Form 10-Q for BOHAI PHARMACEUTICALS GROUP, INC.
19-Nov-2012
Item 2. Management's Discussion and Analysis of Financial Conditions of Operations.
The following discussion and analysis of financial condition and results of operations relates to the operations and financial condition reported in our unaudited condensed consolidated financial statements for the three months ended September 30, 2012, and should be read in conjunction with such financial statements and related notes included in this report. Those statements in the following discussion that are not historical in nature should be considered to be forward looking statements that are inherently uncertain. Actual results and the timing of the events may differ materially from those contained in these forward looking statements due to a number of factors, including those discussed in the "Cautionary Note on Forward Looking Statements" set forth elsewhere in this Report.
Overview
We are engaged in the production, manufacturing and distribution in China of herbal pharmaceuticals based on traditional Chinese medicine, which we refer to herein as Traditional Chinese Medicine, or TCM. We are based in the city of Yantai, Shandong Province, China and our operations are exclusively in China.
Our medicines address rheumatoid arthritis, viral infections, gynecological diseases, cardio vascular issues and respiratory diseases. Our initial operating subsidiary Bohai obtained Drug Approval Numbers (or DANs) for 29 varieties of traditional Chinese herbal medicines in 2004, an additional 14 varieties in December 2010. Through our acquisition of Yantai Tianzheng in August 2011, we obtained DANs for another 5 varieties in August 2011. We currently produce 11 varieties of approved traditional Chinese herbal medicines in seven delivery systems: tablets, granules, capsules, formulations, concentrated powder, tincture and medicinal wine. Of these 11 products, 9 are prescription drugs and 2 are over the counter (or OTC) products.
Three of Bohai's lead products, Tongbi Capsules and Tablets and Lung Nourishing Syrup, are eligible for reimbursement under China's National Medical Insurance Program (or NRDL), which we believe significantly increases the marketability of these products. In addition to these lead products, three of our current products and five of our formulas we acquired in 2010 are eligible for NRDL reimbursement. In addition, one of our current products and four of our newly acquired formulas are currently included on the Chinese government's Essential Drug List (or EDL). Inclusion on either the EDL or NRDL allows for up to 100% insurance coverage by the Chinese government. Yantai Tianzheng owns five prescription products approved by the State Food and Drug Administration of China (which we refer to herein as the SFDA) and currently manufactures four of such products. Among Yantai Tianzheng's products, Fangfengtongsheng Granule has an exclusive status and is on the EDL and NDRL, and Zhengxintai Capsule is in the process of renewal for its protective status and is currently under the NDRL.
Prior to January 5, 2010, we were a public "shell" company operating under the name "Link Resources, Inc." On January 5, 2010, we consummated a share exchange transaction (the "Share Exchange") pursuant to which we acquired Chance High, the indirect parent company of Bohai, our principal operating subsidiary, which is a Chinese variable interest entity that we (through a Chinese wholly-owned foreign enterprise subsidiary) control through certain contractual arrangements. On August 8, 2011, WFOE II, a PRC company and a newly formed subsidiary of Chance High, entered into a Share Purchase Agreement pursuant to which we acquired, from the three individual holders thereof, one hundred percent (100%) of the outstanding shares of Yantai Tianzheng, which became our second operating subsidiary effective as of July 1, 2011. Our current organizational structure is summarized below:
Use of Non-GAAP Financial Measures
We make reference to Non-GAAP financial measures in portions of this "Management's Discussion of Financial Condition and Results of Operations". Management believes that investors may find it useful to review our financial results that exclude certain non-cash income and expense, namely the aggregate change in the fair value of our warrants, amortization of the beneficial conversion features in our convertible notes and the effective interest charges on our convertible notes, stock-based compensation, and deferred income tax expenses as shown in the chart below in the aggregate net amount of $(391,593) and $2,239,624 income/(expenses) for the three months ended September 30, 2012 and 2011, respectively.
Management believes that these Non-GAAP financial measures are useful to investors in that they provide supplemental information to intend to enhance on investors understanding of the underlying business trends and operating performance of our company. We use these Non-GAAP financial measures to evaluate operating performance. However, Non-GAAP financial measures should not be considered as either a substitute or alternative measurement of net income or any other performance measures derived in accordance with GAAP.
The following is a summary of reconciliations of such Non-GAAP financial measures to the most directly comparable GAAP financial measures for the three months ended September 30, 2012 and 2011:
Three Months Ended
September 30,
Increase
2012 2011 (Decrease)
(unaudited) (unaudited) (unaudited)
Net Income available to Common shareholders -GAAP $ 6,395,512 $ 2,655,784 $ 3,739,728
Add Back (Subtract):
Change in fair value of warrants (498,003 ) (332,485 ) (165,517 )
Amortization of beneficial conversion features on
convertible notes converted - 2,328,387 (2,328,387 )
Change in Option and Equity Based Compensation - 22,000 (22,000 )
Deferred income tax expenses - indefinite intangible
assets 106,410 221,722 (115,312 )
Adjusted Net Income available to Common shareholders
-non-GAAP $ 6,003,919 $ 4,895,408 $ 1,108,512
Net income margins -non-GAAP 16.98 % 16.36 % 0.63 %
Basic earnings per share - GAAP $ 0.36 $ 0.15 $ 0.21
Add back (Subtract):
Change in fair value of warrants (0.03 ) (0.02 ) (0.01 )
Amortitized beneficial conversion features on
convertible notes converted - 0.13 (0.13 )
Change in Option Based Compensation - 0.00 0.00
Deferred tax expenses - indefinite intangible assets 0.01 0.01 (0.00 )
Adjusted basic earnings per share non-GAAP $ 0.34 $ 0.27 $ 0.07
Diluted earnings per share-GAAP $ 0.28 $ 0.15 $ 0.23
Add back (Subtract):
Change in fair value of warrants (0.02 ) (0.01 ) (0.02 )
Unamortized beneficial conversion features on
convertible notes converted - 0.10 (0.10 )
Change in Option and Equity Based Compensation - - -
Deferred tax expenses - indefinite intangible assets - 0.01 (0.00 )
Adjusted diluted earnings per share non-GAAP $ 0.26 $ 0.25 $ 0.09
Weighted average number of shares
Basic 17,861,085 17,861,085
Diluted 22,563,585 23,086,085
Principal Factors Affecting Our Financial Performance
We believe that the following factors will continue to affect our financial
performance:
Sales of Key Products
For the three months ended
September 30,
2012 2011
(unaudited) (unaudited)
Tongbi Capsules 25.6 % 22.5 %
Other Products 19.6 % 24.0 %
Fangfengtongsheng Granule 18.5 % 16.5 %
Zhengxintai Capsule 11.7 % 9.9 %
Other Products 9.6 % 9.4 %
Total Sales 100 % 100 %
Our top selling products as a percentage of total net revenue consist of the following:
We expect that a significant portion of our future revenue will continue to be derived from sales of our top five products.
We held the Certificates of Protected Variety of Traditional Chinese Medicine (Grade Two) issued by the SFDA for Tongbi Capsules and Anti-flu Granules which gave the Company exclusive or near-exclusive rights to manufacture and distribute these two medicines. Tongbi Capsules' certificates expired in September 2009. We filed an application for extending the protection period on March 12, 2009 and received certification extension until September 13, 2016. Lung Nourishing Syrup received a patent with duration of 20 years from the State Intellectual Property Office of the PRC and the patent will expire on September 12, 2027.
Experienced Management
Management's marketing strategies and business relationships gives us the ability to expand our product market areas, which provides us with leverage to acquire less sophisticated operators, increase production volumes, and implement quality standards. Our future prospects depend substantially on the continued services of our senior management team, especially our President, Chief Executive Officer and Chairman of the Board, Mr. Qu.
Price Control of Drugs by PRC Government and SDRC
The State Development and Reform Commission of the PRC ("SDRC") and the price administration bureaus of the relevant provinces of the PRC in which the pharmaceutical products are manufactured are responsible for the retail price control over our pharmaceutical products. The SDRC sets the price ceilings for certain pharmaceutical products in the PRC. All of our products except those under the protection periods are subject to such price controls and could affect our future revenue growth. However, due to the direct support of TCM by the Chinese government, China's immense market, and our protected drugs, we are optimistic regarding our continuous growth potential for TCM in China.
Financial Highlights
? Net revenues for the three months ended September 30, 2012 increased 18.1% to $35.3 million compared to the same period in 2011.
o 67% of net revenues was from Bohai and 33% was from Yantai Tianzheng this first fiscal quarter
o Sales were mostly derived from our lead products, Lung Nourishing Syrup, Tongbi Capsules, Tongbi Tablets, Fangfengtongsheng Granule, and Zhengxintai Capsules, which together represented over 80.4% and 76.0% of our total net revenues for the three months ended September 30, 2012 and 2011, respectively.
o 80% of net revenue was derived from sales of prescription products and 20% was from Over-the-Counter products for the three months ended September 30, 2012.
? Non-GAAP net income for the three months ended September 30, 2012 increased 22.6% to $6.0 million compared to the same period in 2011. The difference was mainly due to increased net income offset by net decrease in effective interest charges on convertible notes of $0 million this first quarter ended September 30, 2012 compared to the same quarter in last year. (See above Use of Non-GAAP Financial Measures). GAAP net income for the three months ended September 30, 2012 increased 140.8% to $6.4 million compared to the same period in 2011. The difference was mainly due to increased net income from Tianzheng and Bohai offset by net decrease in effective interest charges on convertible notes of $0 million during the three quarters ended September 30, 2012 compared to the same quarter in last year. (See above Use of Non-GAAP Financial Measures).
o Income from operations increased 27.3% to $8.6 million this first quarter compared to the same quarter in the last fiscal year.
o Net income margin increased from 8.9% for the three months ended September 30, 2011 to 18.1% for the three months ended September 30, 2012. The increase was mainly due to the net decrease in certain non-cash activities such as effective interest charges from convertible notes and increase in gross profit, offset by increased selling and general and administrative expenses.
o Included in the net income this first fiscal quarter were non-cash charges in effective interest of $0 million, a non-cash charge in deferred income tax expenses of $0.1 million, and a non-cash credit of $0.5 million in changes in fair value of warrants.
? Basic and diluted earnings per share were $0.36 and $0.28 for the three months ended September 30, 2012.
o Non-GAAP Diluted earnings per share increased 2.4% to $0.26 for the three months ended September 30, 2012 compared to the same period in 2011.
o Non-GAAP Basic earnings per share increased 24.5% to $0.34 for the three months ended September 30, 2012 compared to the same period in 2011.
? Including restricted cash, our total cash balance was $28.7 million as of September 30, 2012 and cash flow from operating activities was $1.6 million for the three months ended September 30, 2012.
o Total cash and cash equivalents increased by $1.0 million for the three months ended September 30, 2012 compared to June 30, 2012.
Operating Results
Comparison of the three months ended September 30, 2012 and 2011
Net Revenues
Net revenues are comprised of sales of 19 traditional Chinese medicines in China during the three months ended September 30, 2012 (we currently sell 19 medicines following our acquisition of Yantai Tianzheng on August 8, 2011). Net revenues for the three months ended September 30, 2012 increased by $5,420,964, or 18.1%, to $35,348,820 as compared to $29,927,856 for the three months ended September 30, 2011. Net revenues were $23,550,273 and $11,798,547 for Bohai and Yantai Tianzheng, respectively, for the three months ended September 30, 2012. Net revenues were $21,162,188 and $8,765,668 for Bohai and Yantai Tianzheng, respectively, for the three months ended September 30, 2011. The increase in Bohai's revenue was primarily due to a net increase in revenues of 20.6% from our four lead products in Bohai: Lung Nourishing Syrup, Tongbi Capsules, Tongbi Tablets, and Shantongning Tablets, which together accounted for over 86.0% of our total net revenues for Bohai. All of our lead products from Bohai are listed for coverage and reimbursement under national medical insurance program starting in December 2009. The increase in Tianzheng's revenue was primarily due to a net increase in revenue of 33.0% of our two lead products in Tianzheng: Zhengxintai Capsul, Fangfengtongsheng Granule. The sale of our prescription drug products for the three months ended September 30, 2012 represented 80% of total net revenue compared to 74 % for the same period in last year. The increase in prescription sales was primary due to increases in sales volume of our two prescription drugs, Tongbi Capsules and Tongbi Tablets as well as prescription product sales from Yantai Tianzheng.
Cost of Revenues
Cost of revenues is comprised of raw material costs, labor cost, overhead costs associated with the manufacturing processes and related expenses which are directly attributable to our revenues. Our cost of revenues for the three months ended September 30, 2012 was $8,592,104 as compared to $6,943,720 for the three months ended September 30, 2011, representing an increase of $1,648,384, or 23.7%. Cost of revenues were $5,314,633 and $3,277,471 for Bohai and Yantai Tianzheng, respectively, for the three months ended September 30, 2012. Cost of revenues were $4,657,753 and $2,285,967 for Bohai and Yantai Tianzheng, respectively, for the three months ended September 30, 2011. The increase in cost of revenues for the three months ended September 30, 2012, compared to the same period in last year, was mainly due to an increase in total costs of raw materials, labor, and overhead as a result of an increase in overall sales.
Gross Profit
Gross profit represents the difference between net revenues and cost of revenues. We achieved gross profit of $26,756,716 for the three months ended September 30, 2012, as compared to $22,984,136 for the same period in 2011, representing an increase of $3,772,580, or 16.4%, over the same period in 2011. The increase of the gross profit is mainly due to increased revenues.
Our overall gross profit margins as a percentage of net revenues decreased by approximately 1.1% from 76.8% to 75.7% this fiscal quarter at September 30, 2012, as compared to the same period in 2011.The decrease of the gross profit margin is attributable to increases in the cost of raw materials during the three months ended September 30, 2012 compared to the same period last year. Meanwhile, the company also made an effort to improve its cost control to avoid negative inflation effect.
Operating Expenses
Our operating expenses increased by $1,931,517 or 11.9% to $18,166,006, for the three months ended September 30, 2012, as compared to $16,234,489 for the same fiscal period in 2011. The overall increase in selling, general, and administrative expenses was related to increased selling expenses due to services supporting an overall increase in sales activities. The percentage of operating expenses to net revenues was 51.4% and 54.2% for the three months ended September 30, 2012 and 2011, respectively, representing a decrease of 2.9% as a percentage of net revenues. The decrease of percentage of net revenue is because advertising expense decreased this quarter compared to the same period last year.
Total Other Income (Expenses)
Total other income (expenses) are comprised of interest income (expenses), changes in fair value of derivative instruments, other income (expenses), and amortization of deferred financing fees. Total other expenses were $13,952 for the three months ended September 30, 2012 compared to total other expenses of $2,275,504 for the period ended September 30, 2011, a decrease of total other expenses of $2,261,552. The decrease in total other expenses were principally due to a net decrease of $2,109,478 for interest expenses and a net decrease in non-cash gain in fair value of warrants for $165,517 for convertible notes in connection with our private placement on January 5, 2010. The effective interest expense for convertible notes is calculated using a constant effective interest rate, applied to the carrying value of the notes each month. As the carrying value increases, so does the interest expense. On December 31, 2011, the Company entered into an amendment to the Notes with Euro Pacific as representative of the Investors (the "Amendment") which: (i) extended the maturity date of the Notes from January 5, 2012 to April 5, 2012 (such extra three month period, the "Extended Period"); and (ii) increased the interest rate on the Notes to an annual rate of 12% (or 3% for the Extended Period). On May 14, 2012, the Company entered into an amendment to the Notes with Euro Pacific as representative of the Investors (the "Second Amendment") which: (i) extended the maturity date of the Notes from April 5, 2012 to October 5, 2012 (such extra six month period, the "Second Extended Period"); and (ii) remained the interest rate on the Notes at an annual rate of 12% (or 6% for the Second Extended Period). On June 27, 2012, we and Euro Pacific entered into a Third Amendment to the Notes (the "Third Amendment") to remove the limitations on our ability to incur debt, to incur liens or to make capital expenditures. The purpose of the Third Amendment is to provide us with enhanced flexibility to seek potential sources of financing. As of September 30, 2012, there were 4,702,500 shares of the Company's Common Stock issuable upon conversion of the outstanding convertible notes. (See Note 10).
Provision for Income Tax
Our provision for income taxes for the three months ended September 30, 2012 and 2011 were $2,181,246 and $1,818,359, an increase of $362,887, or 20.0%, from this fiscal quarter to date over the same period last year. The increase in provision for income tax was principallydue to an increase in taxable income under the PRC law from Bohai and from Yantai Tianzheng. The effective income tax rates were 25% and 41% for the three months ended September 30, 2012 and 2011, respectively.
Net Income
We had a net income of $6,395,512 for the three months ended September 30, 2012, as compared to net income of $2,655,784 for the three months ended September 30, 2011, an increase in net income of $3,739,728, or 140.8%. This translates into basic earnings per common share of $0.36 and $0.15, and diluted earnings per common share of $0.28 and $0.15, for the three months ended September 30, 2012 and 2011, respectively. The increase in net income was primarily attributable to an increase in total gross profit of $3,772,580 and a decrease in total other expenses (resulting from mostly effective interest charges) of $2,261,552, offset by an increase in selling, general and administrative expenses of $1,931,517 and an increase in the tax provision of $362,887 for this fiscal quarter as compared to the same period of prior year.
Net income margin was 18.1% for the three months ended September 30, 2012 as compared to net income margin 8.9% for the same period last year, an increase of 9.2%. The increase was mainly due to the net decrease in certain non-cash activities such as effective interest charges from convertible notes and increase in gross profit, offset by increased selling and general and administrative expenses.
Total other income included a non-cash charge in effective interest expenses of $0 for the three months ended September 30, 2012 compared to $2,328,387 for the same period in 2011.
Total other income for the three months ended September 30, 2012 also comprised of a non-cash credit for fair value of warrants of $498,002.
Liquidity and Capital Resources
Liquidity is the ability of a company to generate adequate amounts of cash to meet its needs for cash. As of September 30, 2012, we had cash and cash equivalents of $19,379,160 and restricted cash of $9,332,186, substantially almost all of which is located in financial institutions in China. The following table provides detailed information about our net cash flow for financial statement periods presented in this report:
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