SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
YONGYE INTERNATIONAL, INC.
(Exact name of registrant as specified in its charter)
6th Floor, Suite 608, Xue Yuan International Tower,
No. 1 Zhichun Road, Haidian District, Beijing, PRC
(Address of principal executive offices)
+86 10 8231 8866
(Issuer’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Securities Registered Pursuant to Section 12(g) of the Act: None.
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.Yes ¨ No x
Check whether the issuer is not required to file reports pursuant to Section 13 or 15(d) of the Exchange Act.
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Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports); and (2) has been subject to such filing requirements for the past 90 days.
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Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
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Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.£
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
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The aggregate market value of the 36,929,340 shares of common equity stock held by non-affiliates of the Registrant was approximately $254,443,153 on the last business day of the Registrant’s most recently completed second fiscal quarter, based on the last sale price of the registrant’s common stock on the most recent date on which a trade in such stock took place prior thereto.
There were a total of 49,370,711 shares of the registrant’s Common Stock, par value $0.001 per share, outstanding as of March 4, 2011.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant’s Proxy Statement relating to the Registrant’s 2010 Annual Meeting of Shareholders are incorporated by reference into Part III of this Annual Report on Form 10-K
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
This report contains forward-looking statements and information relating to Yongye International, Inc., that are based on the beliefs of our management as well as assumptions made by and information currently available to us. When used in this report, the words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “plan” and similar expressions, as they relate to us or our management, are intended to identify forward-looking statements. These statements reflect our current view concerning future events and are subject to risks, uncertainties and assumptions, including among many others: a general economic downturn; a downturn in the securities markets; Securities and Exchange Commission regulations which affect trading in the securities of “penny stocks,” and other risks and uncertainties. Should any of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those described in this report as anticipated, estimated or expected. Except as required by law, we assume no obligation to update any forward-looking statements publicly, or to update the reasons actual results could differ materially from those anticipated in any forward-looking statements, even if new information becomes available in the future. Important factors that may cause actual results to differ from those projected include the risk factors specified above. Notwithstanding the above, Section 27A of the Securities Act and Section 21E of the Securities Exchange Act expressly state that the safe harbor for forward-looking statements does not apply to companies that issue penny stock. Because we may from time to time be considered as an issuer of penny stock, the safe harbor for forward-looking statements may not apply to us at certain times.
All statements other than statements of historical fact are statements that could be deemed forward-looking statements, including statements regarding new and existing products and opportunities; statements regarding market and industry segment growth and demand and acceptance of new and existing products; any projections of sales, earnings, revenue, margins or other financial items; any statements of the plans, strategies and objectives of management for future operations; any statements regarding future economic conditions or performance; uncertainties related to conducting business in China; any statements of belief or intention; any of the factors mentioned in the “Risk Factors” section of this Form 10-K; and any statements or assumptions underlying any of the foregoing. Also, forward-looking statements represent our estimates and assumptions only as of the date of this report. You should read this report and the documents that we reference in this report, or that we filed as exhibits to this report, completely and with the understanding that our actual future results may be materially different from what we expect.
Except as required by law, we assume no obligation to update any forward-looking statements publicly, or to update the reasons actual results could differ materially from those anticipated in any forward-looking statements, even if new information becomes available in the future.
USE OF CERTAIN DEFINED TERMS
Except as otherwise indicated by the context, references in this report to:
ITEM 1 Business
We are engaged in the manufacture, research, development and sale of fulvic acid based liquid and powder nutrient compounds for plants and animals respectively which are used in the agriculture industry. Currently, we manufacture and sell two principal products. Our universal liquid plant product consists of our fulvic acid compound base mixed with additional nutrients that plants typically need to grow. It is applied to various types of crops by mixing with water and spraying directly on the plants, typically in conjunction with normal fertilizer and pesticide usage. Our animal product is a powder and consists of our fulvic acid base compound mixed with other nutrients and Chinese herbs. Our animal product is currently targeted at and administered to dairy cows by mixing the powder product with cows' food as its antibiotic-type properties typically help decrease inflammation and alleviate pain due to mastitis which occurs as a result of milking. Both of our current products are marketed under the name “Shengmingsu”. We have been engaged in the development of liquid plant products that are tailored for specific crops and powder animal products for cows, pigs, chickens and sheep. These products will supplement our current product offering.
We believe our proprietary process for extracting fulvic acid from humic acid, patented processes for manufacturing liquid plant nutrient product and powder animal nutrient product differentiate us in the China market and enable us to provide high quality products that deliver reliable results for the end users of our products from season to season.
On December 6, 2008, the Inner Mongolia Autonomous Region Scientific and Technology Bureau (IMARSTB), thoroughly reviewed scientific and economic data provided by the Company and reached the opinion that our liquid plant product effectively increases agricultural output, improves the utilization rate of fertilizer, enhances a plant’s resistance to disease and has a lighter weight and higher bio-activity than the other products it tested. In addition, the IMARSTB concluded that large scale experimentation has proven that our product can increase overall yields of staple crops, such as wheat and rice, and vegetables by 10-20% and 15-30%, respectively, while also improving product quality. In a separate study, the IMARSTB concluded that our extraction process is more efficient and produces purer fulvic acid as compared to traditional extraction methods.
Industry and Market Overview
China Agriculture Industry
Limited and Shrinking Arable Land
China faces great pressure on the limited usage of its land to agricultural cultivation than most nations as reported on February 24, 2011 article in China Daily. Currently, crop production in China is limited to approximately 301 million acres of arable farm land, which is approximately 14% of China's land according to a survey conducted by the National Bureau of Statistics of China in 2009, or 0.23 acres of arable farm land per person, which is approximately one-third of the global per capita average and half of the United States’ per capita amount of land devoted to agricultural production.
Moreover, increasing urbanization and desertification in China is encroaching upon farmland, thereby decreasing the amount of land available for crop production. According to the Chinese Academy of Sciences, since 1996, China has lost approximately 6.4% of its arable land to urbanization and China approves approximately 658,667 acres of land for construction each year, which impacts approximately 464,454 acres of farmland, as its urban population continues to increase.
A recently released survey by the State Forestry Department showed that more than a quarter of China's land remained either degraded or lost to sand and gravel due to a combination of a naturally dry climate, centuries of over-cultivation and decades of excessive demand on water and soil from the world's biggest population and fastest growing economy. There were small signs of improvement from 2005 to 2010 with estimates showing the area of desert shrinking by an annual average of 1,717 square kilometers. This was 40% better than the results from 2000-05, the first in China's history to ever show a gain.
Pollution, especially by heavy metals, erosion and the overuse of chemical fertilizers also threatens to render currently arable land unusable or less productive for agriculture.
Source: National Bureau of Statistics of China; Ministry of Land and Resources; Reuters
Increasing Wealth is Expected to Increase Spending on Agricultural Products
As the economy grows and individual purchasing power expands in China, demand for more food products with higher quality is expected to increase. According to the Asian Development Bank, over 50% of China’s population is comprised of low income, rural farmers. The government has pledged to narrow income gaps between urban and rural residents to tackle disparities in wealth levels. With significant 10.3% economic growth in 2010, rural incomes increased the most in over a quarter century with per capita net income for rural residents increasing by 10.9% in real terms. Recently released figures from the National Bureau of Statistics of China show that China's rural residents outpaced urban dwellers in per capita income growth for the first time since 1997.
Government Support for the Agricultural Industry
At a press conference organized by the State Council and held on January 30, 2010, Mr. Chen Xiwen, a top government official in charge of agriculture indicated China’s government budgeted RMB 818.3 billion for spending on agriculture, rural areas and farmers in 2010, an increase of 14.3% from the previous year’s spending. Mr. Chen Xiwen also expressed that he expects even higher growth in government spending on agriculture, rural areas and farmers in 2011. Improvement of agriculture productivity and rural farmers’ living standards will be the focus of government investment. We believe that these government policies and investment will encourage growth in China’s agricultural industry and that we will benefit from such growth.
The 12th Five Year plan will seek to increase domestic consumption by boosting wages. The main focus of the reforms will be on the lagging wages of rural workers, whose per capita incomes are currently only 30 percent of those in urban areas. Also, reforms will target tax policies aimed at boosting rural purchasing power, measures to broaden rural land ownership, and technology-led programs to raise agricultural productivity.
China Fertilizer Industry
Fertilizers are traditionally classified as either organic fertilizers or chemical fertilizers. Organic fertilizers are naturally occurring mineral deposits or naturally occurring compounds manufactured through industrial processes. Chemical fertilizers are also manufactured using naturally occurring deposits, but the compounds are chemically altered. While the use of chemical fertilizers is known to improve crop yields, chemical fertilizers may have long-term adverse impact on the organisms living in soil and a detrimental long-term effect on productivity of the soil. When properly applied, organic fertilizers can improve both the health and productivity of soil and plants, as they provide essential nutrients that encourage plant growth, and thereby increase agricultural yields. According to an article published in Reuters on January 14, 2010, China, the world's largest grain producer and top consumer of fertilizers in 2010 is expected to reduce its reliance on chemical fertilizers by as much as 50% because excessive use has resulted in serious pollution, according to a research report issued by School of Agricultural Economics and Rural Development, Renmin University of China and Greenpeace. The report said farmers, particularly in northern China, used 40 percent more fertilizers than crops needed, resulting in about 10 million tons of fertilizer every year being discharged into water, polluting China's rivers and lakes.
Source: National Bureau of Statistics of China
The rise of a green food industry in China is also increasing demand for organic fertilizers. According to the China Green Food Development Center, a governmental agency, China’s domestic sales of green food increased at a compound annual growth rate of 25.9% from RMB 50 billion in 2001 to RMB 316 billion in 2009, and during the same period, China’s exports of green food increased at a compound annual growth rate of 23.5%, from US$400 million to US$2.2 billion. We believe China’s domestic market for green food will continue to expand as individual purchasing power grows in China.
Source: China Green Food Development Center
China’s Dairy Market
The growth of China’s economy has lead to growth in consumer demand for dairy products and China’s government has attached great importance to the development of this industry, particularly after a food safety incident in China involving milk adulterated with melamine was widely reported in the international media during 2008.
According to The McKinsey Quarterly, the Chinese dairy market generated total revenues of approximately $18 billion in 2008, representing a compound annual growth rate of 7.8% for the period spanning 2004-2008, and was expected to grow to nearly $20 billion by the decade’s end. According to a research report published by Beijing Orient Agribusiness Consultant Ltd., in 2010, the whole milk powder and skim milk powder China imported from New Zealand is expected to exceed 0.4 million metric tons, bringing a major impact on milk powder industry and even the entire dairy industry of China, which is facing tough market conditions. A re-occurrence of a melamine incident in 2010 raised public consciousness regarding dairy quality and safety, directly impacting on the sustainable and healthy development of domestic market consumption and the industry. The Chinese government has increased efforts to regulate the industry and the industry significantly increased barriers to entry.
Source: McKinsey Quarterly; National Bureau of Statistics of China
We believe that our competitive advantages include the following.
Unique and scalable distribution model. We sell our products in China through an effective distribution model mainly comprised of provincial distributors who purchase our products and sell them through a chain of local distributors whose terminal sales point is either a retail store or a large farm. We provide advertising support, training as well as indoor and outdoor promotional display materials for our products to retail stores. These stores agree to become Yongye branded store by prominently displaying our products along with these materials, and having the store front painted with Yongye colors. Our provincial level distributors are our main direct customers. We do not receive any payments from nor do we make any payments to the retail stores selling our products, and the stores normally sell many other agricultural products like seeds, fertilizers and pesticides etc.
As of December 31, 2010, we sold our products through 25 provincial and sub-provincial distributors. There are 24,036 independently owned and Yongye-branded stores in almost all provinces of People’s Republic of China.
We believe our unique distribution model has the following benefits:
Name brand recognition supported by integrated marketing campaign. Both of our current products are marketed under the name “Shengmingsu” and we believe our integrated marketing campaign has led to widespread recognition of our brand name by farmers in the areas serviced by our distribution network.
Our strategy is to build the Yongye brand by getting closer to farmers through both media channels as well as indoor and outdoor displays. We work with our distributors to coordinate advertisements on local television channels and in local newspapers, and from 2009, we began running promotional campaign on CCTV-7, which is the national agriculture channel in China. Our branded stores are decorated with Yongye color and banners, and prominently display our products alongside promotional display materials that we provide. Working together with our distributors, we create posters with village-specific case studies that demonstrate a farmer’s incremental revenue, original investment and harvesting time saved from using our products. We believe these case studies have been a highly effective manner of marketing as they translate our product efficacy directly into dollar terms and are communicated through stories which are highly relevant to farmers.
In addition, we support our distributors and farmers by providing product training courses, conferences and seminars, product demonstrations, and educational pamphlets, magazines and infomercials.
Proprietary extraction processes for high-quality fulvic acid based nutrients backed by strong research and development platform.We have developed a proprietary extraction process for deriving fulvic acid from humic acid, which produces a high-quality fulvic acid compound. As mentioned earlier, the IMARSTB has concluded that our extraction process is more efficient and produces purer fulvic acid as compared to traditional extraction methods. Based on both internal and industry studies, we believe our proprietary fulvic acid extraction process is unique in the industry in that it allows us to create products that are more effective than other fulvic acid mixtures on the market. Both of our plant nutrient and animal nutrient products are protected by invention patent in China. They also won the top award for consecutive years at China Yanglin Agricultural Hi-Tech Fair, one of the most prestigious agriculture trade fairs in China.
In addition to our internal research and development team with extensive experience in the agricultural research fields, we have established project partnerships with certain prestigious national and local agricultural universities and research institutes including Chinese Academy of Agricultural Sciences, Beijing University of Agriculture, Inner Mongolia Agricultural University, and Inner Mongolia Academy of Agricultural Sciences.
Compelling value proposition of return on investment for farmers. Our patented plant product and animal product mixture processes are the result of large scale experimentation to produce specific formula. Our internal experimentation with our products demonstrates increased production yields, shorter harvest times, extended life cycles, and enhanced crop taste, nutrition and appearance. As mentioned earlier, the IMARSTB concluded that it believes our product can increase overall yields of staple crops, such as wheat and rice, and vegetables by 10 – 20% and 15 – 30%, respectively, while improving product quality.
Strength and experience of management team. We believe that our management team collectively has a great deal of experience in our relatively new market for agricultural nutrient products in China. Our chief executive officer, Wu Zishen, in particular, is considered a very successful entrepreneur in our industry. Additionally, our senior management team has many years of experience and strong education background in the Chinese agricultural industry, marketing and distribution, finance and general management.
Our strategic growth plan for 2011 consists of the following key elements.
Pursue vertical integration strategy to improve control of raw material supply and cost structure. In 2010, we entered into an agreement with Wuchuan Shuntong Humic Acid Company Ltd (“Wuchuan Shuntong”) to acquire the permit for the rights to explore, develop and produce lignite coal resources (“Mineral Right”) in a certain area of Wuchuan County. The cash consideration of the permit is approximately RMB 240 million or USD $35 million. The permit allows Yongye Nongfeng to complete all necessary administrative procedures and obtain government approvals to acquire Mineral Right. We believe that the Mineral Rights will allow us to secure a long term supply of humic acid, which is a major raw material used in manufacture of fulvic acid nutrient products, and which is sourced from lignite coals. We are still in the process of securing government approvals to complete this deal. If we are able to successfully execute this vertical integration strategy, we expect that our cost structure will improve as the cost of obtaining humic acid is currently the largest component of our cost of sales.
Geographic expansion of our distribution and branded store network. We believe that there is significant market potential for our products across China and we plan to continue to enhance our coverage and penetration of the Chinese markets in order to increase our market share and commercial opportunities. We believe this will further expand our immediate and long term revenue base. We believe that we can benefit from the growing market demand resulting from the increased need to boost agricultural productivity and decrease the overuse of chemical fertilizers and the rising preference for “green” food in China. In addition to driving further penetration in our historical markets, we plan to increase our distribution network, particularly in central and southern China. We will also work to ensure continued successful replication of our branded store model in new markets by leveraging our provincial distributors capabilities to select high-quality branded stores, by continuing to provide our distributors with value-added technical product and sales leadership training, and through our integrated marketing campaigns.
Enhance brand recognition on national and local levels. We will continue to advertise in national and local media to develop our brand image and increase our exposure in target markets and to provide training and technical support to various levels of distributors, branded stores and farmers.
We were incorporated in the State of Nevada on December 12, 2006 under the corporate name “Golden Tan, Inc.” At that time, we were engaged in the business of offering sunless tanning services and selling tanning lotions. In 2008, we began to pursue an acquisition strategy, whereby we sought to acquire an undervalued business with a history of operating revenues in markets that provide room for growth.
On April 17, 2008, we entered into a share exchange agreement with Fullmax Pacific Limited, a company organized under the laws of the British Virgin Islands (“Fullmax”), the shareholders of Fullmax, who together owned 100% of the equity of Fullmax, and our principal shareholder. Pursuant to the share exchange agreement, the Fullmax shareholders transferred to us 100% of Fullmax’s equity in exchange for 11,444,755 shares of our common stock (the “Share Exchange”). As a result of the Share Exchange, Fullmax became our wholly owned subsidiary.
At the time we acquired Fullmax, it had acquired certain assets that form the basis of our trading business from Inner Mongolia Yongye Biotechnology Co., Ltd., a company organized under the laws of the PRC (“Inner Mongolia Yongye”), and owned and controlled by Wu Zishen, our chairman, chief executive officer and president. The first step in this process occurred in November 2007, when Fullmax’s wholly-owned subsidiary, Asia Standard Oil Limited, a Hong Kong company (“Asia Standard”) entered into a Sino-foreign cooperative joint venture agreement with Inner Mongolia Yongye (the “CJV Agreement”). The CJV which was formed was Yongye Nongfeng Biotechnology Co., Ltd (“Yongye Nongfeng”).
In connection with a September 2008 private placement of our common stock, we agreed with the investors participating in the transaction to complete the remaining steps necessary for acquiring the assets that form the basis of our operations from Inner Mongolia Yongye. We completed these remaining steps, which we refer to as the “Restructuring” in this Annual Report on Form 10-K, on October, 2009. Prior to the Restructuring, Inner Mongolia Yongye owned and operated the principle assets of our business and had been in the business of researching, producing and selling its own fulvic acid based plant and animal products since 2003. Until Yongye Nongfeng obtained the required license to produce our products in May 2009, Inner Mongolia Yongye manufactured such products exclusively for us.
As part of the Restructuring and pursuant to the CJV Agreement, Inner Mongolia Yongye transferred to Yongye Nongfeng its management and other personnel, and the land, buildings and equipment comprising its manufacturing facility. In addition, Inner Mongolia Yongye assisted with obtaining the necessary governmental approvals required for these transfers, as well as with the issuance in May 2009 by the PRC Ministry of Agriculture of a fertilizer license, the patented technology under which was formerly held in the name of Inner Mongolia Yongye, to Yongye Nongfeng.
All of our operations are conducted through Yongye Nongfeng. Pursuant to the terms of the CJV Agreement, we are entitled to 95% of the profits of Yongye Nongfeng and Inner Mongolia Yongye is entitled to 5%. Wu Zishen, our chairman, president and chief executive officer, owns 91.7% of the outstanding equity interests of Inner Mongolia Yongye and, therefore, is entitled to a portion of the profits of Yongye Nongfeng that are payable to Inner Mongolia Yongye. In addition, Mr. Wu and Inner Mongolia Yongye are parties to an employment agreement, pursuant to which Mr. Wu is employed as chairman and chief executive officer of Inner Mongolia Yongye.
The following chart reflects our current organizational structure as of the date hereof. The ownership percentages of Yongye Nongfeng are approximations.
On July 20, 2010, Yongye Nongfeng set up a wholly-owned subsidiary, Inner Mongolia Yongye Fumin Biotechnology Co., Ltd. (“Yongye Fumin”), with the paid in capital of $14,731,880 (equivalent to RMB 100 million). Yongye Fumin is to be engaged in the manufacturing and sale of fulvic acid based liquid and powder nutrient compounds. Yongye Fumin was established to expand the production capacity for fulvic acid based liquid and powder nutrient compounds, and to produce humic acid using lignite coal. The construction of the production plant of Yongye Fumin was completed in the fourth quarter of 2010.
Our Principal Products and Services
The base of our product is our own proprietary fulvic acid base compound, which is extracted from humic acid. Fulvic acid is a complex, acidic, biochemical polymer which is either created naturally through the decomposition of plant material, or can be produced through a manufacturing process. Fulvic acid binds itself to and strengthens the cell walls of plants and cell membranes of animals, thereby increasing the ability of cells to retain vitamins and minerals and to fight sickness and disease. Fulvic acid also acts as a transport agent, dissolving into itself and delivering nutrients that stimulate cell growth, increasing oxygen intake into cells, and binding with and removing toxins such as heavy metals and other pollutants. These attributes maximize enzyme development, which results in better nutrient uptake in plants and digestion in animals.
Liquid Plant Product
Our universal liquid plant product consists of our fulvic acid compound base and nutrients that plants need to grow, and can be applied to various types of crops by spraying the liquid product directly on the plants, typically in conjunction with fertilizers and pesticides. We primarily sell our plant product by the 100 milliliter bottle and in cases of 100 bottles per case.
We believe that when used correctly, our product can help farmers more efficiently use fertilizers and pesticides, which may reduce the farmers’ overall input costs and environmental damage to the farmers’ land. While each crop varies in response to our plant product, we believe based on internal studies that farmers may be expected to experience yield increases on par with the following results when our plant product is properly used along with sufficient amounts of fertilizer and water:
Source: Company research
Powder Animal Product
Our animal nutrient product is a powder which consists of our fulvic acid compound base, with additional nutrients and Chinese herbs that reduce inflammation, and is currently targeted at and administered to dairy cows through mixture with cow feed. We sell our animal product in bags that contain 20, 300 gram packets. In a typical regime, one cow will digest 150 grams daily over a 100 day period.
Our animal product’s ability to reduce inflammation makes it attractive to Chinese farmers because of the prevalence of mastitis, an inflammation of the teats that slows down milk production, which is common in the global dairy industry. The Chinese Journal of Veterinary Medicine has reported that, in China, 50-80% of the cows have some form of mastitis, which is typically treated with antibiotics according to the “Handbook of Organic Food Safety and Quality” (International Standard Book Number 0849391547). Although antibiotics can clear up bacterial infections when used correctly, overuse of antibiotics can lead to drug-resistant strains of bacteria and antibiotics kill healthy gut bacteria, which is vital to a healthy immune system. By using our animal product, Chinese farmers can avoid costs and problems associated with the use of antibiotics to treat mastitis.
Our internal studies show that administration of our animal product to cows increases milk production and milk quality in cows, improves immunity, reduces mastitis and the need for antibiotics, and improves digestion and growth rate.
We are evaluating the prospects for introducing animal products designed for pigs, chickens and sheep.
We have not officially launched any new plant products in 2010 as we believe the market demand for our universal plant product has remained strong. However, we are examining market opportunities for introducing plant products targeted at corn, peppers, wheat, rice, cucumbers, tomatoes, cotton, potatoes, sunflowers, grapes, tropical fruits and flowers.
In 2011, we will continue to evaluate opportunities to develop market driven additions to our product lines.
The principal raw material used in the manufacture of fulvic acid is humic acid. Humic acid is a naturally occurring organic soil matter that exists in coal, peat, oceans and fresh waters. The best sources of humic acid are lignite coal and leonardite coal. China is rich in humic acid resources and its lignite coal reserves are large, widely distributed and high in quality. According to the United States Energy Information Administration, China has approximately 52.3 billion tons of recoverable lignite coal reserves, ranking third in the world.
The humic acid we use comes from lignite coal or leonardite coal which is mined in Inner Mongolia and can be purchased at normal market rates and is typically sold on a per ton basis. We purchase humic acid from suppliers. As the industry is experiencing rapid growth, we believe it is important to control the input of humic acid. Currently, Wuchuan Shuntong is our largest supplier, which is located in Hohhot and accounted for 58% of our raw material purchase for the year ended December 31, 2010.
We use various other ingredients during the production process, including nutrients and Chinese herbs. These additional ingredients can be readily obtained in local markets and do not carry special technical requirements.
The manufacture of our products begins with our proprietary process for extracting fulvic acid from humic acid and creating the fulvic acid compound base used in both our liquid plant product and our powder animal product. We have determined that this first step in our manufacturing process will remain a trade secret due to its importance in the creation of our final product. If we were to patent this process, we would necessarily have to publicly disclose certain information as part of the patent application, and thus risk losing the competitive advantage we believe we currently have.
After we have created our fulvic acid compound base, we mix it with special nutrients and other components specific to our plant and animal products. These processes and mixtures are covered by patents.
Packaging and Shipment
Our liquid plant product is primarily packaged in 100 milliliter bottles and in cases of 100 bottles per case. Our powder animal product is packaged in bags that contain 20, 300 gram packets. Each type of packaging material, along with packaging labels, are purchased from two to three separate manufacturers as these materials are readily available in the market.
After packaging our products at our manufacturing facility, we engage third parties to ship them to our distributors and we bear the risk of loss until our products are received by our customers.
We have implemented and maintain strict quality control procedures. In July 2007, Inner Mongolia Yongye received ISO 9001:2000 accreditation after a third party audit of its quality control procedures at its manufacturing facility. In the Restructuring, Inner Mongolia Yongye transferred its manufacturing facility and personnel to Yongye Nongfeng and Yongye Nongfeng also received ISO 9001:2000 accreditation following a similar third party audit.
We operate two manufacturing facility in Hohhot, Inner Mongolia, China, which in total can produce 35,000 tons per year of our liquid plant product and 11,000 tons per year of powder animal product when operated normally.
Marketing and Sales Support
Our sales staff is trained to work with the distributor network, retail stores and farmers to ensure that our customers have the right product knowledge and good after-sales support. They also help organize training courses, invite local agricultural experts and university professors to speak on proper agricultural techniques as well as the use of our product.
Media Marketing Programs
We work with our distributors to coordinate advertisements on local television channels and in local newspapers, and, from 2009, we began running promotional campaign on CCTV-7, which is the national agriculture channel in China. In addition, we use conferences and seminars, newspaper ads and pamphlets to increase customer brand recognition.
Distribution & Sales Network
We sell our products in China through a distribution network mainly comprised of provincial distributors who purchase our products and sell them through a chain of local distributors whose terminal sales point is either a retail store or large farm. In June 2010, we entered into an agreement to acquire the customer list including the customer relationships, from our provincial level distributor in Hebei Province. The acquisition was completed in July 2010. After the acquisition of the customer list, we sold directly to those customers who are sub-provincial level distributors in Hebei Province. We only sell our products to provincial distributors and sub-provincial distributors in the case of Hebei, and do not sell our products directly to retail stores or to farmers. Nearly all of our sales in 2008 were to distributors operating in Inner Mongolia and Xinjiang autonomous regions, and Gansu and Hebei provinces, which are located in northern China. Beginning in 2009, we expanded our sales in provinces located in central and southern China and plan to continue to expand the geographic reach of our distribution network.
We work with our distributors to identify and recruit independently owned and Yongye-branded retail stores. Thereafter, we provide advertising support, training and indoor and outdoor promotional display materials for our products. These stores agree to prominently display our products along with these materials, and to have the store front painted with Yongye colors.
This network of retail stores creates a “community-direct” model through which our distributors sell our product. We believe these stores have a local feel and have standing community recognition as the “trusted” local agricultural product expert.
The graph below presents the number of Yongye-branded stores at the end of the periods indicated.
Since our inception, we have worked to build and maintain our sales and distribution networks. We have established good relationships with leading agricultural products distributors.
We usually sign three year contracts with distributors that we identify and choose based upon their overall business strength, credit worthiness and proven ability to develop their local markets.
The Chinese fertilizer industry is highly fragmented. As of November 2009, there were over 4,000 fertilizer products in the PRC Ministry of Agriculture’s registry. We compete more directly with producers of humic acid based products, of which there were 522 in the registry as of November 2009.
Moreover, the market for fulvic acid based products has not matured into a saturated market. We believe we have a broader distribution network than our competitors and, therefore, that we are uniquely situated amongst our competitors to take advantage of China’s growing market for fulvic acid based products.
Research and Development
We currently have certain research personnel on staff, including Baosheng Tong, our chief scientist, who has 20 years of experience in China’s agriculture industry and holds a master’s degree in animal nutrition and a bachelor’s degree in animal husbandry from China Agriculture University.
Our research and development process begins with an internal evaluation of market demand for new types of products. After we initially identify market opportunities for new products, we, either alone or in conjunction with our research partners, conduct research activities and develop new products. Once our research and development activities are complete, we make a final judgment regarding whether and when to bring the new product to market based upon a second evaluation of market demand, an estimate of the time and expense that will be required to obtain any necessary governmental approvals, the desirability for obtaining patents or feasibility of protecting our intellectual property by other means, and the results of test marketing. The entire process may take anywhere from one to three years, depending on the product.
We are currently researching and test marketing various customized products for plants and animals. We have not formally launched any products into the market other than our current universal liquid plant product and our powder animal product targeted at cows, and no assurance can be given that we will ultimately bring to market the products we are currently researching or the product we are currently test marketing.
Our intellectual property consists of our invention patents related to our plant product and animal product and our proprietary method for extracting fulvic acid from humic acid. Our extraction process for fulvic acid remains a trade secret and is protected by a non-compete contract with Professor Gao Jing, who developed the extraction process and is the former chief scientist of Innner Mongolia Yongye. We have chosen not to seek a patent covering our method for extracting fulvic acid in order to avoid the public disclosure that would be required in connection with applying for a patent.
On December 6, 2008, the IMARSTB, thoroughly reviewed scientific and economic data provided by the Company and reached the opinion that our liquid plant product effectively increases agricultural output, improves the utilization rate of fertilizer, enhances a plant’s resistance to disease and has a lighter weight and higher bio-activity than the other products it tested. In addition, the IMARSTB concluded that large scale experimentation has proven that our product can increase overall yields of staple crops, such as wheat and rice, and vegetables by 10-20% and 15-30%, respectively, while improving product quality. In a separate study, the IMARSTB has concluded that our extraction process is more efficient and produces purer fulvic acid as compared to traditional extraction methods.
The patents related to our plant product and animal product cover both the mixture process of, and the base formulas for, such products. Our plant and animal patents are valid for 20 years from October 2006 and October 2005, respectively. We will work to ensure that this mixture process is consistently carried out while also protecting our intellectual property.
We have obtained a registered trademark for “Yongye” from the Trademark Bureau of the State Administration of Industry and Commerce of the PRC, which is valid until October 2017.
In addition to trademark and patent protection law in China, we rely on contractual confidentiality and non-compete provisions to protect our intellectual property rights and brand. We also take further steps to limit the number of people involved in the production process and refer to each ingredient by number rather than name when collecting and preparing them for mixture.
The table below presents the number of our employees as of the end of the periods indicated.
The number of manufacturing staffs from 2009 to 2010 decreased by 18 employees, which were mostly contract employee. As we usually hire the contractors in manufacturing function for cost saving from 2010, these contractors would be dismissed during the winter time when our operation is in a relative low season.
Our products and services are subject to regulation by central and provincial governmental agencies in the PRC, which require us to obtain licenses and certifications. We are required to renew, pass an examination with respect to, or make a filing in connection with these licenses and certifications on a regular basis.
Yongye Nongfeng’s business license enables it to research, develop, process, manufacture, market and sell fulvic acid based products and plant and animal nutrients. The business license is valid until January 4, 2018, although it is subject to annual examination, which was passed in 2009.
All fertilizers produced in the PRC must be registered with the PRC Ministry of Agriculture or its local branches at a provincial level. No fertilizer can be manufactured without such registration. As part of the Restructuring process, Yongye Nongfeng applied for its initial fertilizer registration certificate in May 2009 and it was received on June 1, 2009. On November 4, 2009 the long-term certificate with a five-year term has been issued to Yongye Nongfeng.
Producers of animal feed in the PRC are required to obtain a Quality Certificate for the Examination of Feed Production Enterprises. Yongye Nongfeng was granted this certificate in September 2009 by the Inner Mongolia agricultural authority, which is the local branch of the Ministry of Agriculture in Inner Mongolia. Yongye Nongfeng must make an annual filing, including samples of its animal product , and internal quality control test reports, before the end of March each year to maintain its effectiveness.
Environmental, Health and Safety Laws
We are in compliance in all material respects with the various laws, regulations, rules, specifications and permits, approvals and registrations relating to human health and safety and the environment except where noncompliance would not have a material adverse effect on our business, financial condition and results of operations.
We are not a party to any material legal proceedings nor are we aware of any circumstance that may reasonably lead a third party to initiate legal proceedings against us.
Our principal executive offices are located at 6th floor, Xue Yuan International Tower, No. 1 Zhichun Road, Haidian District, Beijing PRC and the telephone number is 86-10-8232-8866. The office space is approximately 1,000 square meters in area. Our manufacturing facilities and the adjacent greenhouses and open field, which serve as a research and product demonstration site, are in the High Tech Economic Development Zone in Hohhot, Inner Mongolia and Economic Development Zone in Wuchuan County, Inner Mongolia.
There is no private ownership of land in China. All land ownership is held by the government of the PRC, its agencies and collectives. Land use rights can be transferred upon approval by the land administrative authorities of the PRC (the State Land Administration Bureau) upon payment of the required land transfer fee. Yongye Nongfeng owns the land use rights for the land on which our manufacturing facilities, greenhouses and open field are situated, which have a term of 50 years that expires in 2057. We lease our principal executive offices under a lease that provides for a three year term.
Our principal executive offices are located on the 6th Floor, Suite 608, at Xue Yuan International Tower, No. 1 Zhichun Road, Haidian District, Beijing, PRC. Our telephone number at that address is 86-10-8232-8866. Our corporate website is www.yongyeintl.com .
Executive Officers of the Company
Because the Proxy Statement for our Annual Meeting of Shareholders will not contain information with respect to all executive officers of Yongye, set forth below is the information with respect to our executive officers:
Zishen Wu, Chief Executive Officer, President and Chairman
Mr. Wu is CEO and Chairman of the Board of Directors of Yongye Nongfeng and Yongye International, Inc. Mr. Wu was General Manager of Inner Mongolia Yongye Biotechnology Co., Ltd. from January 2003 to December 2007. Mr. Wu began his career as official at the State Planning Department in Inner Mongolia from 1984 to 1988. From 1989 to 2000, Mr. Wu was appointed to various managerial positions from General Manager to Chairman of several state owned conglomerates in textile, diary and agriculture industries. In 2001, Mr. Wu founded Yongye Technology Company in Inner Mongolia, an entity that distributed consumer electronics with annual sales of 80 million RMB. In 2003 Mr. Wu founded Yongye Organism Technology Company, an entity that produced plant and animal nutrients. Mr. Wu currently is the deputy director for the Inner Mongolia Charmer of Commerce and a member of executive committee for industry and commerce association in Inner Mongolia.
Sam Yu, Chief Financial Officer
Mr. Sam (Yue) Yu joined the Company as Chief Financial Officer on March 25, 2009. Before joining the Company, Mr. Yu provided capital market consulting services for Chinese companies listed on NASDAQ. Prior to that, Mr. Yu had served as Chief Operating Officer of Lionax International Investment Holding Ltd., a Chinese company listed on NYSE Euronext, from 2007 to 2008. Mr. Yu also previously held positions with Underwriters Laboratories Inc. in Asia and its Chicago headquarters from 2002 to 2007, including General Manager, Fire and Security Sector, Asia Pacific; General Manager, Suzhou Branch; Business Development Manager; and Manager of Financial Analysis. Mr. Yu was awarded a B.S. in Accounting at the University of International Business and Economics in China. He then earned an M.B.A. in General Management from the Stanford Graduate School of Business.
ITEM 1A Risk Factors
An investment in our Common Stock is speculative and involves a high degree of risk and uncertainty. You should carefully consider the risks described below, together with the other information contained in this report, including the consolidated financial statements and notes thereto, before deciding to invest in our Common Stock. The risks described below are not the only ones facing our Company. Additional risks not presently known to us or that we presently consider immaterial may also adversely affect our Company. If any of the following risks occur, our business, financial condition and results of operations and the value of our Common Stock could be materially and adversely affected.
Risks Related to Our Business
Yongye Nongfeng, our CJV, completed the transfer of Shengmingsu manufacturing business from Inner Mongolia Yongye Biotechnology.
We established our PRC cooperative joint venture, Yongye Nongfeng, on January 4, 2008, with the intention of carrying out the business of marketing and distributing, and ultimate goal of manufacturing of our fulvic acid plant and animal nutrient products. As of October, 2009, we have completed the transfer of manufacturing business of our nutrient products from Inner Mongolia Yongye Biotechnology (which is under the control of Mr. Zishen Wu), to the CJV (Mr. Wu is also the CEO of the CJV), including all assets related to the manufacturing, distribution and sales as well as all applicable licenses and titles (the “Restructuring”). On October 10, 2009 the CJV Agreement and CJV's articles were revised to reflect that both the profit distribution percentage and the post-dissolution remaining asset distribution percentage of Inner Mongolia Yongye in the CJV increased to 5% from the previous 0.5%.
The limited operating history and the early stage of development of our CJV may make it difficult to evaluate our business and future prospects. We cannot assure you that the CJV will continue to maintain such profitability or that it will not incur net losses in the future. We expect that our operating expenses will increase as we pursue our growth strategies.
Failure to manage our recent dramatic growth could strain our management, operational and other resources, which could materially and adversely affect our business and prospects.
We have been expanding our operations dramatically and believe they will continue to do so. To meet the demand of our customers, we expect to expand our distribution network in terms of numbers and locations. The rapid growth of our business has resulted in, and if we continue to grow at this rate, will continue to result in, substantial demands on our management, operational and other resources. In particular, the management of our growth will require, among other things:
As we continue this effort, we may incur substantial costs and expend substantial resources. We may not be able to manage our current or future operations effectively and efficiently or compete effectively in new markets we enter. If we are not able to manage our growth successfully, our business and prospects may be materially and adversely affected.
We do not own 100% of the equity interests in the CJV, which may not be as stable and effective in providing operational control as 100% ownership, and potential exists for conflict of interests.
We operate our business through our CJV. If there are disagreements between us and our cooperative joint venture partner, Inner Mongolia Yongye Biotechnology, regarding the business and operations of the CJV, we cannot assure you that we will be able to resolve them in a manner that will be in our best interests. In addition, our joint venture partner may (i) have economic or business interests or goals that are inconsistent with ours; (ii) take actions contrary to our instructions, requests, policies or objectives; (iii) be unable or unwilling to fulfill their obligations; (iv) have financial difficulties; or (v) have disputes with us as to the scope of their responsibilities and obligations. Any of these and other factors may materially and adversely affect the performance of our CJV, which may in turn materially and adversely affect our financial condition and results of operations.
We rely on the CJV Agreement with Inner Mongolia Yongye Biotechnology to operate our business. If Inner Mongolia Yongye Biotechnology fails to perform its obligations under the CJV Agreement, we may have to incur substantial costs and resources to enforce such arrangements and rely on legal remedies under PRC laws, including seeking specific performance or injunctive relief and damages, which we cannot assure you would be effective. Accordingly, it may be difficult for us to change our corporate structure or to bring claims against Inner Mongolia Yongye Biotechnology if it does not perform its obligations under the CJV Agreement with us.
The CJV agreement is governed under PRC law. Accordingly, this agreement would be interpreted in accordance with PRC laws and any disputes would be resolved in accordance with PRC legal procedures. The legal environment in the PRC is not as developed as in other jurisdictions, such as the United States. As a result, uncertainties in the PRC legal system could limit our ability to enforce the CJV Agreement. In the event we are unable to enforce the CJV Agreement, we may not be able to exert effective control over our operating entities, and our ability to conduct our business may be negatively affected.
Mr Zishen Wu, our President and CEO, owns a controlling interest in Inner Mongolia Yongye. The potential exists for conflicts of interests between his duties to us and his ownership interests in Inner Mongolia Yongye. We can provide no assurance that if potential conflicts of interests arise, these conflicts will not result in a significant loss in corporate opportunities for us or a diversion of our resources to Inner Mongolia Yongye Biotechnology, which may not be in the best interest of the Company.
One or more of our distributors could engage in activities that are harmful to our brand and to our business.
Due to our reliance on a distribution network that comprised of provincial or sub-provincial distributors in Hebei province to sell our products, we are susceptible to our distributors and sub-provincial distributors engaging in activities that are harmful to our brand and to our business. If our distributors do not implement our branding strategy properly, our brand name may be damaged. In addition, if our distributors and sub-provincial distributors sell our products under another brand, purchasers will not be aware of our brand name. Moreover, our ability to provide appropriate customer service to these purchasers will be negatively affected, and we may be unable to develop our local knowledge of the needs of these purchasers and their environment. Furthermore, if any of our distributors and sub-provincial distributors sell inferior products produced by other companies under our brand name, our brand and reputation could be harmed, which could make marketing of our products more difficult.
If we are not able to obtain the government approvals to complete the coal resources project, our vertical integration strategy could fail and we need to take back the prepayment from Wuchan Shuntong.
In 2010, we entered into an agreement with Wuchuan Shuntong to acquire the permit for the rights to explore, develop and produce lignite coal resources in a certain area of Wuchuan County. The cash consideration of the permit is approximately RMB 240 million or USD $35 million. The permit allows us to complete all necessary administrative procedures and obtain government approvals to acquire Mineral Right. We believe that the Mineral Rights will allow us to secure a long term supply of humic acid, which is a major raw material used in manufacture of fulvic acid liquid products, and which is sourced from lignite coals. We are still in the process of securing government approvals to complete this deal. If we are not able to obtain the government approvals on the Mineral Rights, our vertical integration strategy could fail. Another risk is that if we are not able to obtain the government approvals on Mineral Rights, we need to take back the prepayment to Wuchuan Shuntong amounting to $34.2 million, and litigation may be necessary. Moreover, the supply of lignite coal to Inner Mongolia Yongye Fumin Biotechnology Co., Ltd (“Yongye Fumin”)’s manufacturing facility will be dependent upon lignite coal availability in the market. If we are unable to obtain adequate quantities of lignite coal at economically viable prices which meet our specifications, our financial condition and results of operation could be adversely affected.
If we cannot renew our fertilizer registration certificate, we will be unable to sell some of our products which will cause our sales revenues to significantly decrease.
All fertilizers produced in the PRC must be registered with the PRC Ministry of Agriculture or its local branches at a provincial level. No fertilizer can be manufactured without such registration. As part of the Restructuring process, the CJV applied for its initial fertilizer registration certificate in May 2009 and it was received on June 1, 2009. On November 4, 2009 the long-term certificate with a five-year term has been issued to Yongye Nongfeng.
However, there is no guarantee that the PRC Ministry of Agriculture will renew our fertilizer registration certificate. If we cannot obtain the necessary renewal, we will not be able to manufacture and sell our fertilizer products in China, which will cause the termination of our commercial operations.
Our proprietary technology for fulvic acid extraction, patented plant product and animal product mixture processes may become obsolete which could materially and adversely affect the competitiveness of our plant and animal nutrient products.
The production of our plant and animal nutrient products is based on our patented plant and animal product mixture processes and nutrient formula. Our future success will depend upon our ability to address the increasingly sophisticated needs of our customers by supporting existing and emerging fulvic acid products and by developing and introducing enhancements to our existing products and new products on a timely basis that keep pace with evolving industry standards and changing customer requirements. If our patented plant and animal product mixture processes and formula become obsolete as our competitors develop better products than ours, our future business and financial results could be adversely affected. In addition, although we entered into confidentiality agreements with our key employees, we cannot assure you if there would be any breach of such agreement in which case our rights over such patented fertilizer formula would be adversely affected.
We may not possess all the licenses required to operate our business, or may fail to maintain the licenses we currently hold. This could subject us to fines and other penalties, which could have a material adverse effect on our results of operations.
In addition to fertilizer registration certificate, we are required to hold a variety of other permits, licenses and certificates to conduct our business in China. We may not possess all the permits, licenses and certificates required for our business. In addition, there may be circumstances under which the approvals, permits, licenses or certificates granted by the governmental agencies are subject to change without substantial advance notice, and it is possible that we could fail to obtain the approvals, permits, licenses or certificates that are required to expand our business as we intend. If we fail to obtain or to maintain such permits, licenses or certificates or renewals are granted with onerous conditions, we could be subject to fines and other penalties and be limited in the number or the quality of the products that we would be able to offer. As a result, our business, result of operations and financial condition could be materially and adversely affected.
Zishen Wu, our chairman, chief executive officer and president, has played an important role in the growth and development of our business since its inception, and a loss of his services in the future could severely disrupt our business and negatively affect investor confidence in us, which may also cause the market price of our common stock to go down.
To date, we have relied heavily on Mr. Wu’s expertise in, and familiarity with, our business operations, his relationships within the industries in which we operate, including with our suppliers, and his reputation and experience. In addition, Mr. Wu continues to be primarily responsible for formulating our overall business strategies and spearheading the growth of our operations. If Mr. Wu were unable or unwilling to continue in his present positions, we may not be able to easily replace him and may incur additional expenses to identify and train his successor. In addition, if Mr. Wu were to join a competitor or form a competing business, it could severely disrupt our business and negatively affect our financial condition and results of operations. Although Mr. Wu is subject to certain non-competition restrictions during and after termination of his employment with us, we cannot assure you that such non-competition restrictions will be effective or enforceable under PRC law. Moreover, even if the departure of Mr. Wu from our Company would not have any actual impact on our operations and the growth of our business, it could create the perception among investors or the marketplace that his departure could severely damage our business and operations and could negatively affect investor confidence in us, which may cause the market price of our common stock to go down. We do not maintain key man insurance for Mr. Wu.
We depend heavily on skilled personnel, and any loss of such personnel, or the failure to continue to attract such personnel in the future, could harm our business.
Our business is specialized and requires the employment of personnel with significant scientific and operational experience in the industry. Accordingly, we must attract, recruit and retain a workforce of technically and scientifically competent employees. Due to the intense market competition for highly skilled workers and experienced senior management and our geographical location, we have faced difficulties locating personnel that have the necessary scientific, technical and operational skills and experience with the fertilizer industry. Our ability to effectively implement our business strategy will depend upon, among other factors, the successful recruitment and retention of additional management and such other key personnel. These individuals are difficult to find in the PRC and we may not be able to retain such skilled employees and replace them within a reasonable period of time, or at all. Our business may be severely disrupted, our financial condition and results of operations may be materially and adversely affected, and we may incur additional expenses in recruiting and training additional personnel. Although our employees and senior management members are subject to certain non-competition restrictions during and after termination of their employment, we cannot assure you that such non-competition restrictions will be effective or enforceable under PRC law. If any of our key personnel joins a competitor or forms a competing business, our business may be severely disrupted. We have no key man insurance with respect to our key personnel that would provide insurance coverage payable to us for loss of their employment due to death or otherwise.
The markets in which we operate are highly competitive and fragmented and we may not be able to maintain market share.
We operate in highly competitive markets and compete with numerous local PRC fertilizer manufacturers and we expect competition to persist and intensify in the future. Our competitors are mainly local fertilizer companies who may have better access in certain local markets to customers and prospects, an enhanced ability to customize products to a particular region or locality and more established local distribution channels within a small region. In future, we may also compete with large PRC SOE national competitors who may have competitive advantages over us in certain areas such as access to capital, technology, product quality, economies of scale and brand recognition and may also be better positioned than us to develop superior product features and technological innovations and to exploit and adapt to market trends. Additionally, we may not be able to conduct in-depth research and analysis on our current or new markets due to the lack of public or third-party sources of competitive information available on our industry and competitors in the PRC. Therefore, we may not have a clear estimate of the current number of our direct competitors or such competitors' revenues or market share.
In addition, China’s entry into the World Trade Organization may lead to increased foreign competition for us. International producers and traders import products into China that generally are of higher quality than those produced in the local Chinese market. If they are localized and become recognized as the type of nutrients we produce, we may face additional competition. If we are not successful in our marketing and advertising efforts to increase awareness of our brands, our revenues could decline, which could have a material adverse effect on our business, financial condition, results of operations and share price. We cannot assure you that additional competitors will not enter our existing markets, or that we will be able to compete successfully against existing or new competition.
If we need additional financing, we may not be available to find such financing on satisfactory terms or at all.
Our capital requirements may be accelerated as a result of many factors, including the growth and timing of our business development activities, budget shortfalls, unanticipated expenses or capital expenditures, future product opportunities, future licensing opportunities and future business combinations. Consequently, we may need to seek additional debt or equity financing, which may not be available on favorable terms, if at all, and which may be dilutive to our stockholders.
We may seek to raise additional capital through public or private equity offerings, debt financings or additional corporate collaboration and licensing arrangements. To the extent we raise additional capital by issuing equity securities, our stockholders may experience dilution. To the extent that we raise additional capital by issuing debt securities, we may incur substantial interest obligations, may be required to pledge assets as security for the debt and may be constrained by restrictive financial and/or operational covenants. Any provider of debt financing would also be superior to our stockholders’ interest in bankruptcy or liquidation. To the extent we raise additional funds through collaboration and licensing arrangements, it may be necessary to relinquish some rights to our technologies or product candidates, or grant licenses on unfavorable terms.
Financial damages may be imposed on us if we are unable to retain certain “financial professionals” as required by the securities purchase agreements.
The purchase agreements entered into in connection with several private capital raises we have consummated obligate us to hire a chief financial officer who has experience as a senior financial officer of a United States public reporting company and who is (i) fluent in English, (ii) residing or will reside, upon employment by us, in Asia, and (iii) familiar with GAAP and auditing procedures and compliance for United States public companies, and to enter into an employment agreement with such an officer for a term of no less than two years. Although we have hired Mr. Sam (Yue) Yu as the chief financial officer in accordance with the preceding obligations, if we fail to continue to comply with the above obligations regarding such an officer, we may incur monthly financial damages in the amount of 1% of the proceeds of the financing, up to an aggregate amount of 6% of the amount of the financing.
The imposition of such financial damages would require us to use capital that we had planned to use, and may require, in connection with our business.
If we fail to adequately protect or enforce our intellectual property rights, or to secure rights to patents and trademarks of others, the value of our intellectual property rights could diminish.
Our success, competitive position and future revenues will depend in part on our ability to obtain and maintain patent protection for our products, methods, processes and other technologies, to preserve our trade secrets, to prevent third parties from infringing on our proprietary rights and to operate without infringing the proprietary rights of third parties.
To date, we have received two patents for our plant and animal products with the State Intellectual Property Office of the PRC. We have obtained a registered trademark for “Yongye” from the Trademark Bureau of the State Administration of Industry and Commerce of the PRC (“CTMO”). Our PRC partner, Inner Mongolia Yongye Biotechnology has filed a trademark application for the brand name of “Shengmingsu” with the CTMO, and Inner Mongolia Yongye Biotechnology will transfer this mark to the CJV upon procurement of trademark registration with the CTMO. In addition, we rely on trade secret protection for our proprietary process of extracting fulvic acid from humic acid and creating the base fulvic acid compound used in both our plant (liquid form) and animal nutrient (powder form) products because we believe if we were to patent this process, we would necessarily have to publicly disclose certain information as part of the patent application, and thus lose our competitive advantage we believe we currently have. However, we cannot predict the degree and range of protection patents, trademarks and trade secrets will afford us against competitors. Third parties may find ways to invalidate or otherwise circumvent our patents, proprietary technology and trademark. Third parties may attempt to obtain patents claiming aspects similar to our patent and trademark applications. If we need to initiate litigation or administrative proceedings, such actions may be costly and may divert management attention as well as expend other resources which could otherwise have been devoted to our business. An adverse determination in any such litigation will impair our intellectual property rights and may harm our business, prospects and reputation. In addition, historically, implementation of PRC intellectual property-related laws has been lacking, primarily because of ambiguities in the PRC laws and difficulties in enforcement. Accordingly, intellectual property rights and confidentiality protections in China may not be as effective as in the United States or other countries, which increases the risk that we may not be able to adequately protect our intellectual property. Moreover, litigation may be necessary in the future to enforce our intellectual property rights. Future litigation could result in substantial costs and diversion of our management’s attention and resources, and could disrupt our business, as well as have a material adverse effect on our financial condition and results of operations. Given the relative unpredictability of China’s legal system and potential difficulties enforcing a court judgment in China, there is no guarantee that we would be able to halt the unauthorized use of our intellectual property through litigation.
If we infringe the rights of third parties, we could be prevented from selling products, forced to pay damages and compelled to defend against litigation.
If our products, formula, methods, processes and other technologies infringe proprietary rights of other parties, we could incur substantial costs, and may have to obtain licenses (which may not be available on commercially reasonable terms, if at all), redesign our products or processes, stop using the subject matter claimed in the asserted patents, pay damages, or defend litigation or administrative proceedings, which may be costly whether we win or lose. All of the above could result in a substantial diversion of valuable management resources.
We believe we have taken reasonable steps, including comprehensive internal and external prior patent searches, to ensure we have freedom to operate and that our development and commercialization efforts can be carried out as planned without infringing others’ proprietary rights. However, we cannot guarantee that no third-party patent has been filed or will be filed that may contain subject matter of relevance to our development, causing a third-party patent holder to claim infringement. Resolving such issues has traditionally resulted, and could in our case result, in lengthy and costly legal proceedings, the outcome of which cannot be predicted accurately.
Our business is sensitive to the current global economic crisis. A severe or prolonged downturn in the global economy could materially and adversely affect our business and results of operations.
Recent global market and economic conditions have been unprecedented and challenging with recession in most major economies persisting in 2009. Continued concerns about the systemic impact of potential long-term and wide-spread recession, energy costs, geopolitical issues, and the availability and cost of credit have contributed to increased market volatility and diminished expectations for economic growth around the world. The difficult economic outlook has negatively affected businesses and consumer confidence and contributed to volatility of unprecedented levels.
The PRC economy also faces challenges. The PRC government has implemented various measures recently to curb inflation. If economic growth slows or an economic downturn occurs, our business and results of operations may be materially and adversely affected.
We rely upon third-party suppliers for raw materials.
We are dependent upon third parties for our supply of humic acid and other raw materials. Currently, Wuchuan Shuntong is our largest supplier, which is located in Hohhot and accounted for 58% of our raw material purchase for the year ended December 31, 2010. Should Wuchuan Shuntong or any of our other suppliers terminate their supply relationships with our CJV, we may be unable to procure sufficient amounts of humic acid on acceptable terms, in a timely manner, that meet our specifications or that meet the demands of our customers and our profitability may be limited. In addition, these suppliers may not perform their obligations as they have to date, and it may not be possible to specifically enforce the relationships we have formed with such suppliers. If we are unable to obtain adequate quantities of humid acid at economically viable prices which meet our specifications, our financial condition and results of operations could be adversely affected.
Any significant fluctuation in our production costs may have a material adverse effect on our operating results.
The prices for the raw materials and other inputs to manufacture our plant and animal nutrient products are subject to market forces largely beyond our control, including the price of lignite or leonardite coal, our energy costs and freight costs. The costs for these inputs may fluctuate significantly based upon changes in the economy and markets. Although we may pass any increase of such costs through to our customers, in the event we are unable to do so, we could incur significant losses and a diminution of our share price.
Disruptions in the supply of raw materials used in our products could cause us to be unable to meet customer demand, which could result in the loss of customers and net sales.
Humic acid is the primary raw material that we use to manufacture our products and is extracted from lignite or leonardite coal. Currently, Wuchuan Shuntong is our largest supplier. If there are any business interruptions at the principal suppliers and we are unable to locate an alternative supply in a timely manner, we may not be able to meet customer demand, which could result in the loss of customers and net sales.
We may be subject to more stringent governmental regulation on our products.
The manufacture and sale of our fertilizer and feed products in the PRC is regulated by the PRC and the provincial government. The legal and regulatory regime governing our industry is evolving, and we may become subject to different, including more stringent, requirements than those currently applicable to us. While we believe a more stringent standard will have a bigger impact on those manufacturers with poor quality products, we cannot assure you any regulatory change will not adversely affect our business.
We have limited insurance coverage and may incur losses due to business interruptions resulting from natural and man-made disasters, and our insurance may not be adequate to cover liabilities resulting from accidents or injuries that may occur.
The insurance industry in China is still at an early stage of development. Insurance companies in China offer limited commercial insurance products. While we carry property insurance on our office building, production facility, raw materials and inventories in Hohhot facilities, and carry auto insurance on our vehicles and maintain workers compensation insurance for our full-time workers, we do not carry any product liability insurance. We believe that current facilities are adequate for our current and immediately foreseeable operating needs. We have determined that balancing the risks of disruption or liability from our business, the cost of insuring for these risks on the one hand, and the difficulties associated with acquiring such insurance on commercially reasonable terms on the other hand, makes it impractical for us to have such insurance.
Should any natural catastrophes such as earthquakes, floods, or any acts of terrorism occur in Inner Mongolia, where our primary operations are located and most of our employees are based, or elsewhere, we might suffer not only significant property damage, but also loss of revenues due to interruptions in our business operations.
The occurrence of a significant event for which we are not fully insured or indemnified, and/or the failure of a party to meet its underwriting or indemnification obligations, could materially and adversely affect our operations and financial condition. Moreover, no assurance can be given that we will be able to maintain adequate insurance in the future at rates we consider reasonable.
Any disruption of the operations in our production facility would damage our business.
All of our fertilizer products are currently manufactured in our production facility in Inner Mongolia, China. Our operations could be interrupted by fire, flood, earthquake and other events beyond our control. Any disruption of the operations in our production facility would have a significant negative impact on our ability to manufacture and deliver products as we would likely be unable to outsource our production on terms favorable to us, if at all. Failure to replace any lost production capability would cause a potential diminution in sales, the cancellation of orders, loss of valuable employees, damage to our reputation and potential lawsuits.
The fertilizer and feed products that we manufacture pose safety risks and could expose us to product liability claims.
Defects in, or unknown harmful effects caused by, organic and inorganic chemicals and elements in our products could subject us to potential product liability claims that our products cause some harm to the human body or the plants and animals which use our products. Although we have adopted safety measures, which we believe meet industry standards, in our research, development and manufacturing processes, accidents may still occur. We do not carry any product liability insurance and any accident, either at the manufacturing phase or during the use of our products, may subject us to significant liabilities to persons and farmers harmed by these products. Public perception that our products are not safe, whether justified or not, could damage our reputation, involve us in litigation, and damage our brand names and our business. As of the date of this report, no product liability claim has ever been brought against us. However, if we are involved in litigation in the future, the potential judgment or settlement along with the litigation costs could harm our financial performance.
An outbreak of food scares in China would materially and adversely affect our business.
Any major outbreak of food scares, such as the milk contamination scandal in the PRC in 2008, may result in significant disruptions to our business operations. A major food scare could result in considerable decreases in the demand for the products in which our products are used, which would materially and adversely affect our business and our profitability. Adverse publicity and concerns resulting from such a food scare may discourage consumers from purchasing products in which our products are used. Such a reduction in demand would adversely impact our financial performance and results of operations.
Because we may rely on dividends and other distributions on equity paid by our current and future Chinese subsidiaries for our cash requirements, restrictions under Chinese law on their ability to make such payments could materially and adversely affect our ability to grow, make investments or acquisitions that could benefit our business, pay dividends to you, and otherwise fund and conduct our businesses.
We have adopted a holding company structure, and our holding companies may rely on dividends and other distributions on equity paid by our current and future PRC subsidiaries for their cash requirements, including the funds necessary to service any debt we may incur or financing we may need for operations other than through our PRC subsidiaries. PRC legal restrictions permit payments of dividends by our PRC subsidiaries only out of their accumulated after-tax profits, if any, determined in accordance with PRC GAAP. Our PRC subsidiaries are also required under PRC laws and regulations to allocate at least 10% of their after-tax profits determined in accordance with PRC GAAP to statutory reserves until such reserves reach 50% of the company’s registered capital. Allocations to these statutory reserves and funds can only be used for specific purposes and are not transferable to us in the form of loans, advances or cash dividends. Any limitation on the ability of our current or future PRC subsidiaries to transfer funds to us could materially and adversely limit our ability to grow, make investments or acquisitions that could be beneficial to our business, pay dividends and otherwise fund and conduct our business.
If we are unable to establish appropriate internal financial reporting controls and procedures, it could cause us to fail to meet our reporting obligations, result in the restatement of our financial statements, harm our operating results, subject us to regulatory scrutiny and sanction, cause investors to lose confidence in our reported financial information and have a negative effect on the market price for shares of our common stock.
Effective internal controls are necessary for us to provide reliable financial reports and effectively prevent fraud. We maintain a system of internal control over financial reporting, which is defined as a process designed by, or under the supervision of, our principal executive officer and principal financial officer, or persons performing similar functions, and effected by our board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.
As a public company, we have significant additional requirements for enhanced financial reporting and internal controls. We are required to document and test our internal control procedures in order to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act of 2002, which requires annual management assessments of the effectiveness of our internal controls over financial reporting. The process of designing and implementing effective internal controls is a continuous effort that requires us to anticipate and react to changes in our business and the economic and regulatory environments and to expend significant resources to maintain a system of internal controls that is adequate to satisfy our reporting obligations as a public company. We cannot assure you that we will not, in the future, identify areas requiring improvement in our internal control over financial reporting. We cannot assure you that the measures we will take to remediate any areas in need of improvement will be successful or that we will implement and maintain adequate controls over our financial processes and reporting in the future as we continue our growth. If we are unable to establish appropriate internal financial reporting controls and procedures, it could cause us to fail to meet our reporting obligations, result in the restatement of our financial statements, harm our operating results, subject us to regulatory scrutiny and sanction, cause investors to lose confidence in our reported financial information and have a negative effect on the market price for shares of our common stock.
Lack of experience as officers of publicly traded companies of our management team may hinder our ability to comply with the Sarbanes-Oxley Act.
It may be time consuming, difficult and costly for us to develop and implement the internal controls and reporting procedures required by the Sarbanes-Oxley Act of 2002. We may need to hire additional financial reporting, internal controls and other finance staff in order to develop and implement appropriate internal controls and reporting procedures. If we are unable to comply with the Sarbanes-Oxley Act’s internal controls requirements, our auditor could not issue an unqualified opinion of our internal control over financial reporting.
We have incurred increased costs as a result of being a public company.
As a public company, we have incurred significant legal, accounting and other expenses that we did not incur as a private company. In addition, the Sarbanes-Oxley Act of 2002, as well as new rules subsequently implemented by the SEC, has required changes in corporate governance practices of public companies. We expect these new rules and regulations to increase our legal, accounting and financial compliance costs and to make certain corporate activities more time-consuming and costly. In addition, we will incur additional costs associated with our public company reporting requirements. 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.
Risks Associated With Doing Business In China
Adverse changes in PRC economic and political policies could have a material adverse effect on the overall economic growth of China, which could reduce the demand for our products and materially and adversely affect our business.
Substantially all of our assets are located in China. Substantially all of our revenue is derived from our operations in China and we anticipate that sales of our products in the PRC will continue to represent a substantial proportion of our total sales in the near future. Accordingly, our results of operations and prospects are subject, to a significant extent, to the economic, political and legal developments in China. The PRC economy differs from the economies of most developed countries in many aspects, including:
While the Chinese economy has grown significantly in the past two decades, the growth has been uneven geographically, among various sectors of the economy and during different periods. We cannot assure you that the Chinese economy will continue to grow or to do so at the pace that has prevailed in recent years, or that if there is growth, such growth will be steady and uniform. In addition, if there is a slowdown, such slowdown could have a negative effect on our business. Any measures taken by the PRC Government, even if they benefit the overall Chinese economy in the long-term, may have a negative effect on us. For example, our financial condition and results of operations may be materially and adversely affected by government control over capital investments. Although the Chinese economy has been transitioning from a planned economy to a more market-oriented economy, a substantial portion of the productive assets in China is still owned by the PRC Government. The continued control of these assets and other aspects of the national economy by the PRC Government could materially and adversely affect our business. The PRC Government also exercises significant control over Chinese economic growth through allocating resources, controlling payment of foreign currency denominated obligations, setting monetary policy and providing preferential treatment to particular industries or companies. Any adverse change in the economic conditions or government policies in China could have a material adverse effect on the overall economic growth and the level of investments and expenditures in China, which in turn could lead to a reduction in consumer demand for our products and consequently have a material adverse effect on our business and financial condition.
We derive a substantial portion of our sales from the PRC.
Substantially all of our sales are generated from the PRC. We anticipate that sales of our products in the PRC will continue to represent a substantial proportion of our total sales in the near future. Any significant decline in the condition of the PRC economy could adversely affect consumer demand for our products, among other things, which in turn would have a material adverse effect on our business and financial condition.
The PRC legal system embodies uncertainties that could limit the legal protections available to you and us.
Unlike common law systems, the PRC legal system is based on written statutes and decided legal cases have little 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 since then has been to significantly enhance the protections afforded to various forms of foreign investment in China. Our PRC operating subsidiary is subject to laws and regulations applicable to foreign investment in China. Our CJV is subject to laws and regulations governing the formation and conduct of domestic PRC companies. Relevant PRC laws, regulations and legal requirements may change frequently, and their interpretation and enforcement involve uncertainties. For example, we may have to resort to administrative and court proceedings to enforce the legal protection 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 under more developed legal systems. Such uncertainties, including the inability to enforce our contracts and intellectual property rights, could materially and adversely affect our business and operations. Accordingly, we cannot predict the effect of future developments in the PRC legal system, particularly with respect to the fertilizer and feed sector, including the promulgation of new laws, changes to existing laws or the interpretation or enforcement thereof, or the preemption of local regulations by national laws. These uncertainties could limit the legal protections available to us and other foreign investors.
Currency fluctuations may adversely affect our business.
Our reporting currency is the U.S. dollar and our operating subsidiary in China uses the local currency as its functional currency. Substantially all of our revenue and expenses are in Renminbi. We are subject to the effects of exchange rate fluctuations with respect to any of these currencies. For example, the value of the Renminbi depends to a large extent on Chinese government policies and China’s domestic and international economic and political developments, as well as supply and demand in the local market. From 1994 to 2005, the official exchange rate for the conversion of Renminbi to the U.S. dollar had generally been stable and the Renminbi had appreciated slightly against the U.S. dollar. However, 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 may fluctuate within a narrow and managed band against a basket of certain foreign currencies. This change in policy has resulted in an approximately 25% appreciation of the Renminbi against the U.S. dollar between July 21, 2005 and December 31, 2010.
It is possible that the PRC Government could adopt a more flexible currency policy, which could result in more significant fluctuations of the Renminbi against the U.S. dollar. We can offer no assurance that the Renminbi will be stable against the U.S. dollar or any other foreign currency.
To the extent the U.S. dollar strengthens against foreign currencies, the translation of foreign currency denominated transactions will result in reduced revenue, operating expenses and net income for our international operations. Similarly, to the extent the U.S. dollar weakens against foreign currencies, the translation of the foreign currency denominated transactions will result in increased revenue, operating expenses and net income for our international operations. We are also exposed to foreign exchange rate fluctuations as we convert the financial statements of Fullmax Ltd., Asia Standard Oil, Ltd., and Yongye Nongfeng into U.S. dollars in consolidation. If there is a change in foreign currency exchange rates, the conversion of our foreign subsidiaries’ financial statements into U.S. dollars will lead to a translation gain or loss which is recorded as a component of other comprehensive income. In addition, we may have certain assets and liabilities that are denominated in currencies other than the relevant entity’s functional currency. Changes in the functional currency value of these assets and liabilities result in foreign exchange gain or loss. We have not entered into agreements or purchased instruments to hedge our exchange rate risks, although we may do so in the future. The availability and effectiveness of any hedging transaction may be limited and we may not be able to successfully hedge our exchange rate risks.
We must comply with the Foreign Corrupt Practices Act.
We are required to comply with the United States Foreign Corrupt Practices Act, which prohibits U.S. companies from engaging in bribery or other prohibited payments to foreign officials for the purpose of obtaining or retaining business. Foreign companies, including some of our competitors, are not subject to these prohibitions. Corruption, extortion, bribery, pay-offs, theft and other fraudulent practices occur from time-to-time in mainland China. If our competitors engage in these practices, they may receive preferential treatment from personnel of some companies, giving our competitors an advantage in securing business or from government officials who might give them priority in obtaining new licenses, which would put us at a disadvantage. Although we inform our personnel and other agents that such practices are illegal, we cannot assure you that our employees or other agents will not engage in such conduct for which we might be held responsible. If our employees or other agents are found to have engaged in such practices, we could suffer severe penalties and other consequences that may have a material adverse effect on our business, financial condition and results of operations.
Changes in foreign exchange regulations in the PRC may affect our ability to pay dividends in foreign currency or conduct other foreign exchange business.
The Renminbi is not currently a freely convertible currency, and the restrictions on currency exchanges may limit our ability to use revenues generated in Renminbi to fund our business activities outside the PRC or to make dividends or other payments in United States dollars. The PRC government strictly regulates conversion of Renminbi into foreign currencies. Over the years, foreign exchange regulations in the PRC have significantly reduced the government’s control over routine foreign exchange transactions under current accounts. In the PRC, the State Administration for Foreign Exchange, or the SAFE, regulates the conversion of the Renminbi into foreign currencies. Pursuant to applicable PRC laws and regulations, foreign invested enterprises incorporated in the PRC are required to apply for “Foreign Exchange Registration Certificates”. Currently, conversion within the scope of the “current account” (e.g. remittance of foreign currencies for payment of dividends, etc.) can be effected without requiring the approval of SAFE. However, conversion of currency in the “capital account” (e.g. for capital items such as direct investments, loans, securities, etc.) still requires the approval of SAFE. In addition, on October 21, 2005, SAFE issued the Notice on Issues Relating to the Administration of Foreign Exchange in Fundraising and Reverse Investment Activities of Domestic Residents Conducted via Offshore Special Purpose Companies (“Notice 75”), which became effective as of November 1, 2005. Notice 75 replaced the two rules issued by SAFE in January and April 2005. According to Notice 75:
Moreover, Notice 75 applies retroactively. As a result, PRC residents who have established or acquired control of offshore companies that have made onshore 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.
In addition, SAFE issued updated internal implementing rules , or the Implementing Rules, in relation to Notice 75. The Implementing Rules were promulgated and became effective on May 29, 2007. Such Implementing Rules provide more detailed provisions and requirements regarding the overseas investment foreign exchange registration procedures. However, even after the promulgation of Implementing Rules there still exist uncertainties regarding the SAFE registration for PRC residents’ interests in overseas companies.
As a result, we cannot predict how they will affect our business operations following a business combination. For example, our ability to conduct foreign exchange activities following a business combination, such as remittance of dividends and foreign-currency-denominated borrowings, may be subject to compliance with the SAFE registration requirements by such PRC residents, over whom we have no control. In addition, we cannot assure you that such PRC residents will be able to complete the necessary approval and registration procedures required by the SAFE regulations. We will require all our shareholders, following a business combination, who are PRC residents to comply with any SAFE registration requirements, if required by Notice 75, Implementing Rules or other applicable PRC laws and regulations, although we have no control over either our shareholders or the outcome of such registration procedures. Such uncertainties may restrict our ability to implement our business combination strategy and adversely affect our business and prospects following a business combination.
Recent PRC regulations relating to mergers and acquisitions of domestic enterprises by foreign investors may increase the administrative burden we face and create regulatory uncertainties.
On August 8, 2006, six PRC regulatory agencies, namely, the PRC Ministry of Commerce, or MOFCOM, the State Assets Supervision and Administration Commission, or SASAC, the State Administration for Taxation, the State Administration for Industry and Commerce, the China Securities Regulatory Commission, or CSRC, and SAFE, jointly adopted the Regulations on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors, or New M&A Rule, which became effective on September 8, 2006 and was amended on June 22, 2009. The New M&A Rule purports, among other things, to require offshore special purpose vehicles, or SPVs, formed for overseas listing purposes through acquisitions of PRC domestic companies and controlled by PRC companies or individuals, to obtain the approval of the CSRC prior to publicly listing their securities on an overseas stock exchange.
On September 21, 2006, pursuant to the New M&A Rule and other PRC laws and regulations, the CSRC, in its official website, promulgated relevant guidance with respect to the issues of listing and trading of domestic enterprises’ securities on overseas stock exchanges (the “Related Clarifications”), including a list of application materials with respect to the listing on overseas stock exchanges by SPVs.
There are substantial uncertainties regarding the interpretation and application of the above rules, and CSRC has yet to promulgate any written provisions or formally to declare or state whether the overseas listing of PRC related company similar to the case of us shall be subject to the approval of CSRC. If CSRC approval is required in connection with our listing, our failure to obtain or delay in obtaining such approval could result in penalties imposed by CSRC and other PRC regulatory agencies. These penalties could include fines and penalties on our operations in China, restriction or limitation on remitting dividends outside of China, and other forms of sanctions that may cause a material and adverse effect to our business, operations and financial conditions.
Notwithstanding those provisions, we are advised by our PRC counsel, Han Kun Law Offices, that CSRC approval is not required in the context of our listing because (i) we are not a special purpose vehicle formed or controlled by PRC companies or PRC individuals, (ii) we are owned or substantively controlled by foreigners, and (iii) establishment of the CJV is not subject to the New M&A rules. However, we cannot assure that the relevant PRC government agencies, including the CSRC, would reach the same conclusion, and we still cannot rule out the possibility that CSRC may deem our listing structure circumvents the New M&A rules, Related Clarifications and PRC Securities Law.
Though the New M&A rules do not have express provisions in terms of penalties against non-procurement of CSRC approval, there are some other penalty provisions in other PRC laws and regulations regulating offshore listing, which can be cited as a reference:
(i) Pursuant to Article 188 of the PRC Securities Law, any entity that issues securities or issues securities in disguised form without verification or examination and approval by the statutory authority shall be ordered to cease issuance and refund the funds thus raised, together with bank deposit interest for the same period, and shall also be fined not less than one percent but not more than five percent of the amount of the proceeds illegally raised. The persons directly in charge and the other persons directly responsible shall be given a disciplinary warning and also be fined not less than RMB30,000 but not more than RMB300,000. However, we believe that this penalty is mainly designed for and targeted at domestic listing because the PRC Securities Law mainly regulate domestic listings, and listing or de-listing of a company’s stock in the US stock market should be subject to the SEC’s regulation, which is beyond the CSRC’s jurisdiction.
(ii) Pursuant to the Circular of the State Council Concerning Further Strengthening the Administration of Overseas Issuance and Listing of Securities, the overseas listing of securities of a PRC related company which violates this Circular shall be deemed an issuance of shares without authorization or approval. Persons in charge of the competent departments responsible for approval of such an overseas issuance could be subject to administrative sanctions if such person in charge is liable for such violation. People heading the issuing entity and other people directly responsible for issuance shall be penalized, including degraded to a lower lever position and termination of employment by the upper level department. If the violation constitutes a crime, criminal liability shall be claimed against relevant responsible persons according to applicable laws. The issuing entity, relevant agencies involved and the responsible people thereof shall be penalized by the CSRC in accordance with the provisions of the Interim Regulations on the Administration of Issuance and Trading of Securities and other relevant provisions.
Government regulations on environmental matters in China may adversely impact on our business.
Our manufacturing operations are subject to numerous laws, regulations, rules and specifications relating to human health and safety and the environment. These laws and regulations address and regulate, among other matters, wastewater discharge, air quality and the generation, handling, storage, treatment, disposal and transportation of solid and hazardous wastes and releases of hazardous substances into the environment. In addition, third parties and governmental agencies in some cases have the power under such laws and regulations to require remediation of environmental conditions and, in the case of governmental agencies, to impose fines and penalties. We make capital expenditures from time to time to stay in compliance with applicable laws and regulations.
We believe we have obtained all permits and approvals and filed all registrations required for the conduct of our business, except where the failure to obtain any permit or approval or file any registration would not have a material adverse effect on our business, financial condition and results of operations. We believe we are in compliance in all material respects with the numerous laws, regulations, rules, specifications and permits, approvals and registrations relating to human health and safety and the environment except where noncompliance would not have a material adverse effect on our business, financial condition and results of operations.
The PRC governmental authorities have not revealed any material environmental liability that would have a material adverse effect on us. We have not been notified by any governmental authority of any continuing noncompliance, liability or other claim in connection with any of our properties or business operations, nor are we aware of any other material environmental condition with respect to any of our properties or arising out of our business operations at any other location. However, in connection with the ownership and operation of our properties (including locations to which we may have sent waste in the past) and the conduct of our business, we potentially may be liable for damages or cleanup, investigation or remediation costs.
No assurance can be given that all potential environmental liabilities have been identified or properly quantified or that any prior owner, operator, or tenant has not created an environmental condition unknown to us. Moreover, no assurance can be given that (i) future laws, ordinances or regulations will not impose any material environmental liability or (ii) the current environmental condition of the properties will not be affected by the condition of land or operations in the vicinity of the properties (such as the presence of underground storage tanks), or by third parties unrelated to us. State and local environmental regulatory requirements change often.
It is possible that compliance with a new regulatory requirement could impose significant compliance costs on us. Such costs could have a material adverse effect on our business, financial condition and results of operations.
We may have difficulty managing the risk associated with doing business in the Chinese fertilizer and feed sector.
In general, the fertilizer and feed sector in China is affected by a series of factors, including, but not limited to, natural, economic and social such as climate, market, technology, regulation, and globalization, which makes risk management difficult. Fertilizer and feed operations in China face similar risks as present in other countries, however, these can either be mitigated or exacerbated due to governmental intervention through policy promulgation and implementation either in the fertilizer and feed sector itself or sectors which provide critical inputs to fertilizer and feed such as energy or outputs such as transportation. While not an exhaustive list, the following factors could significantly affect our ability to do business:
Currently, we do not hold and do not intend to purchase insurance policies to protect revenue in the case that the above conditions cause losses of revenue.
We may have difficulty establishing adequate management, legal and financial controls in the PRC.
The PRC historically has been unaccustomed to and lacking in Western style management and financial reporting concepts and practices, as well as in modern banking, computer and other control systems. We may have difficulty in hiring and retaining a sufficient number of qualified employees to work in the PRC. As a result of these factors, we may experience difficulty in establishing management, legal and financial controls, collecting financial data and preparing financial statements, books of account and corporate records and instituting business practices that meet Western standards. We may have difficulty establishing adequate management, legal and financial controls in the PRC.
We face risks related to health epidemics and other outbreaks.
Our business could be adversely affected by the effects of swine flu, avian flu, severe acute respiratory syndrome, or SARS, or another epidemic or outbreak. From 2005 to 2009, there have been reports on the occurrences of avian flu and swine flu in various parts of China and elsewhere in Asia, including a few confirmed human cases and deaths. Any prolonged recurrence of swine flu, avian flu, SARS or other adverse public health developments in China may have a material adverse effect on our business operations. Our operations may be impacted by a number of health-related factors, including, among other things, quarantines or closures of our factories and the facilities of our supplier and customers which could severely disrupt our operations. Any of the foregoing events or other unforeseen consequences of public health problems could adversely affect our business and results of operations. We have not adopted any written preventive measures or contingency plans to combat any future outbreak of swine flu, avian flu, SARS or any other epidemic.
Inflation in the PRC could negatively affect our profitability and growth.
While the PRC economy has experienced rapid growth, it has been uneven among various sectors of the economy and in different geographical areas of the country. Rapid economic growth can lead to growth in the money supply and rising inflation. If prices for our products do not rise at a rate that is sufficient to fully absorb inflation-driven increases in our costs of supplies, our profitability can be adversely affected.
During the past ten years, the rate of inflation in China has been fluctuating quite significantly. The Chinese government, from time to time, has adopted various corrective measures designed to restrict the availability of credit or regulate growth and contain inflation. In order to control inflation in the past, the PRC government has imposed controls on bank credits, limits on loans for fixed assets and restrictions on state bank lending. The implementation of these and other similar policies can impede economic growth and thereby harm the market for our products.
Because our assets and operations are located in PRC, you may have difficulty enforcing any civil liabilities against us under the securities and other laws of the United States or any state.
We are a holding company, and most of our assets are located in the PRC. In addition, substantially all of our directors and officers are non-residents of the United States, and all or a substantial portion of the assets of these non-residents are located outside the United States. As a result, it may be difficult for investors to effect service of process within the United States upon these non-residents, or to enforce against them judgments obtained in United States courts, including judgments based upon the civil liability provisions of the securities laws of the United States or any state.
There is uncertainty as to whether courts of the PRC would enforce:
Enforcement of a foreign judgment in the PRC also may be limited or otherwise affected by applicable bankruptcy, insolvency, liquidation, arrangement, moratorium or similar laws relating to or affecting creditors’ rights generally and will be subject to a statutory limitation of time within which proceedings may be brought.
We may not receive the preferential tax treatment we previously enjoyed under PRC law, and our global income and dividends paid to us from our operations in China may become subject to income tax under PRC law.
The rate of income tax on companies in China may vary depending on the availability of preferential tax treatment or subsidies based on their industry or location. The PRC government promulgated on March 16, 2007 the new Enterprise Income Tax Law, or the EIT Law, and its implementing rules, which became effective January 1, 2008. Pursuant to the new law, the enterprise income tax of 25% shall be applied to any enterprise. However, in December 2009 we were notified that our tax rate for the full year of 2009 and 2010 would be set at 15%. There is no assurance whether we can receive this preferential rate after 2010 or if any new law may change the preferential treatment granted to us. Any loss or substantial reduction of the tax benefits enjoyed by us would reduce our net profit and have a material adverse effect on our financial condition and results of operations.
Notwithstanding the foregoing provision, the new EIT Law also provides that dividends paid between “qualified resident enterprises” are exempt from enterprise income tax. Under the new EIT Law and its implementing rules, an enterprise established outside the PRC with its “de facto management body” within the PRC is considered a “resident enterprise” and will be subject to the enterprise income tax at the rate of 25% on its worldwide income. The “de facto management body” is defined as the organizational body that effectively exercises overall management and control over production and business operations, personnel, finance and accounting, and properties of the enterprise. It remains unclear how the PRC tax authorities will interpret such a broad definition. Substantially most of our management members or business operations are based in the PRC. If the PRC tax authorities subsequently determine that we should be classified as a resident enterprise, then it is possible that our worldwide income will be subject to income tax at a uniform rate of 25%.
In addition, under the new EIT law and its implementing rules, dividends paid by a foreign invested enterprise in the PRC to its foreign investor who is a non-resident enterprise will be subject to a 10% PRC withholding income tax (5% for a qualified Hong Kong beneficial owner), unless such tax is eliminated or reduced under an applicable tax treaty. Asia Standard Oil, the 95% shareholder of our CJV, is incorporated in Hong Kong. Therefore, if Asia Standard Oil is considered a non-resident enterprise for purposes of the new EIT law, this new withholding income tax imposed on dividends paid to us by our PRC subsidiaries would reduce our net income in the event we decide to declare a dividend, which may have an adverse effect on our operating results.
It is unclear whether the dividends we receive from our CJV will constitute dividends between “qualified resident enterprises” and would therefore qualify for the tax exemption because it is unclear as to (i) the detailed qualification requirements for such exemption and (ii) whether dividend payments by our PRC subsidiary and investee company to us will meet such qualification requirements, even if we are considered a PRC resident enterprise for tax purposes.
Moreover, since ASO, the 95% shareholder of our CJV, is incorporated in Hong Kong, even if ASO is considered a non-resident enterprise, it is also unclear whether ASO should be considered as a Hong Kong beneficial owner. The beneficial owner means persons who possess ownership and right of control on their proceeds or rights or properties generated from such proceeds. The beneficial owner generally engages in substantive operation activities and may be individuals, companies or any other associations. Agents and companies for tax evasion purposes are not beneficial owner. If ASO is not considered Hong Kong beneficial owner, it will be subject to a 10% PRC withholding income tax.
Dividends payable to our non-PRC investors and any gain on the sale of our shares may be subject to taxes under PRC tax laws.
If our dividends payable to our shareholders are treated as income derived from sources within China, then those dividends, and any gain on the sale or transfer of our shares, may be subject to taxes under PRC tax laws.
Under the EIT Law and its implementing rules, a withholding income tax at the rate of 10% is applicable to dividends paid by us to our investors that are non-resident enterprises so long as (i) any such non-resident enterprise investor does not have an establishment or place of business in China, or (ii) despite the existence of an establishment or place of business in China, the relevant income is not effectively connected with such an establishment or place of business in China and (iii) such dividends are derived from sources within PRC. Similarly, any gain realized on the transfer of our shares by such investors is also subject to a 10% withholding income tax if such gain is regarded as income derived from sources within China and we are considered a resident enterprise domiciled in China for tax purposes. If we are required under the EIT Law to withhold PRC income tax on our dividends paid to our foreign shareholders or investors who are nonresident enterprises, or if you are required to pay PRC income tax on the transfer of our shares under the circumstances mentioned above, the value of your investment in our shares may be materially and adversely affected.
In January 2009, the State Administration of Taxation promulgated the Provisional Measures for the Administration of Withholding of Enterprise Income Tax for Non-resident Enterprises (“Measures”). Entities which have the direct obligation to make the following types of payments to a non-resident enterprise will be the relevant tax withholders for such a non-resident enterprise: income from equity investment (including dividends and other return on investment), interest, rent, royalties, and income from assignment of property as well as other income subject to enterprise income taxes received by non-resident enterprises in China. Further, the Measures provide that in the case of an equity transfer between two non-resident enterprises outside of the PRC, the non-resident enterprise which receives the equity transfer payment shall file a tax declaration with the PRC tax authority located at the place of the PRC company whose equity has been transferred, and the PRC company whose equity has been transferred shall assist the tax authorities to collect taxes from the relevant non-resident enterprise. However, it is unclear whether the Measures cover equity transfers of a non-resident enterprise which is a direct or an indirect shareholder of a PRC company. Given these Measures, there is a possibility that we may have an obligation to withhold income tax in respect of the dividends paid to non-resident enterprise investors.
PRC regulation of direct investment and loans by offshore holding companies to PRC entities may delay or limit our ability to use the proceeds of any offering of securities to make additional capital contributions or loans to our PRC operating business.
Any capital contributions or loans that we, as an offshore company, make to our PRC operating business, including from the proceeds of this offering, are subject to PRC regulations. For example, any of our loans to our PRC operating business cannot exceed the difference between the total amount of investment our PRC operating business are approved to make under relevant PRC laws and their respective registered capital, and must be registered with the local branch of SAFE as a procedural matter. In addition, our capital contributions to the CJV must be approved by the NDRC and MOFCOM or their local counterpart and registered with the SAIC or its local counterpart. We cannot assure you that we will be able to obtain these approvals on a timely basis, or at all. If we fail to obtain such approvals, our ability to make equity contributions or provide loans to our PRC operating business or to fund its operations may be negatively affected, which could adversely affect its liquidity and its ability to fund its working capital and expansion projects and meet its obligations and commitments. Furthermore, SAFE promulgated a new circular in August 2008 with respect to the administration of conversion of foreign exchange capital contribution of foreign invested enterprises into RMB. Pursuant to this new circular, RMB converted from foreign exchange capital contribution can only be used for the activities within the approved business scope of such foreign invested enterprise and cannot be used for domestic equity investment or acquisition unless otherwise allowed by PRC laws or regulations. As a result, we may not be able to increase the capital contribution of our operating subsidiary or equity investee and subsequently convert such capital contribution into RMB for equity investment or acquisition in China.
Recent changes in the PRC labor law restrict our ability to reduce our workforce in the PRC in the event of an economic downturn and may increase our labor costs.
In June 2007, the National People’s Congress of the PRC enacted the Labor Contract Law, which became effective on January 1, 2008. To clarify certain details in connection with the implementation of the Labor Contract Law, the State Council promulgated the Implementing Rules for the Labor Contract Law, or the Implementing Rules, on September 18, 2008 which came into effect immediately. The Labor Contract Law provides various rules regarding employment contracts that will likely have a substantial impact on employment practices in China. The Labor Contract Law imposes severe penalties on employers that fail to timely enter into employment contracts with employees. The employer is required to pay a double salary to the employee if it does not enter into a written contract with the employee within one month of the employment, and a non-fixed-term contract is assumed if a written contract is not executed after one year of the employment. Additionally, the Labor Contract Law sets a limit of two fixed-term contracts regardless of the length of each term, after which the contract must be renewed on a non-fixed-term basis should the parties agree to a further renewal unless otherwise required by the respective employee. This requirement curtails the common practice of continuously renewing short-term employment contracts. The Implementing Rules appear to further tighten this rule by suggesting that an employee has the right to demand a non-fixed-term contract upon the completion of the second fixed term regardless of whether the employer agrees to a contract renewal. A non-fixed-term contract does not have a termination date and it is generally difficult to terminate such a contract because termination must be based on limited statutory grounds. The employer can no longer supplement such statutory grounds through an agreement with the employee. In addition, the Labor Contract Law requires the payment of statutory severance upon the termination of an employment contract in most circumstances, including the expiration of a fixed-term employment contract.
Under the Labor Contract Law, employers can only impose a post-termination non-competition provision on employees who have access to their confidential information for a maximum period of two years. If an employer intends to maintain the enforceability of a post-termination non-competition provision, the employer has to pay the employee compensation on a monthly basis post-termination of the employment. Under the Labor Contract Law, a “mass layoff” is defined as termination of more than 20 employees or more than 10% of the workforce. The Labor Contract Law expands the circumstances under which a mass layoff can be conducted, such as when a company undertakes a restructuring pursuant to the PRC Enterprise Bankruptcy Law, suffers serious difficulties in business operations, changes its line of business, performs significant technology improvements, changes operating methods, or where there has been a material change in the objective economic circumstances relied upon by the parties at the time of the conclusion of the employment contract, thereby making the performance of such employment contract impractical. The employer must follow specific procedures in conducting a mass layoff. There is little guidance on what penalties an employer will suffer if it fails to follow the procedural requirements in conducting the mass layoff. Finally, the Labor Contract Law requires that the employer discuss the company’s internal rules and regulations that directly affect the employees’ material interests (such as employees’ salary, work hours, leave, benefits, and training, etc.) with all employees or employee representative assemblies and consult with the trade union or employee representatives on such matters before making a final decision.
All of our employees based exclusively within the PRC are covered by the new laws. As there has been little guidance and precedents as to how the Labor Contract Law and its Implementing Rules shall be enforced by the relevant PRC authorities, there remains uncertainty as to their potential impact on our business and results of operations. The implementation of the Labor Contract Law and its Implementing Rules may increase our operating expenses, in particular our personnel expenses and labor service expenses. If we want to maintain the enforceability of any of our employees’ post-termination non-competition provisions, the compensation and procedures required under the Labor Contract Law may add substantial costs and cause logistical burdens to us. Prior to the new law such compensation was often structured as part of the employee’s salary during employment, and was not an additional compensation cost. In the event that we decide to terminate employees or otherwise change our employment or labor practices, the Labor Contract Law and its Implementing Rules may also limit our ability to effect these changes in a manner that we believe to be cost-effective or desirable, which could adversely affect our business and results of operations. In particular, our ability to adjust the size of our operations when necessary in periods of recession or less severe economic downturns such as the recent financial turmoil may be affected. In addition, during periods of economic decline when mass layoffs become more common, local regulations may tighten the procedures by, among other things, requiring the employer to obtain approval from the relevant local authority before conducting any mass layoff. Such regulations can be expected to exacerbate the adverse effect of the economic environment on our results of operations and financial condition.
Our failure to fully comply with PRC labor laws exposes us to potential liability.
Companies operating in China must comply with a variety of labor laws, including certain social insurance, housing fund and other staff welfare-oriented payment obligations. While we believe we have complied with such obligations, there exist uncertainties to the interpretation, implementation and enforcement of such obligations. If relevant governmental authorities determine that we have not complied fully with such obligations, we may be in violation of applicable PRC labor laws and we cannot assure you that PRC governmental authorities will not impose penalties on us for any failure to comply. In addition, in the event that any current or former employee files a complaint with relevant governmental authorities, we may be subject to making up such staff-welfare oriented obligations as well as paying administrative fines.
Risks Related to the Common Stock
Our common stock may be affected by limited trading volume and may fluctuate significantly.
Our common stock is traded on the Nasdaq Global Select Market. Although an active trading market has developed for our common stock, there can be no assurance that an active trading market for our common stock will be sustained. Failure to maintain an active trading market for our common stock may adversely affect our shareholders’ ability to sell our common stock in short time periods, or at all. In addition, sales of substantial amounts of our common stock in the public market could harm the market price of our common stock. Our common stock has experienced, and may experience in the future, significant price and volume fluctuations. Some of the factors that may materially affect the market price of our common stock are beyond our control, such as changes in financial estimates by industry and securities analysts, conditions or trends in the industry in which we operate or sales of our common stock. These factors may materially adversely affect the market price of our common stock, regardless of our performance. These broad market fluctuations may adversely affect the market price of our common stock.
Shares eligible for future sale may adversely affect the market price of our common stock, as the future sale of a substantial amount of our restricted stock in the public marketplace could reduce the price of our common stock.
From time to time, certain of our stockholders may be eligible to sell all or some of their shares of common stock by means of ordinary brokerage transactions in the open market pursuant to Rule 144, promulgated under the Securities Act (“Rule 144”), subject to certain limitations. In general, pursuant to Rule 144, a stockholder (or stockholders whose shares are aggregated) who has satisfied a six-month holding period may, under certain circumstances, sell within any three-month period a number of securities which does not exceed the greater of 1% of the then outstanding shares of common stock or the average weekly trading-volume of the class during the four calendar weeks prior to such sale. Rule 144 also permits, under certain circumstances, the sale of securities, without any limitations, by a non-affiliate of our company that has satisfied a one-year holding period. Any substantial sale of common stock pursuant to Rule 144 or pursuant to any resale prospectus may have an adverse effect on the market price of our securities.
Your percentage ownership in us may be diluted by future issuances of capital stock, which could reduce your influence over matters on which stockholders vote.
Subject only to any applicable stockholder approval requirements imposed by the Nasdaq Global Select Market, our board of directors has the authority to issue all or any part of our authorized but unissued shares of common stock. Issuances of common stock would reduce your influence over matters on which our stockholders vote.
Stockholders should have no expectation of any dividends.
To date, we have not declared nor paid any cash dividends. The Board of Directors does not intend to declare any dividends in the near future, but instead intends to retain all earnings, if any, for use in the operation and expansion of our business. If we decide to pay dividends, foreign exchange and other regulations in China may restrict our ability to distribute retained earnings from China or convert those payments from Renminbi into foreign currencies.
Techniques Employed by Manipulative Short Sellers in Chinese Small Cap Stocks May Drive Down the Market Price of Our Common Stock
Short selling is the practice of selling securities that the seller does not own but rather has, supposedly, borrowed from a third party with the intention of buying identical securities back at a later date to return to the lender. The short seller hopes to profit from a decline in the value of the securities between the sale of the borrowed securities and the purchase of the replacement shares, as the short seller expects to pay less in that purchase than it received in the sale. As it is therefore in the short seller’s best interests for the price of the stock to decline, many short sellers (sometime known as “disclosed shorts”) publish, or arrange for the publication of, negative opinions regarding the relevant issuer and its business prospects in order to create negative market momentum and generate profits for themselves after selling a stock short. While traditionally these disclosed shorts were limited in their ability to access mainstream business media or to otherwise create negative market rumors, the rise of the Internet and technological advancements regarding document creation, videotaping and publication by weblog (“blogging”) have allowed many disclosed shorts to publicly attack a company’s credibility, strategy and veracity by means of so-called research reports that mimic the type of investment analysis performed by large Wall Street firm and independent research analysts. These short attacks have, in the past, led to selling of shares in the market, on occasion in large scale and broad base. Issuers with business operations based in China and who have limited trading volumes and are susceptible to higher volatility levels than U.S. domestic large-cap stocks, can be particularly vulnerable to such short attacks.
These short seller publications are not regulated by any governmental, self-regulatory organization or other official authority in the U.S., are not subject to the certification requirements imposed by the Securities and Exchange Commission in Regulation AC (Regulation Analyst Certification) and, accordingly, the opinions they express may be based on distortions of actual facts or, in some cases, fabrications of facts. In light of the limited risks involved in publishing such information, and the enormous profit that can be made from running just one successful short attack, unless the short sellers become subject to significant penalties, it is more likely than not that disclosed shorts will continue to issue such reports.
While we intend to strongly defend our public filings against any such short seller attacks, oftentimes we are constrained, either by principles of freedom of speech, applicable state law (often called “Anti-SLAPP statutes”), or issues of commercial confidentiality, in the manner in which we can proceed against the relevant short seller. You should be aware that in light of the relative freedom to operate that such persons enjoy – oftentimes blogging from outside the U.S. with little or no assets or identity requirements – should we be targeted for such an attack, our stock will likely suffer from a temporary, or possibly long term, decline in market price should the rumors created not be dismissed by market participants.
On February 6, 2011, a report was published on the Seeking Alpha website with misleading statements about the Company. Although we have responded to these misconceptions in a press release dated February 7, 2011, there are predictions that 2011 will bring more short seller attacks against Chinese companies. As a result, the price of our stock remains vulnerable to any further attacks in this regard.
If our common stock were delisted and determined to be a “penny stock,” a broker-dealer may find it more difficult to trade our common stock and an investor may find it more difficult to acquire or dispose of our common stock in the secondary market.
If our common stock were removed from listing with the Nasdaq Global Market, it may be subject to the so-called “penny stock” rules. The SEC has adopted regulations that define a “penny stock” to be any equity security that has a market price per share of less than $5.00, subject to certain exceptions, such as any securities listed on a national securities exchange. For any transaction involving a “penny stock,” unless exempt, the rules impose additional sales practice requirements on broker-dealers, subject to certain exceptions. If our common stock were delisted and determined to be a “penny stock,” a broker-dealer may find it more difficult to trade our common stock and an investor may find it more difficult to acquire or dispose of our common stock on the secondary market. Investors in penny stocks should be prepared for the possibility that they may lose their whole investment.
ITEM 1B. Unresolved Staff Comments
ITEM 2 Properties
Our principal executive offices are located at 6th floor, Xue Yuan International Tower, No. 1 Zhichun Road, Haidian District, Beijing PRC and the telephone number is +86-10-8232-8626. The office space is approximately 1,000 square meters in area. Inner Mongolia Yongye’s main production plant is in the High Tech Economic Development Zone in Hohhot City in Inner Mongolia, and Yongye Fumin’s production plant is in the Economic Development Zone in Wuchuan County, Hohhot City, Inner Mongolia.
There is no private ownership of land in China. All land ownership is held by the government of the PRC, its agencies and collectives. Land use rights can be transferred upon approval by the land administrative authorities of the PRC (State Land Administration Bureau) upon payment of the required land transfer fee. Inner Mongolia Yongye owns the land use rights for the land on which its manufacturing facilities are situated, which have a term of 50 years from 2003.
ITEM 3 Legal Proceedings
We are not a party to any material legal proceedings nor are we aware of any circumstance that may reasonably lead a third party to initiate legal proceedings against us.
ITEM 4 [Removed and Reserved]
ITEM 5 Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Our common stock is quoted on The NASDAQ Stock Market (“NASDAQ”) under the trading symbol “YONG”. Between April 30, 2008 and September 3, 2009, our common stock was quoted on the OTC Bulletin Board (“OTCBB”) under the trading symbol “YGII.OB”. Until April 29, 2008, our common stock was traded under the symbol “GDTN.OB”. The closing price for our common stock on NASDAQ on March 11, 2011 was $6.75 per share.
The following table sets forth the high and low bid prices for our common stock prior to September 3, 2009 and the high and low sale prices for our common stock for subsequent periods, as reported by the OTC Bulleting Board System and the Nasdaq Global Select Market, respectively. There were no reported bids for our common stock during 2007, 2006 and the first quarter of 2008. The OTCBB quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not represent actual transactions.
As of December 31, 2010, there were approximately 35 active record holders of our common stock.
We have not paid any cash dividends on shares of our common stock and do not plan to do so in the near future. We currently plan to retain future earnings to fund the development and growth of our business. Any future determination related to our dividend policy will be made at the discretion of our Board of Directors.
Equity Compensation Plan Information
The following table sets forth aggregate information regarding our equity compensation plans in effect as of December 31, 2010:
(a) Includes restricted shares issued pursuant to the Company’s 2010 Equity Incentive Plan (the “2010 Plan”), which was approved by the Company’s stockholders, and which are subject to a vesting schedule pursuant to the terms of the relevant award agreement.
Purchases of Equity Securities by the Company and Affiliated Purchasers
During the fourth quarter of our fiscal year ended December 31, 2010, neither we nor any “affiliated purchaser” (as defined in Rule 10b-18(a)(3) under the Exchange Act) purchased any shares of our common stock, the only class of our equity securities registered pursuant to section 12 of the Exchange Act.
Recent Sales of Unregistered Securities
We have reported all sales of our unregistered equity securities that occurred during 2010 in our Reports on Form 10-Q or Form 8-K, as applicable.
ITEM 6 Selected Financial Data
The following table sets forth selected financial data as of and for the years ended December 31, 2010, 2009, 2008, 2007 and 2006. We derived the selected financial data from our financial statements for those periods. You should read the selected financial data in this table together with, and such selected financial data is qualified by reference to our financial statements and the notes to those financial statements in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Company’s consolidated financial statements.
ITEM 7 Management’s Discussion and Analysis of Financial Condition and Results of Operations
Except for the historical information contained herein, the matters discussed in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and elsewhere in this report are forward-looking statements that involve risks and uncertainties. The factors listed in the section captioned “Risk Factors,” as well as any cautionary language in this report, provided examples of risks, uncertainties and events that may cause our actual results to differ materially from those projected. Except as may be required by law, we undertake no obligation to update any forward-looking statement to reflect events after the date of this prospectus.
We are engaged in the research and development, manufacturing, distribution and sale of liquid and powder nutrient products for plants and animals respectively which are used in the agriculture industry. Our headquarters is in Beijing, China and additional administrative offices and our manufacturing unit are located in Hohhot, Inner Mongolia, China. Currently, we sell two lines of organic nutrient products, both based on our fulvic acid compound base: a plant nutrition liquid compound and animal nutrition powder which is a food additive. Our products start with our proprietary fulvic acid base which is extracted from humic acid, and to which we add other natural substances to customize the base for use in our plant and animal product lines. Based on our internal data and research, we believe our proprietary technology for fulvic acid extraction creates some of the purest and most effective fulvic acid base on the market in China today. We believe that our fulvic acid has a very light weight molecular composition, which may improves the overall permeability of cell walls and allows more complete transport of nutrients across plant membranes, effectively strengthening the overall health of plants. We believe our proprietary process for extracting fulvic acid from humic acid and our patented process for mixing our plant nutrient and animal nutrient are key differentiators in the market. We believe this will help us ensure that we have a high quality product that we can control from procurement of raw materials to final production. We believe this also ensures our products provide reliable results from season to season.
Our products start with our fulvic acid base then, in addition, we add other natural substances to customize the base for use in our plant or animal lines of products. Our plant products are intended to add naturally occurring macro and micro nutrients such as nitrogen, phosphorus, potassium, boron and zinc. Our animal product adds natural herbs which we believe may help to reduce bacterial inflammation (mastitis) in cows. It also assists many animals to digest food more completely and thus we believe that our animal products may help animals who use them to be healthier.
In the year ended December 31, 2010, we sold approximately 18,800 tons of plant product, which represented 97% of our total revenue or $207,514,478. We also sold approximately 1,115 tons of our animal product, which represented 3% of our total revenue or $6,577,238.
From the beginning of 2010, we pursued a vertical integration strategy by seeking to acquire lignite coal resources and constructing a new manufacturing facility nearby that would be capable of extracting humic acid from lignite coal and expanding the production capacity.
In March 2010, we entered into an agreement with Wuchuan Shuntong to acquire the permit for the rights to explore, develop and produce lignite coal resources in a certain area of Wuchuan County. The cash consideration of the permit is approximately RMB 240 million or USD $35 million. The permit allows us to complete all necessary administrative procedures and obtain government approvals to acquire the Mineral Right. This acquisition will not be completed until Yongye Nongfeng makes full payment to Wuchuan Shuntong and receives in return the full, unencumbered title to the development rights. Yongye Nongfeng is still in the process of obtaining the related government approvals. We believe that the Mineral Rights will allow us to secure a long term supply of humic acid, which is a major raw material used in manufacture of fulvic acid nutrient products, and which is sourced from lignite coals. According to a third party valuation report, the project area is estimated to contain approximately 40 million cubic meters of lignite coal which can supply the Company's long-term needs.
On July 20, 2010, Yongye Nongfeng set up a wholly-owned subsidiary in Wuchuan County, Inner Mongolia Yongye Fumin Biotechnology Co., Ltd. (“Yongye Fumin”), with registered capital of $14,731,880 (equivalent to RMB 100 million), whose manufacturing facility is located in Wuchuan County, nearby the lignite coal resources project. Yongye Fumin is to be engaged in manufacturing and sale of fulvic acid based liquid and powder nutrient compounds, with annual production capacity to produce 20,000 ton plant nutrient product and 10,000 ton animal nutrient product. Yongye Fumin was established to expand the production capacity for fulvic acid based liquid and powder nutrient compounds, and to produce humic acid using lignite coal. The construction of the production plant of Yongye Fumin was completed in the fourth quarter of 2010.
After the acquisition of the coal resources project is completed, with the new manufacturing facility, we expect to improve control of raw material supply and improve our cost structure as the cost of obtaining humic acid is currently the largest component of our cost of sales.
In June 2010, Yongye Nongfeng entered into an agreement to acquire the customer list from its provincial level distributor in Hebei Province, which was completed in July 2010. The Company has issued 3.6 million shares of common stock and will pay an additional $3.0 million or equivalent to RMB 20.4 million in cash to the seller on or before March 2011 as consideration for the acquisition. The Company has commenced to trade with these customers in July 2010. The customer list is comprised of all of the sub-provincial level distributors who sell the Company's Shengmingsu plant and animal nutrient products in Hebei Province, which is Yongye's largest market in China, representing approximately 30% and 29% of the Company's revenues in 2009 and 2010, respectively. Previously, in Hebei Province, Yongye sold its products to its provincial level distributor who then resold those products to lower level distributors. After the acquisition of the customer list, Yongye sold directly to the sub-provincial level distributors in Hebei Province. Sales from Hebei increased 428% period over period in the second half year of 2010 and 111% year over year during the year of 2010.
In October 2010, the Company granted 1,183,667 restricted shares to management and independent directors of the Company in accordance with the Yongye International, Inc. 2010 Omnibus Securities and Incentive Plan, as an incentive to such individuals to promote the success of the Company’s business. Shares vest on the six-month anniversary of the date of grant. Management was granted 1,137,000 shares on October 8, 2010, and the independent directors were granted shares of 46,667 shares on October 15, 2010.
Factors affecting our operating results
Demand for our products
One major tenet of the PRC government’s 11th Five-Year National Economic and Social Plan (the “NESDP”) (2006-2010) is the focus towards developing China’s western region. This is one of the top-five economic priorities of the nation. The goal is to increase rural income growth which will in turn increase demand for more food and agriculture products. Currently, a large proportion of our products are sold in this western region and this government focus will increase our opportunity to sell more plant and animal nutrients to farmers who have to keep up with the demand for higher quantity and higher quality of products.
According to the Asian Development Bank statistics, well over 60% of the nation’s 1.3 billion total population is comprised of low-income, rural farmers. According to the 11th Five-Year NESDP (2006-2010), raising the level of rural income is a top economic and social goal for the country. Many government initiatives, including removal of certain agricultural and local product taxes, have been implemented to spur rural income development. The government expects annual rural income to grow between 5% and 10% through 2010 (Xinhua, October 12, 2008). Additionally, according to the National Population and Family Planning Commission, China's population will reach 1.5 billion by 2030. Therefore, the country has the challenge of producing approximately 100 million more tons of crops needed to feed the additional 200 million people. This put pressure on the agricultural system to increase production capacity.
According to the Proposal of the PRC government’s 12th Five-Year National Economic and Social Plan (2011-2015), the party shall adhere to agriculture, rural areas and farmers’ development and insist on supporting the countryside. Improving the agriculture comprehensive production capacity, quicken the construction of large-scale drought-high farmland, and development of high-yield, high-quality and high-efficiency agriculture shall be the party’s focus work in agriculture. Given our products’ ability to increase crop yield, improve quality and enhance drought-resistance, we expect accelerated utilization of fertilizers generally and this government policy will increase demand for our products.
Supply of Finished Goods
Before June 1, 2009, we purchased our finished goods from our main supplier, Inner Mongolia Yongye and then sold them through our distribution system. Upon obtaining the fertilizer license on June 1, 2009, we commenced the manufacturing of our product.
Our Shengmingsu products face seasonality in our sector. In general, the first and fourth quarters are typically our slowest quarters. 12% and 13% of our total sales for the year 2010 were from these quarters, respectively. The second and third quarters drove the bulk of our overall sales in 2010 with 42% and 33%, respectively, of the total 2010 year’s sales.
Agriculture continues to be a heavily invested sector in China. Brand name investors continue to invest into China’s agriculture space because they have confidence in China’s long term outlook. The market volume for agriculture products is large, both for domestic sales and export and there is no set threshold for foreign investment into the sector as opposed to other industries, such as energy, finance, mining, and telecommunications. This is driven by the growing demand for higher quality food products domestically and international reliance on food products from China. Currently, China is the world’s biggest grower and consumer of grains and yet must boost crop yields by at least 1 percent a year to ensure the country has enough food to feed its 1.3 billion people, according to the former Minister of Agriculture, Sun Zhengcai (China Economic Net, July 21, 2008). Additional policy changes are expected to include protecting farmland and working to increase rural incomes to retain farming interest.
The goal is to maintain self-sufficiency in food production because no other country can feed the world’s biggest population, according to Sun. “Our strategy must be based on stable farmland, and seeking ways to improve yields,” Sun said in a speech to local officials, outlining the government’s near- and long-term agriculture policy and objectives. China, which harvested more summer crops, aims also to boost grain and oilseed output this year, Sun said. To ensure next year’s crops, officials must “stabilize” area planted in winter wheat and use idle land in the off season to grow rapeseed, Sun said.
This growth, however, does not come without challenges and China has faced many of these with regards to the continued concern over the quality of milk and eggs sold both domestically and internationally in the dairy industry. We believe that the government is making every effort to bring back consumer confidence in these domestically produced products and overall this will bring about an even stronger industry once planned new licensing and safety procedures have been put into place.
New Land Reform Policy
Farmland in China is owned by the local government, but given to local farmers under 30 year use contracts. With the allure of higher incomes and better living conditions in the city, in some places, farmers have abandoned the land and no others farmers have stepped in to bring it back into production. This has created a shortage of productive agricultural land. The government has acknowledged this issue and recently enacted a new land use reform policy which liberalizes the exchange of land among the nation’s farmers. This creates a new model for China’s 730 million farmers with the idea being to create more stable farmland by shifting the country away from the single household farm plot model to the amalgamation of larger-scale operations which should be more productive due to technology and economies of scale. Farmers will be able to transfer their land-use rights to others through a new market system for rural land-use rights. Chinese authorities commented that, “Without modernizing agriculture, China cannot modernize; without stability and prosperity in rural areas, China cannot have stability and prosperity. These changes are enacted to “ensure national food security and the supply of major agricultural products, and promote increases in agricultural production, farm incomes and rural prosperity.” (China’s Ongoing Agriculture Modernization, USDA, April 2009).
The recent drought across Northern China, which is one of the worst droughts in Northern China in recent years, began in the fourth quarter of 2010, the last time much of the region had significant rain. This drought has already affected millions of acres of farmland and is likely to have a major impact on the incomes of hundreds of thousands of farmers.
We believe one important benefit of Yongye's "Shengmingsu" branded plant nutrient product is to help plants counteract the effects of water deprivation. Crops sprayed with Shengmingsu are able to better withstand the effects of drought and continue to flourish alongside withering crops which received only traditional fertilizer. Yongye's Shengmingsu plant nutrient product is now being used in a number of drought-affected areas to assist local farmers in combating the conditions.
Many regions in China have experienced drought in the past several years and the Company’s growth to date was partly due to the anti-natural disaster feature of its Shengmingsu product. In recent months, the Company has continued to see strong demand from its distributors, who are actively promoting its products as an effective nutrient product for local farmers to counteract the drought.
YONGYE INTERNATIONAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
RESULTS OF OPERATIONS
Fiscal year ended December 31, 2010 compared with Fiscal year ended December 31, 2009 and 2008
Our business for the year ended December 31, 2010 grew at a rate of 118% in net sales or a $116 million increase over the same period in 2009, and for the year ended December 31, 2009, our net sales grew at a rate of 104% or a $50 million increase over the same period in 2008. This increase was driven by higher penetration of our business in our traditional markets, leading to increases in quantities of product sold, and the growth of several new markets.
The following table shows, for the periods indicated, information derived from our consolidated statements of income.
Our financial position at December 31, 2010 and 2009:
The increases in inventories of $23,844,786, accounts receivables of $19,949,017, and property, plant and equipment of $12,390,237, were primarily due to the expansion our business.
Total current liabilities increased by $9,484,927 to $22,154,466 at December 31, 2010 from $12,669,539 at December 31, 2009, which was largely due to an increase in accrued expenses of $2,544,626 and income taxes payable of $2,054,695, as result of the significant growth of our business, and an increase in our net income before income tax. Moreover, other payables increased by $4,757,231 mainly due to $3 million cash consideration payable for the acquisition of Hebei customer list. We repaid the short-term bank loan during 2010, which decreased current liabilities by $2,925,174.
Total equity increased by $92,497,463 to $225,088,285 at the end of December 31, 2010, compared to $132,590,822 at December 31, 2009. The increase in our total equity was primarily due to increase in common stock and additional paid in capital of $26,020,186, which was mainly from the 3,600,000 shares issued for acquisition of the Hebei customer list, the 1,183,667 restricted shares to management and independent directors, and warrants exercised during 2010, collection of subscription receivable of $8,550,000 that was received during 2010, and increase in retained earnings of $48,436,926 due to the net income attributable to Yongye International, Inc. during the period.
Days sales outstanding is defined as average accounts receivable for the period/year divided by net sales for the period/year and decreased by 55 days to 27 days for the year ended December 31, 2010 from 82 days for the three months ended September 30, 2010, as well as decreased by 5 days compared with 32 days for the three months ended June 30, 2010 as result of increased efforts in cash collection. Days sales outstanding were 17 days and 18 days for the year ended December 31, 2009 and 2008, respectively.
Sales of $214,091,716 for the year ended December 31, 2010 increased by $115,998,874 from $98,092,842 in the same period of 2009, an overall increase of 118%. Sales for the year ended December 31, 2009 were $98,092,842, an increase of $50,000,571 or 104%, compared with the corresponding period in 2008.
These increases were driven by higher demand for our plant and animal nutrient product throughout our market area, including higher penetration of our traditional markets, and the growth of several new markets, which resulted in almost all of such growth being due to an increase in the quantity of product sold while our prices remained relatively stable. Additionally, after the acquisition of Hebei customer list, we are selling at a higher price directly to lower level distributors in Hebei, which is Yongye's largest regional market in China, representing approximately 29% of sales in 2010.
Gross profit for the year of 2010 increased 129%, or $67,154,426 from $52,103,456 to $119,257,882, over the year ended December 31, 2009. Gross profit for the year ended December 31, 2009 was $52,103,456, and represented 53% of sales. This was an increase of $27,176,869, or 109%, when compared with $24,926,587 in the corresponding period in 2008.
Gross margin increased between the years of 2010 and 2009 from 53% to 56%, or 3%, and between the years of 2009 and 2008 from 52% to 53%, or 1%. The increase in gross profit was mainly due to the benefits from economics of scale. Moreover, after the acquisition of Hebei customer list in July 2010, our increased margin for the sales made in Hebei province also contributed to the increase of gross profit ratio.
The number of independently owned, Yongye-branded stores reached 24,036 as of December 31, 2010, compared to 21,925 as of September 30, 2010, and 9,110 as of December 31, 2009.
Sales by Product Line
In the year ended December 31, 2010, we sold approximately 18,800 tons of plant product, which represented 97% of our total sales or $207,514,478. We also sold approximately 1,115 tons of our animal product, which represented 3% of our total sales or 6,577,238.
Five major distributors accounted for 56% and one major distributor accounted for 16% of the Company’s total revenue for the year ended December 31, 2010. Five major distributors accounted for 82% and one major distributor accounted for 30% of the Company’s total revenue for the year ended December 31, 2009. Five major distributors accounted for 92% and one major distributor accounted for 43% of total revenue for the year ended December 31, 2008. The Company’s total sales to five major distributors were $119,771,911, $80,274,006 and $44,109,814, for the years ended December 31, 2010, 2009 and 2008, respectively.
Cost of Goods Sold
Cost of goods sold for the year ended December 31, 2010 was $94,833,834, or 44% of revenues. This is an increase of $48,844,448 over the previous period of $45,989,386 and represents an 106% increase. As a percent of revenue, this represented a decrease of 3% when compared with the corresponding period in 2009, which was 47%. The decrease in cost of goods sold as a percentage of revenue for the year of 2010 was mainly due to the benefits from economics of scale, as well as the acquisition of the Hebei customer list.
Selling, General & Administrative and Research & Development expenses
Selling expenses increased by $25,891,643 to $40,612,300 for the year ended December 31, 2010 from $14,720,657 in the corresponding period in 2009, and increased by $6,054,902 for the year ended December 31, 2009 from $8,665,755 in the corresponding period in 2008. As a percentage of sales for the year ended December 31, 2010, selling expenses increased by 4% to 19% as compared to 15% of sales in the year ended December 31, 2009, due to an increase of $16,869,130 in advertising expenses mainly resulting from more promotional activities in 2010, as we entered into more geographic markets and conducted several nation-wide joint programs with China Central Television Station (CCTV). Also there was an increase in training expenses of $6,107,245 for various levels of distributors and staff education. In addition, there was an increase in transportation expenses of $1,358,905 due to increase in sales. As a percentage of sales for the year ended December 31, 2009, selling expenses decreased by 3% to 15% as compared to 18% of sales in the year ended December 31, 2008, due to more efficient use of marketing programs. Selling expenses for the year ended December 31, 2009 increased $6,054,902 compared to 2008, primarily due to increased advertising activities to drive high sales volume.
General & administrative expenses increased by $9,705,448 to $13,994,936 for the year ended December 31, 2010 from $4,289,488 in 2009, and increased by $1,716,471 for the year ended December 31, 2009 from $2,573,017 in 2008. As a percentage of sales for the year ended December 31, 2010, general & administrative expenses increased by 3% to 7% as compared to 4% of sales in the year ended December 31, 2009, due to an increase of $4,310,640 in management compensation expenses resulted from the grant to management of restricted stocks in October 2010, as well as an increase in staff salaries of $1,072,280.
We incurred $4,852,004 of research and development expenses in the year ended December 31, 2010 as compared to $1,690,248 and $0 in the year ended December 31, 2009 and 2008. While we expanded our geographic coverage to several new provinces in 2010, the research and development expenses consist of expenses related to making investments in future new products and conducting various field tests in the Company’s new sales territories. This increase in expenses is mainly the result of more field test areas for different products to both our plant and animal products in the year ended December 31, 2010 compared to 2009.
Loss on change in fair value of derivative liabilities
The warrants issued in our private financings in 2008 and 2009 are accounted for as derivative liabilities and measured at fair value at each reporting date. The increase in fair value during the year ended December 31, 2010 resulted in a loss of $41,212. The increase in fair value of the warrants was primarily due to the increase in our stock price from $8.13 per share at January 4, 2010 to $8.40 at December 31, 2010. The change in fair value of the warrants for the year ended December 31, 2009 resulted in a loss of $24,009,802 as compared with a gain of $2,118,797 for the year ended December 31, 2008.
Corporate Income Taxes
The Company did not carry on any business and did not maintain any branch office in the United States during the years ended December 31, 2010, 2009 and 2008 and does not intend to repatriate any earnings from the Chinese operations. Therefore, no provision for withholding taxes for the undistributed earnings of foreign subsidiaries or U.S. federal income taxes or deferred income tax benefits has been made.
Effective from January 1, 2008, the PRC’s statutory income tax rate is 25%. According to an approval from the Inner Mongolia Autonomous Region National Tax Authority issued on December 11, 2009, Yongye Nongfeng, being a foreign investment enterprise located in the Western Region of the PRC, is entitled to a preferential income tax rate of 15% for the year ended December 31, 2009 and year ended December 31, 2010. For the period from April 1, 2008 to December 31, 2008, Yongye Nongfeng was assessed to use the deemed profit method to determine the amount of income tax provision. Under the deemed profit method, Yongye Nongfeng is subject to income tax at 25% on its deemed profit which is determined based on its revenue less 95% deemed expenses. The Company’s effective income tax rate was 17.47%, 66.65% and 5.66% for the years ended December 31, 2010, 2009 and 2008, respectively. The difference between effective tax rate and statutory tax rate primarily represented the tax effects of certain non-taxable income and non-deductible expenses.
For the year ended December 31, 2010, the Company’s income tax expense was $10,867,857 as compared to $4,997,105 and $864,292 for the years ended December 31, 2009 and 2008, respectively.
Net income for the year ended December 31, 2010 was $51,306,853 (representing a net profit margin of 24%) compared to $2,500,207 (representing a net profit margin of 3%) and $14,413,146 (representing a net profit margin of 30%) in the years ended December 31, 2009 and 2008, respectively. The fluctuation in our net profit margin is primarily due to the impact of the fair value changes of derivative warrants as well as the increase in sales in the year ended December 31, 2010 as compared to 2009 and 2008
Foreign Currency Translation Gains
The financial position and results of operations of the Company’s subsidiaries in the PRC are measured using the Renminbi as the functional currency, while the Company’s reporting currency is the US dollar. Assets and liabilities of the subsidiaries are translated at the prevailing exchange rate in effect at each period end. The income statement is translated at the average rate of exchange during the period. Translation adjustments are included in the cumulative translation adjustment account in the consolidated statements of stockholders’ equity and comprehensive income.
Liquidity and Capital Resources
The Company has historically financed its operations and capital expenditures principally through issuance of common shares and bank loans. As is customary in the industry, we provide credit terms to most of our distributors which typically exceed the terms that we receive from our suppliers. Currently, we typically provide up to six months credit terms to our key distributors and ask for all others to make cash payments upfront or upon delivery. Therefore, the Company’s liquidity needs have generally consisted of working capital necessary to finance receivables and raw material and finished goods inventory. We believe that our existing cash and cash equivalents will be sufficient to meet our anticipated future cash needs for the coming growing season. We may, however, require additional cash resources due to changing business conditions or other future developments, including any investments or acquisitions we may decide to pursue. Therefore, there can be no assurance that such additional investment will be available to us, or if available, that it will be available on terms acceptable to us.
Financial Cash Flow Highlights
Net cash provided by operating activities in the year ended December 31, 2010 was $15,891,251, and net cash used in operating activities in the year ended December 31, 2009 and 2008 were $2,190,379 and $8,666,893, respectively. The cash flow used in operating activities improved by $18,081,630 and $6,476,514 for the year ended December 31, 2010 and 2009 compared to the preceding year, respectively. The change was mainly due to more efficient controls on working capital, effective collection on receivables, as well as the significant growth of sales for the years ended December 31, 2010 and 2009.
Net cash used in investing activities increased by $41,579,448, or 948%, to $45,962,286 in the year ended December 31, 2010, compared to $4,382,838 the same period in 2009. The increase was primarily due to the prepayment of $33,309,976 for the acquisition of the right to develop certain lignite coal resources in the Wuchuan area. Total consideration of the development right is approximately $35 million.
Net cash provided by financing activities decreased by $62,722,590, or 93%, to $4,971,610 in the year ended December 31, 2010, compared to $67,694,200 the same period in 2009. This was mainly due to that we received cash from our offerings in May and December 2009 amounting to $69,547,206, which was offset by expenses incurred in stock issuance costs of $4,528,456, as well as the repayment of loans and payables of $3,512,956 during the year ended December 31, 2010.
Net current assets at December 31, 2010 increased by $16,594,324 to $124,346,639 from $107,752,315, or 15%, over December 31, 2009.
Impact of inflation
We are subject to commodity price risks arising from price fluctuations in the market prices of the raw materials. We have generally been able to pass on cost increases through price adjustments. However, the ability to pass on these increases depends on market conditions influenced by the overall economic conditions in China. We manage our price risks through productivity improvements and cost-containment measures. We do not believe that inflation risk is material to our business or our financial position, results of operations or cash flows at this time.
Off Balance Sheet Arrangements
We do not have any significant off-balance sheet arrangements and accordingly, no such arrangements are likely to have a current or future effect on our financial position, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
Critical Accounting Policies
The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make judgments, assumptions, and estimates that affect the amounts reported in the consolidated financial statements. The footnote 2 to the Company’s financial statements (Summary of Significant Accounting Policies) describes the major accounting policies and methods used in the preparation of the financial statements.
The following are considered to be the Company’s critical accounting policies:
Accounts receivable and allowance for doubtful accounts
We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We determined the allowance by (1) analyzing specific customer accounts that have known or potential collection issues and (2) applying historical loss rates to the aging of the remaining accounts receivable balances. If circumstances related to specific customers change, our estimates of the recoverability of receivables could be further adjusted. In the event that we believe an account receivable will become uncollectible, we record additional provision to increase the allowance for doubtful accounts. The accounting effect of this entry is a charge to income. Currently, we have not provided an allowance to doubtful accounts, since we believe no accounts were uncollectible. However, if the financial condition of our customers deteriorates, in future, an allowance to doubtful accounts would be required to be make, which could be significant.
We value our finished goods inventory at the lower of cost or market value. Cost includes cost of direct labor and raw materials, as well as allocation of variable and fixed production overhead. Variable production overheads are allocated to each unit of production based on the actual use of the production facilities. Fixed production overheads are allocated to the cost of conversion based on the normal capacity of the production facilities. We define normal production capacity as being a reasonable level of production volume supported by sufficient customer demand without any abnormal equipment downtime due to shortages of materials and labor, taking into consideration the loss of production capacity resulting from planned maintenances.
We would write down the cost of excessive inventory. The factors considered in evaluating whether excessive inventory exists are:
Inventory write-downs are recorded in the period in which the impairment occurs. If our current assumptions about future production, inventory levels or demand were to change or if actual market conditions are less favorable than those we have projected, additional inventory write-downs would be required, which could negatively impact our financial condition and results of operations.
Fair value of warrants
The fair values of the warrants are summarized as follows:
The fair values of the warrants outstanding as of December 31, 2010 and 2009 were determined based on the Binominal option pricing model, using the following key assumptions:
Stock based compensation
We measure the cost of employee services received in exchange for an award of equity instruments based on the grant date fair value of the award and recognize the cost over the period the employee is required to provide service in exchange for the award, which generally is the vesting period. We have elected to recognize the compensation cost for an award with only service conditions and a graded vesting schedule on a straight-line basis over the requisite service period for the entire award. However, the cumulative amount of compensation cost recognized at any date equals at least the portion of the grant date value of such award that is vested at that date.
We estimated the fair value of our nonvested shares granted by us to management and independent directors on October 8, 2010 and October 16, 2010 by using the market prices of our shares at the respective grant dates.
ITEM 7A Quantitative and Qualitative Disclosures about Market Risk
Foreign Exchange Risk
All of the Company’s revenue, and majority of costs and expenses are denominated in RMB. Although the conversion of the RMB is highly regulated in China, the value of the RMB against the value of the U.S. dollar or any other currency nonetheless may fluctuate and be affected by, among other things, changes in China’s political and economic conditions. Under current policy, the value of the RMB is permitted to fluctuate within a narrow band against a basket of certain foreign currencies. China is currently under significant international pressures to liberalize this government currency policy, and if such liberalization were to occur, the value of the RMB could appreciate or depreciate against the U.S. dollar.
Because substantially all of our earnings and cash assets are denominated in RMB, other than certain cash deposits we keep in a bank in Hong Kong and U.S., appreciation or depreciation in the value of the RMB relative to the U.S. dollar would affect our financial results reported in U.S. dollar terms without giving effect to any underlying change in our business or results of operations. Fluctuations in the exchange rate will also affect the relative value of any dividend we issue in future that 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. To date, we have not entered into any hedging transactions in an effort to reduce our exposure to foreign currency exchange risk. While we may decide to enter into hedging transactions in the future, the availability and effectiveness of these hedging transactions 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 RMB into foreign currency.
Interest Rate Risk
The Company has not been, nor does it anticipate being, exposed to material risks due to changes in interest rates. Our risk exposure to changes in interest rates relates primarily to the interest income generated by cash deposited in interest-bearing savings accounts. The Company has not used, and does not expect to use in the future, any derivative financial instruments to hedge its interest risk exposure. However, our future interest income may fall short of its expectation due to changes in interest rates in the market.
The Company is exposed to credit risk from its cash in bank and accounts receivable. The credit risk on cash in bank and fixed deposits is limited because the counterparties are recognized financial institutions. Accounts receivable are subjected to credit evaluations. An allowance would be made, if necessary, for estimated irrecoverable amounts by reference to past default experience, if any, and by reference to the current economic environment.
Inflationary factors, such as increases in the cost of our products and overhead costs, could impair our operating results. Although we do not believe that inflation has had a material impact on our financial position or results of operations to date, a high rate of inflation in the future may have an adverse effect on our ability to maintain current levels of gross margin and selling, general and administrative expenses as a percentage of sales revenue if the selling prices of our products do not increase with these increased costs.
Company’s Operations are Substantially in Foreign Countries
Substantially all of our operations are conducted in China and are subject to various political, economic, and other risks and uncertainties inherent in conducting business in China. Among other risks, the Company and its subsidiaries’ operations are subject to the risks of restrictions on transfer of funds; export duties, quotas, and embargoes; domestic and international customs and tariffs; changing taxation policies; foreign exchange restrictions; and political conditions and governmental regulations. Additional information regarding such risks can be found under the heading “Risk Factors” in this Form 10-K.
ITEM 8 Financial Statements and Supplementary Data
Consolidated Financial Statements
The information required by Item 8 appears after the signature page to this report.
ITEM 9 Changes in and Disagreements With Accountants on Accounting and Financial Disclosures
ITEM 9A Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Disclosure Controls and Procedures
The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in reports filed by the Company under the Securities Exchange Act of 1934 (“the Exchange Act”), as amended, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and that such information is accumulated and communicated to our management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. Our Chief Executive Officer and Chief Financial Officer evaluated, with the participation of other members of management, the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e) and 15d-15(e)), as of the end of the period covered by this Annual Report on Form 10-K. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of December 31, 2010.
Although the management of our Company, including the Chief Executive Officer and the Chief Financial Officer, believes that our disclosure controls and internal controls currently provide reasonable assurance that our desired control objectives have been met, management does not expect that our disclosure controls or internal controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.
Management’s Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f) under the Securities Exchange Act of 1934, as amended, to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. Internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and/or Board; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Under the supervision of our principal executive officer and our principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our assessment, management has concluded that the Company maintained effective internal control over financial reporting as of December 31, 2010.
KPMG, an independent registered public accounting firm, has audited the effectiveness of our internal control over financial reporting as of December 31, 2010 as stated in their report which is included below.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Yongye International, Inc.:
We have audited Yongye International, Inc.’s (the “Company”) internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Yongye International, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Yongye International, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Yongye International, Inc. and subsidiaries as of December 31, 2010 and 2009, and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for the years then ended, and our report dated March 14, 2011 expressed an unqualified opinion on those consolidated financial statements.
Hong Kong, China
March 14, 2011
Changes in Internal Controls over Financial Reporting
There were no significant changes in our internal controls over financial reporting identified in connection with this evaluation that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.
ITEM 9B Other Information.
There is no information required to be disclosed in a report on Form 8-K during the fourth quarter of the year covered by this Form 10-K but not reported.
ITEM 10. Directors, Executive Officers and Corporate Governance
The information required by this item relating to our directors and nominees, regarding compliance with Section 16(a) of the Securities Act of 1934, and regarding our Audit Committee is included under the captions “Directors and Executive Officers of the Company” and “Section 16(a) Beneficial Ownership Reporting Compliance,” and “—Role of the Audit Committee” in our Proxy Statement related to the 2010 Annual Meeting of Shareholders and is incorporated herein by reference.
Pursuant to General Instruction G(3) of Form 10-K, the information required by this item relating to our executive officers is included under the caption “Executive Officers of the Company” in Part I of this report.
We have adopted a code of ethics that applies to our principal executive officer and all members of our finance department, including the principal financial officer and principal accounting officer. This code of ethics is posted on our website. The Internet address for our website is www.yongyeintl.com , and the code of ethics may be found from our main web page by clicking first on “Investor Relations” and then on “Corporate Governance” under “Investor Relations,” next on “The Code of Business Ethics and Conduct” under “Corporate Governance.”
We intend to satisfy any disclosure requirement under Item 5.05 of Form 8-K regarding an amendment to, or waiver from, a provision of this code of ethics by posting such information on our website, on the web page found by clicking through to “Code of Business Ethics and Conduct” as specified above.
ITEM 11 Executive Compensation
The information appearing under the headings “Director Compensation” and “Executive Compensation” in our Proxy Statement related to the 2010 Annual Meeting of Shareholders is incorporated herein by reference.
Changes in Control
There are no arrangements known to us, including any pledge by any person of our securities, the operation of which may at a subsequent date result in a change in control of the Company.
ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required by this item relating to security ownership of certain beneficial owners and management is included under the caption “Security Ownership of Management and Certain Beneficial Owners,” and the information required by this item relating to securities authorized for issuance under equity compensation plans is included under the caption “Executive Compensation – Options and Stock Appreciation Rights,” in each case in our Proxy Statement related to the 2010 Annual Meeting of Shareholders, and is incorporated herein by reference.
ITEM 13 Certain Relationships and Related Transactions, Director Independence
For the years ended December 31, 2009 and 2008, Yongye Nongfeng, purchased inventories from Inner Mongolia Yongye amounting to $33,048,126 and $43,509,906, respectively. In January 2008, upon receiving governmental approval of its establishment, Yongye Nongfeng entered into an agreement (the “Agreement”) with Inner Mongolia Yongye, pursuant to which Yongye Nongfeng agreed to purchase finished products from Inner Mongolia Yongye at a fixed price of RMB 350 per case for fulvic acid based plant products and RMB 120 per case for fulvic acid based animal products. The term of the Agreement was for the period from January 15, 2008 to January 14, 2013. Pursuant to the Agreement, the Company could terminate the Agreement by giving one month notice to Inner Mongolia Yongye. Upon Yongye Nongfeng obtaining its own fertilizer license, the Agreement was terminated in July, 2009.
As of December 31, 2009, accounts payable to related party were $880,026 and represented the payable for the purchase of inventories from Inner Mongolia Yongye. The amount was repaid during the year ended December 31, 2010.
For the year ended December 31, 2009, the Company sold fulvic acid plant based products of $2,221,936 to Hubei Longshangxing Xinnongcun Fuwu Youxiangongsi, which is 51% owned by Inner Mongolia Yongye.
As of December 31, 2009, the amount due to a related party was $1,663,191 which mainly represented the payable for the Acquisition from Inner Mongolia Yongye (See Note 3). The Company repaid the amount during the year ending December 31, 2010.
For the year ended December 31, 2008, the Company borrowed $1,617,293 from Yin Ping, the wife of the CEO, $762,524 from Inner Mongolia Yongye and $10,000 from Kim McElroy, a director of the Company who resigned in April 2008. The amounts were repaid in full as of December 31, 2008.
During the year ended December 31, 2010, the Company sold three vehicles with net book value of $135,191 and an apartment with net book value of $102,263 to Inner Mongolia Yongye. In addition, the long-term loans of $144,513 that were secured by these assets were assumed by Inner Mongolia Yongye. Upon disposal, no gain or loss was recorded and the Company received cash of $92,941.
Yongye Nongfeng and Inner Mongolia Yongye entered a series of lease arrangements to lease land, buildings and equipment to and from each other as follows:
Pursuant to these agreements, both Yongye Nongfeng and Inner Mongolia Yongye did not charge any rental to each other for the lease. Additionally, the estimated rental income to be received and the rental expense to be paid by the Yongye Nongfeng are not material to the Company’s 2009 results of operations and therefore have not been included.
Policies and Procedures for Review, Approval or Ratification of Transactions with Related Persons
It is the Company’s policy that the Company will not enter into transactions required to be disclosed under item 404 of the SEC’s Regulation S-K unless the audit committee or another independent body of the board first reviews and approves the transactions.
Promoters and Certain Control Persons
We did not have any promoters at any time during the past five fiscal years. Except as set forth in our discussion above, none of our directors, director nominees or executive officers has been involved in any transactions with us or any of our directors, executive officers, affiliates or associates which are required to be disclosed pursuant to the rules and regulations of the SEC.
ITEM 14. Principal Accountant Fees and Services
The information required by this item is included under the captions “Proposal No. 2: Ratification of Appointment of the Independent Public Accountants — Audit Fees” and “—Pre-Approval Policies and Procedures” in our Proxy Statement related to the 2010 Annual Meeting of Shareholders and is incorporated herein by reference.
Exhibits and Financial Statement Schedules
(1) Incorporated by reference herein to the Report on Form 8-K filed on April 22, 2008.
(2) Incorporated by reference herein to the Company’s Registration Statement on Form S-1/A (Reg. No. 333-150949) filed with the Securities and Exchange Commission on September 9, 2008.
(3) Incorporated by reference herein to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on May 8, 2009.
(4) Incorporated by reference herein to the Company’s Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on May 7, 2009.
(5) Incorporated by reference herein to the Company’s Registration Statement on Form S-1 (Reg. No. 333-159892) filed with the Securities and Exchange Commission on June 11, 2009.
(6) Incorporated by reference herein to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on June 24, 2009.
(7) Incorporated by reference herein to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on August 5, 2009.
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities and Exchange Act of 1934, this Report has been signed below by the following person on behalf of the Registrant and in the capacities and on the dates indicated.