net income per share:
               
Basic
 
$
0.36
   
$
0.75
 
Diluted
 
$
0.36
   
$
0.74
 
 
*    Includes a gain of $1,377 and $0.08 per share (basic and diluted) relating to the change in fair value of the derivative warrant liability relating to the Class A Warrants
**  Includes a gain of $4,927 and $0.29 per share (basic and diluted) relating to the change  in fair value of  the  derivative warrant liability relating to the Class A Warrants

 
15

 
China Sky One Medical, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)

6.
Equity and Share-based Compensation

Effective January 1, 2006, we adopted the fair value recognition provisions of ASC Topic 718, “Compensation - Stock Compensation” (“ASC Topic 718”), for options granted to employees and directors, using the modified prospective transition method, and therefore have not restated results from prior periods. Compensation cost for all stock-based compensation awards granted is based on the grant date fair value estimated in accordance with the provisions of ASC Topic 718. Under the fair value recognition provisions of ASC Topic 718, we recognize stock-based compensation net of an estimated forfeiture rate and only recognize compensation cost for those shares expected to vest on a straight-line prorated basis over the requisite service period of the award. In March 2005, the SEC issued Staff Accounting Bulletin (“SAB”) No. 107, “Share-Based Payment” (“SAB No. 107”), regarding the SEC’s guidance on ASC Topic 718 and the valuation of share-based payments for public companies. We have applied the provisions of SAB No. 107 in the adoption of ASC Topic 718.

In July 2006, the Company’s stockholders approved the 2006 Stock Incentive Plan (the “2006 Plan”). The 2006 Plan provides for the grant of stock options, restricted stock awards, and performance shares to qualified employees, officers, directors, consultants and other service providers. The 2006 Plan originally authorized the Company to grant options and/or rights to purchase up to an aggregate of 1,500,000 shares of common stock.  As of March 31, 2011, a total of 376,095 common shares have been granted pursuant to the 2006 Plan to Company employees and consultants.

7.
Securities Purchase Agreement and Related Transaction

On January 31, 2008 (the “Closing Date”), the Company entered into a Securities Purchase Agreement (the “Purchase Agreement”) with certain accredited investors (the “Investors”), for the purchase and sale of units consisting of an aggregate of: (i) 2,500,000 shares of the Company’s common stock, and (ii) Class A Warrants to purchase 750,000 additional shares of the Company’s common stock exercisable at $12.50 per share, and expiring on December 21, 2013 (the “Class A Warrants”), for a purchase price of $10.00 per unit (the “Unit Purchase Price”), or gross offering proceeds of $25.0 million (the “2008 Offering”).  The Company received net proceeds of approximately $23.5 million in connection with the 2008 Offering.

The Class A Warrants represent the right to purchase an aggregate of 750,000 shares of common stock, at an exercise price of $12.50 per share. Additional information relating to the Class A Warrants is provided in Note 8.

 
16

 
China Sky One Medical, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)

8.
Outstanding Warrants and Options

The following table summarizes information about stock warrants outstanding and exercisable as of March 31, 2011:

         
Weighted
         
Weighted
 
         
average
         
average
 
   
Shares
   
Exercise
   
Shares
   
Exercise
 
   
Underlying
   
Price
   
underlying
   
Price
 
   
Warrants
   
Warrants
   
Options
   
Options
 
                         
Outstanding as of March 31, 2010
    593,800     $ 12.5       -     $ -  
                                 
Exercised
    -       -       -       -  
                                 
Outstanding as of December 31, 2010
    593,800     $ 12.5       -     $ -  
                                 
Exercised
    -       -       -       -  
                                 
Outstanding as of March 31, 2011
    593,800     $ 12.5       -     $ -  
 
The Class A Warrants represented the right to purchase an aggregate of 593,800 shares of Common Stock of the Company granted with the Securities Purchase Agreement, at an exercise price of $12.50 per share and with a weighted average remaining life of approximately 2.7 years, all were exercisable as of March 31, 2011, and have the following additional characteristics:

The Class A Warrants issued in our January 31, 2008 Offering described in Note 7 above, represent the right to purchase an aggregate of 750,000 shares of common stock, at an exercise price of $12.50 per share, and have the following additional characteristics:

 
The Class A Warrants became exercisable beginning on the six-month anniversary of the closing of the January 2008 Offering and were original set to expire on December 21, 2013. Because the Company did not meet its requirements to register the shares underlying the Class A Warrants on a timely basis, the expiration date of the Class A Warrants have been extended to December 21, 2013.

 
Commencing on one-year anniversary of the Closing Date, in the event the Warrant Shares may not be freely sold by the holders of the Class A Warrants due to the Company’s failure to satisfy its registration requirements, and an exemption for such sale is not otherwise available to the Warrant-holders under Rule 144, the Class A Warrants will be exercisable on a cashless basis.

 
The Exercise Price and number of Warrant Shares are subject to adjustment for standard dilutive events, such as dividends or distributions on the Company’s common stock paid in shares of common stock, reclassifications or reorganizations of the common stock, distributions of indebtedness or assets (other than cash) to all holders of the common stock, a merger or consolidation with another corporation in which the Company is not the survivor, or sale, transfer or other distribution of all or substantially all of the Company’s assets to another corporation to prevent dilution to the holders of the Class A Warrants as a result of such event.  The Exercise Price is also subject to adjustment on a weighted-average basis for issuance of common stock, or securities convertible into or exercisable for shares of common stock, at a price per share, or conversion or exercise price per share less than the Class A Warrant exercise price of $12.50 per share (a “Trigger Issuance”).  In the event of a Trigger Issuance, the then-existing Exercise Price shall be reduced, as of the close of business on the effective date of the Trigger Issuance, to a price determined as follows:

Adjusted Warrant Price =   (A x B) + D
A+C
  
where
 
“A” equals the number of shares of the Company’s common stock outstanding, including Additional Shares of Common Stock (as defined below) deemed to be issued hereunder, immediately preceding such Trigger Issuance;

“B” equals the Exercise Price in effect immediately preceding such Trigger Issuance;

“C” equals the number of Additional Shares of Common Stock issued or deemed issued hereunder as a result of the Trigger Issuance; and

“D” equals the aggregate consideration, if any, received or deemed to be received by the Company upon such Trigger Issuance;

Provided, however, that in no event shall the Exercise Price after giving effect to such Trigger Issuance be greater than the Warrant Price in effect prior to such Trigger Issuance.
 
 
17

 
China Sky One Medical, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
For purposes of hereof, “Additional Shares of Common Stock” shall mean all shares of common stock issued by the Company, or deemed to be issued in connection with a the Trigger Issuance, other than certain excluded issuances (as defined in the Class A Warrants).

Upon any adjustment to the Exercise Price for a standard anti-dilution adjustment (other than in the case of a dividend or distribution of indebtedness or assets (other than cash)), or for a below exercise price issuance, the number of Warrant Shares is adjusted to a number of shares obtained by multiplying the number of Warrant Shares immediately prior to such adjustment by a fraction, the numerator of which shall be the Exercise Price in effect immediately prior to such adjustment and the denominator of which shall be the Exercise Price in effect immediately after such adjustment.  On the Closing Date, the Company’s management assessed the Class A Warrants and concluded the Class A Warrants were indexed to the Company’s own stock and as such equity classification was proper pursuant to the scope exception in ASC 815-10-15-74 (formerly paragraph 11(a) of SFAS 133).  There was no issuance of securities during 2010 and 2009 which would have resulted in an adjustment to the Exercise Price or number of Warrant Shares.

In June 2008, the Emerging Issues Task Force issued EITF Consensus No. 07-5 “Determining Whether an Instrument (or Embedded Feature) is indexed to an Entity’s Own Stock”. Under EITF 07-5, instruments which contain full ratchet anti-dilution provisions will no longer be considered indexed to a company’s own stock for purposes of determining whether it meets the first part of the scope exception in paragraph 11 (a) of Statement 133. The adoption of this EITF required us to (1) evaluate our instrument’s contingent exercise provisions and (2) evaluate the instrument’s settlement provisions. Based upon applying this approach to instruments within the scope of this exception , we have determined that the Class A Warrants issued under our January 31, 2008 Private Placement which were classified in stockholders’ equity on December 31, 2008, no longer meet the definition of Indexed to a Company’s Own Stock provided in the Consensus. Accordingly effective on January 1, 2009, we were required to reclassify the Class A Warrants to liabilities under ASC 815-40 (formerly EITF 07-5). The adoption of this new guidance in 2009 had a material impact on our consolidated financial statements.
 
At March 31, 2011, the Company had 593,800 Class A Warrants outstanding. The Company used the Monte Carlo valuation model to estimate the fair value of the Class A Warrants.  Significant assumptions used at March 31, 2011 include a term of approximately 2.7 years; volatility of 70.0% and a risk free interest rate of 1.16%. The outstanding Class A Warrants at March 31, 2011 had a fair value of approximately $297,000. At March 31, 2011, the Company recorded income of $1,377,000 due to the change in fair value of the related derivative warrant liability for the three months ended March 31, 2011.

At March 31, 2010, the Company had 593,800 Class A Warrants outstanding. The Company used the Monte Carlo valuation model to estimate the fair value of the Class A Warrants.  Significant assumptions used at March 31, 2010 include a term of approximately 3.7 years; volatility of 74.0% and a risk free interest rate of 1.94%. The outstanding Class A Warrants at March 31, 2010 had a fair value of approximately $5,636,000. At March 31, 2010, the Company recorded income of $4,927,000 due to the change in fair value of the related derivative warrant liability for the three months ended March 31, 2010.

 
18

 
China Sky One Medical, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)

9.
Inventories

The Company values its inventories at the lower of cost and market method. Inventories are accounted for using the weighted-average method. Inventories include packing materials, raw materials, supplemental materials, work-in-process, and finished products.

As of March 31, 2011 and December 31, 2010, inventories consist of the following:
 
   
($ in thousands)
 
   
March 31, 2011
(Unaudited)
   
December 31, 2010
 
Raw Material
  $ 2,962     $ 1,044  
Work-in-Process
    597       647  
Finished Products
    3,030       718  
Total Inventories
  $ 6,589     $ 2,409  
 
The Company believes the inventory level at March 31, 2011 is sufficient to support its short term sales.

Historically, the Company’s inventory is at its lowest levels at the end of each calendar year and in the first fiscal quarter. The Company draws down its inventory levels in December of each year for two main reasons. First, the Company’s customers want to receive goods prior to the holiday season.  In addition, the first calendar quarter is traditionally the Company’s slowest sales period. Since a lower volume of sales activity normally occurs during the first quarter of each calendar year, the Company believes it is prudent to avoid incurring unnecessary inventory carrying costs. At the appropriate time toward the end of the first calendar quarter of each fiscal year, the Company begins to ramp up its inventory levels to prepare for increased demand during the coming stronger selling periods. The Company’s management increased inventory levels in the first quarter of 2011 in order to satisfy our future production needs, as well as to avoid possible future price increase of raw materials.

Management calculates the Company’s inventory turnover rate using total inventory rather than just finished goods, because its production cycle is of an extremely short duration. The inventory turnover rate is further discussed in the Liquidity section in the Management’s Discussion and Analysis.

10.
Property and Equipment, net

As of March 31, 2011 and December 31, 2010, Property and Equipment, net consist of the following:
   
($ in thousands)
 
   
March 31,
   
December 31,
 
   
2011 (Unaudited)
   
2010
 
Buildings and improvements
  $ 25,397     $ 25,185  
Machinery and equipment
    6,044       5,961  
Transportation equipment
    1,256       1,188  
Furniture and equipment
    398       392  
Total Property and Equipment
    33,095       32,726  
Less: Accumulated Depreciation
    (4,189 )     (3,766 )
Property and Equipment, Net
  $ 28,906     $ 28,960  

 
19

 
China Sky One Medical, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)

For the three months ended March 31, 2011 and 2010, depreciation expense totaled $390,000 and $254,000, respectively.

Depreciation expense included within Cost of Goods Sold for the three months ended March 31, 2011 and 2010 amounted to $127,000 and $104,000, respectively.

11.
Intangible Assets, net

Intangible assets consist of proprietary technologies that the Company purchased during its normal course of business. The SFDA licenses for drug batch numbers were acquired in connection with the Company’s business acquisitions of Tianlong and Peng Lai in 2008, as well as from Heilongjiang Traditional Chinese Medical University in the first quarter of 2011.

A breakdown of the Company’s intangible assets, net by subsidiaries as of March 31, 2011 is as follows:

   
Intangible Assets as of March 31, 2011, net
($ in thousands) (Unaudited)
 
Item
 
TDR
   
Haina
   
Tianlong
   
First
   
Peng Lai
   
Total
 
Proprietary Technologies
 
$
1,135
   
$
-
   
$
4,582
   
$
10,610
   
-
   
$
16,327
 
SFDA licenses for drug batch numbers
   
4,356*
     
-
     
1,552
     
-
     
3,969
     
9,877
 
Goodwill
   
424
     
369
     
-
     
-
     
-
     
793
 
Total
 
$
5,915
   
$
369
   
$
6,134
   
$
10,610
   
$
3,969
   
$
26,997
 

 
*
TDR acquired drug batch numbers from Heilongjiang Traditional Chinese Medical in the first quarter of 2011.

A breakdown of our intangible assets, net by subsidiaries as of December 31, 2010 is as follows:

   
Intangible Assets as of December 31, 2010, net
($ in thousands)
 
Item
 
TDR
   
Haina
   
Tianlong
   
First
   
Peng Lai
   
Total
 
Proprietary Technologies
 
$
1,163
   
$
-
   
$
4,676
   
$
10,869
   
-
   
$
16,708
 
SFDA licenses for drug batch numbers
   
-
     
-
     
1,594
     
-
     
4,067
     
5,661
 
Goodwill
   
420
     
366
     
-
     
-
     
-
     
786
 
Total
 
$
1,583
   
$
366
   
$
6,270
   
$
10,869
   
$
4,067
   
$
23,155
 

Historically, the Company included our proprietary technologies and SFDA licenses for drug batch numbers under the category of patents.  The Company now believes it is more accurate to categorize such intangible assets in separate categories.

As of March 31, 2011, the weighted average amortization period for the Company proprietary technologies and SFDA licenses for drug batch numbers is approximately 8 years.

Amortization expense of our intangible assets with finite lives and land use rights for each of the three months ended March 31, 2011 and 2010 was approximately $1,071,000 and $691,000, respectively.

 
20

 
China Sky One Medical, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)

12.
Taxes Payable

Taxes payable consists of the following:
 
   
($ in thousands)
 
   
March 31, 2011
       
   
(Unaudited)
   
December 31, 2010
 
Value Added Tax, net
  $ 1,207     $ 1,169  
Enterprise Income Tax
    1,929       1,886  
City Tax
    85       81  
Other Taxes and additions
    109       89  
Total Taxes Payable
  $ 3,330     $ 3,225  

13.
Income Taxes

Under the Provisional Regulations of PRC Concerning Income Tax on Enterprises promulgated by the PRC, income tax is payable by enterprises at a rate of 25% of their taxable income. Preferential tax treatment may, however, be granted pursuant to any law or regulations from time to time promulgated by the State Council.

According to “Enterprise Income Tax and Certain Preferential Policies Notice” published by the Ministry of Finance and the National Tax Affairs Bureau, if the enterprise is authorized by the State Council as a special entity, the enterprise income tax rate is reduced to 15%. The following table sets force the income tax rate for TDR and its subsidiaries for the three months ended March 31, 2011 and 2010:

  
 
As of March 31,
 
Income Tax
Rate
 
2011
   
2010
 
TDR
   
15
%
   
15
%
First
   
15
%
   
15
%
Tianlong
   
15
%
   
15
%
Haina
   
25
%
   
25
%
Peng Lai
 
2% of Revenue *
   
2% of Revenue
 

 
*
Reflects a 25% Tax rate on 8% of Peng Lai’s revenue, regardless of its taxable income. As authorized by Peng Lai Municipal Tax Bureau, Peng Lai was not required to pay tax on the remaining 92% of revenue regardless of its taxable income.

All the favorable tax rates for TDR, First, Tianlong and Peng Lai expired by the end of fiscal year 2010. The Company is currently seeking renewal of these favorable tax rates. The Company’s management is confident these favorable tax rates will be renewed. If the Company failed to obtain the favorable tax rates, the impact on the Company’s financial results for the three months ended March 31, 2011 would be immaterial.

The Company records a full valuation allowance to reduce the Company’s deferred tax assets to the amount that is more likely than not to be realized. While the Company has considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event the Company were to determine that it would be able to realize the Company’s deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made.

Pursuant to Sections 382 and 383 of the Internal Revenue Code (“IRC”), annual use of the Company’s net operating losses and tax credit carryforwards may be limited because of cumulative changes in ownership of more than 50% that have occurred. Net operating loss (“NOL”) carryforwards only apply to the Company’s U.S. holding companies because they incurred certain general and administrative expenses without generating any revenue and, therefore, incurred operating losses. In the first quarter of 2011, the $1,185,000 of income before income tax in U.S. holding companies includes a gain of $1,377,000 from the change in fair value of its derivative warrant liability. Management’s position is that it is more likely than not that any future tax benefits from the U.S. holding companies will not be realized, and, as such, a full valuation allowance has been recorded.

 
21

 
China Sky One Medical, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
Therefore, the Company has established a full valuation allowance for the NOL carryforwards incurred by the U.S. holding companies. Provision for the PRC enterprise income tax is calculated at the prevailing rate based on the estimated assessable profits less available tax relief for losses brought forward. The Company does not accrue taxes on unremitted earnings from foreign operations as it is the Company’s intention to invest these earnings in the foreign operations indefinitely.

The Company’s effective tax rate was approximately 23.9% and 16.5% for the three month ended March 31, 2011 and 2010, respectively. A reconciliation of the statutory tax provision to the Company’s tax provision for the three months ended March 31, 2011 and 2010 is as follows:

   
($ in thousands) (Unaudited)
 
   
Three Months Ended March 31, 2011
 
   
China
   
U.S.
   
Total
 
Income before income taxes
  $ 6,859     $ 1,185     $ 8,044  
Statutory tax rate
    25 %     34 %        
Expected statutory income tax expense (benefit)
    1,715       403       2,118  
Tax rate changes – Special Entity
    206       -       206  
Change in valuation allowance
    -       (403 )     (403 )
Income tax expense
  $ 1,921     $ -     $ 1,921  
Effective tax rate
    28.0 %     -       23.9 %

   
($ in thousands) (Unaudited)
 
   
Three Months Ended March 31, 2010
 
   
China
   
U.S.
   
Total
 
Income before income taxes
  $ 10,600     $ 4,500     $ 15,100  
Statutory tax rate
    25 %     34 %        
Expected statutory income tax expense (benefit)
    2,700       1,500       4,200  
Tax rate changes – Special Entity
    (200 )     -       (200 )
Change in valuation allowance
    -       (1,500 )     (1,500 )
Income tax expense
  $ 2,500     $ -     $ 2,500  
Effective tax rate
    23.6 %     -       16.6 %

14.
Land Use Rights and Construction in Progress

The Company considers the fact that, in the PRC, there is no land ownership but rather land use right and it is more appropriate to allocate land use rights under a separate category and amortize land use rights based on 50 years of the land use rights, or the term of the lease. Land use rights, net, are approximately $40,860,000 and $40,844,000 at March 31, 2011 and December 31, 2010, respectively.

During the second quarter of 2010, TDR submitted a bid deposit of approximately $7.3 million to Harbin High Technology Development Zone to participate in an auction for a parcel of land of approximately 85,000 square meters in the “Scientific and Technological Innovation City” in Harbin. The auction is set to take place during the second quarter of 2011. If the TDR’s bid is accepted, the Company plans to build a facility for the research and development and production of the Company’s bio-engineering projects. If TDR’s bid is not accepted, the deposit will be returned to TDR.

 
22

 
China Sky One Medical, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
On December 21, 2010, TDR entered into an agreement with Heilongjiang Tang Wang He Forest Bureau that gives the Company the right to grow and harvest herbs, among other plants, on approximately 74,000 acres of forested land in the Xiao Xing'an Mountain region for 30 years, commencing December 21, 2010. As part of the transaction, the Company paid upfront approximately $36 million (RMB 240 million) in cash. During the second quarter in 2007, TDR entered into an agreement with the Development and Construction Administration Committee of Harbin Song Bei New Development district to purchase land use rights for 50 years for the development of a new corporate headquarters with a biotech engineering lab (the “Corporate Headquarters”). In fiscal 2010, the Company completed construction of the Corporate Headquarters and began occupancy. The Corporate Headquarters was constructed at a cost of approximately $13.0 million.

15.
Commitments and Contingencies

The formulation, manufacturing, processing, packaging, labeling, advertising, distribution and sale of external use Chinese medicine such as those sold by the Company are subject to regulations by one or more federal agencies. The principal federal agencies include the State Food and Drug Administration of the Government of the Peoples Republic of China, the Food and Drug Administration (the “FDA”), Heilongjiang Provincial Food and Drug Administration (“PFDA”) of the People's Republic of China, National Biology Products Inspection Institute (“NBPI”) and the National Food and Drug Administration (“NFDA”) of the People's Republic of China and, to a lesser extent, the Consumer Product Safety Commission. These activities are also regulated by various governmental agencies for the countries, states and localities in which the Company’s products are sold.

Although management believes that the Company is in material compliance with the statutes, laws, rules and regulations of every jurisdiction in which it operates, no assurance can be given that the Company’s compliance with the applicable statutes, laws, rules and regulations will not be challenged by governing authorities or private parties, or that such challenges will not have a material adverse effect on the Company’s financial position, results of operations, or cash flows.

The Company, like any other distributor or manufacturer of products is exposed to the inherent risk of product liability claims in the events of possible injuries caused by the use of its products. The Company does not have liability insurance with respect to product liability claims; the insurance environment of China is neither sufficient nor mature. Inadequate insurance or lack of contractual indemnification from parties supplying raw materials or marketing its products, and product liabilities related to defective products could have a material adverse effect on the Company’s consolidated financial position, results of operations and cash flows.

The Company is not involved in any legal matters arising in the normal course of business. While incapable of estimation, in the opinion of the management, the individual regulatory and legal matters in which the Company might be involved in the future are not expected to have a material adverse effect on the Company’s consolidated financial position, results of operations, or cash flows.

On September 4, 2009, the SEC issued a formal order of investigation relating to, among other things, certain of our accounting, record-keeping and disclosure practices.  Between that time and the present, we have received document and testimonial subpoenas from the SEC. We have complied, and intend to continue to comply, with all such subpoenas.

 
23

 

Item 2.
  Management’s Discussion and Analysis of Financial Condition and Results of Operations.

FORWARD LOOKING STATEMENTS

The following discussion should be read in conjunction with the information contained in our consolidated financial statements and the notes thereto appearing elsewhere herein and in the risk factors and “Forward Looking Statements” summary set forth in the forepart of this Annual Report as well as the “Risk Factors” section above and are afforded the safe harbor provisions of Section 27A of the Securities Act and Section 21E of the Securities Exchange Act of 1934, as amended. Readers should carefully review the risk factors disclosed in this Annual Report and other documents filed by us with the SEC.

DISCUSSION

General

We are engaged, through our China-based indirect subsidiaries described below, in the development, manufacture, marketing and sale of over-the-counter, branded nutritional supplements and over-the-counter plant and herb-based pharmaceutical and medicinal products. Our principal products are external use TCMs. We have evolved into an integrated manufacturer, marketer and distributor of external-use TCM products sold primarily in the PRC and through Chinese domestic pharmaceutical chains. All of our business is conducted through our wholly-owned subsidiary, ACPG which, in turn, wholly owns Harbin TDR, and TDR’s subsidiaries.

For the three months ended March 31, 2011, total revenues was $28,365,000, compared to $28,903,000 for the three months ended March 31, 2010. Our revenues were flat primarily due in part to the termination of two major customer relationships (one domestic distributor and one overseas agent) in the third quarter of 2010. Revenues generated from these two customers in the first quarter of 2010 were approximately $6,305,000 or 21.8% of our total revenues for the three months ended March 31, 2010. Efforts are ongoing to find other distributors to replace the loss of these two key customers.  The table below summarizes the revenues generated from these two distributors in the first quarter of 2010:
 
  
 
Revenues generated from the two distributors
for the three months ended March 31, 2010
 
Product Category
 
($ in thousands)
 
   
Domestic
   
Overseas
 
Ointments
  $ 1,613     $ -  
Patches
    2,350       322  
Wash fluids
    603       -  
Sprays
    65       -  
Diagnostic Kits
    1,352       -  
                 
Total
  $ 5,983     $ 322  
 
Our net income was $6,123,000, or $0.36 per share for the three months ended March 31, 2011, compared to net income of $12,589,000, or $0.74 per share in the same period of 2010, as calculated on a diluted basis.  Excluding the non cash change in fair value of our derivative warrant liability (the change in fair value of our derivative warrant liability was $1,377,000 and $4,927,000 for the three months ended March 31, 2011 and 2010, respectively), the Company realized net income of $4,746,000, or $0.28 per share for the three months ended March 31, 2011, compared to net income of $7,662,000, or $0.45 per share in the same period of 2010, as calculated on a diluted basis.

 
24

 
 
Product Line

During the three months ended March 31, 2011, we manufactured and marketed 117 products, compared to 89 products for the three months ended March 31, 2010. Our manufacturing operations are conducted at our subsidiaries’ facilities located in Heilongjiang Province and Shan Dong Province in the PRC. We sell our products under eight main categories:
 
Product Category
 
2011
   
2010
 
Ointments
    25       18  
Patches 
    5       5  
Wash Fluids
    9       9  
Sprays
    14       15  
Drops
    10       4  
Diagnostic Kits
    4       3  
Suppositories
    16       14  
Others
    34       21  
Total:
    117       89  

Below are our ten highest revenue generating products for the three months ended March 31, 2011, which accounted for 53.8% of our sales revenue in that period.
 
Ointment Category:
 
 Compound Camphor Cream

This product is used for the treatment of various pathogens on the skin surface and subcutaneously, such as mycete, trichopytic, staphylococcal bacteria aureus, bacillus coli, and candida albicans (also known as thrush).

Hemorrhoids Ointment

This product contains Acetate, Radix Notoginseng, and Rhizoma Coptidis.  It is made in soft ointment form and is effective in sterilizing and relieving hemorrhoid symptoms, including itching, distending pain, burning, and bleeding.

Patch Category:

Sumei Slim Patch

The Sumei Slim Patch is marketed and sold within and outside the PRC as a more natural treatment for weight loss.  The Sumei Slim Patch uses Saponin as its major ingredient, and is effective in regulating and restraining the excessive secretion of certain hormones, while promoting others to foster weight loss as well as prevent weight gain.

Pain Relief Patch

A pain relief patch is designed to be applied to the area of the neck, shoulder, and waist.  The patch is used for a number of ailments, including fever, headache, heart dysentery, diarrhea, and stiffness and pain caused by hypertension.

 
25

 
 
Anti-Hypertension Patch

The anti-hypertension patch is based on five thousand years of Chinese herbal vein therapy that has been adapted to a modern transdermal therapeutic system (“TTS”).  The product utilizes a Body-Yong-Guan point technique, which is believed to maximize the effectiveness of the medicinal ingredients.  The product is believed to stimulate blood capillaries and to be effective in improving circulation and reducing blood pressure.

Wash Fluids Category:

Metronidazole and Chlorhexidine Washing Fluid

This is an anti- pathogenic bacteria fluid for the treatment of vaginal inflammation.

Spray Category:

Stomatitis Spray

This spray is used for the treatment of dental ulcers, pharyngitis, and faucitis.  It is made with pure herbal medicines and, thus, has minimum side effects.

Drops Category:

Naphazoline Hydrochloride Eye Drops

Naphazoline Hydrochloride Eye Drops are recommended for the temporary relief of eye redness associated with minor irritations.  This product can comfort the eyes by lubricating them and relieving irritations.

Diagnostic Kit Category:

Cardiac Arrest Early Examination Kit

This product is used for early stage diagnosis of myocardial infarction (heart attacks).

 Other Product Category:

We include 34 of our products under the “Other” product category. There is no single product or category of products within the Other product category that represented 10% or more of our revenues in the three month period ended March 31, 2011. The Other product category includes tablets, liniments, syrups, capsules, granules, injections, aerosols and oral liquids.

Naftopidil Dispersible Tablet

This tablet is designed to treat benign enlargement of the prostate among middle aged males.  It is effective in its treatment because its ingredients can be easily digested and absorbed by the human body.

Please refer to “Sales by Product Line” hereunder for additional information.

Summary of Our Research and Development Activities

Research and Development

We conduct all of our research and development (“R&D”) activities either internally or through collaborative arrangements with universities and research institutions in the PRC. We have our own research, development and laboratory facilities located in the facilities of First and Tianlong.

 
26

 
 
For the three months ended March 31, 2011, total research and development expense was approximately $4,112,000. The major research and development projects that accounted for the majority of our total research and development expense are as follows:

Major Research and Development Expenses during the Three Months Ended March 31, 2011
 
(Unaudited)
 
($ in thousands)
 
                 
Aggregate
 
Estimated
 
                 
Expense Since
 
Additional Cost
 
             
% of total
 
Commencement
 
to Complete
 
Projects
 
Stage
 
Expense
   
R&D
 
of Project
 
Research
 
Antroquinonol
 
Clinical trial
  $ 1,990       48.4     $ 3,233     $ 14,003  
Endostatin
 
Clinical trial
    729       17.7       3,378       8,263  
Injections
 
Lab research and clinical trial
    653       15.9       7,506       2,023  
Diagnostic Kits
 
Lab research, clinical trial and application
    554       13.5       10,558       223  
Breast Cancer Technology
 
Clinical trial
    182       4.4       4,145       6,924  
Total
      $ 4,108       99.9     $ 28,820     $ 31,436  

For the three months ended March 31, 2010, total research and development expense was approximately $3,764,000. The major research and development projects that accounted for the majority of our total research and development expense are as follows:

Major Research and Development Expenses during the Three Months Ended March 31, 2010
 
(Unaudited)
 
($ in thousands)
 
                 
Aggregate
 
Estimated
 
                 
Expense Since
 
Additional Cost
 
             
% of total
 
Commencement
 
to Complete
 
Projects
 
Stage
 
Expense
   
R&D
 
of Project
 
Research
 
Diagnostic Kits
 
Clinical trial
  $ 488       13     $ 3,218     $ 300  
Breast Cancer Technology
 
Clinical trial
    497       13.2       2,767       8,300  
Clindamycin Phosphate for Injection
 
Clinical trial
    424       11.3       475       1,000  
Levofloxacin Hydrochloride Eye Drops
 
Clinical trial
    410       10.9       450       500  
Nimesulide Granules
 
Clinical trial
    439       11.7       455       800  
Optimization Experiments for Three Products
 
Efficacy testing
    622       16.5       780       1,500  
Total
      $ 2,880       76.6     $ 8,145     $ 12,400  
 
 
27

 
 
Historically, research and development expense fluctuates during each quarter. In general, different projects have different requirements and time spans associated with different costs and different payment terms. Some main factors for the R&D expense fluctuation are listed as the following:

 
Each project will go through multi stages before being submitted to the SFDA.

 
Different drugs require different amounts of testing samples or trials which will result in different time spans for the testing and approval process.

 
R&D expense is incurred at different stages of the process based on our agreements with the applicable third party (qualified hospitals or professional research institutions).

 
Since different drugs require different stages of process or different amount of samples to be collected, the same R&D stage for different drugs result in different time spans and different expenses.

 
In some cases, after we submit the completed document to the SFDA, we may be required to supply additional testing or documents, which will result in a longer time span and increased expense.

 
For the R&D projects that are conducted internally, we only record the related personnel and material costs.

Significant Accounting Estimates and Policies

The discussion and analysis of our financial condition and results of operations is based upon our financial statements which have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities. On an on-going basis, we evaluate our methodologies and assumptions used to derive these estimates. We base our estimates on historical experience and on other assumptions that we believes to be reasonable under the circumstances, the results of which form our basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates. Our significant estimates include the following:

Impairment - Long-lived assets are evaluated for impairment whenever indicators of impairment exist. Accounting standards require that if an impairment indicator is present, we must assess whether the carrying amount of the asset is unrecoverable by estimating the sum of the future cash flows expected to result from the asset, undiscounted and without interest charges. If the recoverable amount is less than the carrying amount, an impairment charge must be recognized based on the fair value of the asset.

Income taxes - As part of the process of preparing our financial statements, we are required to estimate our income taxes. This process involves estimating our current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities. We have deemed our temporary tax differences related to our principal business operations in the PRC to be immaterial. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income, and, to the extent we believe that recovery is not likely, we must establish a valuation allowance. To the extent that we establish a valuation allowance or increase this allowance in a period, we must include a tax provision or reduce our tax benefit in the statements of operations. We use our judgment to determine our provision or benefit for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. We believe, based on a number of factors including the continued historical operating losses of China Sky and ACPG, that we will not realize the future benefits of a significant portion of our net deferred tax assets and we have accordingly provided a full valuation allowance against our deferred tax assets. China Sky and ACPG do not generate revenues and were established as the Holding Companies of our foreign operations. Management has no intention to remit to either China Sky or ACPG any undistributed earnings of business operations in China. However, various factors may cause those assumptions to change in the near term.

 
28

 
 
We cannot predict what future laws and regulations might be passed that could have a material effect on our results of operations. We assess the impact of significant changes in laws and regulations on a regular basis and update the assumptions and estimates used to prepare our financial statements when we deem it necessary.

We review our accounting policies on a periodic basis to ensure compliance with GAAP. Our most significant accounting policies are those related to intangible assets and research and development.

Derivative warrant liability– The Class A Warrants (“the Warrants”) issued in connection with our January 31, 2008 private placement include a reset provision which would be triggered if we issue common shares below the exercise price of $12.50 as defined in the Warrant. Effective January 1, 2009 the reset provision of these warrants preclude equity accounting treatment under ASC 815 (formerly EITF 07-5). Accordingly, ASC 815-40 which was effective as of January 1, 2009, has been applied resulting in a reclassification of the warrants as a derivative liability, measured at fair value, with changes in fair value recognized as part of other income or expense for each reporting period thereafter. We used the Monte Carlo valuation model to estimate the fair value of the Warrants. Significant assumptions used at March 31, 2011 include a term of approximately 2.7 years; volatility of 70.0% and a risk free interest rate of 1.16%. Significant assumptions used at March 31, 2010 include a term of approximately 3.7 years; volatility of 74.0% and a risk free interest rate of 1.94%. The outstanding Warrants at March 31, 2011 and 2010 had a fair value of approximately $297,000 and $5,636,000, respectively. Due to the change in fair value of derivative warrant liability the Company realized income of $1,377,000 and $4,927,000 for the three months ended March 31, 2011 and 2010, respectively.
 
Intangible assets –Our intangible assets consists of proprietary technologies, SFDA licenses for drug batch numbers, and goodwill. Proprietary technologies are technologies that we own. The SFDA licenses for drug batch numbers were acquired in connection with the Company’s business acquisitions of Tianlong and Peng Lai in 2008, as well as from Heilongjiang Traditional Chinese Medical University in the first quarter of 2011. We have registered “Kang Xi” as our trademark, which is used for all of the Company’s Tradition Chinese Medicine (“TCM”) products. The “Kang Xi” trademark was developed internally and registered by TDR before the Company became a public company. The Company’s cost basis in the trademark is nominal. Therefore, the Company did not have its “Kang Xi” trademark appraised, or recorded an intangible asset for it. Additionally, none of the costs associated with the trademark have been capitalized.
 
Intangible assets with finite useful lives are amortized while intangible assets with indefinite useful lives are not amortized. Goodwill and intangible assets are tested periodically for impairment. Accordingly, the Company reviews its long-lived assets, including property and equipment and finite-lived intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be fully recoverable. To determine recoverability of its long-lived assets, we evaluate the probability that future undiscounted net cash flows will be less than the carrying amount of the assets. Impairment costs, if any, are measured by comparing the carrying amount of the related assets to their fair value. The Company did not record any impairment charges related to its tangible and intangible assets held during the three months ended March 31, 2011 and 2010. As of March 31, 2011, the weighted average amortization period of our intangible assets approximated 8 years.

 
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Research and development - Research and development expenses include the costs associated with the Company’s internal research and development as well as research and development conducted by third parties. These costs primarily consist of salaries, clinical trials, outside consultants, and materials. All research and development costs are expensed as incurred.
 
Third-party expenses reimbursed under non-refundable research and development contracts are recorded as a reduction to research and development expense in the consolidated statement of operations.

Assets to be used in research and development activities, specifically, compounds that have yet to receive new drug approval and would have no alternative use, should approval not be given, are immediately charged to expense when acquired. Certain assets and high technologies acquired that has a foreseeable future cash flows are capitalized as intangible assets. Such intangible assets are amortized starting from the year revenue is generated and amortized over its estimated life. If a capitalized intangible asset is deemed to have no future benefit, the unamortized carrying value will be expensed.

The Company incurred research and development expenses of approximately $4,112,000 and $3,764,000, for the three months ended March, 2011 and 2010, respectively.

Trends and Uncertainties

In 2008, general worldwide economic conditions declined due to sequential effects of the sub-prime lending crisis, general credit market crisis, collateral effects on the finance and banking industries, concerns about inflation, slower economic activity, decreased consumer confidence, reduced corporate profits and capital spending, adverse business conditions and liquidity concerns. However, since all of our business operations, and most of our sales, are currently conducted in the PRC, we have not been greatly affected by the economic downtown. We cannot predict the timing or duration of any economic slowdown or recession or the timing or strength of a subsequent recovery, worldwide, or in the specific markets we serve. If the markets for our products significantly deteriorate due to these economic effects, our business, financial condition and results of operations may be materially and adversely affected.

We have benefited from the overall economic development in the PRC in recent years and the increase in the number of elderly people in China, which together have resulted in increased expenditures on medicine in the PRC, including TCMs. A slowdown in overall economic growth, an economic downturn or recession or other adverse economic developments in the PRC may materially reduce the demand for our products and materially and adversely affect our business.

During the third quarter of 2010, a domestic distributor and an overseas sales agent terminated their business relationship with us. These two customers accounted for an aggregate of 10%, 21% and 18% of our total revenues for the years 2010, 2009 and 2008, respectively. We are seeking to replace these customers with new relationships over time.

Due to our forecasts for certain cost increases of raw materials, we began to increase our inventory levels toward the second half of 2009. We anticipate vendor price increases of certain raw materials in the future, which may negatively affect our gross margin.

 On December 21, 2010, we entered into an agreement with Heilongjiang Tang Wang He Forest Bureau that gives the Company the right to grow and harvest herbs, among other plants, on approximately 74,000 acres of forested land in the Xiao Xing'an Mountain region commencing December 21, 2010. We believe this arrangement provides our TCM business with a hedge against fluctuations in raw material prices. We plan to evaluate the land in the second quarter of 2011, and develop a strategic plan for its development. Amortization expense recorded on these land use rights approximated $304,000 and is recorded as part of operating costs for the three months ended March 31, 2011.

 
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During the second quarter of 2010, TDR submitted a bid deposit of approximately $7.3 million to Harbin High Technology Development Zone to participate in an auction for a parcel of land of approximately 85,000 square meters in the “Scientific and Technological Innovation City” in Harbin. The auction is set to take place during the second quarter of 2011. If the TDR’s bid is accepted, the Company plans to build a facility for the research and development and production of the Company’s bio-engineering projects. If TDR’s bid is not accepted, the deposit will be returned to TDR.

Results of Operations

For the three months ended March 31, 2011 and 2010

Revenue, Cost of Goods Sold Gross Profit and Gross Profit Margin

The following table sets forth our revenues, cost of goods sold, gross profit and gross profit margin during the three months ended March 31, 2011 and 2010:

 
For the Three Months Ended March 31,
 
 
($ in thousands) (Unaudited)
 
 
2011
 
2010
   
Variance
 
Revenues
  $ 28,365     $ 28,903       -1.9 %
Cost of Goods Sold
    9,064       7,275       24.6 %
Gross Profit
  $ 19,301     $ 21,628       -10.8 %
Gross Profit Margin
    68.0 %     74.8 %     -6.8 %

For the three months ended March 31, 2011, total revenues decreased by approximately $538,000, or 1.9%, as compared to the same period of 2010. This decrease is primarily due to the decline in sales of our Patches and Ointments product categories primarily due to the loss of a domestic distributor and an overseas sales agent in the third quarter of 2010, and is partially offset by the increased revenue from the sales of our Wash Fluids and Others products categories. Another contributing factor was our sales and marketing strategy to promote certain of our products which have less market competition by coordinating with distributors who have extensive market channels. These distributors seek lower sales prices, which has had and will continue to have a negative impact on our overall gross product margins.

Cost of goods sold for the three months ended March 31, 2011 increased by 24.6% compared to the comparable period in 2010. Gross profit margin decreased from 74.8% for the three months ended March 31, 2010 to 68.0% for the three months ended March 31, 2011. Our gross profit margin at December 31, 2010 and 2009 was 72.9% and 75.7%, respectively. The higher cost of goods sold and lower gross profit margin was primarily due to increases in the price of certain raw materials we use to produce our products. On December 21, 2010, we entered into an agreement with Heilongjiang Tang Wang He Forest Bureau that gives us the right to grow and harvest herbs, among other plants, on approximately 74,000 acres of forested land in the Xiao Xing'an Mountain region commencing December 21, 2010. We believe this arrangement provides our TCM business with a hedge against fluctuations in raw material prices. We plan to evaluate the land in the second quarter of 2011, and develop a strategic plan for its development.

Sales by Product Line

We believe that the most meaningful presentation of our products is by categories of method of delivery. The following table sets forth our principal product categories based on application type, and the approximate amount and percentage of revenue from each of such product categories, during each of the three months ended March 31, 2011 and 2010:

 
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For the Three Months Ended March 31,
 
($ in thousands) (Unaudited)
 
 
2011
 
2010
 
Variance
 
                         
 
Sales
   
% of Sales
 
Sales
   
% of Sales
     
Product Category
                                       
Ointments
  $ 6,669       23.5 %   $ 7,805       27.0 %   $ (1,136 )
Patches
    4,771       16.8 %     8,218       28.4 %     (3,447 )
Wash Fluids
    2,707       9.5 %     883       3.1 %     1,824  
Sprays
    2,541       9.0 %     2,999       10.4 %     (458 )
Drops
    2,269       8.0 %     1,809       6.3 %     460  
Diagnostic Kits
    1,935       6.8 %     1,460       5.1 %     475  
Suppositories
    1,933       6.8 %     1,208       4.2 %     725  
Others
    5,540       19.6 %     4,521       15.5 %     1,019  
Total
  $ 28,365       100 %   $ 28,903       100 %   $ (538 )

During the three months ended March 31, 2011, we manufactured and marketed 117 products, compared to 89 products for the three months ended March 31, 2010.

For the three months ended March 31, 2011, revenues from our Ointments decreased by $1,136,000, or 14.6%, as compared to the same period of 2010. The decrease was primarily due to the decreased sales of our Hemorrhoids Ointment. Revenue generated from our Hemorrhoids Ointment was $848,000 and $2,349,000 for the three months ended March 31, 2011 and 2010, respectively. The decrease was due to the SFDA’s enforcement of new regulations on the advertisement of certain medicinal products, which negatively impacted our distributors’ sales. The decrease was partially offset by sales of the 7 new ointment products we launched after the first quarter of 2010. These 7 new ointment products contributed approximately $296,000 for the three months ended March 31, 2011.
 
For the three months ended March 31, 2011, revenues from our Patch products decreased $3,447,000, or 41.9%, as compared to the same period of 2010. The decrease was primarily due to the decreased revenue generated from our Pain Relief Patch and Asthma Patch products. The revenue generated from these two patch products was $2,281,000 and $5,321,000 for the three months ended March 31, 2011 and 2010, respectively. The primary reason for this decrease was our switch to new distributors after one of our key distributors terminated its business relationship with us during the third quarter of 2010.
 
For the three months ended March 31, 2011, revenues from our Wash Fluids products increased by $1,824,000, or 206.6%, as compared to the same period of 2010. The increase was primarily due to the increased sales from our Metronidazole and Chlorhexidine Wash Fluids, and several other Wash Fluids products. Revenue generated from our Metronidazole and Chlorhexidine Wash Fluids increased to $1,408,000 for the three months ended March 31, 2011, compared with $220,000 for the three months ended March 31, 2010, primarily due to the hiring of a new distributor we engaged in the second quarter of 2010.
 
For the three months ended March 31, 2011, revenues from Spray products decreased $458,000, or 15.3%, as compared to the same period of 2010. The decrease was primarily due to the decreased revenue generated from our YinKe Spray, JieYin Spray, and several other spray products.
 
For the three months ended March 31, 2011, revenues from our Drops products increased by $460,000, or 25.4%, as compared to the same period of 2010, primarily due to increased revenues from the sale of the six additional Drops products we launched after the first quarter of 2010. Revenues generated from the six additional Drops products were $474,000 for the three months ended March 31, 2011.

 
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For the three months ended March 31, 2011, revenue generated from our Diagnostic Kits increased by $475,000, or 32.5%, as compared to the same period of 2010. This increase was primarily due to the increased sales from our Cardiac Arrest Early Examination Kits distributor. The revenue generated from our Cardiac Arrest Early Examination Kits was $1,071,000 and $868,000 for the three months ended March 31, 2011 and 2010, respectively.

            For the three months ended March 31, 2011, revenues from our Suppositories products increased by $725,000, or 60.0%, as compared to the same period of 2010, primarily due to the increased sales of our existing products and two additional products launched after the first quarter of 2010. Our existing products contributed an additional $509,000 of revenues for the three months ended March 31, 2011, compared to the same period last year, primarily due to our promotional efforts. Our new Suppositories products contributed revenues of $216,000 for the three months ended March 31, 2011.

              For the three months ended March 31, 2011, revenues from our Other products category increased by $1,019,000, or 22.5% as compared to the same period of 2010, primarily due to increased revenues from the sale of the thirteen additional products we launched after the first quarter of 2010. Revenues generated from the thirteen additional products were $1,481,000 for the three months ended March 31, 2011, which more than offset a $388,000 decrease in same product sales.

Operating Expenses

The following table summarizes the changes in our operating expenses for the three months ended March 31, 2011 and 2010:

    For the Three Months Ended March 31,  
    ($ in thousands) (Unaudited)  
Operating Expenses
 
2011
   
2010
   
Variance
 
Selling expense
  $ 6,300     $ 5,911       6.6 %
General and administrative expense
    920       990       -7.1 %
Depreciation and amortization
    1334       841       58.6 %
Research and development
    4,112       3,764       9.2 %
Total operating expenses
    12,666       11,506       10.1 %
Total revenue
  $ 28,365     $ 28,903       -1.9 %
% of operating expenses to revenue
    44.7 %     39.8 %     4.9 %

 For the three months ended March 31, 2011, selling expense increased by approximately $389,000, or 6.6%, as compared to the same period of 2010. The increase was primarily due to increased advertising spending and promotional fees which aggregated $2,994,000 and $2,686,000 for each of the three months ended March 31, 2011 and 2010, respectively.

For the three months ended March 31, 2011, general and administrative expense decreased by approximately $70,000, or 7.1%, as compared to the same period of 2010. The decrease was primarily due to the implementation of certain cost saving initiatives by management.

For the three months ended March 31, 2011, depreciation and amortization expense increased by approximately $493,000, or 58.6%, as compared to the same period of 2010. The increase was primarily due to the full year effect related to the amortization and depreciation of a higher level of long-lived tangible and intangible assets. The net carrying value of our tangible and intangible assets approximated $93.0 million and $45.0 million as of December 31, 2010 and December 31, 2009, respectively.

 
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For the three months ended March 31, 2011, research and development expense increased by approximately $348,000, or 9.2%, as compared to the same period of 2010. The major research and development projects that accounted for the majority of our total research and development expense are listed as follows:
 
Major Research and Development Expenses during the Three Months Ended March 31, 2011
 
($ in thousands) (Unaudited)
 
               
Aggregate
   
Estimated
 
               
Expense Since
   
Additional Cost
 
          % of total    
Commencement
   
to Complete
 
Projects
 
Expense
    R&D    
of Project
   
Research
 
Antroquinonol
  $ 1,990       48.4 %   $ 3,233     $ 14,003  
Endostatin
    729       17.7 %     3,378       8,263  
Injections
    653       15.9 %     7,506       2,023  
Diagnostic Kits
    554       13.5 %     10,558       223  
Breast Cancer Technology
    182       4.4 %     4,145       6,924  
                                 
Total
  $ 4,108       99.9 %   $ 28,820     $ 31,436  

For the three months ended March 31, 2010, total research and development expense was approximately $3,764,000. The major research and development projects that accounted for the majority of our total research and development expense are listed as follows:

Major Research and Development Expenses during the Three Months Ended March 31, 2010
 
($ in thousands) (Unaudited)
 
             
Aggregate
 
Estimated
 
             
Expense Since
 
Additional Cost
 
          % of total  
Commencement
 
to Complete
 
Projects
 
Expense
    R&D  
of Project
 
Research
 
Diagnostic Kits
  $ 488       13     $ 3,218     $ 300  
Breast Cancer Technology
    497       13.2       2,767       8,300  
Clindamycin Phosphate for Injection
    424       11.3       475       1,000  
Levofloxacin Hydrochloride Eye Drops
    410       10.9       450       500  
Nimesulide Granules
    439       11.7       455       800  
Optimization Experiments for Three Products
    622       16.5       780       1,500  
Total
  $ 2,880       76.6     $ 8,145     $ 12,400  

 
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Other Income

For the three months ended March 31, 2011, we recorded an unrealized gain of $1,377,000 due to the change in fair value of our outstanding derivative warrant liability. For the three months ended March 31, 2010, we recorded an unrealized gain of $4,927,000 due to the change in fair value of our outstanding derivative warrant liability. The derivative warrant liability relates to our issuance of 750,000 common stock purchase warrants with anti-dilution protection in connection with our January 31, 2008 private placement. As of each of March 31, 2011 and 2010, warrants to purchase 593,800 shares remained issued and outstanding.

Liquidity and Capital Resources

The following table summarizes our cash and cash equivalents position, our working capital, and our cash flow activity as of March 31, 2011 and 2010:

   
As of March 31,
 
   
($ in thousands, except ratio and days)
(Unaudited)
 
   
2011
   
2010
 
Cash and cash equivalents
  $ 48,058     $ 65,399  
Current ratio
    6.9       5.8  
Quick ratio
    6.3       5.6  
Average accounts receivable turnover days
    58.3       61.9  
Average inventory turnover days
    44.7       28.6  
Working capital
  $ 61,024     $ 71,327  
 Inventories
  $ 6,589     $ 2,223  
                 
Cash provided by (used in):
               
Operating activities
  $ 9,043     $ 12,616  
Investing activities
  $ (4,501 )   $ (77 )
Financing activities
  $ -     $ 94  

As of March 31, 2011, our cash and cash equivalents were approximately $48,058,000, as compared to $65,399,000 at March 31, 2010. We had working capital at March 31, 2011 of approximately $61,024,000, compared to $71,327,000 at March 31, 2010. We consider current working capital and borrowing capabilities adequate to cover our current operating and capital requirements for the full year 2011. A summary of our cash flows from operating activities, investing activities and finance activities are summarized as follows:

Cash flows provided by operating activities were approximately $9,043,000 for the three months ended March 31, 2011, compared to $12,616,000 in the same period of 2010. The decrease in cash provided by operating activities of approximately $3,573,000 is primarily due to the following reasons: (i) our net income, less non-cash gains from revaluation of warrant liabilities plus the add-back of depreciation and amortization, was $6,207,000, compared to $8,606,000 in the three months ended March 31, 2011 and 2010, respectively, and (ii) we increased our inventory level in the three months ended March 31, 2011.

Cash flows used in investing activities were approximately $4,501,000 for the three months ended March 31, 2011, compared to $77,000 in the same period of 2010. Cash flows used in investing activities in 2011 were primarily related to our expenditures in purchasing China SFDA licenses for thirteen new medical products from Heilongjiang Traditional Chinese Medical University.

Cash flows provided from financing activities were zero for the three months ended March 31, 2011, compared to approximately $94,000 for the same period in 2010. Cash flows provided from financing activities in 2010 were primarily related to warrants cash exercised by certain warrant holders of ours.

 
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Our current ratio was 6.9 at March 31, 2011, compared to 5.8 at March 31, 2010. Our quick ratio was 6.3 at March 31, 2011, compared to 5.6 at March 31, 2010. We endeavor to ensure that funds are available to take advantage of new investment opportunities and that funds are sufficient to meet future liquidity and capital needs.

We calculate accounts receivable turnover by averaging the opening and closing balances of out accounts receivable during that period and dividing that amount by our average daily sales during such period.  Since accounts receivables fluctuate over the course of each quarter, in order to determine a more representative accountant receivables collection days, management calculates the turnover rate on a quarter-by-quarter basis. Our average daily sales, average accountant receivable, and accountant receivable turnover days for each of the three months ended March 31, 2011 and 2010 were as follows:
 
Three Months  Ended
 
Average Daily Sales
   
Average A/R
       
March 31,
 
($ in thousands)
   
($ in thousands)
   
Turnover Days
 
2011
  $ 315     $ 18,379       58.3  
2010
  $ 321     $ 19,865       61.9  

Accounts receivable turnover days decreased to 58.3 in the three months ended March 31, 2011, compared to 61.9 in the three months ended March 31, 2010. Accounts receivable collections are generally slower during the fourth fiscal quarter and the first fiscal quarter, partly due to the Chinese public holidays within that period (about three weeks in total). During the second and third quarter of each year, due to stronger sales volume, the product turnover rate at the Company’s distributors and agents is higher, resulting in their shorter accounts payable periods.

Our inventory turnover days for the three months ended March 31, 2011 and 2010 calculated by using average daily costs of goods sold and average inventory for each quarter were as follows:

Quarters Ended 
 
Average Daily COGS
   
Average Inventory
 
Turnover
 
March 31,
 
($ in thousands)
   
($ in thousands)
 
Days
 
2011
  $ 101     $ 4,500       44.7  
2010
  $ 81     $ 2,318       28.6  

Due to the forecast of certain cost increases of raw materials, management began to increase the inventory levels since the second half of 2009. Our management increased our inventory levels in the first quarter of 2011 in order to satisfy our future production needs, as well as to limit the effects of possible future price increase of raw materials.  The inventory turnover days increased to 44.7 days for the three months ended March 31, 2011, compared to 28.6 days for the three months ended March 31, 2010.

Contractual Obligations and Commercial Commitments

As of March 31, 2011, we did not have any long-term debt obligations, capital lease obligations, operating lease obligations, purchase obligations, and other long term liabilities reflected on our balance sheet under GAAP.
 
 Currency Exchange Fluctuations

All of our revenues and majority of the expenses during the three months ended March 31, 2011 were denominated primarily in RMB, the currency of China, and were converted into U.S. dollars at the exchange rate of 6.5564 RMB to 1 U.S. Dollar at March 31, 2011 from 6.8361 RMB to 1 U.S. Dollar at March 31, 2010. The exchange rate was 6.6118 RMB to 1 U.S. Dollar and 6.8372 RMB to 1 U.S. Dollar at December 31, 2010 and 2009, respectively. There can be no assurance that RMB-to-U.S. dollar exchange rates will remain stable. A devaluation of RMB relative to the U.S. dollar would adversely affect our business, financial condition and results of operations. We do not engage in currency hedging.
 
Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements that are currently material or reasonably likely to be material to our financial position or results of operations.

 
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Item 3.   Quantitative and Qualitative Disclosures About Market Risk.

We are subject to certain risks and uncertainties as described below.  These risks and uncertainties may not be the only ones we face.  There may be additional risks that we do not presently know of, or that we currently consider immaterial.  All of these risks could adversely affect our business, financial condition, results of operations and cash flows.  Our business and operations may be adversely affected if any of such risks are realized.  All investors should consider the following risk factors before deciding to purchase or sell our securities.

As of March 31, 2011, we do not invest or trade market risk sensitive instrument or have any debt subject to interest rate fluctuations.

Substantially all of our revenues and expenses are denominated in RMB.  Since 1994, the exchange rate for the RMB against the U.S. dollar has remained relatively stable, most of the time in the region of approximately RMB 8.00 to U.S. $1.00. However, in 2005, the Chinese government announced that it would begin pegging the exchange rate of the RMB against a number of currencies, rather than just the U.S. dollar. Currently, exchange rates are approximately RMB 6.6 to U.S. $1.00 resulting in the increase in price of Chinese products to U.S. purchasers.  As our operations are primarily in China, any significant revaluation of the Chinese RMB may materially and adversely affect cash flows, revenues and financial condition.  If we decide to convert RMB into U.S. dollars and the U.S. dollar appreciates against the RMB, the U.S. dollar equivalent of the RMB that we convert would be reduced.
 
Inflation in China may materially impact our results of operations.  According to the PRC National Bureau of Statistics, the inflation rate in the consumer price index in China was 3.3%, -0.7% and 5.9%, in 2010, 2009, and 2008, respectively.
 
A significant amount of our cash and cash equivalents are held in commercial bank checking accounts in the PRC and earned an annual interest income yield of approximately 0.4% for the three months ended March 31, 2011. For all the bank accounts in the PRC, we earned interest income of approximately $32,000 and $23,000 for the three months ended March 31, 2011 and 2010, respectively.

Item 4. Controls and Procedures.

Disclosure Controls and Procedures

Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures as of March 31, 2011.  The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Securities Exchange Act are recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.  Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act are accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Our management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures.  Our disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives as described above.  Based on this evaluation, our management, including our chief executive officer and chief financial officer, concluded that as of March 31, 2011, our disclosure controls and procedures were effective at a reasonable assurances level.
 
Changes in Internal Control Over Financial Reporting

There was no change in our internal control over financial reporting that occurred during the three months ended March 31, 2011 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 
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PART II - OTHER INFORMATION

Item 1.  Legal Proceedings.

On September 4, 2009, the SEC issued a formal order of investigation relating to, among other things, certain of our accounting, record-keeping and disclosure practices.  Between that time and the present, we have received document and testimonial subpoenas from the SEC. We have complied, and intend to continue to comply, with all such subpoenas.

Item 1A.  Risk Factors

None.

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds.

In the three month period ended March 31, 2011, we did not engage in any unregistered sales of equity securities.

Item 3.  Defaults upon Senior Securities.

In the three-month period ended March 31, 2011, and subsequent period through the date hereof, we did not default upon any senior securities.

Item 4.  Removed and Reserved.

Item 5.  Other Information.

There was no information we were required to disclose in a report on Form 8-K during the three-month period ended March 31, 2011, or subsequent period through the date hereof, which was not so reported.

Item 6.  Exhibits
 
Exhibit No.
 
Description of Exhibit
     
31.1
 
Certification of Principal Executive Officer pursuant to Rule 13a-14 and Rule 15d-14(a), promulgated under the Securities and Exchange Act of 1934, as amended*
     
31.2
 
Certification of Principal Financial and Accounting Officer pursuant to Rule 13a-14 and Rule 15d-14(a), promulgated under the Securities and Exchange Act of 1934, as amended*
     
32.1
 
Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Principal Executive Officer)*
     
32.2
 
Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Principal Financial and Accounting Officer)*

* Filed herewith

 
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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 
CHINA SKY ONE MEDICAL, INC.
   
Dated: May 10, 2011
By:
/s/ Liu Yan-qing
   
Liu Yan-qing
   
Chairman, Chief Executive Officer and President
     
Dated: May 10, 2011
By:
/s/ Pan Hong-yu
   
Pan Hong-yu
   
Chief Financial Officer and Treasurer
 
 
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