F-1 1 df1.htm FORM F-1 Form F-1
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As filed with the Securities and Exchange Commission on July 24, 2007

Registration No. 333-            

 


SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


FORM F-1

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

 


WuXi PharmaTech (Cayman) Inc.

(Exact name of Registrant as specified in its charter)

 

CAYMAN ISLANDS   2834   NOT APPLICABLE

(STATE OR OTHER JURISDICTION OF

INCORPORATION OR ORGANIZATION)

 

(PRIMARY STANDARD INDUSTRIAL

CLASSIFICATION CODE NUMBER)

 

(I.R.S. EMPLOYER

IDENTIFICATION NUMBER)

288 Fute Zhong Road

Waigaoqiao Free Trade Zone

Shanghai 200131

People’s Republic of China

(86-21) 5046-1111

(Address, including zip code, and telephone number, including area code, of registrant’s principal executive offices)

 


CT Corporation System

111 Eighth Avenue, 13th Floor

New York, New York 10011

(212) 894-8940

(Name, address, including zip code, and telephone number, including area code, of agent for service)

 


Copies to:

 

Kurt J. Berney, Esq.

O’Melveny & Myers LLP

37th Floor, Plaza 66

1266 Nanjing Road West

Shanghai 200040, P.R.C.

86-21-2307-7007

 

Jon L Christianson, Esq.

Skadden, Arps, Slate,

Meagher & Flom LLP

China World Trade Center

East Wing Office, Level 4

No. 1 Jianguomenwai Ave.

Beijing 100004, P.R.C.

86-10-6505-5511

 


Approximate date of commencement of proposed sale to the public:    As soon as practicable after the effective date of this registration statement.

If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box.    ¨

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.    ¨

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.    ¨

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.    ¨

CALCULATION OF REGISTRATION FEE

 


TITLE OF EACH CLASS OF

SECURITIES TO BE REGISTERED(1)(2)

   AMOUNT TO BE
REGISTERED(1)(2)
   PROPOSED MAXIMUM
OFFERING PRICE PER
ORDINARY SHARE(3)
  

AMOUNT OF

REGISTRATION FEE

ORDINARY SHARES, PAR VALUE US$0.02 PER SHARE

   121,338,608    US$1.625    US$6,054

(1) American depositary shares evidenced by American depositary receipts issuable upon deposit of the ordinary shares registered hereby have been registered pursuant to a separate registration statement on Form F-6 filed with the Commission on             , 2007 (Registration No. 333-            ). Each American depositary share represents eight ordinary shares.
(2) Includes (a) all ordinary shares represented by American depositary shares initially offered and sold outside the United States that may be resold from time to time in the United States either as part of the distribution or within 40 days after the later of the effective date of this registration statement and the date the securities are first bona fide offered to the public, and (b) 15,826,776 ordinary shares represented by 1,978,347 American depositary shares that are issuable upon the exercise of the underwriters’ option to purchase additional shares. The ordinary shares are not being registered for the purpose of sales outside the United States.
(3) Estimated solely for the purposes of computing the amount of the registration fee pursuant to Rule 457(o) under the Securities Act of 1933, as amended.

The registrant hereby amends this registration statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this registration statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933, as amended, or until the registration statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine.

 



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The information in this prospectus is not complete and may be changed. We may not sell these shares until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and we are not soliciting an offer to buy these securities in any jurisdiction where the offer or sale is not permitted.

 

SUBJECT TO COMPLETION, JULY 24, 2007

PROSPECTUS

13,188,979 American Depositary Shares

LOGO

WuXi PharmaTech (Cayman) Inc.

(incorporated in the Cayman Islands)

Representing 105,511,832 Ordinary Shares

This is an initial public offering of American Depositary Shares, or ADSs, of WuXi PharmaTech (Cayman) Inc. Each ADS represents eight of our ordinary shares. We are selling 10,000,000 ADSs, representing 80,000,000 ordinary shares, and our selling shareholders are selling 3,188,979 ADSs, representing 25,511,832 ordinary shares. The estimated initial public offering price is between US$11.00 and US$13.00 per ADS. The ADSs will be evidenced by American Depositary Receipts, or ADRs.

Prior to this offering, there has been no public market for our ADSs or ordinary shares. We have applied to have the ADS listed on the New York Stock Exchange under the symbol “WX”.

 

     Per ADS    Total

Initial public offering price

   US$                 US$             

Underwriting discount

   US$      US$  

Proceeds, before expenses, to WuXi PharmaTech (Cayman) Inc.

   US$      US$  

Proceeds, before expenses, to the selling shareholders

   US$      US$  

We have granted the underwriters an over-allotment option for a period of 30 days from the date of this prospectus to purchase up to 1,978,347 additional ADSs.

Investing in our ADSs involves a high degree of risk. See “ Risk Factors” beginning on page 11.

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or passed upon the adequacy or accuracy of this prospectus. Any representation to the contrary is a criminal offense.

The ADSs are expected to be delivered against payment in New York, New York on             , 2007.

 


 

Credit Suisse   JPMorgan

 


Jefferies & Company

            , 2007


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LOGO


Table of Contents

LOGO


Table of Contents

TABLE OF CONTENTS

 

     Page

Prospectus Summary

   1

The Offering

   6

Summary Consolidated Financial Data

   8

Risk Factors

   11

Forward Looking Statements

   35

Our Corporate Structure

   36

Use of Proceeds

   38

Dividend Policy

   39

Capitalization

   40

Dilution

   41

Exchange Rates

   43

Selected Consolidated Financial Data

   44

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   46

Our Industry

   71

Business

   79

Regulation

   91

Management

   98

Principal and Selling Shareholders

   107

Related Party Transactions

   112

Description of Share Capital

   116

Description of American Depositary Shares

   125

Shares Eligible for Future Sale

   134

Taxation

   136

Underwriting

   141

Enforcement of Civil Liabilities

   147

Expenses Relating to This Offering

   148

Legal Matters

   149

Experts

   150

Where You Can Find Additional Information

   151

Index to Consolidated Financial Statements

   F-1

No dealer, salesperson or other person is authorized to give any information or to represent anything not contained in this prospectus. You must not rely on any unauthorized information or representations. This prospectus is an offer to sell only the ADSs offered hereby, but only under circumstances and in jurisdictions where it is lawful to do so. The information in this prospectus is current only as of the date of this prospectus.

Through and including             , 2007 (the 25th day after the date of this prospectus), all dealers that effect transactions in these securities, whether or not participating in this offering, may be required to deliver a prospectus. This is in addition to a dealer’s obligation to deliver a prospectus when acting as an underwriter and with respect to unsold allotments or subscriptions.

In connection with this offering, the underwriters or any person acting on their behalf may over-allot or effect transactions with a view to supporting the market price of the ADSs at a level higher than that which might otherwise prevail for a limited period of time after the issue date. However, there is no obligation on the underwriters or their respective agents to do this. Such stabilization, if commenced, may be discontinued at any time, and must be brought to an end after a limited period.


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PROSPECTUS SUMMARY

The following summary is qualified in its entirety by, and should be read in conjunction with, the more detailed information and financial statements appearing elsewhere in this prospectus. In addition to this summary, we urge you to read the entire prospectus carefully, especially the risks of investing in the ADSs discussed under “Risk Factors” before deciding whether to buy our ADSs.

Our Business

We are the leading China-based pharmaceutical and biotechnology research and development, or R&D, outsourcing company. We provide a broad and integrated portfolio of laboratory and manufacturing services in the drug discovery and development process to pharmaceutical and biotechnology companies. Our services are designed to help our customers address the bottleneck between the discovery of qualified targets, commonly known as therapeutic targets, and the testing of drug candidates in human clinical trials. Our operations are grouped into two segments: laboratory services, consisting of discovery chemistry, service biology, analytical, pharmaceutical development and process development services, and manufacturing, focusing on manufacturing of advanced intermediates and active pharmaceutical ingredients for R&D use, or APIs. In 2006, we provided our services to 70 pharmaceutical and biotechnology customers, including nine of the top 10 pharmaceutical companies in the world, as measured by 2006 total revenues. We have received a number of recognitions and awards from our customers. To date, most of our customers have returned to us for additional and often larger and longer-term projects, and each of our top-ten customers over the last three years continues to be our customer today.

We have increasingly developed broader and more integrated relationships with our customers through our expanded capabilities and services along the drug discovery value chain. Building on our chemistry capability and service biology operations, we intend to develop new services in preclinical development, formulation and manufacturing areas. Our objective is to become a leading full service provider of drug discovery and development outsourcing services to the global pharmaceutical and biotechnology industry. To achieve our objective, we intend to focus on our core competencies by continuing to provide quality services and delivering innovative solutions while maintaining our customers’ trust.

Based in China and headquartered in Shanghai, we are well-positioned to capitalize on the advantages of conducting drug R&D in China, while emphasizing quality, responsiveness, protection of customer intellectual property and reliability. As of May 31, 2007, we had 1,972 employees, including 1,345 scientists and other technical staff. We offer our services on a fee-for-service or on a full-time equivalent, or FTE, basis, or a combination thereof. Our primary facilities include an approximately 630,000 square-foot R&D center in Shanghai Waigaoqiao Free Trade Zone, an approximately 220,000 square-foot process development and manufacturing plant in Jinshan area of Shanghai, built to “current good manufacturing practice,” or cGMP, quality standards, and an approximately 130,000 square-foot R&D center in Tianjin, which is mainly focused on discovery chemistry services. Our net revenues increased from US$20.9 million in 2004 to US$33.8 million in 2005 and US$69.9 million in 2006, representing a two-year compound annual growth rate, or CAGR, of 83%, and a year-over-year growth rate of 107% from 2005 to 2006, and increased from US$12.8 million in the first quarter of 2006 to US$33.8 million in the first quarter of 2007, a growth of 165%. Our net income increased from US$4.3 million in 2004 to US$6.1 million in 2005 and US$8.9 million in 2006 (including total share-based compensation charges of approximately US$0 in 2004, US$3.1 million in 2005 and US$8.4 million in 2006), representing a two-year CAGR of 44%, and a year-over-year growth rate of approximately 44% from 2005 to 2006, and increased from US$0.8 million in the first quarter of 2006 to US$6.0 million in the first quarter of 2007 (including total share-based compensation charges of US$0.3 million in the first quarter of 2006 and US$3.4 million in the first quarter of 2007), a growth of 623%.

 

 

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We have benefited significantly from growth trends in the global pharmaceutical and biotechnology R&D outsourcing industry. These growth trends are being driven by the need to increase the speed and lower the cost of drug development, the unmet medical needs of a growing and ageing population, technological innovations that are increasing the number of qualified leads suitable for further evaluation, heightened regulatory and safety standards, and the increasing demands of the biotechnology industry. In response, many large pharmaceutical and biotechnology companies are “offshoring” and/or outsourcing R&D activities to regions with significant resource and cost advantages, such as China. Advantages offered by China include a large talent pool in the chemistry, biology and medical sciences and other related fields, relatively low-cost labor and capital expenditures, a developed infrastructure and favorable government incentives providing for utility, land and tax advantages.

Our Services

We provide a broad and integrated portfolio of laboratory and manufacturing services to pharmaceutical and biotechnology companies which assist them by reducing the time and cost for drug discovery and development. Our service offerings initially consisted of discovery chemistry services. As we established a track record of customer satisfaction, we have expanded our service offerings extensively. We now provide a comprehensive range of services to our customers including:

 

   

discovery chemistry, such as lead generation, lead optimization and synthetic chemistry;

 

   

service biology, such as assay development and compound screening, drug metabolism and pharmacokinetic, or DMPK, services, which involve the analysis of how drug candidates act in the body over time, in vitro and in vivo absorption, disposition, metabolism and excretion, or ADME, profiling, and metabolite identification;

 

   

pharmaceutical development, focused on formulation development for new chemical entities;

 

   

analytical services, including support of our laboratory and manufacturing services, as well as external services offered to customers;

 

   

process development, including process research and process optimization services to assist customers to manufacture their drug candidates more efficiently; and

 

   

manufacturing of advanced intermediates, which are drug materials prior to refinement into APIs, and APIs.

We believe our customers value our ability to offer a wide breadth of quality services to meet their drug R&D needs, and we expect to continue to expand our service offerings in both preclinical and clinical development in the future.

Our Strengths and Strategies

Our competitive strengths principally include the following:

 

   

proven quality and customer satisfaction;

 

   

experienced management and a talented pool of scientists;

 

   

integrated, expanding and scalable services;

 

   

commitment to protection of our customers’ intellectual property and confidential information;

 

   

world class facilities and equipment; and

 

   

advantages of doing business in China.

 

 

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We plan to continue to grow our business by pursuing the following strategies:

 

   

expand service offerings to provide higher value-added preclinical development and manufacturing services;

 

   

attract, train and retain quality scientists and management;

 

   

increase capacity and expand facilities; and

 

   

grow through selective, complementary strategic partnerships and acquisitions.

Risks and Uncertainties Related to Our Business and Industry

We expect to face risks and uncertainties related to our ability to:

 

   

adapt our business to industry trends, such as fluctuations in the R&D budgets of pharmaceutical and biotechnology industry participants and changes in government regulation or in practices relating to the pharmaceutical and biotechnology industry;

 

   

diversify our customer base and adapt to potential loss of sales to, or significant reduction in orders from, any of our major customers;

 

   

retain senior management and key scientific personnel, as well as attract, train, motivate and retain other skilled scientists and mid-level personnel;

 

   

continue to compete effectively in our industry, which may subject us to increasing pricing pressure and reduce the demand for our services;

 

   

adapt to the discontinuation or phase-out of any of the preferential tax treatments and/or other financial incentives currently available to us in the PRC and potential increases in PRC taxes;

 

   

manage our current and potential future growth;

 

   

expand our capacity and ramp up our operations as anticipated;

 

   

integrate new acquisitions; and

 

   

establish effective internal controls over financial reporting.

See “Risk Factors” for a detailed discussion of these and other risks that we face.

Our Corporate Structure

We are a Cayman Islands holding company and conduct substantially all of our business through our six operating subsidiaries in China. We indirectly own 100% of the equity of all six of our operating subsidiaries.

 

 

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The following diagram illustrates our corporate structure and the place of formation and affiliation of each of our subsidiaries as of the date of this prospectus:

LOGO

Our Offices

Our principal executive offices and corporate headquarters are located at 288 Fute Zhong Road, Waigaoqiao Free Trade Zone, Shanghai 200131, People’s Republic of China, and our telephone number is (86-21) 5046-1111. Our website address is www.wuxipharmatech.com. The information on our website does not form a part of this prospectus. Our agent for service of process in the United States is CT Corporation System located at 111 Eighth Avenue, 13th Floor, New York, New York 10011.

Conventions That Apply to This Prospectus

Unless we indicate otherwise, all information in this prospectus assumes no exercise by the underwriters of their option to purchase up to 1,978,347 additional ADSs representing 15,826,776 ordinary shares.

Except where the context otherwise requires and for purposes of this prospectus only:

 

   

“we,” “us,” “our company,” “our” and “WuXi” refer to WuXi PharmaTech (Cayman) Inc., and its consolidated subsidiaries, WuXi PharmaTech (BVI) Inc., or WXPT BVI, WuXi PharmaTech Co., Ltd., or WXPT, Shanghai PharmaTech Co., Ltd., or SHPT, Shanghai SynTheAll Pharmaceutical Co., Ltd., or STA, Shanghai PharmaTech Chemical Technology Co., Ltd., or SHCT, Tianjin PharmaTech Co., Ltd., or TJPT, and Suzhou PharmaTech Co., Ltd., or SZPT;

 

   

“China” or “PRC” refers to the People’s Republic of China, excluding, for purposes of this prospectus only, Taiwan and the special administrative regions of Hong Kong and Macau;

 

 

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all references to “Renminbi,” or “RMB,” are to the legal currency of China, all references to “U.S. dollars,” “dollars,” “$” or “US$” are to the legal currency of the United States;

 

   

“ordinary shares” refers to our ordinary shares, par value US$0.02 per share;

 

   

“ADSs” refers to our American depositary shares, each of which represents eight ordinary shares;

 

   

“ADRs” refers to American depositary receipts, which, if issued, evidence our ADSs; and

 

   

Unless otherwise indicated, all historical share and per-share data contained in this prospectus has been restated to give retroactive effect to a one-for-fifty forward share split that became effective on July 19, 2007.

 

 

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THE OFFERING

The following assumes that the underwriters will not exercise their option to purchase additional ADSs in the offering, unless otherwise indicated.

 

ADSs offered by WuXi

10,000,000 ADSs

 

ADSs offered by the selling shareholders

3,188,979 ADSs

 

ADSs outstanding immediately after this offering (not including overallotment option)

13,188,979 ADSs

 

Ordinary shares outstanding immediately after this offering

476,400,000 shares, excluding 61,095,000 ordinary shares issuable upon the exercise of outstanding options, 48,993,850 ordinary shares reserved for issuance under our employee share option plans and 30,350,228 ordinary shares reserved for issuance pursuant to outstanding convertible notes, based upon an assumed initial public offering price of US$12.00 per ADS (the mid-point of the estimated initial public offering price range shown on the front cover of this prospectus).

 

ADS to ordinary share ratio

1:8

 

Listing

We have applied for the listing of our ADSs on the New York Stock Exchange.

 

Proposed New York Stock Exchange symbol

“WX”

 

The ADSs

Each ADS represents eight ordinary shares, par value US$0.02 per share. The ADSs will be evidenced by ADRs.

 

   

The depositary will be the holder of the ordinary shares underlying your ADSs and you will have rights as provided in the deposit agreement.

 

   

Although we do not expect to pay dividends in the foreseeable future, if we declare dividends on our ordinary shares, the depositary will pay you the cash dividends and other distributions it receives on our ordinary shares, after deducting its fees and expenses.

 

   

You may turn in your ADSs to the depositary in exchange for ordinary shares underlying your ADSs. The depositary will charge you fees for exchanges.

 

   

We may amend or terminate the deposit agreement without your consent, and if you continue to hold your ADSs, you agree to be bound by the deposit agreement as amended.

 

 

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You should carefully read the section in this prospectus entitled “Description of American Depositary Shares” to better understand the terms of the ADSs. You should also read the deposit agreement, which is an exhibit to the registration statement that includes this prospectus.

 

Depositary

JPMorgan Chase Bank, N.A.

 

Overallotment option to purchase additional ADSs

We have granted to the underwriters an option, exercisable within 30 days from the date of this prospectus, to purchase up to an additional 1,978,347 ADSs.

 

Timing and settlement for ADSs

The ADSs are expected to be delivered against payment on             , 2007. The ADRs evidencing the ADSs will be deposited with a custodian for, and registered in the name of a nominee of, The Depository Trust Company, or DTC, in New York. In general, beneficial interests in the ADSs will be shown on, and transfers of these beneficial interests will be effected only through, records maintained by DTC and its direct and indirect participants.

 

Use of proceeds

Our net proceeds from this offering are expected to be approximately US$107.8 million, or approximately US$129.9 million if the underwriters exercise their option to purchase additional ADSs in full, after deducting underwriting discounts and the estimated offering expenses payable by us and based upon an assumed initial public offering price of US$12.00 per ADS (the mid-point of the estimated initial public offering price range shown on the front cover of this prospectus). We anticipate using the proceeds as follows:

 

   

up to an aggregate of approximately US$40 million for the expansion of our Jinshan facility;

 

   

up to an aggregate of approximately US$40 million for the construction of a preclinical drug safety evaluation center in Suzhou; and

 

   

the balance for general corporate purposes, including working capital, acquisitions and expansion of our service offerings.

We will not receive any of the proceeds from the sale of ADSs by the selling shareholders. See “Use of Proceeds.”

 

Risk factors

See “Risk Factors” and other information included in this prospectus for a discussion of risks you should carefully consider before deciding to invest in our ADSs.

 

Lock-up

We have agreed for a period of 180 days after the date of this prospectus not to sell, transfer or otherwise dispose of any of our ordinary shares or ADSs representing our ordinary shares. Our executive officers, directors and our existing shareholders have also agreed with the underwriters to a lock-up of shares for a period of 180 days after the date of this prospectus. See “Underwriting.”

 

 

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SUMMARY CONSOLIDATED FINANCIAL DATA

The following summary consolidated income statement data for the years ended December 31, 2004, 2005 and 2006, and the summary consolidated balance sheet data as of December 31, 2005 and 2006 have been derived from our audited consolidated financial statements included elsewhere in this prospectus, which have been audited by Deloitte Touche Tohmatsu CPA Ltd., an independent registered public accounting firm. Our summary consolidated income statement data for each of the three month periods ended March 31, 2006 and 2007 and summary consolidated balance sheet data as of March 31, 2007 have been derived from our unaudited consolidated financial statements included elsewhere in this prospectus. We have prepared the unaudited consolidated financial information on the same basis as our audited consolidated financial statements. The unaudited financial information includes all adjustments, consisting only of normal and recurring adjustments, that we consider necessary for a fair presentation of our financial position and operating results for the periods presented. Results for the three months ended March 31, 2007 are not necessarily indicative of results that may be expected for the full year. You should read the summary consolidated financial in conjunction with those financial statements and the accompanying notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Our consolidated financial statements are prepared and presented in accordance with U.S. generally accepted accounting principles, or U.S. GAAP. Our historical results do not necessarily indicate our results expected for any future periods.

     Year Ended December 31,     Three Months
Ended March 31,
 
         2004             2005             2006             2006             2007      
     (in millions of US$, except per share data)  

Consolidated Income Statement Data:

          

Net revenues:

          

Laboratory services

   $ 16.4     $ 29.4     $ 59.8     $ 8.9     $ 21.7  

Manufacturing

     4.5       4.4       10.1       3.9       12.1  
                                        

Total

     20.9       33.8       69.9       12.8       33.8  
                                        

Cost of revenues:

          

Laboratory services

     (7.9 )     (12.8 )     (26.5 )     (3.6 )     (10.8 )

Manufacturing

     (1.4 )     (2.7 )     (9.1 )     (3.8 )     (7.3 )
                                        

Total

     (9.3 )     (15.5 )     (35.6 )     (7.4 )     (18.1 )
                                        

Gross profit

     11.6       18.3       34.3       5.4       15.7  
                                        

Operating expenses:

          

Selling and marketing expenses

     (0.7 )     (1.0 )     (1.9 )     (0.2 )     (0.7 )

General and administrative expenses

     (5.9 )     (8.5 )     (22.3 )     (3.7 )     (9.1 )
                                        

Total

     (6.6 )     (9.5 )     (24.2 )     (3.9 )     (9.8 )
                                        

Operating income

     5.0       8.8       10.1       1.5       5.9  
                                        

Other income

     0.6       0.3       0.5       *       0.8  

Other expenses

     *       (0.6 )     (0.5 )     *       *  

Interest expense

     (0.6 )     (1.3 )     (1.1 )     (0.4 )     (0.7 )

Interest income

     *       *       0.3       *       *  
                                        

Income before income taxes

     5.0       7.2       9.3       1.1       6.1  

Income tax expense

     (0.7 )     (1.1 )     (0.4 )     (0.3 )     (0.1 )
                                        

Net income(1)

   $ 4.3     $ 6.1     $ 8.9     $ 0.8     $ 6.0  
                                        

Basic earnings (loss) per share(2)

   $ 0.02     $ (0.00 )   $ (0.15 )   $ 0.00     $ (0.01 )
                                        

Diluted earnings (loss) per ordinary share(2)

   $ 0.02     $ (0.00 )   $ (0.15 )   $ 0.00     $ (0.01 )
                                        

Dividends declared per ordinary share

   $     $ 0.01     $ 0.02     $     $  
                                        

Dividends declared per preference share

   $     $     $ 0.00     $     $  
                                        

 

 

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* Less than US$50,000.

(1)

Including total share-based compensation charges of approximately US$0 in 2004, US$3.1 million in 2005, US$8.4 million in 2006, and US$0.3 million and US$3.4 million in the first quarter of 2006 and 2007, respectively, allocated as follows:

 

    

Year Ended December 31,

   Three Months
Ended March 31,
         2004            2005            2006            2006            2007    
    

    (in millions of US$)    

Cost of revenues

      $ 0.4    $ 0.5    $ 0.1    $ 1.1

General and administrative expenses

        2.7      7.9      0.2      2.3

 

(2)

The following table sets forth the computation of basic and diluted earnings (loss) for the periods indicated:

 

     Year Ended
December 31,
    Three Months
    Ended March 31,    
 
     2004    2005     2006       2006         2007    
    

    (in millions of US$)    

 

Net income

   $ 4.3    $ 6.1     $ 8.9     $ 0.8     $ 6.0  

Deemed dividend on issuance and repurchase of preference shares

     —        (4.0 )     (24.1 )     —         (7.6 )

Deemed dividend for beneficial conversion feature

     —        (2.2 )     (19.2 )     —         —    

Dividend on preference share

     —        —         (0.7 )     —         —    

Amounts allocated to preference shares for participating rights to dividends

     —        *       —         (0.1 )     —    
                                       

Income (loss) attributable to holders of ordinary shares—basic and diluted

   $ 4.3    $ (0.1 )   $ (35.1 )   $ 0.7     $ (1.6 )
                                       

* Less than US$50,000.

 

 

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     As of December 31,     As of
March 31,
 
         2005            2006             2007      
     (in millions of US$)  

Consolidated Balance Sheet Data:

       

Cash and cash equivalents

   $ 4.9    $ 9.7     $ 49.5  

Total current assets

     14.5      36.7       79.7  

Total assets

     40.9      85.7       133.8  

Total current liabilities

     18.4      30.6       28.6  

Total liabilities

     23.6      37.5       76.2  

Mezzanine equity

     6.1      49.1       100.7  

Total shareholders’ equity (deficit)

     11.2      (0.9 )     (43.1 )

Total liabilities, mezzanine equity and shareholders’ equity (deficit)

   $ 40.9    $ 85.7     $ 133.8  

 

 

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RISK FACTORS

You should consider carefully all of the information in this prospectus, including the risks and uncertainties described below, before investing in our ADSs. Any of the following risks could have a material adverse effect on our business, financial condition, results of operations and prospects. The market price of our ADSs could decline due to any of these risks, and you may lose all or part of your investment.

RISKS RELATING TO OUR BUSINESS

Our limited operating history may make it difficult for you to evaluate our business and future prospects.

We commenced operations and began offering our pharmaceutical and biotechnology R&D outsourcing services in 2001. Accordingly, our operating history upon which you can evaluate the viability and sustainability of our business and its acceptance by industry participants is limited. Our business model continues to evolve in conjunction with the evolution of the pharmaceutical and biotechnology R&D outsourcing market in China and around the world. These circumstances may make it difficult for you to evaluate our business and future prospects, and you should not rely on our past results or our historic growth rate as an indication of our future performance.

A limited number of our customers have accounted and are expected to continue to account for a high percentage of our revenues. The loss of or significant reduction in orders from any of these customers could significantly reduce our revenues and decrease our profitability.

Our two largest customers in 2005 and 2006, Pfizer Inc., or Pfizer, and Merck & Co., Inc., or Merck, accounted for 17.4% and 17.4% in 2005 and 15.4% and 13.7% in 2006 of our net revenues, respectively. No other customer accounted for more than 10% of our net revenues in those years. Our top 10 customers, which varied in each of the last three years, accounted for approximately 83%, 73% and 69% of our net revenues in 2004, 2005 and 2006, respectively. Furthermore, substantially all of our total net revenues over the last three years were generated from sales to customers located in the United States. The loss of sales to, or significant reduction in orders from, any of these customers would have a material and adverse impact on our business. Due to our concentration of business and dependence on a limited number of customers, any one of the following events, among others, may cause material fluctuations or declines in our revenues and have a material adverse effect on our financial condition, results of operations and prospects:

 

   

reduction, delay or cancellation of orders or contracts from one or more of our significant customers and our failure to identify additional or replacement customers;

 

   

decision by one or more of our significant customers to award orders or contracts to our competitors; and

 

   

one or more of our major customers significantly reduce the price they are willing to pay for our services and products.

A payment failure by any of our large customers could significantly harm our cash flows and profitability.

Historically, we have not experienced any significant bad debt or collection problem, but such problems may arise in the future. The failure of any of our customers to make timely payments could require us to write off accounts receivable or increase provisions made against our accounts receivable, either of which could adversely affect our cash flows and profitability.

 

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Our business and growth may be severely disrupted if we lose the services of our senior management and key scientific personnel.

Our future success is significantly dependent upon the continued service of our senior management and key scientific personnel. In particular, we are highly dependent on Dr. Ge Li, our Chairman and Chief Executive Officer, who has managed our business, operations and sales and marketing activities and maintained personal and direct relationships with our major customers since our inception, as well as Dr. Shuhui Chen, our Chief Scientific Officer, Dr. Suhan Tang, our Chief Manufacturing Officer, Mr. Xiaozhong Liu, our Executive Vice President, and other senior members of our management and other key scientific personnel. The loss of any one of them, in particular Dr. Li, would have a material adverse effect on our business and operations. Although each member of our senior management and key scientific personnel has signed a noncompete agreement with us, we may not be able to successfully enforce these provisions in the event of a dispute. If we lose the services of any senior management or key scientific personnel, we may not be able to locate suitable or qualified replacements, and may incur additional expenses to recruit and train new personnel, which could severely disrupt our business and growth.

Any failure to retain our existing customers or expand our customer base may result in our inability to maintain or increase our revenues.

Our existing customers may not continue to generate significant revenues for us once our engagements with them are concluded and our relationships with them may not present further business opportunities. If we fail to build new customer relationships or our relationships with existing customers do not continue to develop, we may not be able to expand our customer base or maintain or increase our revenues.

Our ability to execute projects, maintain, expand or renew existing customer engagements and obtain new customers depends largely on our ability to attract, train, motivate and retain highly skilled scientists and mid-level personnel.

The success of our business is largely dependent on the R&D efforts of mid-level personnel and their ability to keep pace with continuing changes in drug discovery and development technologies and methodologies. In particular, our customers value Western-trained scientists, preferably with experience with large pharmaceutical and/or biotechnology companies. Our success also depends on the depth and quantity of our scientists and mid-level personnel. Any inability to attract, train, motivate and retain such qualified scientists and mid-level personnel, or keep these employees updated and capable of keeping pace with changes in the industry, may have a material adverse effect on our business, financial condition, results of operations and prospects.

We face challenges in attracting and maintaining a consistent quality standard throughout our employee base at our current rate of growth. Our employee base increased from 252 in 2003 to 1,843 in 2006 and 1,972 as of May 31, 2007, and is expected to continue to increase significantly during 2007. We compete vigorously with pharmaceutical, biotechnology and contract research firms and academic and research institutions for qualified and experienced scientists and mid-level personnel, particularly in the areas of chemistry, biology and pharmaceutical manufacturing. To effectively compete, we may be required to offer higher compensation and other benefits which could materially and adversely affect our financial condition and results of operations. We may not be able to hire and retain enough skilled and experienced scientists to replace those who leave. Additionally, we may be unable to redeploy and retrain our professionals to keep pace with continuing changes in technology, evolving standards and changing customer preferences.

We face increasingly intense competition. If we do not compete successfully against new and existing competitors, demand for our services and related revenues may decrease and subject us to increasing pricing pressure.

The global pharmaceutical and biotechnology R&D outsourcing market is highly competitive, and we expect competition to intensify. We face competition based on a number of factors, including quality, ability to

 

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protect confidential information and intellectual property, timeliness, good manufacturing practices, depth of customer relationship, pricing and geography. We compete with contract research and manufacturing companies and research and academic institutions, typically in particular service areas. For example, we compete with Charles River Laboratories International, Inc., which recently partnered with Shanghai BioExplorer Co., Ltd., in the preclinical services area, and Shanghai ChemPartner Co., Ltd. and Bioduro, Inc. in the discovery chemistry area. However, we believe that we do not compete with any single company across the breadth of our service offerings. We expect to increasingly compete against multinational companies, both domestically and internationally, as we continue to offer more complex and sophisticated services along the drug discovery value chain. Some major pharmaceutical and biotechnology companies have made in-house research investments in China, and we expect this trend to continue. These in-house investments may reduce demand for our services and result in increased competition for qualified personnel.

Some of our larger competitors may have:

 

   

greater financial, research and other resources;

 

   

broader scope of services;

 

   

greater pricing flexibility;

 

   

more extensive technical capabilities; and

 

   

greater name recognition.

We also expect increased competition as new companies enter the market and more advanced technologies become available. Our services and expertise may be rendered obsolete or uneconomical by technological advances or new approaches or technologies. The existing approaches of our competitors or new approaches or technologies developed by our competitors may be more effective than those developed by us. Furthermore, increased competition increases pricing pressure for our services, which puts downward pressure on our margins and profitability.

If we fail to effectively manage our growth and our growth strategies, our business, financial condition, results of operations and prospects could suffer.

Pursuing our growth strategies, including expanding our facilities and service offerings to meet our customers’ needs, has resulted in and will continue to result in substantial demands on our management and resources. Managing this growth and our growth strategies will require, among other things:

 

   

continued enhancement of our drug discovery R&D capabilities;

 

   

effective coordination and integration of our research facilities and teams, particularly those located in different or newly opened facilities;

 

   

successful hiring and training of new personnel;

 

   

effective cost controls and sufficient liquidity;

 

   

effective and efficient financial and management controls;

 

   

increased marketing and sales support activities;

 

   

effective quality control; and

 

   

the ability to manage our various vendors and suppliers and leverage our purchasing power.

Any inability to effectively manage our anticipated growth and growth strategies could adversely affect our business, financial condition, results of operations or prospects.

 

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We may be unable to expand our capacity and ramp up our operations as anticipated, possibly resulting in material delay, increased costs and lost business opportunities.

We are engaged in a substantial capacity expansion program. Major projects include the expansion of our Jinshan facility to quadruple the manufacturing capacity of the plant, which is currently expected to commence operations in late 2008, and the construction of a preclinical drug safety evaluation center with a broad range of toxicology services in Suzhou, which we are planning to inaugurate in 2009. These facilities may not be constructed on the anticipated timetable or within budget. Any material delay in bringing these facilities on-line or ramping up operations, or any substantial increase in costs to complete these facilities or ramp up operations, could materially and adversely affect our financial condition and results of operations, and result in lost business opportunities.

We are making a significant commitment of capital to ramp up our services in order to meet our customers’ needs and, as a result, we are dependent on the success of our customers’ projects and the continuation of their business.

Primarily to serve the process development and manufacturing needs of one of our major customers, Vertex Pharmaceuticals Incorporated, or Vertex, related to a single Phase 2b drug candidate, we are expanding our Jinshan facility. Up to US$40 million from this offering may be used to fund this expansion. We expect that manufacturing of this drug candidate will occupy a significant portion of the plant’s capacity. Vertex accounted for 24.8% of our net revenues in the first quarter of 2007, and we expect Vertex to continue to be a significant customer for the foreseeable future. As a result, any downturn in Vertex’s business that affects its ability to continue the drug development project we are servicing could disrupt our growth plan and may harm our financial condition. In addition, Vertex has reported that it plans to initiate Phase 3 clinical trials for this drug candidate in the fourth quarter of 2007. If the FDA does not approve this candidate or if its development is delayed, Vertex may terminate or significantly reduce its orders with us. Consequently, we may be required to re-allocate our resources, which could cause delays in our service offerings and result in lower than expected revenues. As we develop our manufacturing services further, we may become more dependent on the success of specific drug candidates that are in development by one or more of our major customers.

We may fail to effectively develop and market new services, which may harm our growth opportunities and prospects, possibly resulting in related losses.

We may seek to develop and market new services that complement or expand our existing business. We intend to continue to expand our existing laboratory and manufacturing services, offer new services in preclinical development to existing and new customers. Starting in 2007, we began to roll out preclinical development services as well as pharmaceutical development services and manufacturing of clinical trial materials. Whether we are successful in developing or marketing our new services will be determined by our ability to:

 

   

accurately assess and meet customer needs and market demands;

 

   

optimize our drug discovery, development and manufacturing processes to predict and control costs;

 

   

hire, train and retain proper personnel;

 

   

provide services in a timely manner;

 

   

increase customer awareness and acceptance of our services;

 

   

obtain required regulatory clearances or approvals;

 

   

compete effectively with other R&D outsourcing providers;

 

   

price our services competitively; and

 

   

effectively integrate customer feedback into our business planning.

 

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If we are unable to develop new services and create demand for those newly developed services, or expand our service offerings through acquisitions, our future business, results of operations, financial condition, prospects and cash flows could be materially and adversely affected.

We may undertake acquisitions that may divert our management’s attention and resources and hurt our ability to effectively manage our business.

Our growth strategies may involve the acquisition of new technologies, businesses, products or services or the creation of strategic alliances in areas in which we do not currently operate. These activities could require that our management develop expertise in new areas, manage new business relationships and attract new types of customers. Furthermore, these activities may divert significant management attention from existing business operations, which diversion may harm the effective management of our business.

We may experience difficulties in managing and integrating acquisitions, which may significantly disrupt our ability to manage our business.

If we make acquisitions of new technologies, businesses, products or services or create strategic alliances in areas in which we do not currently operate, we may experience difficulties integrating acquired operations, services, corporate cultures and personnel into our existing business and operations. Completed acquisitions may also expose us to potential risks, including risks associated with unforeseen or hidden liabilities, the diversion of resources from our existing businesses and technologies, our inability to generate sufficient revenues to offset the costs, expenses related to the acquisitions and potential loss of, or harm to, relationships with employees or customers as a result of our integration of new businesses, any of which could significantly disrupt our ability to manage our business.

We expect that our overall gross margin may face downward pressure as manufacturing becomes an increasingly large component of our service mix and employee compensation costs rise.

Our overall gross margin has faced downward pressure, decreasing from 55.7% in 2004 to 54.1% in 2005, 49.1% in 2006 and 46.3% in the first quarter of 2007, and we expect this trend to continue in the foreseeable future. The expected decline in our gross margin will be primarily driven by the anticipated growth of our manufacturing segment, which typically has a significantly lower gross margin, as a larger component of our service mix. We also expect our manufacturing segment margins to be adversely impacted by recent changes to China’s value-added tax, or VAT, system. These changes, effective July 1, 2007, reduce potential VAT credits on certain categories of goods manufactured for export from 13% to 5%. To the extent we can not pass along these increased VAT costs to our clients or otherwise mitigate the impact of this change in tax law, our manufacturing segment margins will be lowered. In 2006 and the first quarter of 2007, our manufacturing segment accounted for 14.5% and 35.9% of our net revenues, respectively, and we expect it to continue to be a significant revenue contributor in 2007 and beyond as the expansion of our manufacturing capacity comes online. Employee compensation is also a substantial component of our costs and therefore an important factor in determining our gross profit and margin. Since inception, we have increased staff wages generally in line with rising labor costs in China. We cannot guarantee that we will not increase wages in the future to remain competitive with the market. Our pricing policies and mechanisms may not completely account for the potential wage increases which could negatively impact our gross margin.

Because many of our fee-for-service based contracts are contingent on successful completion and are of a fixed price nature, we may bear financial risk if we do not successfully or timely develop a service or invoke below-cost pricing of our contracts due to competitive pressures or strategic objectives or overrun cost estimates.

A significant portion of our net revenues, including all of our manufacturing segment revenues, are based on fee-for-service contracts, which are contingent on successful completion and are often structured as fixed price or

 

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fee-for-service with a cap. Therefore, we bear financial risk if we do not successfully or timely develop a product or if we intentionally price our fee-for-service based contracts below our cost estimate or otherwise overrun our cost estimates. We also face pricing pressures from some of our competitors, with whom we often compete for new customers. To capture market share and establish cost competitiveness, we have, in the past, intentionally priced some fee-for-service based contracts below our cost estimate. Below-cost pricing or significant cost overruns could have a material adverse effect on our business, financial condition, results of operations and prospects.

Our customer agreements contain provisions that are against our interests or expose us to potential liability.

Our agreements with our customers generally provide that the customers can terminate the agreements or reduce the scope of services under the agreements with short or no notice. For a majority of our customer agreements, our customers have the unilateral right to terminate for convenience upon prior notice ranging from 30 to 90 days. Although we have not been materially and adversely affected by contract cancellations or modifications in the past, if a customer terminates a contract with us, we are only entitled under the terms of the contract to receive revenue earned until the date of termination. Therefore, cancellation or modification of a large contract or proximate cancellation or modification of multiple contracts could materially and adversely affect our business, financial condition, results of operations and prospects.

In some of our customer agreements, we have assumed indemnification obligations for intellectual property infringement by the deliverables that we provide to our customers to the extent that the infringing aspect of the deliverables is created by us. Our liability is usually not capped under these agreements. As a result, if any aspect of our deliverables that we have created for our customers infringes a third party’s intellectual property rights, and particularly if such deliverable ultimately becomes a commercially successful product, we could be potentially exposed to substantial liability.

In addition, some of our customer agreements contain noncompete obligations whereby we have agreed, either by ourselves or together with third parties, not to compete with such customer. We are required to seek the customer’s prior written consent before making compounds chemically similar to those made for the customer. For some customers, our noncompete obligation is onerous. For example, we have agreed that, for up to 10 years after termination of the agreement, any employee who has worked on the customer’s projects may not work on any other project whereby the knowledge gained from such customer’s projects would be relevant. Complying with these noncompete obligations may restrict our ability to expand certain service offerings, and failure to comply could significantly harm our business and reputation, as well as expose us to liability for breach of contract.

Several of our service offerings are dependent on a limited number of supply sources, which, if interrupted, could cause disruption or delay to our services, reduce our sales and force us to use more expensive supply sources.

We depend on a limited number of international sources for certain reagents and other chemicals required in our service offerings, and particularly in connection with our manufacturing services. Disruptions or delays to their continued supply may arise from export or import restrictions or embargoes, foreign government or economic instability, severe weather conditions, disruptions to the air travel system, contract disputes or other disruptions. If the supply of certain materials were interrupted, our manufacturing services would be delayed. We also may not be able to secure alternative supply sources in a timely and cost-effective manner. If we are unable to obtain adequate supplies of required materials that meet our standards or at acceptable costs, or at all, our ability to accept and fulfill customer orders in the required quality and quantity and at the required time could be restricted, which in turn could harm our reputation, reduce our sales, cause us to lose market share, force us to use more expensive sources of supply, and ultimately could materially and adversely affect our business, financial condition, results of operations and prospects.

 

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Our principal laboratory and manufacturing facilities may be vulnerable to natural disasters or other unforeseen catastrophic events.

We conduct our primary R&D activities at our headquarters located in the Shanghai Waigaoqiao Free Trade Zone, as well as other facilities located in the Jinshan area of Shanghai, Tianjin and Suzhou. We depend on these facilities for the continued operation of our business. Natural disasters or other unanticipated catastrophic events, including power interruptions, water shortage, storms, fires, earthquakes, terrorist attacks and wars, or, as occurred in December 2006, the disruption of sea-floor fiber optical cables due to earthquakes, could significantly impair our ability to operate our business in its ordinary course. Our facilities and certain equipment located in these facilities would be difficult to replace in any such event and could require substantial replacement lead time. The occurrence of any such event could materially and adversely affect our business, financial condition, results of operations and prospects.

If we fail to protect the intellectual property rights of our customers, we may be subject to liability for breach of contract and may suffer damage to our reputation.

Protection of intellectual property associated with drug R&D is critical to all our customers. In our business of providing drug R&D services, our customers generally retain ownership of all associated intellectual property, including those they provide to us and those arising from the services we provided. Our success therefore depends in substantial part on our ability to protect the proprietary rights of our customers. This is particularly important for us since our operation is based in China, and China, as well as Chinese companies, has not traditionally enforced intellectual property protection to the same extent as the United States. Despite measures we take to protect the intellectual property of our customers or our own, unauthorized parties may attempt to obtain and use information that we regard as proprietary. Any unauthorized disclosure of our customers’ proprietary information could subject us to liability for breach of contract, as well as significant damage to our reputation, which could materially harm our business, financial condition, results of operations and prospects.

We may be liable for contamination or other harm caused by hazardous materials that we use.

Our drug discovery and development processes involve the use of highly toxic and hazardous materials. Any failure by us to control the use of, restrict adequately the discharge of, or protect our employees from hazardous substances could subject us to potentially significant monetary damages and fines or suspensions in our business operations. We are subject to national, provincial and local regulations governing the use, manufacture, handling, storage and disposal of hazardous materials. We cannot completely eliminate the risk of contamination or injury resulting from hazardous materials and we may incur liability as a result of any contamination or injury, which could have a material and adverse impact on our business, financial condition, results of operations and prospects.

Any failure by us to satisfy our customers’ audits and inspections could harm our reputation and our business, financial condition, results of operations and prospects.

Our customers routinely audit and inspect our facilities, processes and practices to ensure that our services are meeting their internal standards and the regulatory standards they must meet in the drug development process. To date, we have passed all such audits and inspections; however, we may not be able to in the future, and any failure to meet these audits or inspections to our customers’ satisfaction could significantly harm our reputation and materially and adversely affect our business, financial condition, results of operations and prospects.

We have limited insurance coverage, and any claims beyond our insurance coverage may result in our incurring substantial costs and a diversion of resources.

We maintain property insurance policies covering physical damage to or loss of our equipment, facilities, buildings and their improvements, office furniture and inventory, employer’s liability insurance generally

 

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covering death or work injury of employees, product liability insurance covering product liability claims arising from the use, consumption or operation of our small molecular compounds, public liability insurance covering certain incidents to third parties that occur on or in the premises of the company, and directors and officers liability insurance. We do not maintain key man life insurance on any of our senior management or key personnel. Our insurance coverage, however, may not be sufficient to cover any claim for product liability, damage to our fixed assets or injury to our employees. Insurance companies in China offer limited business insurance products and do not, to our knowledge, offer business liability insurance. While business interruption insurance is available to a limited extent in China, we have determined that the risks of disruption, cost of such insurance and the difficulties associated with acquiring such insurance on commercially reasonable terms make it impractical for us to subscribe for such insurance. As a result, we do not have any business liability, disruption or litigation insurance coverage for our operations in China. Any business disruption or litigation, or any liability or damage to, or caused by, our facilities or our personnel beyond our insurance coverage may result in our incurring substantial costs and a diversion of resources.

The lessor of our temporary Suzhou facilities may not possess the required title certificate. We may be required to vacate the premises, causing a disruption to our operations.

We entered into a lease agreement with a Suzhou-based company for use of temporary preclinical facilities in Suzhou, which lease expires in 2012. The lessor has not obtained the relevant title certificates and therefore is unable to register the lease agreement. In June 2007, we received a letter from the competent authority in charge of the administrative district where our Suzhou facilities are located, which permits our use of the facilities within the lease term. Under Chinese law, our lease agreement may be subject to challenges from third parties, and as a result, we may be required to vacate these premises and relocate our Suzhou facility. If the lease is so terminated, we believe we can secure comparable alternative premises. Since the build-out of the alternative premises and the moving of equipment take time, it may cause disruption to the services that we intend to carry out on the leased facilities.

Our quarterly revenues and operating results may be difficult to predict and could fall below investor expectations, which could cause the market price of our ADSs to decline.

Our quarterly revenues and operating results have fluctuated in the past and may continue to fluctuate significantly depending upon numerous factors, including:

 

   

the commencement, completion or cancellation of large contracts;

 

   

the progress of ongoing contracts;

 

   

the delivery schedule of our customers, particularly in relation to our manufacturing business;

 

   

changes in the mix of our revenues from our laboratory and manufacturing services, including the portion of services performed on a fee-for-service or FTE basis;

 

   

the timing of and charges associated with completed acquisitions or other events;

 

   

changes in the industry operating environment;

 

   

changes in government policies or regulations or their enforcement; and

 

   

a downturn in general economic conditions in China, the United States or internationally.

Many of these factors are beyond our control, making our quarterly results difficult to predict, which could cause the trading price of our ADSs to decline below investor expectations.

 

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We may need additional capital in the future, for which we may be unable to obtain in a timely manner or on acceptable terms, or at all.

For us to grow, remain competitive, develop new services and expand our capacity, we may require additional capital in the future. Our ability to obtain additional capital in the future is subject to a variety of uncertainties, including:

 

   

our future financial condition, results of operations and cash flows;

 

   

general market conditions for capital raising activities by healthcare and related companies; and

 

   

economic, political and other conditions in China, the United States and elsewhere.

Needed financing may not be available in amounts or on terms acceptable to us, if at all.

Our future capital needs may require us to sell additional equity or debt securities which may result in dilution to our shareholders or introduce covenants which may restrict our operations or our ability to pay dividends.

Our future capital needs and other business reasons could require us to sell additional equity or debt securities or obtain a credit facility. The sale of additional equity or equity-linked securities could result in additional dilution to our shareholders. The incurrence of indebtedness would result in increased debt service obligations and could result in operating and financing covenants that would restrict our operations or our ability to pay dividends to our shareholders.

We may become a passive foreign investment company, or PFIC, which could result in adverse U.S. tax consequences to U.S. holders.

Depending upon the value of our shares and ADSs and the nature of our assets and income over time, we could be classified as a passive foreign investment company, or PFIC, by the U.S. Internal Revenue Service, or IRS, for U.S. federal income tax purposes. Based on the anticipated value of our outstanding shares during the year and the cash that we anticipate holding and generating during the year, including the cash we raise in our initial public offering, we do not believe we will be classified as a PFIC for the taxable year 2007. However, we may become a PFIC for future taxable years, as PFIC status is tested each year and depends on our assets and income in such year.

We will be classified as a PFIC in any taxable year if either: (1) the average percentage value of our gross assets during the taxable year that produce passive income or are held for the production of passive income is at least 50% of the value of our total gross assets or (2) 75% or more of our gross income for the taxable year is passive income. For example, we would be a PFIC for the taxable year 2007 if the sum of our average market capitalization, which is our share price multiplied by the total amount of our outstanding shares, and our liabilities over that taxable year is not more than twice the value of our cash, cash equivalents, other assets that are readily convertible into cash and other passive assets. In particular, we would likely become a PFIC if the value of our outstanding shares were to decrease significantly while we hold substantial cash and cash equivalents or other passive assets.

If we were classified as a “PFIC” in any taxable year in which you hold our ADSs or shares and you are a U.S. Holder, you would generally be taxed at higher ordinary income rates, rather than lower capital gain rates, if you dispose of ADSs or shares for a gain in a later year, even if we are not a PFIC in that year. In addition, a portion of the tax imposed on your gain would be increased by an interest charge. Moreover, if we were classified as a PFIC in any taxable year, you would not be able to benefit from any preferential tax rate with respect to any dividend distribution that you may receive from us in that year or in any later year. Finally, you would also be subject to special U.S. federal income tax reporting requirements. For more information on the U.S. federal income tax consequences to you that would result from our classification as a PFIC, please see “Taxation — U.S. Federal Income Taxation — U.S. Holders — Passive Foreign Investment Company.”

 

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In the course of preparing our consolidated financial statements for the years ended December 31, 2004, 2005 and 2006 and as of December 31, 2005 and 2006, several material weaknesses and significant deficiencies in our internal control over financial reporting were noted. If we fail to achieve or maintain an effective system of internal control over financial reporting, our ability to accurately and timely report our financial results or prevent fraud may be adversely affected.

Prior to this offering, we have been a private company with a short operating history and limited accounting personnel and other resources with which to address our internal control and procedures over financial reporting. In preparing our consolidated financial statements, several material weaknesses and significant deficiencies in our internal control over financial reporting have been identified, as defined in the standards established by the U.S. Public Company Accounting Oversight Board. The main material weaknesses identified primarily related to: (i) a lack of effective controls over the financial reporting process due to an insufficient complement of personnel with an appropriate level of accounting knowledge, experience and training in the application of U.S. GAAP commensurate with our financial reporting requirements, (ii) inadequate retention and maintenance of accounting books and records, (iii) inadequate documentation and communication of accounting policies and procedures and (iv) instances of insufficient access controls to our enterprise resource planning, or ERP, system. The significant deficiencies noted include: (1) internal control issues related to the lack of management approval process, inadequate segregation of duties and inappropriate recording of cost of sales, and (2) information and technology systems matters related to the lack of change management processes and a need to strengthen information security management.

To remedy these weaknesses and deficiencies, we have adopted several measures to improve our internal control over financial reporting. In late 2006, we recruited an experienced chief financial officer and other accounting staff, and in December 2006 established an internal audit function. In July 2007, we hired a Vice President of Finance, who is experienced in U.S. GAAP and SEC reporting; we expect her to join our staff beginning in early August 2007. In addition, we intend to provide on-going training to our accounting personnel to improve their U.S. GAAP accounting knowledge and to hire additional accounting staff, including a U.S. GAAP/SEC reporting manager and internal audit personnel. We have or are in the process of, among other things, (i) upgrading our record-keeping policies to conform with U.S. GAAP requirements, including procedures in respect of all key transactions, (ii) compiling our accounting policies and procedures as well as our quarterly closing procedures into a manual to ensure our policies are communicated and adhered to by our accounting personnel, (iii) documenting our closing and related procedures, and (iv) immediately remediated the identified instances of unauthorized access to our ERP system. We have also hired an outside consultant to assist us in preparing for compliance with Section 404 of the Sarbanes-Oxley Act of 2002, or Section 404, and another to upgrade our ERP system and address related ERP access and security issues. We will continue to implement measures to remedy these material weaknesses and significant deficiencies in order to meet the deadline imposed by Section 404. However, if we fail to timely achieve and maintain the adequacy of our internal controls, we may not be able to conclude that we have effective internal controls over financial reporting. Moreover, effective internal controls over financial reporting are necessary for us to produce reliable financial reports and are important to help prevent fraud. As a result, our failure to achieve and maintain effective internal controls over financial reporting could result in the loss of investor confidence in the reliability of our financial statements, which in turn could harm our business and negatively impact the market price of our ordinary shares. Furthermore, we anticipate that we will incur considerable costs and use significant management time and other resources in an effort to comply with Section 404.

Investor confidence and the market price of our ordinary shares may be adversely impacted if we or our independent registered public accounting firm are unable to attest to the adequacy of our internal control over financial reporting in accordance with the requirements of Section 404.

Upon the completion of this offering, we will become a public company in the United States subject to the Sarbanes-Oxley Act of 2002, or the Sarbanes-Oxley Act. We would then be required under Section 404 to include a report by management assessing the effectiveness of our internal control over financial reporting in our

 

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Annual Report on Form 20-F beginning with the fiscal year ending December 31, 2008. In addition, our independent registered public accounting firm must attest to and report on the effectiveness of our internal control over financial reporting. Our management may conclude that our internal controls are not effective. Moreover, even if our management concludes that our internal controls are effective, our independent registered public accounting firm may disagree. If our independent registered public accounting firm is not satisfied with our internal control over financial reporting or the level at which our internal control over financial reporting is documented, designed, operated or reviewed, or if the independent registered public accounting firm interprets the requirements, rules or regulations differently than we do, then they may issue an adverse or qualified opinion. Any of these possible outcomes could result in an adverse reaction in the financial marketplace due to a loss of investor confidence in the reliability of our audited consolidated financial statements, which could adversely affect the trading price of our ADSs. Our reporting obligations as a public company will place a significant strain on our management, operational and financial resources and systems for the foreseeable future.

If we grant employee share options and other share-based compensation in the future, our net income could be adversely affected.

Our equity incentive plans and other similar types of incentive plans are important in order to attract and retain key personnel. We have granted share options in the past pursuant to an informal plan, and adopted a formal equity incentive plan for our employees in July 2007 for future grants. As a result of the issuance of options under these plans, we have in the past and expect in the future to incur share-based compensation expenses. We account for compensation costs for all share options, including share options granted to our directors and employees, using the fair value method and recognize the expense in our consolidated statement of operations in accordance with Statement of Financial Accounting Standard No. 123-R, which may have a material adverse effect on our net income. Moreover, the additional expenses associated with share-based compensation may reduce the attractiveness of our equity incentive plans.

Anti-takeover provisions in our charter documents may discourage our acquisition by a third party, which could limit our shareholders’ opportunity to sell their shares, including ordinary shares represented by our ADSs, at a premium.

Our amended and restated memorandum and articles of association to be adopted when we become a public company is expected to include provisions that could limit the ability of others to acquire control of us, modify our structure or cause us to engage in change of control transactions. These provisions could have the effect of depriving our shareholders of an opportunity to sell their shares, including ordinary shares represented by ADSs, at a premium over prevailing market prices by discouraging third parties from seeking to obtain control of us in a tender offer or similar transaction.

For example, our board of directors will have the authority, without further action by our shareholders, to issue preference shares in one or more series and to fix the powers and rights of these shares, including dividend rights, conversion rights, voting rights, terms of redemption and liquidation preferences, any or all of which may be greater than the rights associated with our ordinary shares. Preference shares could thus be issued quickly with terms calculated to delay or prevent a change in control or make removal of management more difficult. In addition, if our board of directors authorizes the issuance of preference shares, the market price of our ADSs may fall and the voting and other rights of the holders of our ordinary shares may be materially and adversely affected. See “Description of Share Capital — Issuance of Additional Ordinary Shares or Preference Shares.”

Our directors will be divided into three classes with staggered terms of three years each, which means that shareholders can elect or remove only a limited number of our directors in any given year. The length of these terms could present an additional obstacle against the taking of action, such as a merger or other change of control, that could be in the interest of our shareholders. See “Description of Share Capital — Board of Directors.”

 

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RISKS RELATING TO OUR INDUSTRY

The outsourcing trend in the preclinical and clinical stages of drug discovery and development may decrease, which could slow our growth.

The success of our business depends primarily on the number of contracts and the size of the contracts that we may obtain from pharmaceutical and biotechnology companies. Over the past several years, our business has benefited from increased levels of outsourcing by pharmaceutical and biotechnology companies of their drug discovery R&D activities. While industry analysts expect the outsourcing trend to continue for the next several years, a reversal or slowing of this trend could result in a diminished growth rate in the sales of one or more of our expected growth areas and adversely affect our business, financial condition, results of operations and prospects.

A reduction in R&D budgets at pharmaceutical and biotechnology companies may result in a reduction or discontinued use of our services, which may adversely affect our business.

Fluctuations in the R&D budgets of pharmaceutical and biotechnology industry participants could have a significant effect on the demand for our services. R&D budgets fluctuate due to changes in available resources, consolidation of pharmaceutical and biotechnology companies, spending priorities and institutional budgetary policies. Our business could be adversely affected by any significant decrease in life sciences R&D expenditures by pharmaceutical and biotechnology companies.

We may also be adversely affected in future periods by general economic or pharmaceutical and biotechnology industry downturns. If pharmaceutical and biotechnology companies discontinue or decrease the use of our services due to factors such as a slowdown in the overall U.S. or global economy, our revenues and earnings could be lower than we currently expect and our revenues may decrease or not grow at historical rates.

Changes in government regulation or in practices relating to the pharmaceutical or biotechnology industries, including potential health care reform could decrease the need for the services we provide.

Governmental agencies throughout the world, particularly in the United States, strictly regulate the drug R&D process. Our business involves helping pharmaceutical and biotechnology companies, among others, navigate the regulatory drug approval process. Changes in regulations, such as a relaxation in regulatory requirements or the introduction of simplified drug approval procedures, or an increase in regulatory requirements that we have difficulty satisfying or that make our services less competitive, could eliminate or substantially reduce the demand for our services.

In recent years, the U.S. Congress and state legislatures have considered various types of health care reform to control growing health care costs. Similar reform movements have occurred in parts of Europe and Asia. Implementation of health care reform legislation that contains costs could limit the profits that can be made from the development of new drugs. This could adversely affect R&D expenditures by pharmaceutical and biotechnology companies, which could in turn decrease the business opportunities available to us in the United States and other countries. We are unable to predict what legislative proposals will be adopted in the future, if any.

Compliance with environmental regulations can be expensive, and noncompliance with these regulations may result in adverse publicity and potentially significant monetary damages and fines.

As our drug discovery and development processes generate waste water, toxic and hazardous substances and other industrial wastes, we are required to comply with all national and local regulations in China regarding protection of the environment. We believe that we are in compliance with present material environmental protection requirements. Because the requirements imposed by environmental laws and regulations may change and more stringent regulations may be adopted in the future, we may be unable to accurately predict the cost of

 

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complying with these laws and regulations, which could be substantial. If we fail to comply with present or future environmental regulations, we may be required to pay substantial fines, suspend production or cease operations. In addition, the risk of accidental contamination or injury from these hazardous materials cannot be eliminated. If we fail to prevent contamination or injury, we could be liable for any resulting damages, which could have a material and adverse impact on our business, financial condition, results of operations and prospects.

Negative attention from special interest groups may impair our ability to operate our business efficiently.

The services that we provide our customers are essential to the drug discovery and development process, and are almost universally mandated by law. Some of the services we provide, or intend to provide in the future, involve the use of large and small animals, as well as non-human primates. Certain special interests groups categorically object to the use of animals for valid research purposes. Historically, our core research model activities with small animals have not been the subject of animal rights media attention, and as we expand our service biology offerings into toxicology, we anticipate that we will work extensively with large animals and non-human primates. However, research activities with animals have been the subject of adverse attention, with negative impact on our industry. Any negative attention or threats directed against our animal research activities in the future could impair our ability to operate our business efficiently. In addition, if regulatory authorities were to mandate a significant reduction in safety testing procedures which utilize laboratory animals (as has been advocated by certain groups), our business could be materially and adversely affected.

Any failure to comply with existing regulations and industry standards could harm our reputation and our business, financial condition, results of operations and prospects.

A number of governmental agencies or industry regulatory bodies in China, the United States and Europe, impose strict rules, regulations and industry standards as to how drug R&D should be conducted which apply to our customers and us. Any failure on our part to comply with existing regulations could result in the termination of ongoing research or the disqualification of data for submission to regulatory authorities. This could harm our reputation, our prospects for future work and our operating results. For example, if we were to treat research animals inhumanely and not in accordance with international standards set out by the Association for Assessment and Accreditation of Laboratory Animal Care, or AAALAC, an accreditation we intend to pursue, AAALAC could revoke any such accreditation and the accuracy of our animal research data could be questioned. Furthermore, any material violation by us of standards for “good clinical practice,” known as GCP, “good laboratory practice,” known as GLP, or cGMP, in each case as determined by the U.S. Food and Drug Administration, or FDA, could cause our customers to terminate their contracts with us and thus materially and adversely affect our business, financial condition, results of operations and prospects.

For our client’s future drugs to be marketed in the United States, we may need to obtain clearance from the FDA and our operations will need to comply with FDA standards. Any adverse action by the FDA against us would negatively impact on our ability to offer our services to our customers and harm our business and prospects.

As we expand our service offerings, it is likely that we will need to obtain clearance by the FDA in the event that our customers’ clinical trials reach the stage of filing a New Drug Application, or NDA, with the FDA, to grant permission to market the drug in the United States. All facilities and manufacturing techniques used to manufacture drugs in the United States must conform to standards that are established by the FDA. The FDA may conduct scheduled periodic inspections of our facilities to monitor our compliance with regulatory standards. If the FDA finds that we have failed to comply with the appropriate regulatory standards, it may impose fines or take other actions against us or our customers, or we may no longer be able to offer our services to U.S. customers. The resulting corrective measures may be lengthy and costly. As a result, we may be unable to fulfill our contractual obligations. Any adverse action by the FDA would have a material and adverse impact on our reputation and our business, financial condition, results of operations and prospects. We may or may not obtain clearance from the FDA standards in the event that we are inspected, or maintain such clearance over time.

 

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In providing our pharmaceutical and biotechnology R&D outsourcing services, we face health and safety liability and product liability risks.

In providing our services in connection with drug development, we face a range of potential liabilities which include risks that disease models and animals infected with diseases for research interests may be harmful, or even lethal, to themselves and humans despite preventive measures we take for the quarantine and handling of animals.

We also face product liability risks should the drugs we assist in developing be subject to product liability claims. We provide services in the development, testing and manufacturing of drugs that may ultimately be used by humans. If any of these drugs harm people, we may be required to pay damages to those persons. Damages awarded in a product liability action could be substantial and could have a material and adverse impact on our business, financial condition, results of operations and prospects.

New technologies or methodologies may be developed, validated and increasingly used in the global pharmaceutical and biotechnology R&D outsourcing industry that could reduce demand for some of our services.

The global pharmaceutical and biotechnology R&D outsourcing industry is constantly evolving, and we must keep pace with new technologies and methodologies in the industry to maintain our competitive position. For example, a new drug discovery method, known as “genome-to-drug-lead” approach, in which chemicals can be virtually screened against computer-predicted protein targets, could offer a solution to reduce labor requirements for chemists who experimentally search for drug leads, one of the most significant obstacles to drug discovery. The method may also allow chemists to better exploit the extensive availability of drug targets at the gene level, and ultimately improve the success of moving discoveries from the laboratory to actual patients.

As a result, we must continue to invest significant human and capital resources in R&D to enhance our technology and our existing services and introduce new services utilizing advanced technologies that customers will use. However, we may not be successful in adapting to or commercializing these new technologies if developed. New technologies could decrease the need for our existing technologies, and we may not be able to develop new service or technologies effectively or in a timely manner. Our failure to develop, enhance or adapt, to new technologies and methodologies could significantly reduce demand for our services and harm our business and prospects.

RISKS RELATED TO DOING BUSINESS IN CHINA

The discontinuation of any of the preferential tax treatments currently available to us in the PRC or imposition of any additional PRC taxes on us could adversely affect our financial condition and results of operations.

China currently has a dual tax system that contains one set of tax rules for PRC domestic enterprises and one for foreign investment enterprises, or FIEs. Though both domestic enterprises and FIEs are subject to the same income tax rate of 33%, there are various preferential tax treatments that are generally only available to FIEs, which results in the effective tax rates of FIEs being generally lower than those of domestic enterprises.

All of our PRC subsidiaries are FIEs that are eligible to receive certain preferential tax treatments, in the form of reduced tax rates and/or tax holidays pursuant to current PRC tax laws and regulations. WXPT is an FIE engaged in manufacturing businesses with a business term of over ten years and located in the Wuxi Taihu National Tourist Resort Zone, and as such its head office is entitled to a two-year exemption from enterprise income tax beginning from its first profitable year of operation and a 12% enterprise income tax rate for the subsequent three years followed by a three-year 12% tax rate so long as it continues to qualify as an “advanced

 

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technology enterprise with foreign investment.” The Shanghai branch of WXPT located in Shanghai Waigaoqiao Free Trade Zone is entitled to a two-year exemption from enterprise income tax beginning from its first profitable year of operation and a 7.5% enterprise income tax rate for the subsequent three years followed by a three-year 10% tax rate so long as WXPT continues to qualify as an “advanced technology enterprise with foreign investment.” SHPT is an FIE engaged in manufacturing businesses with a business term of over ten years and located in Shanghai Waigaoqiao Free Trade Zone, and as such it is entitled to a two-year exemption from enterprise income tax beginning from its first profitable year of operation and a 7.5% enterprise income tax rate for the subsequent three years. Subject to confirmation by the local state tax bureaus, STA, TJPT and SZPT might be entitled to reduced tax rates and/or tax holidays from their first profitable year of operation.

On March 16, 2007, the National People’s Congress of the PRC passed the Enterprise Income Tax Law, or new EIT Law, which will take effect as of January 1, 2008. In accordance with the new EIT Law, a unified enterprise income tax rate of 25%, a unified deduction measure and standard and unified tax preferential treatment will be applied to both foreign invested and domestic enterprises. The new EIT Law also provides for transitional measures for enterprises established prior to the promulgation of the new EIT Law and eligible for lower tax rate preferential treatment in accordance with the then prevailing tax laws and administrative regulations. These enterprises will gradually become subject to the new, unified tax rate over a five-year period; enterprises eligible for regular tax reductions or exemptions may continue to enjoy tax preferential treatments after the implementation of the new EIT Law and until their preferential treatment expire. The preferential treatment period of enterprises which have not enjoyed any preferential treatments for the reason of not having made any profits, however, shall be deemed as starting from the implementation of the new EIT Law. In addition, under the new EIT Law, an enterprise established outside of the PRC with “de facto management bodies” within the PRC may be considered a resident enterprise and will normally be subject to the enterprise income tax at the rate of 25% on its global income. The new EIT Law, however, does not define the term “de facto management bodies.” If the PRC tax authorities subsequently determine that, notwithstanding our status as the Cayman Islands holding company of our business, we should be classified as a resident enterprise, then our global income will be subject to PRC income tax at a tax rate of 25%. Furthermore, under the new EIT Law, the exemption to the 20% withholding tax on dividends distributed by FIEs to their foreign investors under the current tax laws may no longer be available. See “— Risks Related to Doing Business in China — We rely principally on dividends and other distributions paid by our operating subsidiaries to fund cash and financing requirements, and limitations on the ability of our operating subsidiaries to pay dividends to us could have a material adverse effect on our ability to conduct our business.” Given that the new EIT Law has been promulgated only recently, its implementation has yet to be further clarified in practice. Moreover, our historical operating results may not be indicative of our operating results for future periods as a result of the expiration of the tax holidays we enjoy.

The discontinuation of any of the financial incentives currently available to us in the PRC could adversely affect our results of operations and prospects.

Since inception, we have enjoyed either exemptions or subsidies with respect to income tax and sales tax. Our eligibility to receive these financial incentives requires that we continue to qualify for these financial incentives, which is subject to the discretion of the central government or relevant local government authorities, who could determine at any time to immediately eliminate or reduce these financial incentives, generally with prospective effect. Since our receipt of the financial incentives is subject to periodic time lags and inconsistent government practice, for so long as we continue to receive these financial incentives, our net income in a particular period may be higher or lower relative to other periods based on the potential changes in these financial incentives in addition to any business or operating related factors we may otherwise experience. For example, we expect future margins on goods manufactured for export to be lower due to changes in China’s VAT system reducing the potential VAT credits on certain categories of goods from 13% to 5%.

 

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Fluctuations in exchange rates have resulted and are expected to continue to result in foreign currency exchange losses and negatively impact our profitability.

In 2006, approximately 98% of our net revenues were generated from sales denominated in U.S. dollars, and a significant portion of our operating costs and expenses were denominated in Renminbi. As a result, fluctuations in exchange rates between U.S. dollars and Renminbi affect the relative purchasing power of our revenue, the proceeds of this offering and our balance sheet and earnings per share in U.S. dollars. In addition, appreciation or depreciation in the value of the Renminbi relative to the U.S. dollar will affect our financial results reported in U.S. dollar terms without giving effect to any underlying change in our business, financial condition or results of operations. Since July 2005, the Renminbi is no longer pegged solely to the U.S. dollar. Instead, the Renminbi is reported to be pegged against a basket of currencies, determined by the People’s Bank of China. As a result, from July 21, 2005 to July 20, 2007, the Renminbi has appreciated approximately 9.29% against the U.S. dollar. The Renminbi may appreciate or depreciate significantly in value against the U.S. dollar in the long term, depending on the fluctuation of the basket of currencies against which it is currently valued, or it may be permitted to enter into a full float, which may also result in a significant appreciation or depreciation of the Renminbi against the U.S. dollar. Fluctuations in the exchange rate will also affect the relative value of any dividend we issue after this offering which will be exchanged into U.S. dollars and earnings from and the value of any U.S. dollar-denominated investments we make in the future.

Very limited hedging transactions are available in China to reduce our exposure to exchange rate fluctuations. We periodically purchase derivative financial instruments such as foreign exchange forward contracts to hedge our exposure to U.S. dollar — Renminbi currency exchange risk. While we may decide to enter into hedging transactions in the future, the availability and effectiveness of these hedges may be limited and we may not be able to successfully hedge our exposure at all. In addition, our currency exchange losses may be magnified by PRC exchange control regulations that restrict our ability to convert Renminbi into foreign currency.

Changes in China’s economic, political and social condition could adversely affect our business, financial condition, results of operations and prospects.

We conduct a substantial majority of our business operations in China. Accordingly, our business, financial condition, results of operations and prospects are affected to a significant degree by economic, political and social conditions in China. The PRC economy differs from the economies of most developed countries in many respects, including the amount of government involvement, level of development, growth rate, control of foreign exchange and allocation of resources. The PRC government has implemented various measures to encourage, but also to control, economic growth and guide the allocation of resources. Some of these measures benefit the overall PRC economy but may also have a negative effect on us. For example, our financial condition and results of operations may be adversely affected by changes in tax regulations applicable to us. Furthermore, the PRC government, through the People’s Bank of China, continues to implement interest rate increases to control the pace of economic growth. These measures may cause decreased economic activity in China, which in turn could adversely affect our business, financial condition, results of operations and prospects.

The PRC legal system embodies uncertainties that could limit the legal protections available to you and us.

The PRC legal system is a civil law system based on written statutes. Unlike common law systems, it is a system in which decided legal cases have limited precedential value. In 1979, the PRC government began to promulgate a comprehensive system of laws and regulations governing economic matters in general. The overall effect of legislation over the past three decades has significantly increased the protections afforded to various forms of foreign investment in China. Our PRC operating subsidiaries are foreign-invested enterprises and are subject to laws and regulations applicable to foreign investment in China as well as laws and regulations applicable to foreign-invested enterprises. These laws and regulations change frequently, and their interpretation

 

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and enforcement involve uncertainties. In addition, some regulatory requirements issued by certain PRC government authorities may not be consistently applied by other government authorities (including local government authorities), thus making strict compliance with all regulatory requirements impractical, or in some circumstances, impossible. For example, we may have to resort to administrative and court proceedings to enforce the legal protections that we enjoy either by law or contract. However, since PRC administrative and court authorities have significant discretion in interpreting and implementing statutory and contractual terms, it may be more difficult to evaluate the outcome of administrative and court proceedings and the level of legal protection we enjoy than in more developed legal systems. These uncertainties may also impede our ability to enforce the contracts we have entered into. By way of further example, although required by PRC law, many foreign-invested enterprises, including our PRC subsidiaries, have not historically obtained approvals from the National Development and Reform Commission or its counterparts, or NDRC, before receiving the approval from the Ministry of Commerce or its counterparts for their establishment. The NDRC has recently reiterated its position that the establishment of foreign-invested enterprises is subject to the NDRC’s approval, in addition to any other required PRC government approvals, but the legal consequence for failure to obtain the NDRC approval by those foreign-invested enterprises, including our PRC subsidiaries, is not prescribed under the current PRC law. As a result, these uncertainties together with any development or interpretation of the PRC law that is adverse to us could materially and adversely affect our business, financial condition, results of operations and prospects.

Our failure to obtain the prior approval of the China Securities Regulatory Commission, or the CSRC, of the listing and trading of our ADSs on the New York Stock Exchange could have a material adverse effect on our business, operating results, reputation and trading price of our ADSs, and may also create uncertainties for this offering.

On August 8, 2006, six PRC regulatory agencies, including the CSRC, promulgated a regulation that became effective on September 8, 2006. This regulation, among other things, has some provisions that purport to require that an offshore special purpose vehicle, or SPV, formed for listing purposes and controlled directly or indirectly by PRC companies or individuals shall obtain the approval of the CSRC prior to the listing and trading of such SPV’s securities on an overseas stock exchange. On September 21, 2006, the CSRC published on its official website procedures specifying documents and materials required to be submitted to it by SPVs seeking CSRC approval of their overseas listings. The application of this PRC regulation remains unclear with no consensus currently existing among the leading PRC law firms regarding the scope and applicability of the CSRC approval requirement.

Our PRC counsel, Commerce & Finance Law Offices, has advised us that because we completed our restructuring before September 8, 2006, the effective date of the new regulation, it is not necessary for us to submit the application to the CSRC for its approval, and the listing and trading of our ADSs on the New York Stock Exchange does not require CSRC approval. A copy of Commerce & Finance Law Offices’ legal opinion regarding this PRC regulation is filed as an exhibit to our registration statement on Form F-1 in connection with this offering, which is available at the SEC’s website at www.sec.gov.

If the CSRC or another PRC regulatory agency subsequently determines that CSRC approval is required for this offering, we may face regulatory actions or other sanctions from the CSRC or other PRC regulatory agencies. These regulatory agencies may impose fines and penalties on our operations in the PRC, limit our operating privileges in the PRC, delay or restrict the repatriation of the proceeds from this offering into the PRC, or take other actions that could have a material adverse effect on our business, financial condition, results of operations, reputation and prospects, as well as the trading price of our ADSs. The CSRC or other PRC regulatory agencies also may take actions requiring us, or making it advisable for us, to halt this offering before settlement and delivery of the ADSs offered hereby. Consequently, if you engage in market trading or other activities in anticipation of and prior to settlement and delivery, you do so at the risk that settlement and delivery may not occur.

 

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Also, if the CSRC later requires that we obtain its approval, we may be unable to obtain a waiver of the CSRC approval requirements, if and when procedures are established to obtain such a waiver. Any uncertainties and/or negative publicity regarding this CSRC approval requirement could have a material adverse effect on the trading price of our ADSs.

PRC regulations relating to offshore investment activities by PRC residents may increase the administrative burden we face and create regulatory uncertainties, and a failure by our shareholders who are PRC residents to complete any required applications and filings pursuant to such regulations may prevent us from distributing profits and could expose us and our PRC resident shareholders to liability under PRC law.

The PRC State Administration of Foreign Exchange, or SAFE, has promulgated several regulations that require PRC residents to register with and/or obtain approvals from branches of SAFE in connection with their direct or indirect offshore investment activities. The SAFE regulation issued in October 2005, known as Notice 75, requires: (i) PRC residents to register with the local SAFE branch before establishing or controlling any offshore company, referred to as an “offshore special purpose company”, for the purpose of acquiring any assets or equities of PRC companies and raising funds from overseas; (ii) any PRC resident who is a shareholder of an offshore special purpose company to amend such shareholder’s SAFE registration with the relevant SAFE branch with respect to such company in connection with any increase or decrease of capital, transfer of shares, merger, division, equity investment or creation of any security interest over any assets located in China, and (iii) registration by March 31, 2006 of direct or indirect investments previously made by PRC residents in such companies. In November 2005 and May 2007, SAFE promulgated certain implementing rules with respect to Notice 75, known as the Notice 75 Implementing Rules.

We have urged our shareholders who are PRC residents to make the necessary registrations and filings as required under these regulations, and these shareholders have made efforts to register their investments in our company with the local SAFE branch in Wuxi, China. However, the local SAFE branch in Wuxi declared that registrations under Notice 75 were not required from these shareholders. As Notice 75 Implementing Rules are relatively new, it remains unclear how Notice 75, and any future PRC legislation concerning offshore or cross-border transactions, will be interpreted and implemented by the relevant PRC government authorities, and whether the local SAFE branch in Wuxi correctly interpreted Notice 75 as to its application to certain of our shareholders. Therefore, we cannot assure you that all relevant shareholders have made and will make and obtain all applicable registrations or filings required by these regulations or other related legislation. Our PRC counsel has advised us that if any of our PRC shareholders fails to make any required SAFE registrations and amendments thereto, our ability to inject capital into our PRC subsidiaries may be limited, and our PRC subsidiaries may be prohibited from distributing their profits and the proceeds from any reduction in capital, share transfer or liquidation to us. Moreover, the failure to comply with SAFE registration and amendment requirements described above could result in liability under PRC laws for evasion of applicable foreign exchange restrictions.

We rely principally on dividends and other distributions on equity paid by our operating subsidiaries to fund cash and financing requirements, and limitations on the ability of our operating subsidiaries to pay dividends to us could have a material adverse effect on our ability to conduct our business.

We are a holding company, and we rely principally on dividends and other distributions on equity paid by our six operating subsidiaries in China for our cash and financing requirements, including the funds necessary to pay dividends and other cash distributions to our shareholders, service any debt we may incur and pay our operating expenses. If any of our six subsidiaries in China incurs debt on its own behalf in the future, the instruments governing the debt may restrict its ability to pay dividends or make other distributions to us. Furthermore, relevant PRC laws and regulations permit payments of dividends by the subsidiary only out of its retained earnings, if any, as determined in accordance with PRC accounting standards and regulations.

 

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Under PRC laws and regulations, each of our operating subsidiaries in China is required to set aside a portion of its net income each year to fund specific reserve funds. These reserves are not distributable as cash dividends. A wholly foreign owned enterprise is required to set aside at least 10% of its after-tax profits of the preceding year as its reserve funds. It may stop contributing if the aggregate amount of the reserve funds has already accounted for more than 50% of its registered capital. Moreover, it may, upon a board resolution, set aside certain amount from its after-tax profits of the preceding year as bonus and welfare funds for staff and workers. An equity joint venture enterprise is required to set aside reserve funds, bonus and welfare funds for staff and workers and development funds, percentage of which shall be determined by the board. As a result of these PRC laws and regulations, each of the operating subsidiaries in China is restricted in its ability to transfer a portion of its net assets to us whether in the form of dividends, loans or advances. As a result of PRC laws and regulations, our PRC subsidiaries are restricted in their ability to transfer a portion of their net assets, either in the form of dividends, loans, or advances. As of December 31, 2006, the restricted portion of their net assets amounted to US$21.0 million, which is composed of the registered capital and the statutory reserve of the PRC subsidiaries. Limitations on the ability of our operating subsidiaries in China to pay dividends to us could materially and adversely limit our ability to grow, make investments or acquisitions that could be beneficial to our businesses, pay dividends, or otherwise fund and conduct our business.

In addition, under a new PRC tax law to be effective in January 2008, dividends from our PRC subsidiaries to us will be subject to a withholding tax at a rate of 20%. The withholding tax on dividends may be exempted or reduced by the State Council of the PRC. Furthermore, the ultimate tax rate will be determined by treaty between the PRC and the tax residence of the holder of the PRC subsidiary. We are actively monitoring the proposed withholding tax and are evaluating appropriate organizational changes to minimize the corresponding tax impact.

Restrictions on currency exchange may limit our ability to utilize our revenues effectively.

Under China’s existing foreign exchange regulations, each of our subsidiaries in China is able to pay dividends in foreign currencies, without prior approval from SAFE or its local counterparts by complying with certain procedural requirements. However, the PRC government may take further measures in the future to restrict access to foreign currencies for current account transactions.

Foreign exchange transactions by our subsidiaries under capital accounts continue to be subject to significant foreign exchange controls and require the approval of, or registration with, PRC governmental authorities. In particular, if one subsidiary borrows foreign currency loans from us or other foreign lenders, these loans must be registered with SAFE or its local counterparts, and if we finance such subsidiary by means of additional capital contributions, these capital contributions must be approved by certain government authorities including the Ministry of Commerce or its local counterparts. These limitations could affect the ability of our subsidiaries to obtain foreign exchange through debt or equity financing.

PRC regulation of loans and direct investment by offshore holding companies to PRC entities may delay or prevent us from using the proceeds of this offering to make loans or additional capital contributions to our PRC operating subsidiaries.

In utilizing the proceeds of this offering in the manner described in “Use of Proceeds,” as an offshore holding company of our PRC operating subsidiaries, we may make loans to our PRC subsidiaries, or we may make additional capital contributions to our PRC subsidiaries. Any loans to our PRC subsidiaries are subject to PRC regulations. For example, loans by us to our subsidiaries in China, which are foreign-invested enterprises, to finance their activities cannot exceed statutory limits and must be registered with SAFE or its local counterparts.

We may also decide to finance our subsidiaries by means of capital contributions. These capital contributions must be approved by the PRC Ministry of Commerce or its local counterpart. We may not be able to obtain these government approvals on a timely basis, if at all, with respect to future capital contributions by us to our PRC subsidiaries. If we fail to receive such approvals, our ability to use the proceeds of this offering and

 

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to capitalize our PRC operations may be negatively affected, which could adversely affect our liquidity and our ability to fund and expand our business.

Any future outbreak of severe acute respiratory syndrome or avian flu in China, or similar adverse public health developments, may severely disrupt our business and operations.

Adverse public health epidemics or pandemics could disrupt businesses and the national economy of China and other countries where we do business. From December 2002 to June 2003, China and other countries experienced an outbreak of a new and highly contagious form of atypical pneumonia now known as severe acute respiratory syndrome, or SARS. On July 5, 2003, the World Health Organization declared that the SARS outbreak had been contained. However, a number of isolated new cases of SARS were subsequently reported, most recently in central China in April 2004. During May and June of 2003, many businesses in China were closed by the PRC government to prevent transmission of SARS. Moreover, some Asian countries, including China, have recently experienced incidents of the H5N1 strain of bird flu, or avian flu. We are unable to predict the effect, if any, that avian flu may have on our business. In particular, any future outbreak of SARS, avian flu or similar adverse public health developments may, among other things, significantly disrupt our ability to adequately staff our business and may adversely affect our operations. Furthermore, an outbreak may severely restrict the level of economic activity in affected areas, which may in turn materially and adversely affect our business and prospects. As a result, any future outbreak of SARS, avian flu or similar adverse public health developments may have a material adverse effect on our business, financial condition, results of operations and prospects.

RISKS RELATING TO THIS OFFERING

An active trading market for our ADSs may not develop, which may result in a decline in the market price of our ADSs.

Prior to this offering, there has been no public market for our ADSs or our ordinary shares underlying the ADSs. If an active public market for our ADSs does not develop after this offering, the market price and liquidity of our ADSs may be adversely affected. We have applied to have our ADSs quoted on the New York Stock Exchange. A liquid public market for our ADSs may not develop. The initial public offering price for our ADSs will be determined by negotiation between us and the underwriters based upon several factors, and the price at which our ADSs trade after this offering may decline below the initial public offering price. As a result, investors in our ADSs may experience a decrease in the value of their ADSs regardless of our operating performance or prospects.

The trading prices of our ADSs are likely to be volatile, which could result in substantial losses to you.

The trading prices of our ADSs are likely to be volatile and could fluctuate widely in response to factors beyond our control. In particular, the performance and fluctuation of the market prices of other companies with business operations located mainly in China that have listed their securities in the United States may affect the volatility in the price of and trading volumes for our ADSs. Recently, a number of PRC companies have listed their securities, or are in the process of preparing for listing their securities, on stock markets in the United States. Some of these companies have experienced significant volatility, including significant price declines after their initial public offerings. The trading performances of these PRC companies’ securities at the time of or after their offerings may affect the overall investor sentiment towards PRC companies listed in the United States and consequently may impact the trading performance of our ADSs. These broad market and industry factors may significantly affect the market price and volatility of our ADSs, regardless of our actual operating performance.

In addition to market and industry factors, the price and trading volume for our ADSs may be highly volatile for specific business reasons. In particular, factors such as variations in our revenue, earnings and cash flow,

 

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announcements of new investments and cooperation arrangements or acquisitions, could cause the market price for our ADSs to change substantially. Any of these factors may result in large and sudden changes in the volume and trading price of our ADSs. In the past, following periods of volatility in the market price of a company’s securities, shareholders have often instituted securities class action litigation against that company. If we were involved in a class action suit, it could divert the attention of senior management, and, if adversely determined, could have a material adverse effect on our business, financial condition, results of operations and prospects.

Recent volatility in global capital markets could lead to substantial losses to investors.

On February 27, 2007, the Shanghai Stock Exchange’s Composite Index dropped by 8.84%. This was immediately followed by drops in certain international stock exchange benchmarks, including, among others, the Dow Jones Industrial Average Index in the United States, the Hang Seng Index in Hong Kong and the Nikkei 225 Stock Average in Japan. The trading prices for our ADSs may be materially and adversely affected by the performance and fluctuations of such benchmarks. Additionally, volatility in global capital markets may affect overall investor sentiment towards our ADSs, which could also negatively affect the trading prices for our ADSs.

The sale or availability for sale of substantial amounts of our ADSs could adversely affect their trading price and could materially impair our future ability to raise capital through offerings of our ADSs.

Sales of substantial amounts of our ADSs in the public market after the completion of this offering, or the perception that these sales could occur, could adversely affect the market price of our ADSs and could materially impair our future ability to raise capital through offerings of our ADSs.

There will be 476,400,000 ordinary shares outstanding immediately after this offering, or 492,226,776 ordinary shares if the underwriters exercise their option to purchase additional ADSs in full. In addition, as of the date of this prospectus, there were outstanding options to purchase 61,095,000 ordinary shares, 24,228,500 of which were exercisable as of that date, 48,993,850 ordinary shares reserved for issuance under our employee share option plans, and 30,350,228 ordinary shares issuable upon conversion of outstanding convertible notes, assuming the initial public offering price of US$12.00 per ADS, the mid-point of the estimated initial public offering price range shown on the front cover of this prospectus. All of the ADSs sold in this offering will be freely tradable without restriction or further registration under the U.S. Securities Act of 1933, as amended, or the Securities Act, unless held by our “affiliates” as that term is defined in Rule 144 under the Securities Act, or Rule 144. The 396,400,000 ordinary shares outstanding prior to this offering (assuming the conversion of all outstanding preference shares into ordinary shares) are “restricted securities” as defined in Rule 144 and may not be sold in the absence of registration other than in accordance with Rule 144 or another exemption from registration.

In connection with this offering, we, our directors, executive officers and certain of our existing shareholders have agreed, among other things, not to sell any ordinary shares or ADSs for 180 days after the date of this prospectus without the written consent of the underwriters. However, the underwriters may release these securities from these restrictions at any time, subject to applicable regulations of the New York Stock Exchange. We cannot predict what effect, if any, market sales of securities held by our significant shareholders or any other shareholder or the availability of these securities for future sale will have on the market price of our ADSs.

Restrictions on our operations contained in convertible notes may limit the manner that we may conduct our business, including the payment of dividends to our shareholders.

On February 9, 2007, we issued US$40 million in convertible notes to a consortium of investors. These notes contain restrictions on our major corporate actions that may limit the manner in which we conduct our business, including the payment of dividends to our shareholders. For so long as at least 50% of the initial

 

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principal amount of all of the notes is outstanding, we may not take any of the following actions without the prior written consent of a majority in interest of the noteholders:

 

   

redeem any of our equity securities if the amount of such redemptions, when aggregated with all other redemptions of equity securities during the period from the date of the issuance of the notes to the date of such redemption, exceeds US$2,500,000;

 

   

pay, in whole or in part, of any indebtedness for borrowed money, other than all present and future bank and purchase money loans, equipment financings and equipment leasings; or

 

   

declare or pay any dividends or other distributions to any equity securities, other than the declaration and payment of (i) a cash dividend in any fiscal year which, when aggregated with all other cash dividends declared during such fiscal year, does not exceed 50% of our audited consolidated net income for our most recently completed fiscal year, calculated in accordance with U.S. GAAP or (ii) any dividend for which an adjustment is made in accordance with the terms of the notes.

As the initial public offering price is substantially higher than the pro forma net tangible book value per share, you will incur immediate and substantial dilution.

If you purchase ADSs in this offering, you will pay more for your ADSs than the amount paid by existing shareholders for their ordinary shares on a per ADS basis. As a result, you will experience immediate and substantial dilution of approximately US$8.76 per ADS (assuming no exercise of outstanding options to acquire ordinary shares), representing the difference between our pro forma net tangible book value per ADS as of March 31, 2007, after giving effect to this offering and the initial public offering price of US$12.00 per ADS (the mid-point of the estimated initial public offering price range shown on the front cover of this prospectus). In addition, you will experience further dilution to the extent that our ordinary shares are issued upon the exercise of share options. All of the ordinary shares issuable upon the exercise of currently outstanding share options will be issued at a purchase price on a per ADS basis that is less than the initial public offering price per ADS in this offering. See “Dilution” for a more complete description of how the value of your investment in our ADSs will be diluted upon the completion of this offering.

We are a Cayman Islands company, and you may have less protection of your shareholder rights than you would under U.S. law.

Our corporate affairs are governed by our amended and restated memorandum and articles of association, the Cayman Islands Companies Law and the common law of the Cayman Islands. The rights of shareholders to take action against the directors, actions by minority shareholders and the fiduciary responsibilities of our directors to us under Cayman Islands law are to a large extent governed by the common law of the Cayman Islands. The common law of the Cayman Islands is derived in part from comparatively limited judicial precedent in the Cayman Islands as well as from English common law, which has persuasive, but not binding, authority on a court in the Cayman Islands. The rights of our shareholders and the fiduciary responsibilities of our directors under Cayman Islands law are not as clearly established as they would be under statutes or judicial precedent in some jurisdictions in the United States. In particular, the Cayman Islands has a less developed body of securities laws than the United States. In addition, some states in the United States, such as Delaware, have more fully developed and judicially interpreted bodies of corporate law than the Cayman Islands.

Moreover, as a non-U.S. company with foreign private issuer status, we have been exempted from, and you are not provided with the benefits of, some of the New York Stock Exchange corporate governance requirements, including that:

 

   

a majority of our board of directors must be independent directors;

 

   

the compensation of our chief executive officer must be determined or recommended by a majority of the independent directors or a compensation committee comprised solely of independent directors; and

 

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our director nominees must be selected or recommended by a majority of the independent directors or a nomination committee comprised solely of independent directors.

As a result, our independent directors will not have as much influence over our corporate policy as they would if we were not a foreign private issuer.

As a result of all of the above, public shareholders may have more difficulty in protecting their interests in the face of actions taken by management, members of the board of directors or controlling shareholders than they would as public shareholders of a U.S. company.

Certain judgments obtained against us by our shareholders may not be enforceable.

We are a Cayman Islands company and substantially all of our assets are located outside of the United States. All of our operations are conducted in the PRC. In addition, many of our directors and officers are nationals and/or residents of countries other than the United States. A substantial portion of the assets of these persons are located outside the United States. As a result, it may be difficult for you to effect service of process within the United States upon these persons. It may also be difficult for you to enforce in U.S. courts judgments obtained in U.S. courts based on the civil liability provisions of the U.S. federal securities laws against us and our officers and directors, most of whom are not resident in the United States and the substantial majority of whose assets are located outside of the United States. In addition, there is uncertainty as to whether the courts of the Cayman Islands or the PRC would recognize or enforce judgments of U.S. courts against us or such persons predicated upon the civil liability provisions of the securities laws of the United States or any state. In addition, there is uncertainty as to whether such Cayman Islands or PRC courts would be competent to hear original actions brought in the Cayman Islands or the PRC against us or such persons predicated upon the securities laws of the United States or any state. See “Enforcement of Civil Liabilities.”

We have not determined a specific use for a portion of the net proceeds from this offering, and we may use these proceeds in ways with which you may not agree.

We have not determined a specific use for a portion of the net proceeds of this offering. Our management will have considerable discretion in the application of these proceeds received by us. You will not have the opportunity, as part of your investment decision, to assess whether the proceeds are being used appropriately. You must rely on the judgment of our management regarding the application of the net proceeds of this offering. The net proceeds may be used for corporate purposes that do not improve our profitability or increase our ADS price. The net proceeds from this offering may also be placed in investments that do not produce income or lose value.

The voting rights of holders of ADSs are limited in several significant ways by the terms of the deposit agreement.

Holders of our ADSs may only exercise their voting rights with respect to the underlying ordinary shares in accordance with the provisions of the deposit agreement. Upon receipt of voting instructions from a holder of ADSs in the manner set forth in the deposit agreement, the depositary will endeavor to vote the underlying ordinary shares in accordance with these instructions. Under our amended and restated memorandum and articles of association and Cayman Islands law, the minimum notice period required for convening a general meeting is ten days. When a general meeting is convened, you may not receive sufficient notice of a shareholders’ meeting to permit you to withdraw your ordinary shares to allow you to cast your vote with respect to any specific matter at the meeting. In addition, the depositary and its agents may not be able to send voting instructions to you or carry out your voting instructions in a timely manner. We will make all reasonable efforts to cause the depositary to extend voting rights to you in a timely manner, but you may not receive the voting materials in time to ensure that you can instruct the depositary to vote your shares. Furthermore, the depositary and its agents will not be responsible for any failure to carry out any instructions to vote, for the manner in which any vote is cast or for the

 

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effect of any such vote. As a result, you may not be able to exercise your right to vote and you may lack recourse if your ordinary shares are not voted as you requested.

You may not receive distributions on our ordinary shares or any value for them if it is illegal or impractical to make them available to you.

The depositary of our ADSs has agreed to pay you cash dividends or other distributions it or its custodian receives on our ordinary shares or other deposited securities after deducting its fees and expenses. You will receive these distributions in proportion to the number of our ordinary shares your ADSs represent. However, the depositary is not responsible if it is unlawful or impractical to make a distribution available to any holders of ADSs. For example, it would be unlawful to make a distribution to a holder of ADSs if it consists of securities that require registration under the Securities Act but that are not properly registered or distributed pursuant to an applicable exemption from registration. The depositary is not responsible for making a distribution available to any holders of ADSs if any government approval or registration required for such distribution cannot be obtained after reasonable efforts made by the depositary. We have no obligation to take any other action to permit the distribution of our ADSs, ordinary shares, rights or anything else to holders of our ADSs. This means that you may not receive the distributions we make on our ordinary shares or any value for them if it is illegal or impractical for us to make them available to you. These restrictions may have a material and adverse effect on the value of your ADSs. We intend to retain all available funds and any future earnings for use in the operation and expansion of our business, and do not anticipate paying any cash dividends on our ordinary shares, or indirectly on our ADSs, in the foreseeable future. See “Dividend Policy.”

You may not be able to participate in rights offerings and may experience dilution of your holdings.

We may, from time to time, distribute rights to our shareholders, including rights to acquire securities. Under the deposit agreement, the depositary will not distribute rights to holders of ADSs unless the distribution and sale of rights and the securities to which these rights relate are either exempt from registration under the Securities Act with respect to all holders of ADSs, or are registered under the provisions of the Securities Act. The depositary may, but is not required to, attempt to sell these undistributed rights to third parties, and may allow the rights to lapse. We may be unable to establish an exemption from registration under the Securities Act, and we are under no obligation to file a registration statement with respect to these rights or underlying securities or to endeavor to have a registration statement declared effective. Accordingly, holders of ADSs may be unable to participate in our rights offerings and may experience dilution of their holdings as a result.

You may be subject to limitations on transfer of your ADSs.

To the extent you hold certificated ADRs rather than holding ADSs through your bank, broker or other nominee through the Depositary Trust Company, your ADSs represented by ADRs will be transferable on the books of the depositary. However, the depositary may close its books at any time or from time to time when it deems expedient in connection with the performance of its duties. The depositary may close its books from time to time for a number of reasons, including in connection with corporate events such as a rights offering, during which time the depositary needs to maintain an exact number of ADS holders on its books for a specified period. The depositary may also close its books in emergencies, and will close its books on weekends and public holidays. The depositary may refuse to deliver, transfer or register transfers of our ADSs generally when our books or the books of the depositary are closed, or at any time if we or the depositary thinks it is advisable to do so because of any requirement of law or any government or governmental body, or under any provision of or circumstance permitted by the deposit agreement.

 

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FORWARD LOOKING STATEMENTS

This prospectus contains forward-looking statements that are based on our current expectations, assumptions, estimates and projections about us and our industry. All statements other than statements of historical fact in this prospectus are forward-looking statements. These forward-looking statements can be identified by words or phrases such as “anticipate,” “believe,” “continue,” “estimate,” “expect,” “intend,” “is/are likely to” “may,” “plan,” “should,” “will,” or other similar expressions. The forward-looking statements included in this prospectus relate to, among others:

 

   

our goals and strategies;

 

   

our future business development, financial condition and results of operations;

 

   

the expected growth of the pharmaceutical and biotechnology outsourcing industry in China and internationally;

 

   

market acceptance of our services;

 

   

our expectations regarding demand for our services;

 

   

our ability to stay abreast of market trends and technological advances;

 

   

our ability to effectively protect our intellectual property rights and not infringe on the intellectual property rights of others;

 

   

competition in the pharmaceutical and biotechnology outsourcing industry;

 

   

PRC governmental policies and regulations relating to the pharmaceutical and biotechnology outsourcing industry; and

 

   

general economic and business conditions in China.

These forward-looking statements involve various risks and uncertainties. Although we believe that our expectations expressed in these forward-looking statements are reasonable, our expectations may turn out to be incorrect. Our actual results could be materially different from our expectations. Important risks and factors that could cause our actual results to be materially different from our expectations are generally set forth in the “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and “Business” and other sections in this prospectus.

The forward-looking statements are made as of the date of this prospectus. We undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date on which the statements are made or to reflect the occurrence of unanticipated events.

Market Data and Forecasts

Unless otherwise indicated, information in this prospectus concerning economic conditions and our industry is based on information from independent industry analysts and publications, as well as our estimates. Except where otherwise noted, our estimates are derived from publicly available information released by third-party sources, as well as data from our internal research, and are based on such data and our knowledge of our industry, which we believe to be reasonable. None of the independent industry publications used in this prospectus were prepared on our or our affiliates’ behalf.

This prospectus also contains data related to the global pharmaceutical and biotechnology outsourcing industry. These market data include estimates and projections that are based on a number of assumptions. If any one or more of the assumptions underlying the market data turn out to be incorrect, actual results may differ significantly from the projections. For example, the global pharmaceutical and biotechnology outsourcing market may not grow at the rate projected by market data, or at all. In addition, the rapidly changing nature of the pharmaceutical and biotechnology outsourcing industry subjects any projections or estimates relating to the growth prospects or future condition of our market to significant uncertainties.

 

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OUR CORPORATE STRUCTURE

We are a Cayman Islands holding company and conduct substantially all of our business through our six operating subsidiaries in China. We own 100% of the equity of all our six operating subsidiaries, directly or indirectly, through WuXi PharmaTech (BVI) Inc., or WXPT BVI, an intermediate holding company incorporated in the British Virgin Islands on June 3, 2004, with no significant assets and or operations of its own. Our corporate structure reflects common practice for companies with operations in the PRC where separate legal entities are often required or advisable for purposes of obtaining relevant tax and other incentives in such jurisdictions. Our holding company structure allows our management and shareholders to take significant corporate actions without having to submit these actions for approval or consent of the administrative agencies in every country where we have significant operations. Moreover, our choice of the Cayman Islands as the jurisdiction of incorporation of our ultimate holding company was motivated in part by its relatively well-developed body of corporate law, various tax and other incentives, and its wide acceptance among internationally recognized securities exchanges as a jurisdiction for companies seeking to list securities.

Substantially all of our business is conducted in the PRC through our primary operating subsidiary, WuXi PharmaTech Co., Ltd., or WXPT, which was established in December 2000 in Wuxi, China. Immediately prior to becoming a wholly-owned subsidiary of WXPT BVI, WXPT was an equity joint venture held by three immediate shareholders: (i) ChinaTechs Inc., or ChinaTechs, a company owned and controlled by our founders and certain of our shareholders, Dr. Ge Li, Dr. Ning Zhao, Mr. Xiaozhong Liu, Mr. Tao Lin, Mr. Zhaohui Zhang, Mr. Peng Li and Mr. Walter Greenblatt, (ii) Jiangsu Taihushui Group Company, or THS, incorporated in the PRC, and (iii) Dr. John J. Baldwin, one of our directors until July 2007, each of whom held 55.54%, 39.46% and 5% equity interests in WXPT, respectively. In March 2001, WXPT established a Shanghai branch, known as WXPT Shanghai Branch, in Shanghai Waigaoqiao Free Trade Zone.

To effect our offshore reorganization, effective July 13, 2005, WXPT BVI and WXPT’s shareholders, together with new third party investors, undertook a series of interrelated transactions whereby WXPT BVI: (i) issued 155,500,000 and 14,000,000 ordinary shares to ChinaTechs and Dr. John J. Baldwin, respectively, in exchange for approximately 60.54% of the outstanding equity interests in WXPT, (ii) issued to the new third party investors 30,940,000 Series A preference shares for US$2,210,000 in cash, (iii) issued 79,560,000 ordinary shares, or approximately 28.41% of the outstanding equity interests of WXPT BVI, to the new investors to be held for the benefit of THS shareholders, and (iv) acquired THS’s remaining interest in WXPT, representing 11.05% of WXPT’s outstanding equity interests, for US$2,210,000 in cash. After the reorganization, WXPT BVI owned 100% of the equity of WXPT. The new investors agreed to temporarily hold the 79,560,000 ordinary shares on behalf of THS shareholders to facilitate the reorganization. As a PRC company with PRC nationals as shareholders, neither THS nor its shareholders were initially able to take title to WXPT BVI’s ordinary shares in a timely manner due to PRC law. In October 2006, the ordinary shares held for the benefit of the THS shareholders were transferred to Rexbury, a Hong Kong company established by the shareholders of THS.

We have five other operating subsidiaries in which we, directly and indirectly, hold a combined 100% equity interest. In 2002 and 2003, WXPT established two domestic subsidiaries, Shanghai PharmaTech Co., Ltd., or SHPT, and Shanghai SynTheAll Pharmaceutical Co., Ltd., or STA. WXPT held a 90% equity interest in each of SHPT (with the remaining 10% equity interest held by Wuxi Century Biology Company) and STA (with the remaining 10% equity interest held by SHPT). Through a series of restructurings in 2006, WXPT BVI then acquired a 30% equity interest in each of SHPT (with the remaining 70% equity interest held by WXPT) and STA (with the remaining 70% equity interest held by SHPT), respectively. As a result, SHPT and STA were converted from purely domestic companies into equity joint ventures. WXPT BVI wholly owns, directly or indirectly, three additional subsidiaries: (i) Shanghai PharmaTech Chemical Technology Co., Ltd., or SHCT, located in Shanghai, which was established in January 2006 and in which WXPT BVI holds a 30% equity interest and SHPT holds a 70% equity interest, (ii) Tianjin PharmaTech Co., Ltd., or TJPT, located in Tianjin, which was established in June 2006 in which WXPT BVI holds a 45% equity interest and WXPT holds a 55% equity interest in TJPT, respectively, and (iii) Suzhou PharmaTech Co., Ltd., or SZPT, located in Suzhou, which

 

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was established in October 2006 and in which WXPT BVI holds a 53.33% equity interest and WXPT holds a 46.67% equity interest. We are in the process of dissolving SHCT due to inactivity.

We undertook a separate restructuring in anticipation of our initial public offering, involving a holding company we incorporated in the Cayman Islands on March 16, 2007. This holding company became our ultimate holding company upon completion of a one-for-one share exchange with the existing shareholders of WXPT BVI on June 15, 2007. The exchange was for all shares of equivalent classes that these shareholders previously held in WXPT BVI.

The following diagram illustrates our corporate structure and the place of formation and affiliation of each of our subsidiaries as of the date of this prospectus:

LOGO

 

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USE OF PROCEEDS

We estimate that we will receive net proceeds from this offering of approximately US$107.8 million, or approximately US$129.9 million if the underwriters exercise their option to purchase additional ADSs in full, after deducting underwriting discounts and the estimated offering expenses payable by us and based upon an assumed initial public offering price of US$12.00 per ADS (the mid-point of the estimated initial public offering price range shown on the front cover of this prospectus). We will not receive any of the proceeds from the sale of ADSs by the selling shareholders.

We intend to use the net proceeds we receive from this offering as follows:

 

   

up to an aggregate of approximately US$40 million for the expansion of our Jinshan facility,

 

   

up to an aggregate of approximately US$40 million for the construction of a preclinical drug safety evaluation center in Suzhou, and

 

   

the balance for general corporate purposes, including working capital, acquisitions and expansion of our service offerings.

We do not currently have any agreements or understandings to make any acquisitions of, or investments in, other businesses. We may use the proceeds to fund, through loans or capital contributions, operations of our China operating subsidiaries in the future if they require additional cash resources. Any loans to our operating subsidiaries in China, because each is an FIE, cannot, in the aggregate, exceed the difference between their respective approved total investment amount and their respective approved registered capital amount. Furthermore, any foreign loan must be registered with SAFE or its local counterparts for the loan to be effective. Any increase in the amount of the total investment and registered capital must be approved by the PRC Ministry of Commerce or its local counterpart. We may not be able to obtain these government approvals on a timely basis, if at all, which could result in a delay in the process of making these loans. See “Risk Factors — Risks Related to Doing Business in China — Recent PRC regulations relating to offshore investment activities by PRC residents may increase the administrative burden we face and create regulatory uncertainties, and a failure by our shareholders who are PRC residents to complete any required applications and filings pursuant to such regulations may prevent us from distributing profits and could expose us and our PRC resident shareholders to liability under PRC law” and “— PRC regulation of loans and direct investment by offshore holding companies to PRC entities may delay or prevent us from using the proceeds of this offering to make loans or additional capital contributions to our PRC operating subsidiaries.”

The foregoing represents our intentions with respect of the use and allocation of the net proceeds from this offering based upon our present plans and business conditions. Our management, however, will have significant flexibility and discretion in applying the net proceeds from the offering. Unforeseen events or changed business conditions may result in application of the proceeds from this offering in a manner other than as described in this prospectus. See “Risk Factors — Risks Relating to this Offering — We have not determined a specific use for a portion of the net proceeds from this offering, and we may use these proceeds in ways with which you may not agree.”

Pending their use, we intend to invest the net proceeds from this offering in short-term, interest bearing, debt instruments or bank deposits. These investments may have a material adverse effect on the U.S. federal income tax consequences of your investment in our ADSs. In particular, it is possible that we may become a passive foreign investment company for U.S. federal income tax purposes, which could result in negative tax consequences for you. See “Risk Factors — Risks Relating to Our Business — We may become a passive foreign investment company, or PFIC, which could result in adverse U.S. tax consequences to U.S. holders” and “Taxation — U.S. Federal Income Taxation — U.S. Holders — Passive Foreign Investment Company.”

 

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DIVIDEND POLICY

We intend to retain all available funds and any future earnings for use in the operation and expansion of our business, and do not anticipate paying any cash dividends on our ordinary shares, or indirectly on our ADSs, for the foreseeable future. Future cash dividends, if any, will be at the discretion of our board of directors and will depend upon our future operations and earnings, capital requirements and surplus, general financial conditions, shareholders’ interests, contractual restrictions and other factors as our board of directors may deem relevant. We can pay dividends only out of profits or other distributable reserves.

In addition, our ability to pay dividends depends substantially on the payment of dividends to us by our six operating subsidiaries in China, namely, WXPT, SHPT, STA, SHCT, TJPT and SZPT. Each of the operating subsidiaries may pay dividends only out of its accumulated distributable profits, if any, determined in accordance with its articles of association, and the accounting standards and regulations in China. WXPT, being a wholly owned foreign enterprise, is required to set aside at least 10% of its after-tax profits of the preceding year as its reserve funds. It may stop such setting aside if the aggregate amount of the reserve funds has already accounted for more than 50% of its registered capital. Moreover, it may, upon a board resolution, set aside certain amount from its after-tax profits of the preceding year as bonus and welfare funds for staff and workers. The other five operating subsidiaries are equity joint ventures which are required to set aside reserve funds, bonus and welfare funds for staff and workers and development funds, percentage of which shall be determined by the board. Further, if any subsidiary incurs debt on its own behalf in the future, the instruments governing the debt may restrict its ability to pay dividends or make other payments to us. Any limitation on the payment of dividends by our subsidiary could materially and adversely limit our ability to grow, make investments or acquisitions that could be beneficial to our businesses, pay dividends and otherwise fund and conduct our businesses. See “Risk Factors — Risks Related to Doing Business in China — We rely principally on dividends and other distributions on equity paid by our operating subsidiaries to fund cash and financing requirements, and limitations on the ability of our operating subsidiaries to pay dividends to us could have a material adverse effect on our ability to conduct our business.”

Furthermore, our outstanding convertible notes contain restrictions on our major corporate actions that may limit the manner that we may conduct our business, including the payment of dividends to our shareholders. For so long as at least 50% of the initial principal amount of all of the notes is outstanding, we may not, without the prior written consent of a majority in interest of the noteholders, declare or pay any dividends or other distributions to any equity securities, other than the declaration and payment of (i) a cash dividend in any fiscal year which, when aggregated with all other cash dividends declared during such fiscal year, does not exceed 50% of our audited consolidated net income for our most recently completed fiscal year, calculated in accordance with U.S. GAAP or (ii) any dividend for which an adjustment is made in accordance with the terms of the notes. See “Risk Factors — Risks Relating to this Offering — Restrictions on our operations contained in convertible notes may limit the manner that we may conduct our business, including the payment of dividends to our shareholders.”

We paid no dividends in 2004. Our primary operating subsidiary in China, WXPT, declared a cash dividend of US$2.4 million in 2005 to its then-current shareholders. We declared and paid a cash dividend of US$6.0 million in 2006 to our shareholders. We paid no dividends in the first quarter of 2007. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources — Financing Activities.”

Holders of ADSs will be entitled to receive dividends, subject to the terms of the deposit agreement, to the same extent as holders of our ordinary shares, less the fees and expenses payable under the deposit agreement. Cash dividends will be paid by the depositary to holders of ADSs in U.S. dollars. Other distributions, if any, will be paid by the depositary to holders of our ADSs in any means it deems legal, fair and practical. See “Description of American Depositary Shares — Share Dividends and Other Distributions.”

 

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CAPITALIZATION

The following table sets forth our capitalization as of March 31, 2007:

 

   

on an actual basis;

 

   

on an as adjusted basis to give effect to: (i) the automatic conversion of all 216,498,550 of our Series A, Series B and Series C preference shares outstanding as of March 31, 2007 into 216,498,550 ordinary shares upon completion of this offering, and (ii) the issuance and sale by us of 10,000,000 ADSs offered in this offering at an assumed initial public offering price of US$12.00 per ADS, the mid-point of the estimated public offering price range shown on the front cover of this prospectus, after deducting underwriting discounts, commissions and estimated offering expenses payable by us; and

 

   

on a pro forma basis to give effect to: (i) the automatic conversion of all 216,498,550 of our Series A, Series B and Series C preference shares outstanding as of March 31, 2007 into 216,498,550 ordinary shares upon completion of this offering, (ii) the conversion of up to 30,350,228 ordinary shares (assuming an initial public offering price of US$12.00 per ADS, the mid-point of the estimated initial public offering price range shown on the front cover of this prospectus) reserved for issuance pursuant to outstanding convertible notes issued on February 9, 2007 and (iii) the issuance and sale by us of 10,000,000 ADSs offered in this offering at an assumed initial public offering price of US$12.00 per ADS, the mid-point of the estimated public offering price range shown on the front cover of this prospectus, after deducting underwriting discounts, commissions and estimated offering expenses payable by us.

 

You should read this table in conjunction with “Selected Consolidated Financial Data,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our audited consolidated financial statements and related notes included elsewhere in this prospectus.

 

    As of March 31, 2007  
    Actual    

As Adjusted

    Pro Forma  
    (in millions of US$, except for share
and per share data)
 

Short term bank borrowings, including current portion of long-term debt

  $ 4.5     $ 4.5     $ 4.5  

Long-term debt, excluding current portion

    5.8       5.8       5.8  

Convertible note

    40.6       40.6       0.0  

Mezzanine equity:

     

Convertible redeemable Series A, Series B and Series C preference shares ($0.0002 par value: 250,000,000 shares authorized and 216,498,550 shares issued and outstanding, actual; and none pro forma)

    100.7       —         —    

Shareholders’ equity (deficit):

     

Ordinary shares ($0.02 par value: 550,000,000 shares authorized and 197,901,450 shares issued and outstanding(1), actual; and             
pro forma)

    4.0       9.9       10.5  

Additional paid-in capital

    36.4       239.0       279.0  

Retained earnings (accumulated deficit)

    (85.2 )     (85.2 )     (85.2 )

Accumulated other comprehensive income

    2.1       2.1       2.1  

Less 18,000,000 treasury shares, at cost

    (0.4 )     (0.4 )     (0.4 )

Total shareholders’ equity (deficit)(2)

    (43.1 )     165.4       206.0  

Total capitalization(2)

    108.5       216.3       216.3  

(1)

Excludes 61,445,000 ordinary shares issuable upon exercise of outstanding options granted pursuant to our prior employee share option grants as of March 31, 2007, 150,000 shares issuable upon exercise of options granted on May 18, 2007, 2,949,450 options reserved for future issuance and 46,044,400 ordinary shares reserved for future issuance under our 2007 Employee Share Incentive Plan.

(2)

Assuming the number of ADSs sold by us in the offering remains the same as set forth on the cover page, a US$1.00 increase (decrease) in the assumed initial public offering price would increase (decrease) the total capitalization by approximately US$9.3 million.

 

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DILUTION

If you invest in our ADSs, your interest will be diluted to the extent of the difference between the initial public offering price per ADS and our net tangible book value per ADS after this offering. Dilution results from the initial public offering price per ordinary share underlying the ADSs substantially exceeding the book value per ordinary share attributable to our presently outstanding ordinary shares.

Our net tangible book value as of March 31, 2007 was approximately US$57.0 million, or US$0.29 per ordinary share outstanding at that date, and US$2.30 per ADS. Net tangible book value is determined by subtracting the value of our intangible assets and total liabilities from our total assets. Dilution is determined by subtracting net tangible book value per ordinary share, after giving effect to the conversion of all outstanding preference shares into ordinary shares upon completion of this offering, from the assumed initial public offering price per ordinary share, which is the mid-point of the estimated initial public offering price range shown on the front cover of this prospectus and after deducting the underwriting discounts and commissions and estimated offering expenses payable by us.

Without taking into account any other changes in net tangible book value after March 31, 2007, other than to give effect to (i) the issuance and sale by us of the 10,000,000 ADSs offered in this offering at the assumed initial public offering price of US$12.00 per ADS, the mid-point of the estimated price range shown on the front cover of this prospectus, with estimated net proceeds of approximately US$107.8 million after deducting underwriting discounts and commissions and estimated offering expenses payable by us, (ii) the conversion of up to 30,350,228 ordinary shares (assuming an initial public offering price of US$12.00 per ADS, the mid-point of the estimated initial public offering price range shown on the front cover of this prospectus) reserved for issuance pursuant to outstanding convertible notes issued on February 9, 2007, and (iii) automatic conversion of all 216,498,550 of our Series A, Series B and Series C preference shares outstanding as of March 31, 2007 into 216,498,550 ordinary shares upon completion of this offering, our pro forma net tangible book value at March 31, 2007 would have been US$205.4 million, or US$0.41 per outstanding ordinary share, including ordinary shares underlying our outstanding ADSs, and US$3.24 per ADS. This represents an immediate increase in pro forma net tangible book value of US$0.12 per ordinary share, or US$0.94 per ADS, to existing shareholders and an immediate dilution in pro forma net tangible book value of US$1.09 per ordinary share, or US$8.76 per ADS, to new investors in this offering. The following table illustrates this per ordinary share dilution:

 

         US$    

Assumed initial public offering price per ordinary share

   1.50

Net tangible book value per ordinary share at March 31, 2007

   0.29

Increase in net tangible book value per ordinary share attributable to this offering

   0.12

Net tangible book value per ordinary share after the offering

   0.41

Dilution in net tangible book value per ordinary share to new investors in the offering

   1.09

Dilution in net tangible book value per ADS to new investors in the offering

   8.76

A US$1.00 increase (decrease) in the assumed initial public offering price would increase (decrease) (i) net tangible book value per share by US$0.15 and (ii) dilution per share by US$0.85, assuming no change to the number of ADSs offered by us as set forth on the cover page of this prospectus, and after deducting underwriting discounts and commissions and other operating expenses.

 

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The following table summarizes the number of ordinary shares purchased from us as of March 31, 2007, the total consideration paid to us and the average price per ordinary share paid by existing investors and by new investors purchasing ordinary shares evidenced by ADSs in this offering at the initial public offering price of US$12.00 per ADS and without giving effect to underwriting discounts and commissions and other estimated offering expenses payable by us. The total number of ordinary shares does not include ordinary shares underlying the ADSs issuable upon the exercise of the overallotment option granted to the underwriters.

 

    

Ordinary Shares Purchased

    Total Consideration     Average
Price Per
Ordinary
Share
Equivalent
   Average
Price Per
ADS
Equivalent
     Number     Percent     Amount    Percent       

Existing shareholders

   426,750,228 (1)   84.2 %   $ 145,306,202    54.8 %   $ 0.34    $ 2.72

New investors

   80,000,000     15.8       120,000,000    45.2       1.50      12.00
                              

Total

   506,750,228     100.0 %   $ 265,306,202    100 %   $ 0.52    $ 4.19
                              

(1)

Assumes automatic conversion of all of our outstanding preference shares into ordinary shares upon completion of this offering and the conversion of up to 30,350,228 ordinary shares of the outstanding convertible note issued on February 9, 2007.

The discussion and tables above also assume no exercise of any outstanding share options. As of March 31, 2007, there were 61,445,000 ordinary shares issuable upon exercise of outstanding share options at a weighted average exercise price of US$0.035 per share, and there were additional ordinary shares available for future issuance upon the exercise of future grants under our 2007 Employee Share Incentive Plan.

 

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EXCHANGE RATES

This prospectus contains translations of RMB amounts into U.S. dollars at specific rates solely for the convenience of the reader. Unless otherwise noted, all translations from RMB to U.S. dollars and from U.S. dollars to RMB in this prospectus were made at a rate of RMB7.7232 to US$1.00, the noon buying rate in New York, New York for cable transfers in Renminbi per U.S. dollar as certified for customs purposes by the Federal Reserve Bank of New York, or the noon buying rate, as of March 30, 2007. We make no representation that any RMB or U.S. dollar amounts could have been, or could be, converted into U.S. dollars or RMB, as the case may be, at any particular rate, the rates stated below, or at all. The PRC government imposes control over its foreign currency reserves in part through direct regulation of the conversion of RMB into foreign exchange and through restrictions on foreign trade. On July 23, 2007, the noon buying rate was RMB7.5652 to US$1.00.

The following table sets forth information concerning exchange rates between the RMB and the U.S. dollar for the periods indicated. These rates are provided solely for your convenience and are not necessarily the exchange rates that we used in this prospectus or will use in the preparation of our periodic reports or any other information to be provided to you. The source of these rates is the Federal Reserve Bank of New York.

 

Period

   Noon Buying Rate
   Period-End    Average(1)    Low    High

2002

   8.2800    8.2770    8.2700    8.2800

2003

   8.2767    8.2772    8.2765    8.2800

2004

   8.2765    8.2768    8.2764    8.2774

2005

   8.0702    8.1940    8.0702    8.2765

2006

   7.8041    7.9723    7.8041    8.0702

2007

           

January

   7.7714    7.7876    7.7705    7.8127

February

   7.7410    7.7502    7.7410    7.7632

March

   7.7232    7.7369    7.7232    7.7454

April

   7.7090    7.7247    7.7090    7.7345

May

   7.6516    7.6773    7.6463    7.7065

June

   7.6120    7.6333    7.6120    7.6680

July (period through July 23, 2007)

   7.5652    7.5793    7.5580    7.6055

(1)

Annual averages are calculated from month-end rates. Monthly averages are calculated using the average of the daily rates during the relevant period.

 

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SELECTED CONSOLIDATED FINANCIAL DATA

The following selected consolidated income statement data for the years ended December 31, 2004, 2005 and 2006, and the selected consolidated balance sheet data as of December 31, 2005 and 2006 have been derived from our audited consolidated financial statements included elsewhere in this prospectus, which have been audited by Deloitte Touche Tohmatsu CPA Ltd., an independent registered public accounting firm. Our selected consolidated balance sheet data as of December 31, 2004 were derived from our audited consolidated financial statements that are not included in this prospectus. Our selected consolidated financial information for the years ended December 31, 2002 and 2003 have been derived from our unaudited consolidated financial statements, which are not included in this prospectus. Our selected consolidated income statement data for each of the three month periods ended March 31, 2006 and 2007 and selected consolidated balance sheet data as of March 31, 2007 have been derived from our unaudited consolidated financial statements included elsewhere in this prospectus. We have prepared the unaudited consolidated financial information on the same basis as our audited consolidated financial statements. The unaudited financial information includes all adjustments, consisting only of normal and recurring adjustments, that we consider necessary for a fair presentation of our financial position and operating results for the periods presented. Results for the three months ended March 31, 2007 are not necessarily indicative of results that may be expected for the full year. You should read the selected consolidated financial data in conjunction with those financial statements and the accompanying notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Our consolidated financial statements are prepared and presented in accordance with U.S. GAAP. Our historical results do not necessarily indicate our results expected for any future periods.

     Year Ended December 31,     Three Months Ended
March 31,
 
         2002             2003             2004             2005             2006             2006             2007      
     (in millions of US$, except per share data)  

Consolidated Income Statement Data:

              

Net revenues:

              

Laboratory services

   $ 3.1     $ 7.8     $ 16.4     $ 29.4     $ 59.8     $ 8.9     $ 21.7  

Manufacturing

     *       1.9       4.5       4.4       10.1       3.9       12.1  
                                                        

Total

     3.1       9.7       20.9       33.8       69.9       12.8       33.8  
                                                        

Cost of revenues:

              

Laboratory services

     (1.3 )     (3.7 )     (7.9 )     (12.8 )     (26.5 )     (3.6 )     (10.8 )

Manufacturing

     *       *       (1.4 )     (2.7 )     (9.1 )     (3.8 )     (7.3 )
                                                        

Total

     (1.3 )     (3.7 )     (9.3 )     (15.5 )     (35.6 )     (7.4 )     (18.1 )
                                                        

Gross profit

     1.8       6.0       11.6       18.3       34.3       5.4       15.7  
                                                        

Operating expenses:

              

Selling and marketing expenses

     (0.3 )     (0.7 )     (0.7 )     (1.0 )     (1.9 )     (0.2 )     (0.7 )

General and administrative expenses

     (1.3 )     (3.5 )     (5.9 )     (8.5 )     (22.3 )     (3.7 )     (9.1 )
                                                        

Total

     (1.7 )     (4.2 )     (6.6 )     (9.5 )     (24.2 )     (3.9 )     (9.8 )
                                                        

Operating income

     0.2       1.8       5.0       8.8       10.1       1.5       5.9  
                                                        

Other income

     *       *       0.6       0.3       0.5       *       0.8  

Other expenses

     *       *       *       (0.6 )     (0.5 )     *       *  

Interest expense

     *       (0.1 )     (0.6 )     (1.3 )     (1.1 )     (0.4 )     (0.7 )

Interest income

     *       *       *       *       0.3       *       *  
                                                        

Income before income taxes

     0.2       1.7       5.0       7.2       9.3       1.1       6.1  

Income tax expense

     *       *       (0.7 )     (1.1 )     (0.4 )     (0.3 )     (0.1 )
                                                        

Net income(1)

   $ 0.2     $ 1.7     $ 4.3     $ 6.1     $ 8.9     $ 0.8     $ 6.0  
                                                        

Basic earnings (loss) per share(2)

   $ 0.00     $ 0.01     $ 0.02     $ (0.00 )   $ (0.15 )   $ 0.00     $ (0.01 )
                                                        

Diluted earnings (loss) per share(2)

   $ 0.00     $ 0.01     $ 0.02     $ (0.00 )   $ (0.15 )   $ 0.00     $ (0.01 )
                                                        

Dividends declared per ordinary share

   $     $ 0.00     $     $ 0.01     $ 0.02     $     $  
                                                        

Dividends declared per preference share

   $     $     $     $     $ 0.00     $     $  
                                                        

 

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* Less than US$50,000.

(1)

Including total share-based compensation charges of approximately US$0 in 2004, US$3.1 million in 2005, US$8.4 million in 2006 and US$0.3 million and US$3.4 million in the first quarter of 2006 and 2007, respectively, allocated as follows:

 

    

Year Ended December 31,

   Three Months Ended
March 31,
         2004            2005            2006            2006            2007    
    

    (in millions of US$)    

Cost of revenues

   —      $ 0.4    $ 0.5    $ 0.1      $ 1.1  

General and administrative expenses

   —        2.7      7.9      0.2        2.3  

 

(2)

The following table sets forth the computation of basic and diluted earnings (loss) for the periods indicated:

 

     Year Ended
December 31,
   

Three Months

Ended March 31,

 
     2004    2005     2006         2006             2007      
    

    (in millions of US$)    

 

Net income

   $ 4.3    $ 6.1     $ 8.9     $ 0.8     $ 6.0  

Deemed dividend on issuance and repurchase of preference shares

     —        (4.0 )     (24.1 )     —         (7.6 )

Deemed dividend for beneficial conversion feature

     —        (2.2 )     (19.2 )     —         —    

Dividend on preference share

     —        —         (0.7 )     —         —    

Amounts allocated to preference shares for participating rights to dividends

     —        *       —         (0.1 )     —    
                                       

Income (loss) attributable to holders of ordinary shares—basic and diluted

   $ 4.3    $ (0.1 )   $ (35.1 )   $ 0.7     $ (1.6 )
                                       

* Less than US$50,000.

 

     As of December 31,     As of
March 31,
 
     2002    2003    2004    2005    2006     2007  
     (in millions of US$)  

Consolidated Balance Sheet Data:

                

Cash and cash equivalents

   $ 2.6    $ 2.0    $ 3.3    $ 4.9    $ 9.7     $ 49.5  

Total current assets

     4.6      5.8      9.0      14.5      36.7       79.7  

Total assets

     7.6      16.8      28.6      40.9      85.7       133.8  

Total current liabilities

     3.9      6.6      11.7      18.4      30.6       28.6  

Total liabilities

     3.9      11.4      19.0      23.6      37.5       76.2  

Mezzanine equity

                    6.1      49.1       100.7  

Total shareholders’ equity (deficit)

     3.7      5.4      9.6      11.2      (0.9 )     (43.1 )

Total liabilities, mezzanine equity and shareholders’ equity (deficit)

   $ 7.6    $ 16.8    $ 28.6    $ 40.9    $ 85.7     $ 133.8  

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

You should read the following discussion and analysis of our financial condition and results of operations in conjunction with the sections entitled “Summary Consolidated Financial Data” and “Selected Consolidated Financial Data” and our audited consolidated financial statements and the related notes included elsewhere in this prospectus. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results and the timing of selected events could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under “Risk Factors” and elsewhere in this prospectus.

Overview

We are the leading China-based pharmaceutical and biotechnology R&D outsourcing company. We provide a broad and integrated portfolio of laboratory and manufacturing services in the drug discovery and development process to pharmaceutical and biotechnology companies. Our services are designed to help our customers address the bottleneck between the discovery of therapeutic targets and the testing of drug candidates in human clinical trials. Our operations are grouped into two segments: laboratory services, consisting of discovery chemistry, service biology, analytical, pharmaceutical development and process development services, and manufacturing, focusing on manufacturing of advanced intermediates and APIs. Prior to 2007, our net revenues were derived principally from our discovery chemistry services in our laboratory segment and the sale of advanced intermediates and APIs in our manufacturing segment.

Our net revenues increased from US$20.9 million in 2004 to US$33.8 million in 2005 and US$69.9 million in 2006, representing a two-year CAGR of 83%, and a year-over-year growth rate of 107% from 2005 to 2006, and increased from US$12.8 million in the first quarter of 2006 to US$33.8 million in the first quarter of 2007, a growth of 165%. Our net income increased from US$4.3 million in 2004 to US$6.1 million in 2005 and US$8.9 million in 2006 (including total share-based compensation charges of approximately US$0 in 2004, US$3.1 million in 2005 and US$8.4 million in 2006), representing a two-year CAGR of 44%, and a year-over-year growth rate of approximately 44% from 2005 to 2006, and increased from US$0.8 million in the first quarter of 2006 to US$6.0 million in the first quarter of 2007 (including total share-based compensation charges of US$0.3 million in the first quarter of 2006 and US$3.4 million in the first quarter of 2007). Our gross margins were 55.7% in 2004, 54.1% in 2005, 49.1% in 2006 and 46.3% in the first quarter of 2007. Our historical growth has been attributable primarily to an increase in the number of our customers and resulting projects, expansion of our capabilities, an increase in our service offerings along the drug discovery value chain and the continued development of our existing customer base towards long-term, integrated service contracts. In 2006, we provided our services to 70 pharmaceutical and biotechnology customers, including nine of the top 10 pharmaceutical companies in the world, as measured by 2006 total revenues. We had 533, 890, 1,843 and 1,972 employees as of December 31, 2004, 2005 and 2006, and May 31, 2007, respectively.

We have benefited significantly from growth in the global pharmaceutical and biotechnology outsourcing industry. This growth is being driven by the need to increase the speed and lower the cost of drug development, unmet medical needs of an ageing population, technological innovations that are increasing the conversion of lead candidates to drugs, increasing regulatory and safety standards, and the demands of the biotechnology industry. In response, many large pharmaceutical and biotechnology companies are “offshoring” and/or outsourcing R&D activities to regions with significant resource and cost advantages, such as China. Advantages offered by China include a large talent pool in the chemistry, biology and medical sciences and other related fields, relatively low-cost labor and capital expenditures, a developed infrastructure and favorable government incentives providing for utility, land and tax advantages.

We intend to focus in the near term on successfully expanding our service capabilities in chemistry, service biology and manufacturing. Beginning in 2007, we began to offer preclinical development services, such as

 

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DMPK, general toxicology services, as well as pharmaceutical development services and manufacturing of clinical trial materials. We also intend to expand our capacity and facilities. We recently opened our Tianjin facility, adding approximately 130,000 square feet of R&D space, and began the expansion of our Jinshan plant to quadruple the manufacturing capacity of the plant. We are planning to construct a preclinical drug safety evaluation center in Suzhou, which we plan to inaugurate in 2009.

We expect our manufacturing segment, which typically has a significantly lower gross margin than our laboratory services segment, will represent an increasing percentage of our net revenues in 2007 and beyond and consequently may result in our reporting a lower overall gross margin. Moreover, we expect that the anticipated manufacturing projects at our expanded Jinshan facility will result in even lower margins as we evolve our business from small-scale, discrete projects to large scale, higher-volume projects. We also expect our margins on manufactured drug products to be adversely impacted by changes effective July 1, 2007 in the PRC’s value-added tax, or VAT, credit system. These changes will result in higher manufacturing costs of revenue to the extent we are unable to charge our end-user customers the VAT payable on manufactured drug products sold to them. Historically, VAT amounts we were required to pay were not significant and, consequently, we did not pass along VAT to our customers. Despite the potential for lower margins, we believe that a broader manufacturing business adds to the stability and predictability of our revenues and enables us to continue to grow our net income. Revenues in our manufacturing segment are prone to quarterly fluctuation, principally based on the delivery schedules of our customers, which vary from period to period.

Our longer term goal is to become a leading full service provider of drug discovery and development outsourcing services to the global pharmaceutical and biotechnology industry. To achieve our objectives, we intend to focus on our core competencies by continuing to provide services along the drug discovery value chain and delivering new, innovative solutions to meet our customers’ needs, while maintaining our customers’ trust through quality, responsive, value-added services and protection of their intellectual property. Related challenges include our ability to successfully expand our manufacturing capabilities, adapt our business to industry trends, diversify our customer base and adapt to potential loss of sales to, or significant reduction in orders from, any of our major customers, and continue to compete effectively in our industry, which may subject us to increasing pricing pressure and reduce the demand for our services. To address these challenges, among other things, we regularly evaluate our relationship with and satisfaction of our customers. In turn, as appropriate, we adjust our service offerings, sales and marketing efforts and business strategy.

Net Revenues

Our net revenues represent our total revenues from operations, less sales taxes.

Laboratory services

We offer our laboratory services on a fee-for-service basis, FTE basis or a combination thereof. From an operational perspective, there is no difference between our scientists and other employees that work on an FTE basis and those that work on a fee-for-service basis: all are our full-time employees.

We derive FTE-based revenues primarily from our discovery chemistry services. An FTE arrangement differs from conventional fee-for-service arrangements in that a team of company scientists is dedicated to the specific needs of an individual customer for a period of time. The customer pays a fixed rate per FTE regardless of the workload, overtime or how the assignment may change, as determined in each contract, and generally includes the materials costs incurred. While our per-FTE fixed rate has remained relatively stable over time, our underlying labor costs per scientist have increased in line with overall increases in labor costs in China, which has resulted in pressure on our margins. A significant portion of our laboratory services revenues has been derived from the growth of our FTE-based contracts as we have increased both our number of customers and the scope of services we provide to existing customers; however, we expect to decrease such portion in the future as we expand into higher margin areas, such as service biology, which we intend to pursue increasingly on a

 

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fee-for-service basis. We also expect to secure more multi-year contracts with our customers in the future, which we believe will add to the stability and predictability of our revenues.

We derive fee-for-service revenues primarily from our discovery chemistry services. A significant portion of our net revenues from these projects are contingent on success and are often structured as fixed price or fee-for-service with a cap.

We also derive limited revenues from our service biology, pharmaceutical development, analytical and process development services, on a combination of FTE and fee-for-service basis. Although revenues from these new services represented an aggregate of only 1.1%, 1.8% and 1.1% of our total net revenues in 2004, 2005 and 2006, respectively, we expect that these activities will increasingly contribute to the growth of our business, in particular as our service biology offerings gain traction with our customer base.

Manufacturing

We derive manufacturing revenues from manufacturing of advanced intermediates and APIs on a fee-for-service basis. Prior to the construction of our primary manufacturing facility in Jinshan, we leased a facility in Taizhou for our manufacturing needs. We terminated this lease in mid-2004. In 2004, we completed the construction of our Jinshan facility, and in 2005 our major customers performed audits to determine that our facilities met internal customer standards. As a result, we experienced in 2006 a surge in manufacturing revenues. Since that time, revenues in our manufacturing segment have been, and are expected to continue to be, prone to significant quarterly fluctuation, principally based on the delivery schedules of our customers. Generally speaking, we expect that our manufacturing revenues will fluctuate with the orders we fill. For example, we expect that revenues in our manufacturing segment in the second quarter of 2007 will be less than half of the revenues in our manufacturing segment in the first quarter of 2007, due to the delivery schedules of our customers in the first part of 2007. Primarily to serve the process development and manufacturing needs of one of our major customers, Vertex, we are expanding our Jinshan facility to quadruple the manufacturing capacity of the plant. We expect to allocate up to an aggregate of approximately US$40 million of the net proceeds from this offering to this expansion project and expect it to account for a significant portion of our capital expenditures for 2007 and 2008.

Substantially all of our total net revenues over the last three fiscal years were generated from sales to customers located in the United States.

Cost of revenues

Laboratory services

Cost of laboratory services consists primarily of (i) labor, which includes salaries and associated benefits of employees involved in the provision of laboratory services, such as bonuses, (ii) raw materials, which include catalysts, solutions, reagents and solvents and lab supplies, and (iii) overhead, which includes primarily the allocated costs of the internal support component of our analytical services department; our health, safety, environmental, quality control, quality assurance, engineering, warehouse and procurement departments, as well as direct depreciation and associated direct expenses and staff salaries and benefits associated with each such department; depreciation for our primary facility in Shanghai Waigaoqiao Free Trade Zone and property, plant and equipment; and utilities.

Labor is a significant component of our cost of laboratory services and therefore an important factor affecting our profitability. We expect labor costs to increase as a percentage of total net revenues over time due to overall rising labour costs, which we expect to be partially offset by efficiencies gained by our scientists and by entering into higher margin services. Overall, we expect labor costs to increase substantially in absolute terms: to meet our anticipated growth needs, we anticipate that we will hire a significant number of employees during 2007, increasing our headcount substantially.

 

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As we expand our service biology department and our toxicology offerings, we expect that the overall costs related to providing these services to become more significant. Overall, we are taking steps to reduce raw materials costs, such as improving the efficiency of our scientists’ use of such materials.

Manufacturing

Cost of manufacturing services consists primarily of (i) overhead, (ii) raw materials used in manufacturing and (iii) VAT taxes payable to the extent not charged to our customers. We expect overhead costs to increase primarily as a result of depreciation of our expanded Jinshan manufacturing facility. We expect raw materials costs to increase significantly in absolute terms as our manufacturing business expands, offset in part by economies of scale derived from better bargaining power and volume discounts associated with larger purchases. We expect our net VAT costs to increase following changes effective July 1, 2007 to the VAT credit system, to the extent we are unable to pass along the increased costs to our customers.

Cost of revenues also includes an allocation of our share-based compensation charges based on the nature of work which certain employees were assigned to perform. See “— Critical Accounting Policies — Share-Based Compensation Expenses.”

Gross Profit and Margin

Gross profit is equal to net revenues less cost of revenues. Gross margin is equal to gross profit divided by net revenues. Changes in our gross profit and margin from period to period are primarily driven by our service mix and pricing, as well as exchange rate variations. We expect our gross margin to continue to face pressure as a result of the anticipated growth of our manufacturing segment, which is a volume-based business and typically has a significantly lower gross margin than our other services, as a larger component of our service mix, as well as increased VAT costs on manufactured goods and the anticipated appreciation of the Renminbi relative to the U.S. dollar. We expect to offset this pressure on our gross margin to a certain extent by concurrently expanding our laboratory services segment into higher margin areas such as our preclinical and service biology offerings.

Operating Expenses

Our operating expenses consist of selling and marketing expenses and general and administrative expenses.

Selling and Marketing Expenses

Selling and marketing expenses consist primarily of export agent fees and freight charges related to samples and products shipped to our customers and salaries and benefits for our customer service department. We expect that our selling and marketing expenses will continue to decrease as a percentage of sales as these costs are relatively fixed and do not increase in direct proportion to net revenues. In the future, we anticipate our sales and marketing expenses may increase as we build sales and marketing teams in the U.S., Europe and Japan. In the future, we expect that selling and marketing expenses will include an allocation of share-based compensation charges based on the nature of the work which certain employees were assigned to perform.

General and Administrative Expenses

General and administrative expenses consist primarily of salary and welfare funds, plus bonuses and profit sharing amounts, for senior management, and all employees in our administration departments including finance, human resources, executive office, legal, information technology and public/investor relations; legal counseling and auditing fees; depreciation and amortization of our land use rights and intangible assets. General and administrative expenses include, and are offset by, government cash subsidies for our general use, which are awarded at the discretion of local authorities. General and administrative expenses also include an allocation of our share-based compensation charges based on the nature of work which certain employees were assigned to perform. See “— Critical Accounting Policies — Share-Based Compensation Expenses.”

 

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We expect our general and administrative expenses to increase as our business expands, including hiring more senior executives and management staff, in future periods and as we incur increased costs related to complying with our reporting obligations under the U.S. securities laws as a public company. These increased costs will include those related to our obligations under Section 404 of the Sarbanes-Oxley Act of 2002, requiring that, beginning with our annual report on Form 20-F for 2008, we include our management’s report on internal control over financial reporting and an attestation by our independent registered public accounting firm as to our management’s assessment of the effectiveness of our internal control over financial reporting.

Other Income

Other income consists primarily of rental income derived from leasing excess office space, and gains recognized on foreign exchange forward contracts. Rental income relates to the lease of one of the buildings at our primary facility in Shanghai Waigaoqiao Free Trade Zone. The lease began in April 2006 and terminated in May 2007.

Other Expenses

Other expenses primarily consists of losses recognized on foreign exchange forward contracts.

Interest Expense

Interest expense consists of interest expense associated with finance costs for loans, as well as interest expense due to a financing arrangement related to our primary facility in Shanghai Waigaoqiao Free Trade Zone. In March 2006, we cancelled the financing arrangement and fully repaid the indebtedness in June 2007. On February 9, 2007, we issued US$40 million in convertible notes to certain investors. The note holders are entitled to a stated interest at the rate of 5% per annum on the principal amount of the note, unless a qualifying IPO (as defined in the notes) is not consummated prior to January 1, 2008, whereby the interest will be adjusted upwards to the rate of 12% per annum for the period retroactively to the date of issuance. Upon the consummation of a qualifying IPO, interest will cease to accrue. The contingently convertible notes are recorded as a long-term liability without any substantial premium or discount for the amount of US$40 million. We are accruing interest at 12% per annum on the notes as the 5% interest rate is applicable only upon the consummation of a qualifying IPO, which is not within our control. The notes are contingently convertible into our ordinary shares at the option of the note holder at any time after the earlier of the completion of this offering or a sales transaction. The conversion price is 90% of either (a) the final offering price per share in an IPO or (b) the price per share offered to us for our ordinary shares in a sale transaction. The 10% discount may result in the Company recording a beneficial conversion feature, or BCF, which is calculated as the difference between the actual conversion price and the fair value of our ordinary shares on the note issuance date (February 9, 2007) of $0.719, multiplied by the number of shares into which the notes are convertible. Therefore, an offering or sales price below $0.799 will result in a BCF. This BCF will be recorded on the date of the offering or sales transaction as additional interest expense.

Interest Income

Interest income consists of income earned on cash and cash equivalents and restricted cash.

Taxes and Incentives

Cayman Islands

We are incorporated in the Cayman Islands. Under the current laws of the Cayman Islands, we are not subject to income or capital gains tax. In addition, dividend payments are not subject to withholding tax in the Cayman Islands.

 

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British Virgin Islands

Our intermediate offshore holding company, WXPT BVI, is incorporated in the British Virgin Islands. Under the current laws of the British Virgin Islands, WXPT BVI is not subject to income or capital gains tax. In addition, dividend payments are not subject to withholding tax in the British Virgin Islands.

PRC

Most of our PRC subsidiaries are FIEs that are eligible to receive certain preferential tax treatments, in the form of reduced tax rates and/or tax holidays pursuant to current PRC tax laws and regulations. WXPT is an FIE engaged in manufacturing businesses with a business term of over ten years and located in the Wuxi Taihu National Tourist Resort Zone, and as such its head office is entitled to a two-year exemption from enterprise income tax beginning from its first profitable year of operation and a 12% enterprise income tax rate for the subsequent three years followed by a three-year 12% tax rate so long as it continues to qualify as an “advanced technology enterprise with foreign investment”. The Shanghai branch of WXPT located in Shanghai Waigaoqiao Free Trade Zone is entitled to a two-year exemption from enterprise income tax beginning from its first profitable year of operation and a 7.5% enterprise income tax rate for the subsequent three years followed by a three-year 10% tax rate so long as WXPT continues to qualify as an “advanced technology enterprise with foreign investment”. SHPT is an FIE engaged in manufacturing businesses with a business term of over ten years and located in Shanghai Waigaoqiao Free Trade Zone, and as such it is entitled to a two-year exemption from enterprise income tax beginning from its first profitable year of operation and a 7.5% enterprise income tax rate for the subsequent three years. Subject to confirmation by the local state tax bureaus, STA, TJPT and SZPT might be entitled to reduced tax rates and/or tax holidays from their first profitable year of operation.

The following table illustrates the tax benefits for our principal operating subsidiaries and branches:

 

Entity Name

  

Normal Tax
Rate

  

Tax Holiday

WXPT (Head Office)

   24%    Tax holiday - 2 years tax free (2002, 2003); 3 years tax at 12% (2004-2006); 3 years tax at 12% (2007-2009)

Shanghai Branch of WXPT

   15%    Tax holiday - 2 years tax free (2002, 2003); 3 years tax at 7.5% (2004-2006); 3 years tax at 10% (2007-2009)

SHPT

   15%    Tax holiday - 2 years tax free (2006, 2007); 3 years tax at 7.5% (2008-2010)

Preferential tax treatments granted to our subsidiaries by the local governmental authorities are subject to review and may be adjusted or revoked at any time. The discontinuation of any preferential tax treatments currently available to us and our wholly owned subsidiaries will cause our effective tax rate to increase, which could have a material adverse effect on our results of operations.

On March 16, 2007, the National People’s Congress of the PRC passed the new EIT Law, which will take effect as of January 1, 2008. In accordance with the new EIT Law, a unified enterprise income tax rate of 25%, a unified deduction measure and standard and unified tax preferential treatment will be applied to both FIEs and domestic enterprises. The new EIT Law also provides for transitional measures for enterprises established prior to the promulgation of the new EIT Law and eligible for lower tax rate preferential treatment in accordance with the then prevailing tax laws and administrative regulations. These enterprises will gradually become subject to the new, unified tax rate over a five-year period; enterprises eligible for regular tax reductions or exemptions may continue to enjoy tax preferential treatments after the implementation of the new EIT Law and until their preferential treatment expire. The preferential treatment period of enterprises which have not enjoyed any preferential treatments for the reason of not having made any profits, however, shall be deemed as starting from the implementation of the new EIT Law.

 

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Furthermore, under the new EIT Law, an enterprise established outside of the PRC with “de facto management bodies” within the PRC may be considered a resident enterprise and will normally be subject to the enterprise income tax at the rate of 25% on its global income. The new EIT Law, however, does not define the term “de facto management bodies.” If the PRC tax authorities subsequently determine that, notwithstanding our status as the Cayman Islands holding company of our business, we should be classified as a resident enterprise, then our global income will be subject to PRC income tax at a tax rate of 25%. In addition, under the new EIT Law, dividends from our PRC subsidiaries to us will be subject to a withholding tax at a rate of 20%. The withholding tax on dividends may be exempted or reduced by the State Council of the PRC. Furthermore, the ultimate tax rate will be determined by treaty between the PRC and the tax residence of the holder of the PRC subsidiary. We are actively monitoring the proposed withholding tax and are evaluating appropriate organizational changes to minimize the corresponding tax impact.

Given that the new EIT Law has been promulgated only recently, its implementation has yet to be further clarified in practice. Moreover, our historical operating results may not be indicative of our operating results for future periods as a result of the expiration of the tax holidays we enjoy. See “Risk Factors — Risks Related to Doing Business in China — The discontinuation of any of the preferential tax treatments currently available to us in the PRC or imposition of any additional PRC taxes on us could adversely affect our financial condition and results of operations.”

Since inception, we have enjoyed either exemptions or subsidies with respect to income tax and sales tax. Our eligibility to receive these financial incentives requires that we continue to qualify for these financial incentives, which is subject to the discretion of the central government or relevant local government authorities, who could determine at any time to immediately eliminate or reduce these financial incentives, generally with prospective effect. Since our receipt of the financial incentives is subject to periodic time lags and inconsistent government practice, for so long as we continue to receive these financial incentives, our net income in a particular period may be higher or lower relative to other periods based on the potential changes in these financial incentives in addition to any business or operating related factors we may otherwise experience. See “Risk Factors — Risks Related to Doing Business in China —The discontinuation of any of the financial incentives currently available to us in the PRC could adversely affect our results of operations and prospects.”

Our effective tax rate was 14.5% for 2004, 14.9% for 2005 and 4.3% for 2006.

Internal Control over Financial Reporting

In connection with our preparation of the consolidated financial statements, several material weaknesses and significant deficiencies in our internal control over financial reporting have been identified, as defined in the standards established by the U.S. Public Company Accounting Oversight Board. The main material weaknesses identified primarily related to: (i) a lack of effective controls over the financial reporting process due to an insufficient complement of personnel with an appropriate level of accounting knowledge, experience and training in the application of U.S. GAAP commensurate with our financial reporting requirements, (ii) inadequate retention and maintenance of accounting books and records, (iii) inadequate documentation and communication of accounting policies and procedures and (iv) instances of insufficient access controls to our ERP system. The significant deficiencies noted include: (1) internal control issues related to the lack of management approval process, inadequate segregation of duties and inappropriate recording of cost of sales, and (2) information and technology systems matters related to the lack of change management processes and a need to strengthen information security management.

To remedy these weaknesses and deficiencies, we have adopted several measures to improve our internal control over financial reporting. In late 2006, we recruited an experienced chief financial officer and other accounting staff, and in December 2006 established an internal audit function. In July 2007, we hired a Vice President of Finance, who is experienced in U.S. GAAP and SEC reporting; we expect her to join our staff

 

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beginning in early August 2007. In addition, we intend to provide on-going training to our accounting personnel to improve their U.S. GAAP accounting knowledge and to hire additional accounting staff, including a U.S. GAAP/SEC reporting manager and internal audit personnel. We have or are in the process of, among other things, (i) upgrading our record-keeping policies to conform with U.S. GAAP requirements, including procedures in respect of all key transactions, (ii) compiling our accounting policies and procedures as well as our quarterly closing procedures into a manual to ensure our policies are communicated and adhered to by our accounting personnel, (iii) documenting our closing and related procedures, and (iv) immediately remediated the identified instances of unauthorized access to our ERP system. We have also hired an outside consultant to assist us in preparing for Section 404 compliance and another to upgrade our ERP system and address related ERP access and security issues.

In addition to Section 404, the Sarbanes-Oxley Act also mandates, among other things, that companies adopt new corporate governance measures, imposes comprehensive reporting and disclosure requirements, sets stricter independence and financial expertise standards for audit committee members, and imposes increased civil and criminal penalties for companies, their chief executive officers, chief financial officers and directors for securities law violations. For example, in response to the Sarbanes-Oxley Act, the New York Stock Exchange has adopted additional comprehensive rules and regulations relating to corporate governance. We expect these new laws, rules and regulations will increase the scope, complexity and cost of our corporate governance and future reporting and disclosure practices. Our current and future compliance efforts will continue to require significant management attention. We are currently evaluating and monitoring developments with respect to these new rules, and we cannot predict or estimate the amount of additional costs we may incur or the timing of such costs. It has also become more difficult and more expensive for companies such as ours to obtain director and officer liability insurance, and we may be required to accept reduced coverage and/or incur substantially higher costs to obtain coverage.

Results of Operations

The following table sets forth a summary of our consolidated results of operations by amount and as a percentage of our total net revenues for 2004, 2005 and 2006. This information should be read together with our audited consolidated financial statements and related notes included elsewhere in this prospectus. The operating results in any period are not necessarily indicative of the results that may be expected for any future period.

 

    Year Ended December 31,     Three Months Ended March 31,
    2004     2005     2006     2006   2007
    Amount    

Net
Revenues %

    Amount    

Net
Revenues %

    Amount    

Net
Revenues %

   

Amount

    Net
Revenues %
 

Amount

    Net
Revenues %
    (in millions of US$)     (in millions of US$)

Net revenues

  $ 20.9     100 %   $ 33.8     100 %   $ 69.9     100 %   $ 12.8     100%   $ 33.8     100%

Cost of revenues

    (9.3 )   44.3       (15.5 )   45.9       (35.6 )   50.9       (7.4 )   57.8        (18.1 )   53.7   
                                                                 

Gross profit

    11.6     55.7       18.3     54.1       34.3     49.1       5.4     42.2        15.7     46.3   

Operating expenses:

                   

Selling and marketing

    (0.7 )   3.4       (1.0 )   3.0       (1.9 )   2.6       (0.2 )   1.5        (0.7 )   2.1   

General and administrative

    (5.9 )   28.1       (8.5 )   25.1       (22.3 )   31.9       (3.7 )   29.0        (9.1 )   26.9   
                                                                 

Total operating expenses

    (6.6 )   31.5       (9.5 )   28.1       (24.2 )   34.5       (3.9 )   30.8        (9.8 )   29.1   
                                                                 

Other income

    0.6     2.9       0.3     0.8       0.5     0.7       *     0.1        0.8     2.4   

Other expenses

    *     **       (0.6 )   1.8       (0.5 )   0.7       *     0.1        *     **   

Interest expense

    (0.6 )   3.3       (1.3 )   3.8       (1.1 )   1.6       (0.4 )   3.1        (0.7 )   2.0   

Interest income

    *     0.1       *     0.1       0.3     0.3       *     0.1        *     0.1   

Income tax expense

    (0.7 )   3.4       (1.1 )   3.2       (0.4 )   0.6       (0.3 )   2.2        (0.1 )   0.2   
                                                                 

Net income(1)

    4.3     20.5       6.1     18.1       8.9     12.7       0.8     6.5        6.0     17.6%
                                                 

Income (loss) attributable to holders of ordinary shares, basic and diluted

  $ 4.3       $ (0.1 )     $ (35.1 )     $ 0.7       $ (1.6 )  
                                                 

 

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* Less than US$50,000.
** Less than 0.1%.

(1)

Including total share-based compensation charges of approximately US$0 in 2004, US$3.1 million in 2005, US$8.4 million in 2006, and US$0.3 million and US$3.4 million for the first quarter of 2006 and 2007, respectively.

Comparison of Three Months Ended March 31, 2006 and March 31, 2007

Net Revenues

The following table sets forth the percentage of our net revenues by segment for the three months ended March 31, 2006 and 2007:

 

     Three Months Ended March 31,  
     2006     2007  
     Net
Revenues
   Net
Revenues %
    Net
Revenues
   Net
Revenues %
 
     (in millions of US$)  

Segment Data:

          

Laboratory services

   $ 8.9    69.4 %   $ 21.7    64.1 %

Manufacturing

     3.9    30.6       12.1    35.9  
                          

Total net revenues

   $ 12.8    100 %   $ 33.8    100 %
                          

Our net revenues increased from US$12.8 million in the first quarter of 2006 to US$33.8 million in the first quarter of 2007, or 164.8% growth, primarily due to an increase in both our number of projects and the scope of services we provide to our existing customers. Our average revenues per top-ten customer increased from US$0.9 million in the first quarter of 2006 to US$2.6 million in the first quarter of 2007. We also increased our service offerings beyond our core discovery chemistry services, significantly expanded the capacity of our chemistry services, introduced our biological assays capacity to broaden our offerings in the higher margin service biology department and added a new portfolio of pharmaceutical development services, as well as expanded our manufacturing business.

Sales of all of our laboratory services are subject to sales tax. Our revenues are recorded net of sales tax. However, we have historically received substantial sales tax exemptions. Sales tax exemptions were US$0.4 million in the first quarter of 2006 and US$1.1 million in the first quarter of 2007.

Laboratory services

Net revenues from our laboratory services segment increased from US$8.9 million in the first quarter of 2006 to US$21.7 million in the first quarter of 2007, or 143.8% growth. This increase was primarily due to the growth in demand for our FTE-based services from US$7.8 million in the first quarter of 2006 to US$16.0 million in the first quarter of 2007, or 106.2% growth, as well as increased net revenues from our fee-for-service based services increased from US$1.1 million in the first quarter of 2006 to US$5.7 million in the first quarter of 2007, or 419% growth, primarily due to an increase in demand and for our discovery chemistry services as well as our laboratory services capacity.

     Three Months Ended March 31,  
     2006     2007  
     Net
Revenues
   Net
Revenues %
    Net
Revenues
   Net
Revenues %
 
     (in millions of US$)  

FTE

   $ 7.8    87.8 %   $ 16.0    74.0 %

Fee-for-service

     1.1    12.2       5.7    26.0  
                          

Total laboratory services revenues

   $ 8.9    100 %   $ 21.7    100 %
                          

 

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Manufacturing

Net revenues from our manufacturing segment increased from US$3.9 million in the first quarter of 2006 to US$12.1 million in the first quarter of 2007, or 211% growth. The increase was primarily due to the delivery of finished goods that were held and not shipped until the first quarter of 2007, as a result of our customers’ delivery schedules, as well as the growth in demand for our manufacturing services.

Cost of revenues

The following table sets forth the percentage of our cost of revenues and cost of revenues by segment for the three months ended March 31, 2006 and 2007:

 

     Three Months Ended March 31,  
     2006     2007  
     Cost of
Revenues
   Cost of
Revenues %
    Cost of
Revenues
   Cost of
Revenues %
 
     (in millions of US$)  

Segment Data:

          

Laboratory services

   $ 3.6    48.7 %   $ 10.8    60 %

Manufacturing

     3.8    51.3       7.3    40  
                          

Total cost of revenues

   $ 7.4    100 %   $ 18.1    100 %
                          

Our total cost of revenues increased from US$7.4 million in the first quarter of 2006 to US$18.1 million in the first quarter of 2007, or 149% growth.

Laboratory services

The increases in our cost of laboratory services reflect growth in our revenues and were primarily due to increases in: (i) direct labor and related increases in salaries, benefits and associated payments, due primarily to growth in the number of scientists dedicated to laboratory services from 587 at the end of the first quarter of 2006 to 1,320 at the end of the first quarter of 2007, (ii) total raw materials, due primarily to substantial increases in revenues from our fee-for-service based services, which consume more raw materials than our FTE-based services, and (iii) overhead costs, due primarily to new investments in our property, plant and equipment and higher related depreciation costs.

Manufacturing

The increase in our cost of manufacturing services was primarily due to increases in overhead and raw material costs, in each case primarily as a result of the delivery of a large project in the first quarter of 2007 as described above.

Cost of revenues also included an allocation of our share-based compensation charges based on the nature of work which certain employees were assigned to perform, which amounted to US$0.1 million and US$1.1 million in the first quarter of 2006 and the first quarter of 2007, respectively.

Gross Profit and Margin

Our gross profit increased from US$5.4 million in the first quarter of 2006 to US$15.7 million in the first quarter of 2007, or 188.5% growth. This increase was primarily due to an increase in revenues from our laboratory services segment, in particular from FTE revenues. Overall gross margin increased from 42.5% in the first quarter of 2006 to 46.3% in the first quarter of 2007. Gross margin for our laboratory services segment decreased from 59.7% in the first quarter of 2006 to 49.8% in the first quarter of 2007, primarily due to increases

 

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in our raw materials costs as a result of increases in our fee-for-services based services. Gross margin for our manufacturing segment increased from 3.6% in the first quarter of 2006 to 40.2% in the first quarter of 2007, primarily due to increased manufacturing activity resulting in higher utilization and a reduction in unallocated overhead, and economies of scale, which translated into better absorption of overhead charged to our cost of revenues. In the first quarter of 2007, our manufacturing segment accounted for 35.9% of our net revenues, up from 30.6% in the first quarter of 2006, and we expect it to continue to be a significant revenue contributor and key component of our overall business in the future as the expansion of our manufacturing capacity is completed.

Operating Expenses

Our total operating expenses increased from US$3.9 million in the first quarter of 2006 to US$9.8 million in the first quarter of 2007, or 149.5% growth. Our operating expenses as a percentage of net revenues were 30.8% in the first quarter of 2006 and 29.1% in the first quarter of 2007.

Selling and Marketing Expenses

Our selling and marketing expenses increased 216.6% from US$0.2 million in the first quarter of 2006 to US$0.7 million in the first quarter of 2007, primarily due to an increase in our export agent fees related to the increase in our manufacturing revenues. Selling and marketing expenses as a percentage of net revenues increased from 1.8% in the first quarter of 2006 to 2.2% in the first quarter of 2007, primarily because these costs were relatively fixed and did not increase in direct proportion to net revenues.

General and Administrative Expenses

Our general and administrative expenses increased from US$3.7 million in the first quarter of 2006 to US$9.1 million in the first quarter of 2007, or 145.3% growth. This increase was primarily due to an increase in: (i) salary and welfare costs, plus bonus and profit sharing amounts, reflecting an increase in the headcount of our senior management and administrative employees and increased profits, and (ii) our leasing expenses, which were attributable to increased employee transportation and housing expenses as a result of the increase in our employee base over the periods presented. Our general and administrative expenses also included an allocation of our share-based compensation charges based on the nature of work which certain employees were assigned to perform, amounting to US$0.2 million and US$2.3 million in the first quarter of 2006 and the first quarter of 2007, respectively.

Other Income

Our other income increased from US$24,300 in the first quarter of 2006 to US$0.8 million in the first quarter of 2007, primarily due to rental income for the lease of one of the buildings at our primary facility in Shanghai Waigaoqiao Free Trade Zone, which lease began in April 2006 and terminated in May 2007.

Other Expenses

Our other expenses decreased from US$40,365 in the first quarter of 2006 to US$671 in the first quarter of 2007, primarily related to a decrease in foreign exchange losses.

Interest Expense

Our interest expense increased from US$0.4 million in the first quarter of 2006 to US$0.7 million in the first quarter of 2007, primarily due to our beginning to accrue interest on convertible notes in the aggregate amount of US$40.0 million that we issued on February 9, 2007.

Interest Income

Our interest income increased from US$14,975 in the first quarter of 2006 to US$40,772 in the first quarter of 2007, primarily due to the increases in interest earned on increased balances of cash and cash equivalents and restricted cash.

 

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Income Tax Expense

Our income tax expense decreased from US$0.3 million in the first quarter of 2006 to US$0.1 million in the first quarter of 2007, primarily due to the tax holidays that we received. Our effective tax rate was 25.8% in the first quarter of 2006 and 1.3% in the first quarter of 2007. We converted our subsidiaries from PRC domestic companies to Sino-foreign equity joint ventures at the end of the first quarter of 2006; as such, we immediately became entitled to more favorable tax treatment.

Net Income

As a result of the foregoing, our net income increased from US$0.8 million in the first quarter of 2006 to US$6.0 million in the first quarter of 2007, reflecting 623% growth (including total share-based compensation charges of approximately US$0.3 million in the first quarter of 2006 and US$3.4 million in the first quarter of 2007).

Income (loss), attributable to holders of ordinary shares, basic and diluted

In the first quarter of 2007, we had a deemed dividend to preference shareholders of US$7.6 million associated with the repurchase from our existing shareholders of 10,041,300 Series A preference shares and 1,581,100 Series B preference shares for the amount in excess of the recorded value of the preference shares, which reduced the aggregate net income available to ordinary shares.

Comparison of 2004, 2005 and 2006

Net Revenues

The following table sets forth the percentage of our net revenues and net revenues by segment for 2004, 2005 and 2006:

 

     Year Ended December 31,  
     2004     2005     2006  
     Net
Revenues
   Net
Revenues %
    Net
Revenues
   Net
Revenues %
    Net
Revenues
   Net
Revenues %
 
     (in millions of US$)  

Segment Data:

               

Laboratory services

   $ 16.4    78.5 %   $ 29.4    87.0 %   $ 59.8    85.6 %

Manufacturing

     4.5    21.5       4.4    13.0       10.1    14.4  
                                       

Total net revenues

   $ 20.9    100.0 %   $ 33.8    100.0 %   $ 69.9    100.0 %
                                       

Our net revenues increased from US$20.9 million in 2004 to US$33.8 million in 2005 and US$69.9 million in 2006, or 61.7% and 106.8% growth, respectively, primarily due to an increase in both our number of customers and the scope of services we provide to our existing customers particularly in our laboratory services segment. Our total number of customers increased from 55 in 2004 to 70 in 2006, while our average revenues per top-ten customer increased from US$1.7 million in 2004 to US$4.8 million in 2006. We also increased our service offerings beyond our core discovery chemistry services, principally the commencement of our manufacturing services.

Sales tax exemptions for total net revenues were US$0.3 million in 2004, US$0.4 million in 2005 and US$3.0 million in 2006.

 

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Laboratory services

Net revenues from our laboratory services segment increased from US$16.4 million for 2004 to US$29.4 million for 2005 and US$59.8 million for 2006, or 79.3% and 103.4% growth, respectively. This increase was primarily due to the growth in demand for our FTE-based services from US$14.1 million for 2004 to US$20.8 million for 2005 and US$43.9 million for 2006, or 47.5% and 111.1% growth, respectively. We increased our scientific staff from 323 in 2004 to 552 in 2005 and 1,244 in 2006. Net revenues from our fee-for-service based services increased from US$2.3 million for 2004 to US$8.6 million for 2005 and US$15.9 million for 2006, or 273.9% and 84.9% growth, respectively. The increase in demand for our FTE-based services and our fee-for-service based services were primarily due to an increase in demand for our discovery chemistry services.

 

     Year Ended December 31,  
     2004     2005     2006  
     Net
Revenues
   Net
Revenues %
    Net
Revenues
   Net
Revenues %
    Net
Revenues
   Net
Revenues %
 
     (in millions of US$)  

FTE

   $ 14.1    86.0 %   $ 20.8    70.7 %   $ 43.9    73.4 %

Fee-for-service

     2.3    14.0       8.6    29.3       15.9    26.6  
                                       

Total laboratory services revenues

   $ 16.4    100.0 %   $ 29.4    100.0 %   $ 59.8    100.0 %
                                       

Manufacturing

Net revenues from our manufacturing segment were US$4.5 million in 2004, US$4.4 million in 2005 and US$10.1 million in 2006, with 129.5% growth from 2005 to 2006. Prior to June 2004, we had limited production capacity while we completed construction of our Jinshan manufacturing facility. During the rest of 2004 and throughout 2005, many of our customers conducted their quality assurance audits on our Jinshan facility. Our net revenues were flat during 2004 and 2005. The increase from 2005 to 2006 was primarily due to the growth in demand for manufacturing services once our customers satisfactorily completed their audits of our facilities.

Cost of revenues

The following table sets forth the percentage of our cost of revenues and cost of revenues by segment for 2004, 2005 and 2006:

 

     Year Ended December 31,  
     2004     2005     2006  
     Cost of
Revenues
   Cost of
Revenues %
    Cost of
Revenues
   Cost of
Revenues %
    Cost of
Revenues
   Cost of
Revenues %
 
     (in millions of US$)  

Segment Data:

               

Laboratory services

   $ 7.9    84.9 %   $ 12.8    82.6 %   $ 26.5    74.5 %

Manufacturing

     1.4    15.1       2.7    17.4       9.1    25.5  
                                       

Total cost of revenues

   $ 9.3    100.0 %   $ 15.5    100.0 %   $ 35.6    100.0 %
                                       

Our total cost of revenues increased from US$9.3 million in 2004 to US$15.5 million in 2005 and US$35.6 million in 2006, or 66.7% and 129.7% growth, respectively, in line with the increases to our net revenues.

Laboratory services

The increases in our cost of laboratory services reflect growth in our revenues and were primarily due to increases in: (i) direct labor and related increases in salaries, benefits and associated payments, accounting for approximately 33%, 35% and 33% of such costs in 2004, 2005 and 2006 — our employee base grew from 533 at the end of 2004 to 890 at the end of 2005 and 1,843 at the end of 2006, or 58.6% and 109.6% growth, respectively, including 240 and 350 new scientist hires in 2005 and 2006, (ii) total raw materials, accounting for approximately 32%, 32% and 31% of such costs in 2004, 2005 and 2006, and (iii) overhead costs, accounting for

 

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approximately 35%, 33% and 36% of such costs in 2004, 2005 and 2006, respectively, reflecting new investments in our property, plant and equipment and higher related depreciation costs.

Manufacturing

The increase in our cost of manufacturing services was primarily due to increases in: (i) overhead costs, accounting for approximately 51%, 59% and 56% of such costs in 2004, 2005 and 2006, respectively, which was a result of increased depreciation charges, as our new Jinshan manufacturing facility was ramping up, and (ii) raw materials, accounting for approximately 39%, 34% and 37% of such costs in 2004, 2005 and 2006, respectively, which was a result of the overall increase in our business over the period. Our cost of revenues relating to our manufacturing segment has also increased in each period as a result of increased headcount in our manufacturing segment, principally from 2005 to 2006.

Cost of revenues also included an allocation of our share-based compensation charges based on the nature of work which certain employees were assigned to perform, which amounted to US$0, US$0.4 million and US$0.5 million in 2004, 2005 and 2006, respectively.

Gross Profit and Margin

Our gross profit increased from US$11.6 million in 2004 to US$18.3 million in 2005 and US$34.3 million in 2006, or 57.8% and 87.4% growth, respectively. This increase was primarily due to an increase in revenues from our laboratory services segment, in particular from FTE revenues. Overall gross margin has decreased slightly from 55.7% in 2004 to 54.1% in 2005 and 49.1% in 2006. Gross margin for our laboratory services segment remained relatively stable at 52.4% in 2004, 56.5% in 2005 and 55.7% in 2006. Gross margin for our manufacturing segment decreased from 68.0% in 2004 to 37.8% in 2005 and 10.4% in 2006, primarily due to an increase in costs described above without a commensurate increase in revenues. In 2006, our manufacturing segment accounted for 14.5% of our net revenues, but we expect it to become a much more significant revenue contributor and key component of our overall business in the future as the expansion of our manufacturing capacity is completed. We expect our manufacturing segment, which typically has a significantly lower gross margin than our laboratory services segment, will represent an increasing percentage of our net revenues in 2007 and beyond and consequently may result in our reporting a lower overall gross margin. Moreover, we expect that the anticipated manufacturing projects at our expanded Jinshan facility will result in even lower margins as we evolve our business from small-scale, discrete projects to large scale, higher-volume projects.

Operating Expenses

Our total operating expenses increased from US$6.6 million in 2004 to US$9.5 million in 2005 and US$24.2 million in 2006, or 45.2% and 153.4% growth, respectively. Our operating expenses as a percentage of net revenues over the past three years were 31.5% in 2004, 28.1% in 2005 and 34.5% in 2006.

Selling and Marketing Expenses

Our selling and marketing expenses increased from US$0.7 million in 2004 to US$1.0 million in 2005 and US$1.9 million in 2006. Selling and marketing expenses as a percentage of net revenues have declined steadily over the past three years from 3.4% in 2004, 3.0% in 2005 and 2.6% in 2006. This stability and decline as a percentage of net revenues was primarily because these costs are relatively fixed and do not increase in direct proportion to net revenues.

General and Administrative Expenses

Our general and administrative expenses increased from US$5.9 million in 2004 to US$8.5 million in 2005 and US$22.3 million in 2006, or 45.9% and 161.7% growth, respectively. This increase was primarily due to an increase in: (i) the salary and welfare costs, plus bonus and profit sharing amounts, collectively accounting for

 

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approximately 55.2%, 75.4% and 74.0% of such expenses in 2004, 2005 and 2006, respectively, reflecting an increase in the headcount of our senior management and administrative employees, and (ii) our leasing expenses, which are attributable to increased employee transportation and housing expenses as a result of the increase in our employee base over the periods presented. Our general and administrative expenses also included an allocation of our share-based compensation charges based on the nature of work which certain employees were assigned to perform, amounting to US$0, US$2.7 million and US$7.9 million in 2004, 2005 and 2006, respectively. Our general and administrative expenses were partially offset by government cash subsidies, which increased from US$0.2 million in 2004 to US$2.0 million in 2005 and then decreased to US$0.9 million in 2006. General and administrative expenses have increased as a percentage of net revenues over the past three years: from 28.1% in 2004, 25.1% in 2005 to 31.9% in 2006.

Other Income

Our other income decreased from US$0.6 million in 2004 to US$0.3 million in 2005 and then increased to US$0.5 million in 2006.

Other Expenses

Our other expenses increased from US$557 in 2004 to US$0.6 million in 2005 and decreased to US$0.5 million in 2006, reflecting primarily foreign exchange losses.

Interest Expense

Our interest expense increased from US$0.6 million in 2004 to US$1.3 million in 2005, then decreased to US$1.1 million in 2006, primarily due to our financing arrangement for our primary facility in Shanghai Waigaoqiao Free Trade Zone, which commenced operation in January 2004. We cancelled the financing arrangement in March 2006 and fully repaid the indebtedness in June 2007.

Interest Income

Our interest income increased from US$24,324 in 2004 to US$41,583 in 2005 and US$0.3 million in 2006. This increase was primarily due to the increases in interest earned on increased balances of cash and cash equivalents and restricted cash.

Income Tax Expense

Our income tax expense increased from US$0.7 million in 2004 to US$1.1 million in 2005 and then decreased to US$0.4 million in 2006. The increase from 2004 to 2005 was in line with the increase in income before income taxes. The decrease from 2005 to 2006 was primarily due to the tax holidays that we received. Our effective tax rate remained stable at 14.5% in 2004 and 14.9% in 2005 and then decreased to 4.3% in 2006.

Net Income

As a result of the foregoing, our net income increased from US$4.3 million in 2004 to US$6.1 million in 2005 and US$8.9 million in 2006, reflecting 43.0% and 44.5% growth, respectively (including total share-based compensation charges of approximately US$0 in 2004, US$3.1 million in 2005 and US$8.4 million in 2006).

Income (loss), attributable to holders of ordinary shares, basic and diluted

In 2005 and 2006, we incurred deemed dividends on our preference shares as they included a beneficial conversion feature and due to our selling to the investors preference shares with a fair value significantly in excess of the cash purchase price. The decision to sell the preference shares at a discount was made in part in

 

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recognition of terms stemming from negotiations with the investors which began in 2004. These deemed dividends totaling US$6.2 million and US$43.3 million in 2005 and 2006, respectively, resulted in reducing aggregate net income available to ordinary shares to US$(0.1) million in 2005 and a loss of US$(35.1) million in 2006. See “Deemed Dividend on Issuance of Preference Shares” below and note 10 to our consolidated financial statements.

Quarterly Results of Operations

The following table sets forth a summary of our consolidated results of operations by amount and as a percentage of our total net revenues, each derived from our unaudited consolidated financial statements for the three-month periods ended on the dates indicated. You should read the following table in conjunction with the audited consolidated financial information and related notes contained elsewhere in this prospectus. We have prepared the unaudited consolidated financial information on the same basis as our audited consolidated financial statements. The unaudited financial information includes all adjustments, consisting only of normal and recurring adjustments, that we consider necessary for a fair presentation of our financial position and operating results for the quarters presented.

    Three Months Ended  
    March 31,
2006
    June 30,
2006
    September 30,
2006
    December 31,
2006
   

March 31,
2007

 
    Amount    

Net
Revenues
%

    Amount    

Net
Revenues
%

    Amount    

Net
Revenues
%

    Amount    

Net
Revenues
%

    Amount    

Net
Revenues
%

 
    (in millions of US$)  

Net revenues, total

  $ 12.8     100.0 %   $ 15.1     100.0 %   $ 19.1     100.0 %   $ 22.9     100.0 %   $ 33.8     100.0 %

Laboratory services

    8.9     69.4       12.4     81.9       16.8     87.8       21.7     94.9       21.7     64.1  

Manufacturing

    3.9     30.6       2.7     18.1       2.3     12.2       1.2     5.1       12.1     35.9  

Cost of revenues, total

    (7.4 )   57.5       (8.1 )   53.8       (10.0 )   52.6       (10.0 )   43.9       (18.1 )   53.6  

Laboratory services

    (3.6 )   28.0       (5.7 )   37.8       (8.0 )   41.9       (9.2 )   40.2       (10.8 )   32.2  

Manufacturing

    (3.8 )   29.5       (2.4 )   16.1       (2.0 )   10.7       (0.8 )   3.7       (7.3 )   21.5  
                                                                     

Gross profit

    5.4     42.5       7.0     46.2       9.1     47.4       12.8     56.0       15.7     46.3  

Operating expenses:

                   

Selling and marketing

    (0.2 )   1.8       (0.4 )   2.7       (0.6 )   2.9       (0.6 )   2.8       (0.7 )   2.2  

General and administrative

    (3.7 )   29.0       (5.1 )   33.5       (5.6 )   29.2       (8.0 )   34.8       (9.1 )   26.9  
                                                                     

Total operating expenses

    (3.9 )   30.8       (5.5 )   36.2       (6.2 )   32.1       (8.6 )   37.6       (9.8 )   29.1  
                                                                     

Other income

    *     0.2       0.1     0.7       0.3     1.3       0.1     0.6       0.8     2.5  

Other expenses

    *     0.3       (0.1 )   0.8       (0.1 )   0.6       (0.2 )   0.9       *     **  

Interest expense

    (0.4 )   3.0       (0.3 )   2.0       (0.2 )   1.1       (0.2 )   0.9       (0.7 )   2.0  

Interest income

    *     0.1       *     0.3       *     0.1       0.1     0.5       *     0.1  

Income tax expense

    (0.3 )   2.2       *     0.1       *     0.2       (0.1 )   0.3       (0.1 )   0.2  
                                                                     

Net income

  $ 0.8     6.5 %   $ 1.2     8.1 %   $ 2.9     14.8 %   $ 4.0     17.3 %   $ 6.0     17.7 %
                                                                     

* Less than US$50,000.
** Less than 0.1%.

Our quarterly net revenues, gross profit and net income have experienced sequential quarter-on-quarter growth in the five quarters ended March 31, 2007. These increases are primarily due to an increase in the number of projects and an expansion in the scope of services we provide to our existing customers, particularly in our laboratory services segment, and the expansion and ramping up of our manufacturing facilities.

Our net revenues from our laboratory services segment were flat from the fourth quarter of our fiscal year through the first quarter of the following year due to (i) spending patterns of our large customers, who put more emphasis on the third and fourth quarter of each year, and (ii) there being fewer working days in the first quarter in the PRC as a result of traditional Chinese holidays.

 

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Revenues in our manufacturing segment are prone to quarterly fluctuation, principally based on the delivery schedules of our customers, which vary from period to period. Generally speaking, we expect that our manufacturing revenues will fluctuate with the orders we fill. Prior to June 2004, we had limited production capacity while we completed construction of our Jinshan manufacturing facility. During the rest of 2004 and throughout 2005, many of our customers conducted their quality assurance audits on our Jinshan facility. Once our customers satisfactorily completed their audits of our facilities, our manufacturing revenues began to increase. The increase in the first quarter of 2007 was primarily due to the delivery of manufactured goods to Vertex. We do not expect our manufacturing revenues in the first quarter of 2007 to reflect our quarterly manufacturing revenues throughout the remainder of 2007 and beyond. For example, we expect that revenues in our manufacturing segment in the second quarter of 2007 will be less than half of the revenues in our manufacturing segment in the first quarter of 2007, due to the delivery schedules of our customers. See “Risk Factors — Our limited operating history may make it difficult for you to evaluate our business and future prospects”; and “— Our quarterly revenues and operating results may be difficult to predict and could fall below investor expectations, which could cause the market price of our ADSs to decline.”

This growth was offset in part by a corresponding increase in our cost of revenues and operating expenses.

Critical Accounting Policies

We prepare our financial statements in conformity with U.S. GAAP, which requires us to make estimates and assumptions that affect our reporting of, among other things, assets and liabilities, contingent assets and liabilities and net revenues and expenses. We continually evaluate these estimates and assumptions based on the most recently available information, our own historical experiences and other factors that we believe to be relevant under the circumstances. Since our financial reporting process inherently relies on the use of estimates and assumptions, our actual results could differ from what we expect. This is especially true with some accounting policies that require higher degrees of judgment than others in their application. We consider the policies discussed below to be critical to an understanding of our audited consolidated financial statements because they involve the greatest reliance on our management’s judgment.

Impairment of Long-Lived Assets

We review our long-lived assets for impairment whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. Recoverability of these assets is measured by comparison of its carrying amounts to the future undiscounted cash flows the assets are expected to generate. If the sum of the expected undiscounted cash flow is less than the carrying amount of the assets, we would recognize an impairment loss equal to the amount by which the carrying value of the asset exceeds its fair market value.

Revenue Recognition

Revenues are recognized when persuasive evidence of an arrangement exists, the sales price is fixed or determinable, delivery of the product or performance of the service has occurred and there is reasonable assurance of collection of the sales proceeds. Revenue is recognized net of sales-related taxes.

For laboratory services provided on a fee-for-service basis, we recognize revenues upon finalization of the project terms, and delivery and acceptance of the final product, which is generally in the form of a technical laboratory report. The service period required to complete such contracts is generally two to three months.

For laboratory services provided under FTE-based contracts, the customer pays a fixed rate per FTE and we recognize revenue as the services are provided. The FTE contracts do not require acceptance by the customer or fixed deliverables by us.

 

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Revenues from the sale of manufactured products are recognized upon delivery and acceptance by the customer when title and risk of loss has been transferred. We record deferred revenues for payments received from the customer prior to the delivery of the products.

Income Taxes

We follow the asset and liability method of accounting for income taxes. Under the asset and liability method, the change in the net deferred tax asset or liability is included in the computation of net income. Deferred tax assets and liabilities are measured using the enacted tax rates applicable to taxable income in the years in which the temporary differences are expected to be recovered or settled. Deferred tax assets are evaluated and, if realization is not considered to be “more-likely-than-not,” a valuation allowance is provided.

Share-Based Compensation Expenses

In 2005, 2006 and 2007, we entered into individual option agreements pursuant to which we granted 71,595,000 ordinary shares as of the date of this prospectus, as set forth in the table below:

 

Date of Grant

   Options Granted

July 18, 2005

   27,895,000

June 1, 2006

   33,250,000

July 24, 2006

   3,000,000

February 1, 2007

   4,150,000

February 8, 2007

   3,150,000

May 18, 2007

   150,000

In addition, in 2006, certain shareholders contributed 5,707,200 ordinary shares to compensate four of our management shareholders. We recognized compensation expense in our statement of operations based on the fair value of the ordinary shares on June 1, 2006.

Under SFAS No. 123R, we are required to recognize share-based compensation as compensation expense in our statement of operations based on the fair value of equity awards on the date of the grant, with the compensation expense recognized over the period in which the recipient is required to provide services to us in exchange for the equity award. For shares granted to our employees, we record share-based compensation expense based on the fair value of the shares on the date of the grant over the period in which the shares vest. We have categorized these share-based compensation expenses in our (i) cost of revenues and (ii) general and administrative expenses, depending on the job functions of the grantees of our shares.

When estimating the fair value of our ordinary shares, our management has considered a number of factors, including the result of a third-party appraisal and an equity transaction of our company, while taking into account standard valuation methods and the achievement of certain events.

As a private company, we determined the fair value of our ordinary shares in connection with our share or option grants on each grant date with the assistance of American Appraisal China Limited, an independent third party. The valuation used was based on a combination of a market approach and an income approach.

The market approach focuses on comparing our company to comparable publicly traded companies. In applying this method, valuation multiples are: (1) derived from historical operating data of comparable companies; (2) evaluated and adjusted, if necessary, based on the strengths and weaknesses of our company relative to the selected guideline companies; and (3) applied to the appropriate operating and future projected financial data of our company to arrive at an indication of fair market value for our company’s equity.

 

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In the income approach, equity value is dependent on the present value of future economic benefits such as cost savings, periodic income, or revenues. Indications of equity value are developed by discounting future net cash flows to their present value at a discount rate that reflects both the current return requirements of the market and the risks inherent in the specific investment. A discount rate is the expected rate of return that an investor would theoretically need to give up by investing in our company instead of in available alternative investments that are comparable in terms of risk and other investment characteristics. In most circumstances, the discount rate is the weighted average cost of capital, or WACC, which takes into account the cost of equity and the cost of debt. Our cost of equity was derived using the Capital Asset Pricing Model, which takes into account the risk-free interest rate and a required risk premium. Our required risk premium takes into account the equity risk premium, a small stock premium and a country risk premium for China.

The valuation model then allocated the equity value between our ordinary shares and our preference shares. The fair value of the equity interest allocated to the preference shares was calculated using the option pricing method. The fair value of the ordinary shares was calculated as the residual, or the total equity value less the fair value of the preference shares. Under the option pricing method, we treated the preference shares as a call option on our equity value, with the exercise price based on the liquidation preference of the preference shares. Because a call option is used, the option pricing method commonly used is the Black-Scholes model, which takes into account the expected life of the option, a risk-free interest rate, dividend yield and a measure of volatility. Because we are a private company, we approximated volatility using the historical volatility of comparable publicly traded companies.

We incurred employee share-based compensation charges in 2005 and 2006 totaling US$11.5 million, and in the first quarter of 2007 totaling US$3.4 million. The table below sets forth the allocation of our share-based compensation charges on our cost of revenues and operating expense line items based on the nature of work which they were assigned to perform:

Allocation of Share-based Compensation Expenses

 

    

Year Ended December 31,

   Three Months
Ended
March 31,
         2004            2005            2006        2006    2007
    

    (in millions of US$)    

Cost of revenues

   —      $ 0.4    $ 0.5    $ 0.1    $ 1.1

General and administrative expenses

   —        2.7      7.9      0.2      2.3
                                

Total

   —      $ 3.1    $ 8.4    $ 0.3    $ 3.4
                              

Based on grants outstanding at March 31, 2007, and assuming no change in the estimated forfeiture rates, our total share-based compensation expenses for future periods in respect of the equity awards that we have granted to date is expected to be as follows (not including share-based compensation expenses relating to 150,000 options granted in May 2007):

 

Period

       (in millions of US$)    

Year Ending December 31, 2007

   $ 7.4

Year Ending December 31, 2008

     2.8

Year Ending December 31, 2009

   $ 0.3

Determining the value of our share-based compensation expense in future periods requires the input of highly subjective assumptions, including estimated forfeitures and the price volatility of the underlying shares. We estimate our forfeitures of our shares based on past employee retention rates, our expectations of future retention rates, and we will prospectively revise our forfeiture rates based on actual history. Our share

 

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compensation charges may change based on changes to our actual forfeitures. Our actual share-based compensation expenses may be materially different from our current expectations. In addition to the subjective assumptions and estimates discussed above, see “Forward Looking Statements” for information regarding the various risks and uncertainties inherent in estimates of this type.

Liquidity and Capital Resources

Our primary sources of liquidity have historically been cash generated from operating and financing activities, which have consisted of private placements of preference shares and bank borrowings. As of March 31, 2007, we had approximately US$49.5 million in cash and cash equivalents. Our cash and cash equivalents consist of cash on hand. We expect to require cash to fund our ongoing business needs, particularly salary and benefits and material costs and expenses. Other cash needs include primarily the working capital for our daily operations, the purchase of equipment for our laboratory segment and expenditures related to our Jinshan and Suzhou expansion projects. We believe that our cash and cash equivalents, anticipated cash flow from operations, as well as the net proceeds we expect to receive from this offering will be sufficient to meet our anticipated cash needs for the foreseeable future, including the expansion of our manufacturing facilities in Jinshan and the construction of our preclinical drug safety evaluation center in Suzhou. The following table sets forth a summary of our cash flows for the periods indicated:

 

     Year Ended December 31,     Three Months Ended
March 31,
 
         2004             2005             2006             2006             2007      
     (in millions of US$)  

Cash and cash equivalents

   $ 3.3     $ 4.9     $ 9.7     $ 4.4     $ 49.5  

Net cash provided by operating activities

     5.1       9.1       15.3       7.8       15.5  

Net cash used in investing activities

     (6.3 )     (11.2 )     (26.2 )     (9.3 )     (10.3 )

Net cash provided by financing activities

   $ 2.5     $ 3.6     $ 15.5       1.0       34.5  

Operating Activities

Net cash provided by operating activities consisted primarily of our net income increased by non-cash adjustments such as share-based compensation charges and depreciation of property, plant and equipment, as well as changes in assets and liabilities such as accounts receivable, accounts payable and inventory. Net cash provided by operating activities increased, year over year, primarily as a result of increases in net income, driven by our expanding revenue base. Our accounts receivable increased by US$1.8 million in 2004, by US$1.5 million in 2005, by US$7.8 million in 2006 and by US$0.4 million in the first quarter of 2007, primarily due to the growth of our business and timing of revenue recognized and collection of accounts receivable. Our accounts payable increased by US$0.9 million in 2004, by US$0.3 million in 2005, by US$3.2 million in 2006 and by US$0.5 million in the first quarter of 2007, primarily due to increased purchases related to the growth of our business and the timing of our payables. Our inventory balances increased by US$0.9 million in 2004, by US$2.4 million in 2005, by US$6.0 million in 2006, due primarily to increases in finished manufacturing goods for customers, as well as raw materials and consumable supplies, and decreased by US$1.6 million in the first quarter of 2007 due primarily to the larger quantity of goods delivered.

Investing Activities

Net cash used in investing activities largely reflects our (i) capital expenditures, which consists of purchases of property, plant and equipment made in connection with the expansion and upgrade of our laboratory and manufacturing facilities, purchases of intangible assets and purchase of land use rights and (ii) our purchase of a minority interest for US$2.2 million in connection with our offshore reorganization and related series of transactions. These capital expenditures were US$8.3 million in 2004, US$9.1 million in 2005, US$26.9 million in 2006 and US$8.3 million in the first quarter of 2007. The significant increase in 2006 was primarily due to our

 

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repurchase of our primary facility at Shanghai Waigaoqiao Free Trade Zone. In the first quarter of 2007, these expenditures related primarily to the purchase of R&D equipment to support our laboratory services and construction payments related to our Jinshan plant. We expect our net cash used in investing activities over the next several years to increase significantly from previous levels as we execute our expansion plan to further upgrade and improve our existing facilities, particularly the expansion of our manufacturing capacity at our Jinshan plant and construction of a preclinical drug safety evaluation center in Suzhou. See “— Capital Expenditures.”

Financing Activities

Net cash provided by financing activities in 2006 consists primarily of issuance and sale of convertible preference shares, dividends and principal payments on debt and bank borrowings. Net cash used in financing activities in 2006 was primarily attributable to our repayment of debt and bank borrowings in the aggregate amount of US$4.6 million and our payment of dividends in the aggregate amount of US$6.8 million to our shareholders. Net cash used in financing activities was offset by cash provided by our issuance and sale of Series B preference shares in the amount of US$18.9 million (net of direct issuance costs), and from debt and bank borrowings in the aggregate amount of US$10.0 million.

Net cash used in financing activities in 2005 was primarily attributable to our repayment of debt and bank borrowings in the aggregate amount of US$3.6 million and our payment of dividends in the aggregate amount of US$1.7 million to our shareholders. Net cash used in financing activities was partially offset by cash provided by our issuance and sale of Series A preference shares in the amount of US$2.2 million (net of direct issuance costs), and debt and bank borrowings in the aggregate amount of US$5.0 million.

Net cash used in financing activities in 2004 was primarily attributable to repayment of debt and bank borrowings in the aggregate amount of US$4.1 million, which was offset by cash provided by debt and bank borrowings in the aggregate amount of US$6.6 million.

As of March 31, 2007, we had three bank loans with two different domestic PRC banks with aggregate outstanding loan amounts of US$10.3 million. The weighted average interest rate for these loans is 5.67%. To ensure our repayment capability and reduce the banks’ risk, each of our loan agreements has a general covenant that, in the event of any occurrence which would adversely affect the rights of the banks, such as share reform, mergers and acquisitions or dissolution, we must inform the bank in writing 20 to 30 days in advance and obtain the bank’s prior consent. We have also pledged assets to secure banking facilities.

In the first quarter of 2007, net cash provided by financing activities reflects US$54.2 million and US$40 million received from the issuance of our Series C preference shares and convertible notes, respectively, offset by (i) US$54.5 million used to repurchase and retire Series A and Series B preference shares and ordinary shares concurrent to issuing the Series C preference shares and convertible notes and (ii) US$5.2 million used to repay short-term bank borrowings.

Our US$40 million in notes are contingently convertible, in whole or in part, into our ordinary shares at the option of the note holders at any time after the earlier of completion of this offering or a sale transaction. The notes are convertible into our ordinary shares at a conversion price of 90% of either (i) the final offering price per share of this offering or (ii) the price per share offered for our ordinary shares based on the valuation of us in a sale transaction. The maximum conversion price is US$1.737. The notes contain restrictions on major corporate actions that may limit the manner that we may conduct our business, including the payment of dividends to our shareholders. For so long as at least US$20.0 million is outstanding, we may not, without the prior written consent of a majority in interest of the noteholders, pay, in whole or in part, any indebtedness for borrowed money, other than all present and future bank and purchase money loans, equipment financings and equipment leasings, or declare or pay any dividends or other distributions to any equity securities, other than the declaration and payment of (i) a cash dividend in any fiscal year which, when aggregated with all other cash dividends declared during such fiscal year, does not exceed 50% of our audited consolidated net income for our most recently completed fiscal year,

 

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calculated in accordance with U.S. GAAP or (ii) any dividend for which an adjustment to the conversion ratio is made in accordance with the terms of the notes. The notes are recorded as a long-term liability without any substantial premium or discount for the amount of US$40 million and we are accruing interest equal to 12% per annum.

We are in compliance with all financial covenants contained in our debt and bank borrowing facilities. This offering will have no impact on future compliance with any such financial covenants.

Deemed Dividend on Issuance of Preference Shares

2005 and 2006

We began negotiating with our initial group of international investors in 2004. In the course of related negotiations, we reached an understanding to issue our Series A and Series B preference shares for cash proceeds of US$2,210,000 and US$19,200,000, respectively. These investments closed in August 2005 and June 2006, respectively. Given the strategic value of the investments, we did not seek to renegotiate the sales price of our preference shares, notwithstanding the increase in the value of our company over time. As such, we recognized the discount between the fair value of our preference shares at the time of closing, and the prices paid, respectively, as a deemed dividend on issuance of preference shares of US$4.0 million in 2005 and US$24.1 million in 2006. In addition, the Series A and Series B preference shares, which are convertible into one ordinary share each, were deemed to include a beneficial conversion feature on their date of issuance. The beneficial conversion feature of US$2.2 million in 2005 and US$19.2 million in 2006 were recorded as a deemed dividend against additional paid-in-capital and recognized immediately as the Series A and Series B preference shares were convertible upon issuance.

First Quarter 2007

Concurrently with the issuance of Series C preference shares, pursuant to a share purchase agreement dated January 26, 2007, we offered to the then existing shareholders the opportunity to sell to us shares at a price equal to $0.869 per share for a maximum of 62,780,950 shares. Pursuant to this offer, we acquired 10,041,300 Series A preference shares, 1,581,100 Series B preference shares and 51,158,550 ordinary shares, each at a price of $0.869 per share, and immediately retired the shares. We believe this offer, which represents a premium over the fair value of the preference and ordinary shares, represents a benefit to the shareholders. We recognized the amount in excess of the recorded value of the preference shares as a deemed dividend of $7,611,820. We also recognized the amounts paid for ordinary shares as a purchase of treasury shares with a reduction to retained earnings for $43,419,285.

Capital Expenditures

Our capital expenditures are incurred primarily in connection with purchases of property, plant and equipment, construction of our facilities, leasehold improvements and investment in equipment, technology and operating systems. Our capital expenditures were US$8.3 million in 2004, US$9.1 million in 2005, US$26.9 million in 2006 and US$8.3 million in the first quarter of 2007. Our primary planned capital expenditures for 2007 and 2008 are: (i) the expansion of our Jinshan facility, for which we will allocate up to an aggregate of approximately US$40 million from the net proceeds of this offering and which is scheduled to commence operations in the fourth quarter of 2008, and (ii) construction of a preclinical drug safety evaluation center in Suzhou, for which we will allocate up to an aggregate of approximately US$40 million from the net proceeds of this offering and which we plan to inaugurate in 2009.

 

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Contractual Obligations

The following table sets forth our contractual obligations, including interest portion, as of December 31, 2006:

 

     Payment Due December 31,
     Total    2007    2008    2009    2010    2011 and
Thereafter
     (in millions of US$)

Operating lease obligations

   $ 10.6    $ 1.7    $ 1.7    $ 1.7    $ 1.5    $ 4.0

Long-term debt(1)

     6.5      —        0.7      5.8      —        —  

Short-term debt(2)

     10.0      10.0      —        —        —        —  
                                         

Total(3)

   $ 27.1    $ 11.7    $ 2.4    $ 7.5    $ 1.5    $ 4.0
                                         

(1)

Consists of long-term debt.

(2)

Consists of short-term bank borrowings and current portion of long-term debt.

(3)

Excludes US$40 million in convertible notes issued on February 9, 2007.

Off-Balance Sheet Commitments and Arrangements

We do not have any outstanding off-balance sheet guarantees, interest rate swap transactions or foreign currency forward contracts. We do not engage in trading activities involving non-exchange traded contracts. In our ongoing business, we do not enter into transactions involving, or otherwise form relationships with, unconsolidated entities or financials partnerships that are established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

Quantitative and Qualitative Disclosure About Market Risk

Foreign Exchange Risk

The value of the Renminbi against the U.S. dollar and other currencies may fluctuate and is affected by, among other things, changes in China’s political and economic conditions. The conversion of Renminbi into foreign currencies, including U.S. dollars, has been based on rates set by the People’s Bank of China. On July 21, 2005, the PRC government changed its policy of pegging the value of the Renminbi to the U.S. dollar. Under the new policy, the Renminbi will be permitted to fluctuate within a band against a basket of certain foreign currencies. This change in policy resulted initially in an approximately 2.0% appreciation in the value of the Renminbi against the U.S. dollar. There remains significant international pressure on the PRC government to adopt a substantial liberalization of its currency policy, which could result in a further and more significant appreciation in the value of the Renminbi against the U.S. dollar.

We use the U.S. dollar as our functional and reporting currency for our financial statements. All transactions in currencies other than the U.S. dollar during the year are re-measured at the exchange rates prevailing on the respective relevant dates of such transactions. Monetary assets and liabilities existing at the balance sheet date denominated in currencies other than the U.S. dollar are re-measured at the exchange rates prevailing on such date. Exchange differences are recorded in our consolidated income statement. The financial records of the our subsidiaries are maintained in local currency, the Renminbi, which is the functional currency. Assets and liabilities are translated at the exchange rates at the balance sheet date, equity accounts are translated at historical exchange rates and revenues, expenses, gains and losses are translated using the average rate for the year. Translation adjustments are reported as cumulative translation adjustments and are shown as a separate component of accumulated other comprehensive income in the Statement of Shareholders’ Equity (Deficit) and Comprehensive Income. Transaction gains and losses are recognized in the statements of operations in other income (expenses).

 

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Fluctuations in exchange rates directly affect our cost of revenues and net income, and have a significant impact on fluctuations in our operating margins. For example, in 2006, 98% of our net revenues were generated from sales denominated in U.S. dollars, and 75% of our operating costs and expenses were denominated in Renminbi. Fluctuations in exchange rates also affect our balance sheet. For example, to the extent that we need to convert U.S. dollars into Renminbi for our operations, appreciation of the Renminbi against the U.S. dollar would have an adverse effect on the Renminbi amount that we receive from the conversion. Conversely, if we decide to convert our Renminbi into U.S. dollars for the purpose of paying dividends on our ordinary shares or ADSs or for other business purposes, appreciation of the U.S. dollar against the Renminbi would have a negative effect on the corresponding U.S. dollar amount available to us. Considering the amount of our cash and cash equivalents as of March 31, 2007, a 1.0% change in the exchange rates between the Renminbi and the U.S. dollar would result in an increase or decrease of approximately US$84,992 to our total cash and cash equivalents.

We periodically purchase derivative financial instruments such as foreign exchange forward contracts to hedge our exposure to U.S. dollar — Renminbi currency exchange risk. The counterparty for these contracts is generally a bank. These contracts mature between one to 12 months. We recorded gains (losses) of US$261,172, (US$383,115), US$2,255 and US$862,582 on account of foreign exchange forward contracts in 2004, 2005, 2006 and the first quarter of 2007, respectively. Our accounting policy requires us to mark to market at the end of each reporting period and recognize the change in fair value in earnings immediately. We held such contracts with an aggregate notional amount of US$80 million as of March 31, 2007.

Interest Rate Risk

Our exposure to interest rate risk primarily relates to the interest rates for our outstanding debt and convertible notes and the interest income generated by excess cash invested in liquid investments with original maturities of three months or less. As of March 31, 2007, our total outstanding loans amounted to US$10.3 million with a weighted average rate of 5.67%. Each of our loans is subject to a variable interest rate. A 1.0% increase in each applicable interest rate would add US$0.1 million to our interest expense in 2007. We have not used any derivative financial instruments to manage our interest risk exposure. Interest-earning instruments carry a degree of interest rate risk. We have not been exposed, nor do we anticipate being exposed, to material risks due to changes in interest rates. However, our future interest income may be lower than expected due to changes in market interest rates.

Inflation

Inflation in China has not materially impacted our results of operations in recent years. According to the National Bureau of Statistics of China, the change of consumer price index in China was 3.9%, 1.8%, and 1.5% in 2004, 2005 and 2006, respectively.

Recent Accounting Pronouncements

In July 2006 the Financial Accounting Standards Board, or FASB, released Interpretation No. 48, Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109, or FIN 48, which clarifies the accounting and disclosure for uncertainty in tax positions, as defined in that statement. FIN 48 prescribes a more-likely-than-not threshold for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This interpretation also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, accounting for income taxes in interim periods and income tax disclosures. We adopted the provisions of FIN 48 effective January 1, 2007. Based on our FIN 48 analysis documentation, we have made our assessment of the level of tax authority for each tax position (including the potential application of interest and penalties) based on the technical merits, and have measured the unrecognized tax benefits associated with the tax positions. As of March 31, 2007, the adoption of FIN 48 did not have any impact on our total liabilities or shareholders’ equity (deficit).

 

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In September 2006, the FASB issued Statement No. 157, Fair Value Measurement, or SFAS 157, which defines fair value, establishes a framework for measuring fair value and expands disclosures about assets and liabilities measured at fair value. We will be required to adopt SFAS 157 in fiscal year 2008. Our management is currently evaluating the requirements of SFAS 157 and has not yet determined the impact on our financial position or results of operations.

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, or SFAS 159. SFAS No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. We are currently evaluating the impact, if any, of SFAS 159 on our financial position, results of operations and cash flows.

 

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OUR INDUSTRY

Pharmaceutical R&D Outsourcing Market

Global R&D expenditures for both pharmaceutical and biotechnology companies have grown from US$47.6 billion in 2004 to US$55.2 billion in 2006, according to PhRMA. R&D expenditures for the U.S. pharmaceutical industry grew from US$20 billion in 1997 to US$40 billion in 2005, and are expected to reach US$58 billion in 2009, according to Kalorama Information. While R&D expenditures for the U.S. pharmaceutical industry are projected to grow at an annual rate of approximately 5% to 6% over the period from 2005 to 2010, according to Kalorama Information, annual growth for R&D outsourcing is expected to be approximately 15% to 18% over the same period. Furthermore, R&D outsourcing has increasingly been accepted as an alternative by both pharmaceutical and biotechnology companies over the last decade: for example, in 1997, only 37% of pharmaceutical companies outsourced R&D projects and by 2005 the percentage had grown to 70%.

In response to time and cost pressures for developing more innovative, safe and effective drugs, many large pharmaceutical and biotechnology companies are “offshoring” and/or outsourcing R&D activities to regions with significant resource and cost advantages, such as China. Pharmaceutical companies have been outsourcing drug development, clinical and manufacturing services for many years. Outsourcing companies servicing this demand have developed and become efficient and cost effective, while providing high quality service. Pharmaceutical and biotechnology companies are consistently relying on outsourcing companies, and as a result, service offerings are increasing in number and complexity as outsourcing companies broaden their offerings along the drug discovery value chain.

Drug Discovery Services

The growing use of outsourcing in drug discovery is driven by two major benefits: reduced operating costs and an increased number of drugs moving into development. As illustrated in the table below, the percentage that pharmaceutical companies spend on R&D outsourcing has increased from 10% of total U.S. pharmaceutical industry R&D spending in 1997 to 33% in 2005, and is expected to grow to 41% by 2009. The market for outsourced drug discovery is expected to grow at 15% per annum from US$4.1 billion in 2005 to US$7.2 billion in 2009.

 

     U.S. Pharmaceutical Industry R&D Spending (US$ billions)  

Year

   Internal
Spending
   Total
Outsourcing
   Outsourcing —
Discovery
Services
  

Outsourcing —

Clinical Services

   Total
Spending
   %
Outsourced
 

1997

   $ 18    $ 2    $ 0    $ 2    $ 20    10 %

2001

     22      7      2      5      29    24  

2005

     27      13      4      9      40    33  

2009

   $ 34    $ 24    $ 7    $ 17    $ 58    41 %

Source: Kalorama Information

Manufacturing Services

Demand for outsourced drug manufacturing services for both pharmaceutical and biotechnology companies is growing as well. According to Kalorama Information, the pharmaceutical industry spends US$15 billion on outsourcing manufacturing, formulation and packaging of drugs, a market growing at a rate of 10% to 12% per annum, and the percentage of pharmaceutical and biotechnology companies that have outsourced some of their manufacturing needs is expected to grow from 35% in 2004 to nearly 50% by 2009. According to Kalorama Information, the global outsourced manufacturing market is expected to exceed US$17.5 billion in 2006, up 8% from 2005 sales of US$16.2 billion, and is expected to reach more than US$26.0 billion in 2011. Pharmaceutical companies are expected to continue to fuel much of this growth as they outsource their manufacturing needs for

 

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an increasing number of prescription pharmaceutical products. Biotechnology companies also contribute to this trend as they seek to bring their products to market without making capital investments in their own manufacturing facilities.

Growth Drivers of the Pharmaceutical and Biotechnology Outsourcing Industry

The following chart sets forth the current R&D process in the United States:

LOGO


Source: PhRMA

(1)

Includes US$4.4 billion (11% of total R&D expenditures in 2005) of uncategorized expenditures.

The principal growth drivers for the global pharmaceutical and biotechnology outsourcing industry can be summarized as follows:

Time to Market

Pharmaceutical and biotechnology companies, facing patent expirations, lackluster drug pipelines, slowing growth and profitability and poor share price performance are under increasing pressure to deliver new drugs to market and reduce the time required for drug development. In response to these time pressures, many large pharmaceutical and biotechnology companies look to outsourcing to accelerate their development timelines. Drug discovery outsourcing can reduce time to market by as much as 30%, according to Frost & Sullivan.

Cost Control

Pharmaceutical and biotechnology companies are facing cost pressures from a variety of sources, including falling drug revenues, patent expirations, generic competition and government regulated pricing, particularly in

 

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Europe and Asia. According PhRMA, it currently takes an average of 10 to 15 years and approximately US$802 million (in 2000 dollars) to develop a safe and effective drug, including the cost of failures and capital. It is estimated that the cost of developing a biologic drug (a drug generally composed of large and complex molecules and produced through a cell culture rather than chemistry) is approximately US$1.2 billion (in 2005 dollars). Furthermore, for every 5,000 to 10,000 compounds tested as a potential drug, only one receives regulatory approval and becomes a new treatment. This long and costly process is due largely to the inability of science to predict accurately which of a virtually infinite number of possible drug candidates will prove to be safe and effective. Drug discovery outsourcing companies offer a means to counter this process through reduced testing costs.

Growing Unmet Medical Needs

According to PhRMA, health care needs are growing as populations are getting older. In the United States, the number of citizens over age 65 is expected to double over the next 40 years, meaning that illnesses like Alzheimer’s disease are becoming more common, increasing the need for treatments to prevent or delay the onset of diseases for seniors. More people in the United States are suffering from chronic diseases as well; for example, the prevalence of diabetes is expected to nearly double between the years 2000 and 2030. This growing incidence of disease, coupled with a concurrent improvement in living standards and general disposable income, is a major reason for rising health care spending.

Technological Innovation in Drug Discovery and Development

New technologies are providing an ever-increasing number of new drug leads that can be evaluated. This demands greater speed and efficiency to accurately identify and evaluate the greater number of leads generated. Due to their speed, scalability, capacity and efficiency, drug discovery outsourcing companies are well-positioned to address the increasing demand to process leads in a cost-effective manner.

Increasing Safety Standards

The FDA and other regulators have placed a greater emphasis on safety testing following recent failures in identifying potentially harmful side effects of medications prior to manufacturing. Consequently, and in conjunction with ongoing efforts to terminate unsuccessful pipeline candidates as soon as possible, sponsors are looking to ascertain toxicity profiles of candidates earlier in the drug discovery and development process. These efforts demand more preclinical resources, capacity and specialized expertise. We believe that outsourcing companies have the expertise, scale and resources to determine the safety profiles of drug candidates in accordance with the FDA’s stringent regulations.

Biotechnology Industry Demands

Many biotechnology companies are formed based on their novel lead generation methodologies and understanding of disease models and pathways. However, these companies often lack the resources to fully develop their own internal chemistry discovery capabilities, which would involve significant investments in capital expenditures for laboratories and human capital in hiring scientists, and other preclinical testing capabilities. Also, rather than out-license future product rights or sell equity to a pharmaceutical partner in exchange for chemistry and preclinical expertise, many biotechnology companies have elected to outsource their drug discovery needs.

Outsourced Manufacturing Demands

Many pharmaceutical and biotechnology companies have determined that manufacturing of chemistry-derived drugs (as opposed to biological compounds) is not as critical a component of their internal process such that they need to keep these capabilities in-house rather than outsourcing to adequately meet their needs and provide various benefits. These benefits include the access to the latest manufacturing technologies, specialized production, large scale and flexibility and reduction in scale-up time. Outsourcing also allows companies to avoid the relatively large fixed costs, such as investments in facilities, capital expenditures and personnel.

 

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Characteristics of Drug Discovery and Manufacturing Outsourcing

In response to time and cost pressures for more innovative and effective safe drugs, many large pharmaceutical and biotechnology companies are “offshoring” and/or outsourcing R&D activities to regions with significant resource and cost advantages, such as China. Characteristics of this trend in outsourcing include:

 

   

Quality — a quality drug candidate is essential in drug development. It is insufficient to generate a large number of compounds: the key is generating high quality compounds with the proper purity and targeted characteristics. This depends on quality equipment, quality control and quality people. To secure such quality, customers value the experience, track records and advanced degrees of an outsourcing company’s scientists and management.

 

   

Effectiveness — the effectiveness of drug discovery to improve screening and increase the conversion rate of hits to leads results in reduced time to market.

 

   

Speed — faster discovery results accelerate the drug discovery and development timeline, thereby shortening the time to commercialization and realization of revenues and profits.

 

   

Flexibility and scale — as the outsourcing market grows, more and more options become available to customers. Customers can choose one supplier to integrate all aspects of drug discovery and development, providing only their targets or lead compound for optimization. Alternatively, they can outsource disciplines for which they do not have in-house capabilities: chemistry work for the bio-based customers; biology work for chemistry-based customers. They can also “cherry-pick” outsourcing services for research where they lack or need added capacity.

 

   

Cost — outsourcing budgets are finite, and the savings achieved by outsourcing companies enable customers to engage in more projects and pursue more leads. Outsourcing to China, for example, offers additional resource and cost advantages.

 

   

Manufacturing characteristics — a reduction in overall costs by 30% to 35%, improved manufacturing efficiencies, reduction in excess production capacities, minimized investment and diversion of resources to other core activities.

Overview of the Drug R&D Process

Drug R&D is the process of creating drugs for the treatment of human disease. To develop a new drug, the first step is to identify a promising target, such as a protein that plays a crucial role in a particular disease. Teams of chemists, pharmacologists and biologists then engineer or screen thousands of compounds and modify them to increase disease fighting activity and/or minimize undesirable patient side effects. Hundreds of potential drugs emerge from this process. However, because of the complexity and uncertainty of drug development, most of these potential drugs will never be approved for patients under the current drug R&D process. The drug research process aims to generate safe and effective drug candidates, while the drug development process involves the testing of these drug candidates for safety and efficacy in animals and humans.

Drug characteristics are the criteria that measure the effectiveness of a drug in treating a particular disease, such as: (i) potency, or the amount of a drug required to effectively treat the disease; (ii) selectivity, or the extent to which a drug interacts only with the disease-causing target; (iii) toxicity, or the presence and significance of any harmful side effects; (iv) metabolism, or how rapidly the drug works and how long it stays effective; and (v) formulation, or how the drug is administered to patients, i.e., orally or by injection.

 

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The role of biology in drug research is primarily focused on the early stages of drug research, including understanding the mechanism of diseases and identifying potential drug targets for therapeutic intervention. The role of chemistry in drug research is the actual creation of safe and effective drug candidates to address these targets. Below is a more detailed description of the drug R&D process:

LOGO

Drug Discovery

Target Discovery

The mapping and sequencing of the human genome, which is the set of all human genes, has identified large numbers of genes that encode the chemical information for cells to produce proteins. These proteins determine human physiology, with some also capable of causing disease. These disease-related proteins are potential targets for therapeutic intervention with drugs. Biologists identify the targets against which chemists create drugs. Many of these potential drug targets have not yet been validated, meaning that their roles in causing disease are imperfectly understood.

Lead Generation

Lead generation is the process of identifying hits, which are either chemical compounds or therapeutic antibodies, genes or proteins that interact with a potential drug target with sufficient potency and selectivity to warrant further testing and refinement as possible drug candidates. These potential drug candidates are called leads.

Assay development and compound screening. Once biologists identify a potential drug target, biochemists must develop tests, called assays, to evaluate or screen potential drug compounds against these targets for their therapeutic value. Depending on the target and what is understood about its biology, biologists develop many types of primary assays conducted in test tubes, called in vitro assays, to measure the relative potency and specificity of interaction of a potential drug compound with a target. Biochemists further evaluate the drug characteristics of compounds by creating more complex secondary assays that combine in vitro techniques with in vivo methods that are conducted in animals. A typical screening campaign for a given target entails screening small amounts of thousands of chemical compounds from collections of chemical compounds known as libraries.

Compound libraries. Chemists design compound libraries to provide a starting point to identify leads in the drug discovery process and to better understand the biochemistry and therapeutic relevance of targets. A well-designed library increases the likelihood of finding a hit that is suitable for optimization of its drug characteristics. Screening of low quality libraries often produces either numerous false hits or hits that are not suitable for optimization, creating a bottleneck in secondary screening and downstream chemistry.

Compound synthesis. Compound synthesis is the process by which chemists use a small set of commercially available starting materials as building blocks to create new compounds. Compound synthesis is accomplished by adding building blocks to a core chemical structure, called a scaffold, through a chemical reaction, either one reaction at a time or in a parallel fashion. Chemists determine which compounds to prepare and try to choose a method that will minimize the number of steps and the time required for synthesis. Compound synthesis often involves multiple separate chemical steps. While new technologies have increased productivity, the synthesis of compounds with desirable drug characteristics remains a rate-limiting step in the drug discovery process.

 

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Lead Optimization

Lead optimization is the complex, multi-step process of refining the chemical structure of a hit to improve its drug characteristics, with the goal of producing a preclinical drug candidate. By definition, a quality lead can be readily optimized into a potential drug candidate. At the initiation of a drug discovery project, goals defining the desired drug characteristics, or candidate criteria, are established. Medicinal chemistry involves the design, selection and synthesis of compounds to achieve these specified drug characteristics. Any hits obtained from screening against targets are evaluated relative to these candidate criteria. Typically, one or more hits are evaluated in secondary assays, and a set of structurally-related compounds, called analogs, are synthesized and screened as well. Chemists determine which hits or analogs to optimize based on a combination of their potential drug characteristics, ease of synthesis and structure-activity relationship, or SAR. SAR is quantitative information that correlates changes in chemical structure to biological data generated from screening assays. The ability of chemists to make informed decisions as to which changes in structure will optimize a hit’s valuable drug characteristics is based mostly on experience and is a key parameter for productivity in drug discovery.

This optimization process can be accomplished by an empirical, linear approach where each analog is evaluated to determine its drug characteristics and, based upon this analysis, an additional analog is synthesized. Alternatively, a rational, parallel approach can be used to simultaneously create multiple analogs, called focused libraries. These focused libraries can be screened against targets to generate a matrix of SAR information, resulting in accelerated optimization.

Process R&D

The compounds chemists create for screening in lead generation and lead optimization are typically synthesized in relatively small, milligram quantities. The synthetic process to make compounds for screening typically uses a parallel synthesis approach to explore drug characteristics, rather than to optimize ease of synthesis. Before a drug candidate can be taken into preclinical and clinical trials, kilogram quantities must be synthesized. The goal of process research is to improve the ease with which compounds can be synthesized in these larger quantities, typically by minimizing the number of steps, and to determine how to reduce the time and cost of production. Process development refers to the production scale-up and further refinement of compounds required for clinical trials and commercial manufacturing.

Preclinical Candidates

A preclinical candidate is a lead that has been optimized to meet particular drug candidate criteria and that is ready for toxicity testing. Chemists utilize SAR information, derived from focused libraries, complex secondary assays, and other technologies to engineer hits with desired drug characteristics into leads. Complex secondary assays, such as those using human tissues and animal models, can help define the potential of drugs to be safe and effective in humans. Technologies that help improve the prediction of clinical success include x-ray crystallography, which can determine the exact three-dimensional structure of potential drug compounds bound to targets, and molecular modeling, a computational method that helps chemists to design more potent and selective compounds. Ultimately, the experience, intuition and synthetic skills of medicinal chemists are important factors in creating a successful drug candidate. Chemists can use databases correlating chemical structure to biology, generally referred to as chemoinformatics, to help predict SAR to optimize desired drug characteristics. While historically performed in a linear process, chemists now refine drug characteristics in parallel at every point in the lead optimization process.

Preclinical Development

Potential drug candidates identified during drug discovery undergo years of additional testing. During this phase, both laboratory and animal studies may be used to evaluate a drug’s safety and demonstrate that it has biological activity against the disease target. For example, chemistry tests establish the compound’s purity,

 

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stability and shelf life, while other studies explore possible dosing, packaging and formulation, i.e. pill, inhaler or injection. For regulatory purposes, a potential drug candidate must undergo extensive in vitro and in vivo studies to predict human drug safety, including toxicity over a wide range of doses and how the drug is metabolized. The objective of preclinical testing is to obtain results that will enable the preclinical drug candidate to be approved for human testing by the appropriate regulatory authorities, such as the FDA, through an IND application. Only drugs with strong evidence of safety and potential benefit move forward to clinical trials. According to PhRMA, it is estimated that for every 250 compounds that enter preclinical testing, only five make it into clinical trials.

Preclinical development activities include:

 

   

Assay development and compound screening — the development of biochemical and cell-based assays to examine the activity of experimental compounds at receptors, enzymes and signal transaction pathways.

 

   

DMPK — includes in vivo rodent pharmacokinetic screening for rapid drug candidate selection and large animals and non-human primate pharmacokinetic screening for prediction of drug properties in humans.

 

   

ADME profiling — the study of a drug molecule’s essential elements of absorption, disposition, metabolism and excretion. ADME consists of the four basic biological processes that determine how an environmental substance is handled by the body’s natural physiological processes and defenses. Understanding these processes is an important part of drug discovery research, and when integrated with our discovery chemistry services reduces the time and cost typically required to identify the most viable drug candidate. ADME screening provides the physiological profiles of drug candidates, and candidates with desirable ADME properties are further modified to increase their biological activity.

 

   

Metabolite identification — the determination of the structural information on metabolites, which can be particularly useful in enhancing and streamlining the process of developing new drug candidates. The ability to produce this information early in the discovery phase is becoming increasingly important as a basis for judging whether or not a drug candidate merits further development. Metabolite identification enables early identification of potential metabolic susceptibilities or issues and assists in the prediction of the metabolic pathways of potential drug candidates chosen for development. It provides a metabolism perspective that guides the synthetic route with the aim of either blocking or enhancing metabolism to optimize the pharmacokinetic and safety profiles of newly synthesized drug candidates.

 

   

Toxicology services — includes general toxicology, which involves the scientific analysis of the effects of toxic chemical substances, either in vitro, on cultured bacteria or mammalian cells, or in vivo, in living animals.

 

   

Formulation — the combination of products with other active or inert ingredients to create a human pharmaceutical product. A successful formulation process has four stages: preformulation, stabilization of the active substance in bulk form, formulation in the designated dosage forms (drug delivery), and fill and finish of aseptic manufacturing activities. Preformulation is a branch of pharmaceutical sciences that utilizes biopharmaceutical principles in the determination of physicochemical properties of a drug substance. The goals of preformulation studies are to choose the correct form of the drug substance, evaluate its physical properties, and generate a thorough understanding of the material’s stability under various conditions, leading to the optimal drug delivery system.

Clinical Development

Clinical trials, or human tests of a potential drug candidate to determine safety and efficacy, are typically conducted in three sequential phases. A successful clinical trial will typically result in the filing of an NDA with the FDA to seek permission to market the drug in the United States. Similarly, clinical trials must be conducted and regulatory approvals secured before a drug can be marketed in other countries.

 

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Commercialization

Before approving a drug, the FDA requires that manufacturing procedures and operations conform to cGMP regulations, a set of guidelines published by the International Conference on Harmonization, or ICH, and manufacturing guidelines published by the FDA. Manufacturing procedures and operations must be in compliance with all regulatory and quality regulations at all times during the manufacture of commercial products and APIs for approved drugs. Once a drug has received all necessary approvals, the manufacture, marketing and sale of commercial quantities of the approved drug may commence.

Manufacturing

Most pharmaceutical and biotechnology companies outsource at least part of their manufacturing. Historically, large companies that are inclined to manufacture in-house do so primarily to maximize their return on investment in facilities and capital by operating at maximum capacity. However, because of the unpredictability of the drug development pipeline, sizing a plant to maintain maximum capacity is challenging. To reduce risks, a growing number of drug companies divert some of their manufacturing to outsourcing companies. Such partnering arrangements enable companies to manage surges in capacity needs without tying up assets during slower periods. In addition, smaller companies often do not have the resources or capital to invest in process development and manufacturing facilities, and thus tend to outsource more of their manufacturing costs.

Outsourced manufacturing includes primary manufacturing, which includes APIs for approved drugs and chemical intermediates, and secondary manufacturing, which involves formulation, dosage form and packaging manufacturing, and can range in scale from clinical amounts to commercial scale amounts.

 

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BUSINESS

Overview Of WuXi

We are the leading China-based pharmaceutical and biotechnology R&D outsourcing company. We provide a broad and integrated portfolio of laboratory and manufacturing services in the drug discovery and development process to pharmaceutical and biotechnology companies. Our services are designed to help our customers address the bottleneck between the discovery of therapeutic targets and the testing of drug candidates in human clinical trials. Our operations are grouped into two segments: laboratory services, consisting of discovery chemistry, service biology, analytical, pharmaceutical development and process development services, and manufacturing, focusing on manufacturing of advanced intermediates and APIs. In 2006, we provided our services to 70 pharmaceutical and biotechnology customers, including nine of the top 10 pharmaceutical companies in the world, as measured by 2006 total revenues. We have received a number of recognitions and awards from our customers. To date, most of our customers have returned to us for additional and often larger and longer-term projects, and each of our top-ten customers over the last three years continues to be our customer today.

We have increasingly developed broader and more integrated relationships with our customers through our expanded capabilities and services along the drug discovery value chain. Building on our chemistry capability and service biology operations, we intend to develop new services in preclinical development, formulation and manufacturing. Our objective is to become a leading full service provider of drug discovery and development outsourcing services to the global pharmaceutical and biotechnology industry.

Based in China and headquartered in Shanghai, we are well-positioned to capitalize on the advantages of conducting drug R&D in China, while emphasizing quality, responsiveness, protection of customer intellectual property and reliability. As of May 31, 2007, we had 1,972 employees, including 1,345 scientists and other technical staff. We offer our services on a fee-for-service basis or on an FTE basis, or a combination thereof. Our primary facilities include an approximately 630,000 square-foot R&D center in Shanghai Waigaoqiao Free Trade Zone, an approximately 220,000 square-foot process development and manufacturing plant in Jinshan area of Shanghai and an approximately 130,000 square-foot R&D center in Tianjin, which is mainly focused on discovery chemistry services and helps us access the Northern China talent pool. Our net revenues increased from US$20.9 million in 2004 to US$33.8 million in 2005 and US$69.9 million in 2006, representing a two-year compound annual growth rate or CAGR, of 83%, and a year-over-year growth rate of 107% from 2005 to 2006, and increased from US$12.8 million in the first quarter of 2006 to US$33.8 million in the first quarter of 2007, a growth of 165%. Our net income increased from US$4.3 million in 2004 to US$6.1 million in 2005 and US$8.9 million in 2006 (including total share-based compensation charges of approximately US$0 in 2004, US$3.1 million in 2005 and US$8.4 million in 2006), representing a two-year CAGR of 44%, and a year-over-year growth rate of approximately 44% from 2005 to 2006, and increased from US$0.8 million in the first quarter of 2006 to US$6.0 million in the first quarter of 2007 (including total share-based compensation charges of US$0.3 million in the first quarter of 2006 and US$3.4 million in the first quarter of 2007, a growth of 623%).

Our Strengths

We believe we are well-positioned to capture the market opportunities and to benefit from the expected growth in the pharmaceutical and biotechnology R&D outsourcing market through our competitive strengths, which principally include the following:

Proven quality and customer satisfaction. We are able to provide our customers with dedicated resources, facilities and experienced scientists dedicated to the specific needs of individual customers. We have received a number of recognitions and awards from our customers, including the “Supplier Appreciation Award” from Merck in 2005, the “Chemical Product R&D Preferred Partner” from Eli Lilly and Company in 2006, and most recently the “Outstanding Strategic Collaboration Award” from Merck in February 2007. To date, most of our customers have returned to us for additional and often larger and longer-term projects, and each of our top-ten customers over the last three years continues to be our customer today. We believe that our operational track

 

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record in successful project management, responsiveness, turnaround times and productivity has led to steady growth in our revenues and profits.

Experienced management and talented pool of scientists. Our management team has extensive experience both overseas and in China’s pharmaceutical and biotechnology industry, as well as an understanding of Chinese and international industry best practices. Our management team is composed of Western-trained Ph.D.s and MBAs with experience in drug R&D methodologies and Western-style business practices with a track record of managing the rapid growth of our business over the last five years. Collectively, our senior management has more than 100 patents pending or granted, published more than 500 publications and has an average of 10 years of experience working in major international pharmaceutical and biotechnology companies. Furthermore, of our 1,972 employees at May 31, 2007, approximately 4.6% were Ph.D.s, 35.9% had master’s degrees and 31.7% had bachelor’s degrees.

Integrated, expanding and scalable services. We have matured from a discovery chemistry-focused contract research company to an integrated provider of R&D services spanning the drug discovery value chain. We have the ability to ramp up our operations quickly to meet our customer needs. In 2006 and in the first five months of 2007, for example, we added more than 700 and 117 scientists, respectively, and significantly expanded the capacity of our chemistry services, introduced our biological assays capacity to broaden our offerings in the higher margin service biology department and added a new portfolio of pharmaceutical development services. We believe that we are well-positioned as a “one-stop shop” for drug discovery services for our customers to advance their drug discovery programs from the conceptual stage through preclinical and clinical trials.

Commitment to protection of our customers’ intellectual property and confidential information. Since our inception, we have made it a strategic priority to safeguard our customers’ propriety rights by using well-established and strictly enforced intellectual property protection procedures. Each customer project has dedicated laboratory spaces equipped with key card access control systems. For certain major customers, we provide not only dedicated teams of scientists, but also dedicated laboratory facilities, analytical support, and independent information technology and security services. This physical and operational separation of customer projects ensures enhanced security and protection of our customers’ intellectual property.

World-class facilities and equipment. We have world-class facilities, technology and equipment, including an approximately 630,000 square-foot R&D center in Shanghai Waigaoqiao Free Trade Zone, an approximately 220,000 square-foot manufacturing plant in the Jinshan Chemical Industry Development Zone of Shanghai, which is undergoing an expansion to quadruple its manufacturing capacity, and an approximately 130,000 square-foot R&D center in Tianjin, mainly focused on our discovery chemistry services. Our manufacturing facilities are cGMP-quality and meet China’s State Food and Drug Administration, or SFDA, standards, and are ISO 9001:2000 certified.

Advantages of doing business in China. Because we conduct almost all of our operations in China, we are strategically positioned to benefit from the advantages that make China an attractive pharmaceutical outsourcing destination: low cost structure for labor and materials, a developed infrastructure, a large talent pool to support the workforce and utility, land use and tax advantages. According to Kalorama Information, China has 200,000 science graduates per year, and labor costs are expected to remain comparatively low for the next five to 10 years. We believe that experienced scientists in China are generally paid only 20% to 30% of the salaries paid to their counterparts in the United States.

Our Growth Strategy

Our objective is to become a leading full service provider of drug discovery and development outsourcing services to the global pharmaceutical and biotechnology industry. To achieve our objective, we intend to focus on our core competencies by continuing to provide quality services along the drug discovery value chain and delivering new, innovative solutions to meet our customers’ needs, while maintaining our customers’ trust

 

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through quality, responsive, value-added services and protection of their intellectual property. We also plan to continue to grow our business by pursuing the following strategies:

Expand service offerings and enter the higher value-added preclinical development and manufacturing spaces. Since inception, we have expanded our service offerings across the drug discovery and development value chain to keep pace with our customers’ changing needs. We intend to continue to expand our service capabilities in chemistry, service biology and manufacturing, to offer new services in preclinical development, and to leverage our existing customer base to achieve a “one-stop shop” solution. Starting in 2007, we began to roll out preclinical development services, such as DMPK general toxicology services, as well as pharmaceutical development services and manufacturing of clinical trial materials.

Attract, train and retain quality talent. We plan on continuing to aggressively recruit quality talent from China’s large talent pool and anticipate that we will hire a significant number of employees during 2007, increasing our headcount substantially. With facilities from Shanghai to our new site in Tianjin, near Beijing, we are able to access the major talent pools in China. We also will continue to recruit overseas, primarily focusing on Chinese scientists and managers who have been educated or worked overseas and return to China with knowledge of Western business practices and foreign language skills, known as returnees, and other scientists with significant educational and/or industry background with major pharmaceutical and biotechnology companies. We believe that through our internal training system, returnees and other senior scientists are able to quickly impart their experience and knowledge to new hires.

Increase capacity and facilities. We intend to expand our capacity and facilities. We have opened our Tianjin facility, adding approximately 130,000 square feet of R&D space, and in 2006 began the expansion of our Jinshan plant to quadruple the manufacturing capacity of the plant. We are planning to construct a preclinical drug safety evaluation center in Suzhou, which is expected to be focused primarily on preclinical research. We have also recently completed construction of an approximately 22,000 square-foot cGMP-quality pilot lab, located near our main facility in Shanghai Waigaoqiao Free Trade Zone, focused on formulation projects for Phase I to II clinical trials material manufacturing.

Grow through selective, complementary strategic partnerships and acquisitions. We intend to expand our service capabilities through strategic acquisitions of companies or technologies that complement our existing capabilities, and leverage our existing customer base to provide a “one-stop shop” solution. We believe that the pharmaceutical and biotechnology R&D outsourcing market is significantly fragmented. Many companies have strong services, but lack the scale or complement of services to compete with the industry leaders in the long term. We intend to identify and strategically acquire companies that we believe could broaden the functionality and strength of our existing services.

Our Services

We provide a broad and integrated portfolio of quality chemistry, biology and manufacturing services in the drug discovery and development process to pharmaceutical and biotechnology companies. Our core operations are grouped into two segments: laboratory services and manufacturing. Our laboratory services segment consists of discovery chemistry, service biology, analytical, pharmaceutical development and process development services, which we conduct primarily at our headquarters in Shanghai Waigaoqiao Free Trade Zone and our R&D center in Tianjin. Our manufacturing segment focuses on cGMP-quality manufacturing of advanced intermediates and APIs, which we conduct from our Jinshan facility.

Our service offerings initially consisted of lead generation and lead optimization discovery chemistry services. As we established a track record of customer satisfaction, we have expanded our service offerings extensively. We believe our customers value our ability to offer a wide breadth of quality services to meet their drug R&D needs, and we expect to continue to expand our service offerings in both preclinical and clinical development in the future.

 

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The following chart sets forth the drug R&D process and our services:

LOGO

Laboratory Services

Discovery Chemistry

Our core offering is discovery chemistry services, consisting primarily of lead generation and lead optimization services. We believe that we are one of the few companies that can independently offer chemistry-based services across the entire spectrum of the drug discovery process. The extensive experience and expertise of our scientists enable us to provide discovery chemistry services tailored to our customers’ specific needs. As of May 31, 2007, our discovery chemistry team consisted of 1,127 employees. We believe that we are well-positioned to ramp up quickly for projects and to be responsive to customer needs. Our discovery chemistry services include:

 

   

Lead generation. Our lead generation services include designing and synthesizing libraries, as well as templates for library synthesis, benchmark compound synthesis and custom synthesis. We have developed a scalable purification lab, which simplifies a costly and cumbersome process into an efficient system for purifying compounds, resulting in lower cost and shorter time to market to benefit our customers and allowing for the purification of 500,000 library compounds annually.

 

   

Lead optimization. Our lead optimization services include designing and synthesizing focus libraries, which contain a smaller number of compounds per library compared to the general screening libraries prepared in our lead generation activities. We also focus on a traditional medicinal chemistry approach, a process through which a series of compounds are carefully designed with the aid of modern computational chemistry or/and related structure-activity relationship, or SAR, information analysis, followed by their chemical synthesis, biological activity and ADME property evaluation.

 

   

Synthetic chemistry. Our synthetic chemistry services include providing synthesis of complex assay standards and benchmark compounds. We have completed a number of complex custom synthesis projects, all of which required more than 30 steps.

 

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Service Biology

Based on strong customer demand, we established our service biology department in 2006. We anticipate that this department will increasingly contribute to the growth and profitability of our business. As of May 31, 2007, our service biology team consisted of 33 employees. Currently, our service biology offerings include:

 

   

Assay development and high throughput screening. We develop biochemical and cell-based assays to examine the activity of small molecule compounds at receptors, enzymes, ion channels and signal transaction pathways.

 

   

DMPK. Our DMPK services include in vivo rodent screening based on pharmacokinetic characteristics for rapid drug candidate selection and dog and non-human primate PK for prediction of drug properties in humans. We have the expertise to administer drugs to animals using various dosing routes, which include orally, intravenously and by infusion. We perform mass balance studies by administering radioactive drug molecules to animals and monitor metabolites in plasma, urine, bile and tissue samples.

 

   

ADME profiling. Our in vitro ADME profiling services include analyzing (i) the metabolic stability of drug candidates in cell particles and liver cells, (ii) drug-drug interaction, (iii) plasma protein binding and (iv) the manner in which drugs are transported in the body through transporter assays.

 

   

Metabolite identification. Our metabolite identification services include metabolite profiling, characterization and structure identification, bulk metabolite isolation and purification, synthesis of authentic standards of metabolites and pharmacokinetic evaluation of parent and metabolites in preclinical and clinical development.

 

   

Animal disease modeling. We develop rodent efficacy models to evaluate compounds in various therapeutic categories including inflammation, cancer, central nervous system and metabolic diseases.

 

   

Toxicology services. We began offering our toxicology services in the second quarter of 2007. Our toxicology services are expected to include general toxicology in rodents, dogs and non-human primates. In the interim, we have leased and renovated an approximately 13,000 square-foot toxicology facility in Xishan, 60 kilometers from Shanghai. We have partnered with another company to secure a supply of toxicology subjects and access to a breeding facility. We intend to build an approximately 215,000 square-foot preclinical drug safety evaluation center in Suzhou, which we expect to be fully operational in 2009. The future center will offer comprehensive drug safety evaluation services, including general toxicology, safety pharmacology, development and reproductive toxicology and carcinogenicity studies.

Pharmaceutical Development

Our pharmaceutical development services group, staffed by 11 scientists, focuses on formulation development for new chemical entities supported by preformulation studies, analytical development, stability evaluation and regulatory submission preparation services, moving our customers’ new chemical entities from the preclinical stage to NDA filings. We expect to grow our pharmaceutical development services group in 2007 with the recent completion of an approximately 22,000 square-foot cGMP-quality pilot lab, located near our main facility in Shanghai Waigaoqiao Free Trade Zone, focused on formulation projects for Phase I to II clinical trials material manufacturing.

Analytical

Our analytical services group provides integrated analytical support for our internal discovery chemistry, biology, DMPK, toxicology, process chemistry and manufacturing services in characterizing and determining the quality and quantity of samples and products. As of May 31, 2007, our analytical services group consisted of 185 scientists and technicians. Our analytical services consist of:

 

   

Core analytical services. Internally supports synthetic chemistry, lead generation and lead optimization services, and offers external services focused on chiral separation, bulk material purification and high-throughput library purification.

 

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Bioanalytical services. Internally supports DMPK, toxicology and biology services, and offers external services, immunoassay for protein drugs and biomarkers, which are traits, proteins or other substances used to measure or indicate the progress or existence of a disease or condition, and metabolite identification. The laboratory is compliant with GLP, providing quantitative and qualitative sample analysis for preclinical and clinical studies.

 

   

Analytical development services/quality control. Internally supports process R&D and manufacturing, and offers external services focused on analytical method development, method validation, in-process quality control and stability testing.

Process Development

Our process development service involves optimizing the chemical synthesis process in order to yield much larger quantities of the drug than were needed in the previous development phases. By optimizing and selecting the most effective method of compound synthesis, chemists reduce the cost of synthesis. This may be achieved by reducing the number of products used in synthesis, improving the yield of the desired compound and accelerating the time needed for synthesis. Our process development service assists our customers to manufacture their drug candidates more efficiently. Our cGMP-quality kilo-lab and pilot plant assist our customers to develop processes to manufacture drugs in increasing quantities from lab quantities, which are measured in milligrams/grams, to scale-up quantities, which are measured in kilograms, to process optimization quantities, which are measured in hundreds of kilograms, to commercial process development quantities, which are measured in tonnage, to meet the increased demands of clinical trials and commercialization. As of May 31, 2007, our process development service group consisted of 106 employees.

Manufacturing

We began offering our manufacturing services in 2003 to meet the growing demand for outsourced manufacturing services from our customers. Our manufacturing services are integrated with our laboratory services, with the goal of reducing overall development time for our customers. As of May 31, 2007, our manufacturing group consisted of 303 employees.

We have an approximately 220,000 square-foot cGMP-quality multi-purpose manufacturing facility in the Jinshan Chemical Industry Development Zone of Shanghai, established in May 2004, with 41,000L of reactor volume. The plant is in compliance with SFDA standards, and is ISO 9001:2000 certified. In January 2007, we began the expansion of our Jinshan facility by an additional approximately 350,000 square feet, which we anticipate will quadruple the capacity of the cGMP-quality facility with an additional 172,000L of reactor volume. The new facility will concentrate on commercial production with advanced automation and cryogenic capability, in anticipation of the increased need for our manufacturing services. The expansion is scheduled to commence operations in late 2008.

We are also currently engaged in manufacturing activities in Changzhou, approximately 200 kilometers from Shanghai, through an exclusive entrustment arrangement with a local factory, giving us access to an approximately 18,000 square-foot plant in Changzhou with a maximum reactor volume of 55,500L. We are in the process of setting up a branch of STA in Changzhou. Once the branch is set up, we intend to lease either the existing facility or find a suitable alternative. The Changzhou plant is focused on manufacturing of registration starting materials.

 

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Our Facilities

We are headquartered in Shanghai and currently conduct our laboratory and manufacturing activities in three primary facilities:

 

   

Approximately 630,000 square-foot R&D center in Shanghai Waigaoqiao Free Trade Zone, primarily for laboratory services. We own approximately 400,000 square feet of the Waigaoqiao facility, which is currently mortgaged to China Construction Bank to secure a RMB100 million maximum amount loan agreement for a term of three years, ending in April 2009. We lease the remaining 230,000 square feet of the facilities in Waigaoqiao for varying lease terms.

 

   

Approximately 130,000 square-foot R&D center in Tianjin, mainly focused on our discovery chemistry services. We lease the facilities in Tianjin for a term of 10 years.

 

   

Approximately 220,000 square-foot manufacturing plant in the Jinshan Chemical Industry Development Zone of Shanghai, which we own. The manufacturing facilities in Jinshan are used for the manufacturing of advanced intermediates and APIs.

We intend to expand our capacity and facilities. We recently opened our Tianjin facility, adding approximately 130,000 square feet of R&D space, and in 2006 began the expansion of our Jinshan plant to quadruple the manufacturing capacity of the plant. We are planning to construct a preclinical drug safety evaluation center in Suzhou, which is expected to be focused primarily on preclinical research. We recently completed construction of an approximately 22,000 square-foot cGMP-quality pilot lab, located near our main facility in Shanghai Waigaoqiao Free Trade Zone, focused on formulation projects for Phase I to II clinical trials material manufacturing. We intend to finance these expansions from the proceeds of this offering, with the exception of the pilot lab which we are funding from cash flow from operations. See “Use of Proceeds” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Capital Expenditures.”

Sales and Marketing

We market our services directly to customers through meetings with senior management of pharmaceutical and biotechnology companies, maintenance of an extensive Internet website and participation in trade conferences and shows. We also receive a significant amount of business from customer referrals. In particular, members of our senior management team have managed our sales and marketing activities and maintained personal, direct relationships with our major customers and suppliers since our inception.

New customers typically first assign us a small-scale assignment to test our capabilities. After we successfully complete the assignment, the customer often increases the size and term of the next contract, and hires us for more types of assignments. We intend to increase our customer base by targeting biotechnology companies that often lack in-house drug discovery and development capabilities and for which outsourcing is an attractive option for them to achieve their objectives.

Customers

Our customers consist primarily of large pharmaceutical and biotechnology companies located throughout the world. In 2006, we provided our services to 70 pharmaceutical and biotechnology customers, including nine of the top 10 pharmaceutical companies in the world, as measured by 2006 total revenues. Substantially all of our total net revenues over the last three years were generated from sales to customers located in the United States. We have received a number of recognitions and awards from our customers, including the “Supplier Appreciation Award” from Merck in 2005, the “Chemical Product R&D Preferred Partner” from Eli Lilly and Company in 2006, and most recently the “Outstanding Strategic Collaboration Award” from Merck in February 2007. To date, most of our customers have returned to us for additional and often larger and longer-term projects, and each of our top-ten customers over the last three years continues to be our customer today. As a result, our

 

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customer base has been stable. We typically enter into collaboration or service agreements with our customers, which range in duration from one to four years, and have increasingly entered into multi-year contracts with our customers.

The table below illustrates our growing and repeat customer base:

 

     As of December 31,
         2004            2005            2006    

Top ten customer concentration (% of revenues)

   83    73    69

Total number of customers

   55    69    70

Retention of top ten customers (repeat %)

   100    100    100

Average revenues per top ten customer (millions of US$)

   1.7    2.5    4.8

For certain major customers, we provide not only dedicated teams of scientists, but also dedicated laboratory facilities, analytical support, and independent information technology and security services. This physical and operational separation of customer projects ensures enhanced security and protection of our customers’ intellectual property. The laboratory configuration and setup, research plan, operating procedures, information technology and security protocols all can be tailored to our customers’ specifications.

Our two largest customers in 2005 and 2006, Pfizer and Merck, accounted for 17.4% and 17.4% in 2005 and 15.4% and 13.7% in 2006 of our net revenues, respectively. No other customer accounted for more than 10% of our net revenues in those years. Vertex accounted for 24.8% of our net revenues in the first quarter of 2007, and we expect Vertex to continue to be a significant customer for the foreseeable future. See “Risk Factors — Risks Relating to Our Business — A limited number of our customers have accounted and are expected to continue to account for a high percentage of our revenues. The loss of or significant reduction in orders from any of these customers could significantly reduce our revenues and decrease our profitability,” “— Any failure to retain our existing customers or expand our customer base may result in our inability to maintain or increase our revenues” and “— We are making a significant commitment of capital to ramp up our services in order to meet our customers’ needs and, as a result, we are dependent on the success of our customers’ projects and the continuation of their business.”

Project Management and Customer Support

We believe that we have an established reputation among our customers for high productivity, rapid turnaround times and comprehensive customer support. We generally assume full project management responsibility in each of our service offerings. We seek to strictly adhere to our internal quality and project management processes. We believe these processes, methodologies, knowledge management systems and tools reduce the overall cost to the customer and enhance the quality and speed of delivery. We have developed a project management methodology to ensure timely, consistent and accurate delivery of quality services. To facilitate project management, we developed an online monitoring and reporting system allowing a customer’s project manager to monitor the progress of their projects through a secure encrypted website. Additionally, our project team interacts with the customer’s project management team via regular conference calls, daily e-mails and bi-weekly reports. Our project management is closely collaborated with our strategic imperative to protect our customers’ confidentiality and intellectual property. See “— Intellectual Property” below.

We conduct frequent external customer satisfaction surveys on a number of key performance indicators to improve our planning, execution, evaluation, and support. Internally, we focus on operation improvement and innovation to achieve lower direct costs, better use of assets, faster development time, increased accuracy, greater customization or precision, more added value, and simplified processes. Our customer support department focuses on sales support and relationship management with our customers, and is dedicated to improving responsiveness to our customers’ needs and inquiries. Less than satisfactory marks and comments are scrutinized for root causes to continuously improve operations and services.

 

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Employees

We had 533, 890 and 1,843 employees in 2004, 2005 and 2006, respectively. As of May 31, 2007, we had 1,972 employees, including 1,345 in our laboratory services segment, 238 in our manufacturing segment and 389 in general and administrative functions. Of the total 1,972 employees, 1,502 worked in our R&D center in Shanghai Waigaoqiao Free Trade Zone, 303 worked in our manufacturing facilities in the Jinshan Chemical Industry Development Zone of Shanghai and 167 worked in our R&D center in Tianjin. The following charts show our employee composition by educational level and a historical headcount as of the end of the periods indicated:

 

LOGO

 

LOGO

To meet our anticipated growth needs, we expect to hire a significant number of employees during 2007, increasing our headcount substantially. To achieve these requirements, we will hire both recent graduates as well as experienced professionals. Our primary hiring strategy is to recruit from universities and some of the most well-known technical training schools in China. We also recruit overseas, primarily focusing on returnees and Ph.D.s with significant educational and/or industry background with major pharmaceuticals, many of whom are our customers, and through referrals, headhunters, job fairs and internships. As of May 31, 2007, our scientists and technical staff numbered 1,345 employees, and collectively possesses expertise in synthetic, medicinal, combinatorial, computational, analytical, bioanalytical, service biology, and process chemistry. Our future growth and profitability depends upon the research and efforts of our highly experienced and skilled scientists and mid-level managers, and their ability to keep pace with changes in drug discovery and development technologies. We compete vigorously with pharmaceutical firms, biotechnology firms, contract research firms, and academic and research institutions to recruit scientists and mid-level managers and employees. See “Risk Factors — Risks Relating to Our Business — Our ability to execute projects, maintain, expand or renew existing customer engagements and obtain new customers depends largely on our ability to attract, train, motivate and retain highly skilled scientists and mid-level personnel.”

From time to time, we employ part-time employees to support our laboratory services segment. As of May 31, 2007, we had an additional 137 employees on a part-time basis.

We are focused on training and retention. We have a comprehensive training program for new employees, in addition to an ongoing, on-the-job mentor/mentee program. In addition, we cultivate the quality of our scientists with our in–house seminar series, performance reviews that include goal setting and a talent review process, dual career path development (technical or management), management competency enhancement training and team building and integration efforts.

 

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We offer our employees both a base salary and a profit sharing program composed of performance bonuses and rewards for exceptional performance. As required by PRC regulations, we participate in various employee benefit plans that are organized by municipal and provincial governments, including pension, work-related injury benefits, maternity insurance, medical and unemployment benefit plans. We are required under PRC law to make contributions to the employee benefit plans at specified percentages of the salaries, bonuses and certain allowances of our employees, up to a maximum amount specified by the local government from time to time. Members of the retirement plan are entitled to a pension equal to a fixed proportion of the salary prevailing at the member’s retirement date.

We have not experienced any labor disputes or disputes with the labor department of the PRC government since our inception.

Intellectual Property

Protection of intellectual property associated with drug R&D is critical to all our customers. In our business of providing drug R&D services, our customers generally retain ownership of all associated intellectual property, including those they provide to us and those arising from the services we provide. Our success therefore depends in substantial part on our ability to protect the proprietary rights of our customers. This is particularly important for us since our operation is based in China, and China, as well as Chinese companies, have not traditionally enforced intellectual property protection to the same extent as the United States. Since our inception, we have made it a strategic priority to safeguard our customers’ proprietary rights.

We take all necessary precautions to protect the intellectual property of our customers. As one aspect of our system of protecting intellectual property rights, including our customers’ and our own, we enter into agreements with all our employees, under which all intellectual property made by them during their employment belongs to us, and our employees waive all relevant rights or claims to such intellectual property. All our employees are also bound by confidentiality obligations and have agreed to disclose and assign to us all inventions conceived by them during their term of employment. Furthermore, our service agreements provide that all intellectual property generated during the course of a project is exclusively the property of the customer for whom we are conducting the project.

As another aspect of our intellectual property protection system, we have established documentation procedures, powered by the industry standard Laboratory Information Management System, or LIMS, licensed by Thermo Watson, to control information access on a need-to-know basis and restrict system access in connection with our DMPK studies in drug discovery and development. A typical bioanalytical laboratory generates hundreds or even thousands of test results daily which must be securely stored for long periods. LIMS is designed for tracking individual samples and the information obtained on them with various analytical tools. Only after the results of all bioanalytical techniques have been reviewed in LIMS is a product released or rejected. We believe that our LIMS complies with FDA requirements regarding security, particularly in data integrity, compatibility and audit trail generation.

We have also created an intellectual property protection process, whereby we periodically scan signed and dated notebooks of every scientist onto diskettes and then engage the Shanghai Notary Public Office to notarize the records. Notebooks are critical to the process of drug R&D, as the scientists’ notes are often used as original data in support of patent applications and disputes. Our process preserves the documentation necessary to establish intellectual property ownership should any disputes arise in the future. As such, it not only significantly enhances the protection of key original information, but also significantly enhances customers’ confidence and trust in our company. Furthermore, each customer project has dedicated laboratory spaces equipped with key card access control systems.

We do not believe that our own proprietary technology and intellectual property is material to our business. Although our own intellectual property rights are important to our results of operations, we believe that such factors as the technical expertise, knowledge, ability and experience of our employees are more important, and that, overall, these technological capabilities provide significant benefits to our customers.

 

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Despite measures we take to protect intellectual property of our customers or our own, unauthorized parties may attempt to obtain and use information that we regard as proprietary. See “Risk Factors — Risks Relating to Our Business — If we fail to protect the intellectual property rights of our customers, we may be subject to liability for breach of contract and may suffer damage to our reputation.” To date, we are not aware of any such breaches.

We have five trademarks registered in China and are pursuing registration of our trademarks in the United States.

Competition

We compete with contract research and manufacturing companies and research and academic institutions. We anticipate that we will face increased competition in the future as new companies enter the market and advanced technologies become available. See “Risk Factors — Risks Relating to Our Business — We face increasingly intense competition. If we do not compete successfully against new and existing competitors, demand for our services and related revenues may decrease and subject us to increasing pricing pressure.”

The pharmaceutical and biotechnology R&D outsourcing market remains highly fragmented. According to Kalorama Information, no single supplier has more than one percent of the drug discovery outsourcing market. We compete with industry players in particular service areas, for example with Charles River Laboratories International, Inc., which recently partnered with Shanghai BioExplorer Co., Ltd., in the preclinical services area, and Shanghai ChemPartner Co., Ltd. and Bioduro, Inc. in the discovery chemistry area, but we believe that we do not compete with any single company across the breadth of our service offerings.

We believe we compete primarily on the basis of the relative quality of our services, the quality of our customer service and our ability to be responsive to and efficient with our customers’ requests. We adhere to GLP and GMP quality standards, and have a strategic emphasis on protection of customer intellectual property, both of which result in greater customer acceptance of our services. We believe we also compete on the basis of our relationships with customers. In particular, we believe our 100% customer retention rate of our top-ten customers by revenues for the last three years has led to a steady and increasing revenue stream. In addition, we believe we also compete on the basis of our turnaround time, price and geography. We believe we compete favorably on the basis of each of these factors. However, many of our current or future competitors may have longer operating histories, better name recognition, greater levels of consumer trust, stronger management capabilities, better supplier relationships, a larger technical staff and sales force and/or greater financial, technical or marketing resources than we do.

We believe that the successful recruitment and retention of qualified Ph.D., master and bachelor level scientists is a key element in achieving our strategic goals. We believe that as competitive pressures in the pharmaceutical industry increase, the recruitment and retention of scientists will become increasingly competitive. To meet this challenge, we actively recruit scientists at colleges and universities and through several other means. We believe the sophisticated chemistry performed in the course of our business will assist us in attracting and retaining qualified scientists. We offer competitive salaries and benefits as a means to recruit and retain highly skilled scientists.

Insurance

We maintain property insurance policies covering physical damage or loss of our equipment, facilities, buildings and their improvements, office furniture and inventory, employer’s liability insurance generally covering death or work injury of employees, product liability insurance covering product liability claims arising from the use, consumption or operation of our small molecular compounds, public liability insurance covering certain incidents to third parties that occur on or in the premises of the company and directors and officers liability insurance. While we believe that our insurance coverage is comparable to similarly situated companies in China, it may not be sufficient to cover any claim for product liability or damage to our fixed assets. We do not maintain key man life insurance for any of our senior management or key personnel.

 

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Insurance companies in China offer limited business insurance products and do not, to our knowledge, offer business disruption insurance. While business disruption insurance is available to a limited extent in China, we have determined that the risks of disruption, cost of such insurance and the difficulties associated with acquiring such insurance on commercially reasonable terms make it impractical for us to have such insurance. As a result, we do not have any business disruption insurance coverage for our operations in China. See “Risk Factors — Risks Relating to Our Business — We have limited insurance coverage, and any claims beyond our insurance coverage may result in our incurring substantial costs and a diversion of resources.”

Legal Proceedings

We are not currently a party to any material legal proceedings. From time to time, we may be subject to various claims and legal actions arising in the ordinary course of business.

 

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REGULATION

Regulation of the Pharmaceutical Research Industry in China

We operate in a legal environment where there is little formalized regulation over a number of our activities. The following laws, regulations and regulatory authorities are relevant to our business:

SFDA

In the PRC, the SFDA is the authority that monitors and supervises the administration of pharmaceutical products and medical appliances and equipment as well as food, health food and cosmetics. The SFDA’s predecessor, the State Drug Administration, or the SDA, was established in August 1998 as an organization under the State Council to assume the responsibilities previously handled by the Ministry of Health of the PRC, or the MOH, the State Pharmaceutical Administration Bureau of the PRC and the State Administration of Traditional Chinese Medicine of the PRC. The SFDA was founded in March 2003 to replace the SDA.

The primary responsibilities of the SFDA include:

 

   

monitoring and supervising the administration of pharmaceutical products, medical appliances and equipment as well as food, health food and cosmetics in the PRC;

 

   

formulating administrative rules and policies concerning the supervision and administration of food, health food, cosmetics and the pharmaceutical industry;

 

   

evaluating, registering and approving of new drugs, generic drugs, imported drugs and traditional Chinese medicine;

 

   

approving and issuing permits for the manufacture and export/import of pharmaceutical products and medical appliances and equipment and approving the establishment of enterprises to be engaged in the manufacture and distribution of pharmaceutical products; and

 

   

examining and evaluating the safety of food, health food and cosmetics and handling significant accidents involving these products.

We are currently not involved in the business of providing drug development services in the Chinese market that are subject to the SFDA approval process or manufacturing or marketing any drug to be sold in China. We are a China-based pharmaceutical and biotechnology R&D outsourcing company, whose customers (principally in the United States) are developing drugs for the U.S. and major international markets. As such, the primary regulatory authority that impacts our business is the U.S. FDA. Although we voluntarily comply with certain SFDA standards, except in the following instances, we are not currently, and are not likely to be in the future, subject to the SFDA regulation:

 

   

In the future, our PRC operating subsidiary in Suzhou will need to obtain a verification of “good laboratory practices” from the SFDA or its local branch if it elects to provide any preclinical services; and

 

   

In order to use the term “pharmaceutical” in its company name, our PRC manufacturing subsidiary in Jinshan was required by the relevant local government to obtain, and has obtained, a pharmaceutical manufacturing certificate from the Shanghai branch of the SFDA.

Blood and reagent import/export

According to the Circular on Strengthening Administration on Entry and Exit Inspection and Quarantine of Special Articles for Medical Use, import or export of medical special articles, including without limitation blood and reagents, must be inspected by the relevant inspection and quarantine authorities and be approved by the Ministry of Health or its local counterparts or other authorities, as the case may be.

 

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Drug research

The PRC Drug Administration Law as promulgated by the Standing Committee of the National People’s Congress in 1984 and the Implementing Measures of the PRC Drug Administration Law as promulgated by the MOH in 1989 have set forth the legal framework for the establishment of pharmaceutical manufacturing enterprises, pharmaceutical trading enterprises and for the administration of pharmaceutical products, which includes the development, research and manufacturing of new drugs and medical preparations by medical institutions. The PRC Drug Administration Law also regulates the packaging, trademarks and advertisements of pharmaceutical products in the PRC.

Certain revisions to the PRC Drug Administration Law took effect in December 2001. They were formulated to strengthen the supervision and administration of pharmaceutical products, and to ensure the quality and safety of pharmaceutical products for human use. The revised PRC Drug Administration Law applies to entities and individuals engaged in the development, production, trade, application, supervision and administration of pharmaceutical products. It regulates and prescribes a framework for the administration of pharmaceutical manufacturers, pharmaceutical trading companies, medical preparations of medical institutions and the development, research, manufacturing, distribution, packaging, pricing and advertisement of pharmaceutical products.

The PRC Drug Administration Implementing Rules promulgated by the State Council took effect in September 2002 to provide detailed implementing regulations for the revised PRC Drug Administration Law.

Safety, Health and Environmental Matters

Our operations and properties are subject to extensive environmental protection and health and safety laws and regulations. These laws and regulations govern, among other things, the generation, storage, handling, use and transportation of hazardous materials and the handling and disposal of hazardous and biohazardous waste generated at our facilities.

These laws and regulations generally impose liability regardless of the negligence or fault of a responsible party, unless it has legally defined immunities. These laws and regulations also require us to obtain permits from governmental authorities for certain operations. If we violate or fail to comply with these laws, regulations or permits, we could be fined or otherwise sanctioned by regulators. Under certain environmental laws and regulations, we could also be held responsible for all of the costs relating to any contamination at our past or present facilities and at third party waste disposal sites.

Although we believe that our costs of complying with current and future environmental laws, and our liabilities arising from past or future releases of, or exposure to, hazardous substances will not materially adversely affect our business, results of operations or financial conditions, they may do so. We do not expect to incur material costs to comply with relevant environmental laws and regulations. Because the requirements imposed by these laws and regulations may change, however, we may be unable to accurately predict the cost of complying with these laws and regulations. In addition, although we believe that we currently comply with the standards prescribed by these laws and regulations, the risk of accidental contamination or injury from these materials cannot be eliminated. In that event, we could be liable for any resulting damages, which could exceed our resources and harm our results of operations. See “Risk Factors — Risks Relating to Our Industry — Compliance with environmental regulations can be expensive, and noncompliance with these regulations may result in adverse publicity and potentially significant monetary damages and fines.”

Trade Secrets

According to the Anti-unfair Competition Law of the PRC, the term “trade secrets” refers to technical information and business information which is unknown to the public, which has utility and may create business

 

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interest or profit for its legal owners or holders, and which is maintained as secrets by its legal owners or holders. Under this law, business persons are prohibited from employing the following methods to infringe trade secrets: (a) to obtain the trade secrets from the legal owners or holders by any unfair methods such as stealing, solicitation or coercion; (b) to disclose, use or permit others to use the trade secrets obtained illegally under item (a) above; or (c) to disclose, use or permit others to use the trade secrets in violation of any contractual agreements or any requirements of the legal owners or holders to keep such trade secrets in confidence. If a third party knows or should have known the above-mentioned illegal conducts but nevertheless obtain, use or disclose such trade secrets of others, it may be deemed to have committed an infringement of others’ trade secrets. Infringed parties may petition for administrative corrections, and competent regulatory authorities may stop any illegal activities and may fine infringing parties in the amount of RMB10,000 to RMB200,000. Alternatively, infringed persons may file lawsuits for damages caused due to the infringement of the trade secrets in a competent PRC court.

The measures to protect trade secrets include oral or written agreements or other reasonable measures to require the employees of or persons in business contact with legal owners or holders to keep such trade secrets confidential. As soon as the legal owners or holders request others to keep the trade secrets confidential and adopt reasonable protection measures, the requested persons shall bear the liability to keep the trade secrets confidential.

Animal Test Permit and Other Related Regulatory Requirements

According to the Administrative Measures on Certificate for Animal Experimentation (Trial), it is mandatory to obtain a Certificate for Use of Laboratory Animals to carry out animal experimentation. Applicants must satisfy the conditions as follows: (1) laboratory animals must be qualified and from entities that have Certificates for Production of Laboratory Animals; (2) environment and facilities for laboratory animals’ living and propagating must meet state requirements; (3) laboratory animals’ feed must meet state requirements; (4) workers feeding or experimenting on laboratory animals must have received professional training; (5) management systems must be effective and efficient; and (6) other requirements as stipulated by PRC laws and regulations.

Other National and Provincial Level Laws and Regulations in China

We are subject to evolving regulations under many other laws and regulations administered by PRC governmental authorities at the national, provincial and city levels, some of which are, or may be, applicable to our business.

We must comply with numerous additional state and local laws relating to matters such as safe working conditions, manufacturing practices, environmental protection and fire hazard control. We believe we are currently in compliance with these laws and regulations in all material respects. We may be required to incur significant costs to comply with these laws and regulations in the future. Unanticipated changes in existing regulatory requirements or adoption of new requirements could have a material adverse effect on our business, financial condition and results of operations.

Foreign Exchange Control and Administration

Foreign exchange in China is primarily regulated by:

 

   

The Foreign Currency Administration Rules (1996), as amended; and

 

   

The Administration Rules of the Settlement, Sale and Payment of Foreign Exchange (1996), or the Administration Rules.

Under the Foreign Currency Administration Rules, the Renminbi is convertible for current account items, including the distribution of dividends, interest payments, and trade and service-related foreign exchange

 

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transactions. Conversion of Renminbi into foreign currency for capital account items, such as direct investment, loans, investment in securities and repatriation of funds, however, is still subject to the approval of SAFE or its local counterparts. Under the Administration Rules, foreign-invested enterprises may only buy, sell and/or remit foreign currencies at banks authorized to conduct foreign exchange transactions after providing valid commercial documents and, in the case of capital account item transactions, only after obtaining approval from SAFE or its local counterparts. Capital investments directed outside of China by foreign-invested enterprises are also subject to restrictions, which include approvals by the PRC Ministry of Commerce, SAFE or its local counterparts and the PRC State Reform and Development Commission. Under our current structure, our income will be primarily derived from dividend payments from our operating subsidiaries in China.

The value of the Renminbi against the U.S. dollar and other currencies may fluctuate and is affected by, among other things, changes in China’s political and economic conditions. The conversion of Renminbi into foreign currencies, including U.S. dollars, has been based on rates set by the People’s Bank of China. On July 21, 2005, the PRC government changed its policy of pegging the value of the Renminbi to the U.S. dollar. Under the new policy, the Renminbi will be permitted to fluctuate within a band against a basket of certain foreign currencies. This change in policy resulted initially in an approximately 2.0% appreciation in the value of the Renminbi against the U.S. dollar. There remains significant international pressure on the PRC government to adopt a substantial liberalization of its currency policy, which could result in a further and more significant appreciation in the value of the Renminbi against the U.S. dollar.

Dividend Distributions

Pursuant to the Foreign Currency Administration Rules promulgated in 1996 and amended in 1997 and various regulations issued by SAFE or its local counterparts, and other relevant PRC government authorities, the PRC government imposes controls on the convertibility of the Renminbi into foreign currencies and, in certain cases, the remittance of currency out of China.

The principal regulations governing the distribution of dividends paid by Sino-Foreign equity joint venture enterprises and wholly foreign owned enterprises include:

 

   

The Sino-Foreign Equity Joint Venture Enterprise Law (1979), or EJV Law, as amended;

 

   

The Sino-Foreign Equity Joint Venture Enterprise Law Implementing Rules (1983), as amended;

 

   

The Wholly Foreign Owned Enterprise Law ( 1986), or WFOE Law, as amended; and

 

   

The Wholly Foreign Owned Enterprise Law Implementing Rules (1990), as amended.

Under these laws and regulations, Sino-foreign equity joint venture enterprises and wholly foreign owned enterprises in China may pay dividends only out of their accumulated profits, if any, determined in accordance with PRC accounting standards and regulations. WXPT, being a wholly owned foreign enterprise, is required to set aside at least 10% of its after-tax profits of the preceding year as its reserve funds. It may stop such setting aside if the aggregate amount of the reserve funds has already accounted for more than 50% of its registered capital. Moreover, it may, upon a board resolution, set aside a certain amount from its after-tax profits of the preceding year as bonus and welfare funds for staff and workers. The other five operating subsidiaries are equity joint ventures which are required to set aside reserve funds, bonus and welfare funds for staff and workers and development funds, a percentage of which shall be determined by the board.

Regulation of Foreign Exchange in Certain Onshore and Offshore Transactions

On October 21, 2005, SAFE issued the Notice on Issues Relating to the Administration of Foreign Exchange in Fund-raising and Reverse Investment Activities of Domestic Residents Conducted via Offshore Special Purpose Companies, or Notice 75, which became effective as of November 1, 2005. According to Notice 75:

 

   

prior to establishing or assuming control of an offshore company for the purpose of financing that offshore company with assets or equity interests in an onshore enterprise in the PRC, each PRC

 

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resident who is an ultimate controller, whether a natural or legal person, must complete the overseas investment foreign exchange registration procedures with the relevant local SAFE branch;

 

   

an amendment to the registration with the local SAFE branch is required to be filed by any PRC resident that directly or indirectly holds interests in that offshore company upon either (1) the injection of equity interests or assets of an onshore enterprise to the offshore company or (2) the completion of any overseas fund raising by such offshore company; and

 

   

an amendment to the registration with the local SAFE branch is also required to be filed by such PRC resident when there is any material change involving a change in the capital of the offshore company, such as (1) an increase or decrease in its capital, (2) a transfer or swap of shares, (3) a merger or division, (4) a long-term equity or debt investment or (5) the creation of any security interests over the relevant assets located in China.

Moreover, Notice 75 applies retroactively. As a result, PRC residents who have established or acquired control of offshore companies that have made onshore reverse investments in the PRC in the past are required to complete the relevant overseas investment foreign exchange registration procedures by March 31, 2006. Under the relevant rules, failure to comply with the registration procedures set forth in Notice 75 may result in restrictions being imposed on the foreign exchange activities of the relevant onshore company, including the payment of dividends and other distributions to its offshore parent or affiliate and the capital inflow from the offshore entity, and may also subject relevant PRC residents to penalties under PRC foreign exchange administration regulations.

As a Cayman Islands company, and therefore a foreign entity, if we purchase the assets or equity interest of a PRC company owned by PRC residents in exchange for our equity interests, such PRC residents will be subject to the registration procedures described in Notice 75. Moreover, PRC residents who are beneficial holders of our shares are required to register with SAFE or its local counterparts in connection with their investment in us. If any PRC shareholder of our offshore company fails to make the required SAFE registration and amendment registration, the six PRC subsidiaries of our offshore company may be prohibited from distributing their profits and proceeds from any reduction in capital, share transfer or liquidation to the offshore company. In addition, failure to comply with the SAFE registration and amendment registration requirements described above could result in liability under the PRC laws for evasion of applicable foreign exchange restrictions. We require all our shareholders who are PRC residents to comply with any SAFE registration requirements, but we have no control over either our shareholders or the outcome of such registration procedures. Such uncertainties may restrict our ability to implement our acquisition strategy and materially and adversely affect our business and prospects.

Regulations on Employee Stock Incentive Plan

According to the Administration Measures on Individual Foreign Exchange Control issued by the People’s Bank of China, or PBOC, on December 25, 2006 and its Implementation Rules issued by SAFE on January 5, 2007, both of which took effect on February 1, 2007, collectively known as the Forex Measures, employee stock ownership plans or stock option plans of overseas listed companies in which PRC individuals participate shall be approved by SAFE or its authorized branch before foreign exchange matters involving these plans can be settled.

On March 28, 2007, SAFE released detailed registration procedures for employee stock ownership plans or share option plans to be established by overseas listed companies and for individual plan participants, known as Option Plan Registration Rules. Any failure to comply with the Option Plan Registration Rules may affect the effectiveness of the employee stock ownership plans or share option plans and subject the plan participants, the company offering the plans or the relevant intermediaries, as the case may be, to penalties under PRC foreign exchange regime.

Once we are listed on the NYSE, we may be subject to the Forex Measures and Option Plan Registration Rules and will need to be in compliance with the procedures provided therein.

 

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Regulation on Overseas Listings

On August 8, 2006, six PRC regulatory agencies, including the Ministry of Commerce, or the MOFCOM, and the CSRC, jointly adopted the Regulations on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors, or the New M&A Rule, which became effective on September 8, 2006. The New M&A Rule, among other things, purports to require an offshore special purpose vehicle, or SPV, formed for the purpose of listing the SPV’s securities on an offshore securities exchange and controlled directly or indirectly by PRC companies or individuals, to obtain the approval of the CSRC prior to such offshore listing and trading. On September 21, 2006, the CSRC published on its official website procedures specifying documents and materials required to be submitted to it by SPVs seeking CSRC approval of their overseas listings. However, substantial uncertainty remains regarding the scope and applicability of the New M&A Rule to overseas listings of offshore SPVs.

Our PRC counsel, Commerce & Finance Law Offices, has advised us that, based on its understanding of the current PRC laws, regulations and rules, it is not necessary for us to obtain the CSRC’s approval for this offering because we obtained approval from relevant authorities for the acquisition of our operating subsidiaries in the PRC before September 8, 2006, the effective date of the New M&A Rule.

A copy of Commerce & Finance’s legal opinion regarding the New M&A Rule is filed as an exhibit to our registration statement on Form F-1.

Company Law

In October 2005, the Standing Committee of the National People’s Congress adopted amendments to the PRC Company law, which substantially overhauled the PRC company law system and removed a number of legal restrictions and hurdles on the management and operations of limited liability companies and companies limited by shares.

WXPT is governed by both the PRC Company Law and the WFOE Law and its implementation rules and other five operating subsidiaries are governed by both the PRC Company Law and the EJV Law and its implementation rules. The Amended PRC Company Law eliminates a restriction which limited the amount of equity investments that a company could make to a maximum of 50% of such company’s net assets. With the removal of such a restriction our operating subsidiaries in China may have more flexibility in making equity investments or planning potential acquisitions. In addition, the amended PRC Company Law now permits the establishment of single-shareholder limited liability companies. As a result, subject to industry limitations, WXPT may acquire 100% of the equity interest in a PRC limited liability company and become the sole shareholder of such limited liability company. The amended PRC Company Law includes requirements about the establishment of supervisory committee.

Regulations in Other Jurisdictions

Regulatory Agency Approvals

Our customers are subject to substantial regulation by governmental agencies in the United States and other countries. Virtually all pharmaceutical and biotechnology products are subject to rigorous preclinical and clinical testing and other approval procedures by the FDA and other foreign regulatory agencies. Various federal and state laws and regulations also govern or influence the manufacturing, safety, labeling, storage, record keeping and marketing of these pharmaceutical and biotechnology products. This approval process is time-consuming and expensive and there are no assurances that approval will be granted on a timely basis, or at all. Even if regulatory approvals are granted, a marketed product is subject to continual review. Later discovery of previously unknown problems or a failure to comply with applicable regulatory requirements may result in restrictions on the marketing of a product or the withdrawal of the product, as well as possible civil or criminal sanctions. To the extent our customers are unable to obtain the necessary regulatory approvals to market their products, or fail to continue to comply with regulatory requirements, we may be unable to realize revenue from milestone and/or royalty payments.

 

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Good Laboratory Practice (GLP)

The conduct of preclinical studies must comply with the statutory or regulatory requirements for GLP. GLP regulations describe a quality system concerned with the organizational process and conditions under which nonclinical laboratory studies are planned, performed, monitored, recorded, archived and reported. GLP compliance is required by such regulatory agencies as the FDA, the U.S. Environmental Protection Agency and the Japanese Ministry of Health and Welfare.

Current Good Manufacturing Practice (cGMP)

All facilities and manufacturing techniques used in the manufacture of products for clinical use or for sale in the United States must be operated in conformity with cGMP guidelines as established by the FDA. Failure on our part to comply with applicable requirements could result in the termination or ongoing research or the disqualification of data for submission to regulatory authorities or our customers. A finding that we had materially violated cGMP requirements could result in a termination of our service agreements with our customers and significant fines, which would materially and adversely affect our business, financial condition and results of operations. To date, we have not received any FDA inspections.

 

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MANAGEMENT

Directors and Executive Officers

The following table sets forth certain information relating to our directors and executive officers as of July 20, 2007. The business address of each of our directors and executive officers is 288 Fute Zhong Road, Waigaoqiao Free Trade Zone, Shanghai 200131, People’s Republic of China.

 

Name

   Age   

Position

Ge Li, Ph.D.(1)

   40    Chairman, Chief Executive Officer and Founder

Xiaozhong Liu

   43    Executive Vice President, Director and Founder

Tao Lin

   39    Vice President of Internal Operations, Director and Founder

Zhaohui Zhang

   37    Vice President of Domestic Marketing, Director and Founder

Benson Tsang

   42    Chief Financial Officer

Shuhui Chen, Ph.D.

   44    Chief Scientific Officer

Suhan Tang, Ph.D.

   41    Chief Manufacturing Officer

Kian-Wee Seah(2)(3)

   44    Director

Sean Tong(4)

   33    Director

Cuong Viet Do(1)(2)(3)(4)

   41    Director

Shawn Wang(2)(3(4)

   40    Director

Daniel Auerbach(5)

   49    Director

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